We learned that time in Provence is a very elastic commodity...we…came to terms with the Provençal clock.

Peter Mayle

“A Year in Provence”

(1989)

Apple Store

Aix en Provence, France

(2015)

Modern Economics and Growth

The first voyage of the explorer Christopher Columbus in 1492 marked the beginning of Globalization, a process that political economist John Gray defines as, “…the increasing interconnection of economic and cultural life in distant parts of the world.” ¹ He distinguishes this process from the spread of free market economics, which is the present form of global economic organization, as championed by the U.S. and multinational organizations

 To tease out truth from complexity. Take two utterly opposed views of economic organization, capitalism and socialism. Capitalism operates through voluntary self-interest expressed in markets. Socialism operates under command and control without markets. The success of the first is now obvious in nearly every country. Socialism, when adopted by political command and control societies, wasted or destroyed millions of lives. The 1991 implosion of the Soviet Union marked the failure of an entire civilization.

 But the late historian Arthur M. Schlesinger noted that (totally free) markets cause tempestuous worldwide change. In a notable book, "False Dawn," the former London School of Economics professor, John Gray, discusses the consequences of free trade theory.

“In the classical theory of free trade capital is immobile. Ricardo’s doctrine of comparative advantage – which is still regularly invoked in defence of unregulated global free trade – says that when comparatively inefficient enterprises or industries shrink in any country, others will grow, absorbing the capital and labour released from the declining activities. Within each trading country capital will move to those economic activities in which it is most productive. Ricardian comparative advantage applies internally in trading nations, not externally between them. It implies that in a regime of unrestricted free trade the allocation of resources will be maximally productive within each trading nation, and thereby, by inference, throughout the world.…Ricardo understood that this could be true only so long as capital is not to any significant extent internationally mobile…” ²

With capital mobility, free markets will not lead to the best of all possible worlds.

An important legacy of the eighteenth century Enlightenment is the assumption that society exists for the benefit of its members. An argument justifying the free market system must assert that it maximizes overall prosperity. Gray believes that the free market system has run amok, whose consequences Karl Marx also described.

Social breakdown in the U.S. has resulted in a 2015 incarceration rate of 698/100,000 population, which is almost 7X the rate in France and more than 9X (sic) the rate in Germany. ³ The free market system has also led to extreme inequality. Piketty and Saez estimate that the share of income captured by the top 1 percent of taxpayers climbed from 9.9 percent in 1979 to 23.5 percent in 2007, dropping slightly to 22.5% in 2012 after the Great Recession.⁴ This leads - as human nature is sometimes wont - to extreme solutions: in Congress, elsewhere in the developed world and in the pathological Mideast.

 In all the above, the base view looks backwards to some imagined Golden Age.  It nostalgically says, "By straying from the correct path, we have done something wrong and are now being punished for our transgressions." To get to the real reasons, “New technologies and the deskilling of parts of the population by inadequate education are central causes of long-term unemployment in advanced western societies.” ⁵

A progressive view of society looks forward, asking how the system, as it exists, can be improved. In their book, "Creating a Learning Society," Columbia University economists, Joseph Stiglitz and Bruce Greenwald, describe an alternative to ineffectual nostalgic revolution. The authors derive practical policies from modern economic principles.

 Learning? Isn't that how we acquired the toolkit with which we set out into the world after graduation? But on immediate second thought, everyone has, and should continue, to learn - and so will cognitive computers. You learn from your coworkers. Companies learn as they develop their processes. In Silicon Valley, companies learn from each other as they cooperate and compete. Developing nations learn from developed ones, often making the transfer of technology a condition of market access. Changing markets require that everyone learn. The learning concept, at the core of modern economic theory, enables us to accomplish, "...our ends - in ways which require less resources and less time." ⁶ Because humans learn from each other, we don’t live in caves. ^6a

The social world that concerns economics is complex, yet neoclassical economics assumes it is very simple. The authors challenge the major classical economic assumption of static equilibrium where:

1) All factors of commodity production (known singly as "supply") are pushed to maximum marginal efficiency by everyone, so Marginal Cost = Marginal Revenue.

2) The state of technology is merely an assumption.

3) Economic information is identical for all participants.

4) There is no such thing as economic structure.

They assume the economic reality of differences, the complex reality of interacting individuals, companies and government. For the sake of clarity, we emphasize the effect of government policy on an entire economy's ability to learn - and its ability to adapt itself to a changing world.

The book makes its arguments based upon equations relating economic concepts. It starts with a more realistic description of the economy; logically relates the factors through equations and outputs them as policy prescriptions. This procedure results in a logical recommended policy that relates to the major facts. Opponents may then argue that correspondence to reality should not be an attribute of economic policy; maybe neoclassical economics policy should be aspirational, like the value of “freedom.” Our rejoinder to the proponents of unreality in economic policy is that they simply want their way, regardless.

Kenneth Arrow helped found modern economics. Among his contributions is endogenous growth theory, the idea that people primarily, “learn by doing.” Innovations and technical change occur when people engage in economic activity and thus, “…(rather than allocating) factors to ensure marginal returns are the same for each use…we can affect the flow of knowledge; we can affect learning; these are affected by economic policies, institutions, the design of economic structures, and resource allocations…” In particular, economic actors can affect the production possibilities of the economy. ⁷

The authors then go about examining a more complex (non-commodity) economic reality where innovation and learning are generated by the economic model itself, rather than merely assumed, as is the neoclassical case. Simple neoclassical markets then fail to increase the welfare of society because in those innovation and learning do not occur, or at least are not promoted.

Innovation

The transactions based neoclassical model is realistic only for commodities, like wheat, for it considers the state of a society’s technologies given. But the authors note, “…markets and economies in which innovation…is important are rife with market failures.” ⁸ We note that this model totally neglects the growth of industry and American inventions that transformed the world – electric lights and power systems, assembly lines, aircraft, computers, parsing the genome and – of course – developing the internet. ^8a

The following Graph I illustrates the main thesis of this book. If economic analysis is not your utility, we suggest you skip the next paragraph. The way we handled this apparently complicated model was to begin by describing its simpler components.

The authors begin by assuming a differentiated economy that produces two types of goods, manufacturing (M) and agricultural/crafts (A). The latter description is closer to the economic reality in less developed economies. Both are produced only by labor:

1) The X-axis is the agricultural output, C_A. The Y-axis is the manufacturing output, C_M.

2) Labor results in the production and consumption of agricultural and manufactured goods.

3) The two straight lines l2, l1 with slopes of (-1) are the economy’s production possibility curves, with the total amount of labor in the economy fixed.

4) Consumption results in a utility curve labeled u(t). The intersection of the production and utility curves at (C*) is the neoclassical optimum that maximizes current welfare. It cannot be improved, because there is no surplus to be invested in learning and therefore no possible improvement in a society's production possibilities and standard of living.

5) But governments around the world usually try to improve the amount of learning by encouraging R&D and by importing a knowledge of new practices and discoveries from abroad. “If the government can induce a small shift in consumption at time t from (C*) to {C_M**, C_A**)...then there will be a small decrease in welfare the first period…but the second period production possibility schedule will shift out (to the second straight line l2 and a greater utility u(t+1)), by an amount reflecting the increase in growth (enhanced learning) resulting from increased industrial production, generating a first-order improvement in welfare…It always pays for government to encourage the learning sector.” ⁹

Large shifts in the production possibility curve due to learning affect welfare much more than slight allocative changes along this curve, a lesson that has been thoroughly learned abroad, but apparently not in the U.S. Congress.

Importance of Industry

Why is the industry sector the source of innovation? Firms in this sector are generally:

1) Large, so that “…particular innovations are far more valuable to large organizations that can apply them to many units of output.” ¹⁰ This is likely true at GE but not so in Silicon Valley, which seeks “disruptive change.”

2) Opportunities and incentives for accumulating human capital are likely to be far greater in large, complex, long-lived industrial enterprises.

3) Knowledge diffuses readily across densely co-located large scale industrial enterprises. This is why there are innovation clusters, groups of firms in related businesses that locate near each other. Industrialization also has a spillover effect creating a greater demand for a well-educated labor force.

4) The potential for cross-border learning is greater in the industrial sectors, where learning from one firm spills over to others cross-border due to competition.

We might also note that the technical knowledge of industrial firms is much greater than elsewhere, thus that knowledge can be leveraged and developed (often by tinkering) into new products. All of the above, combined with the high ratio of revenues to direct labor costs, are reasons why governments value industry. The post-industrial society of the U.S. has let its industrial benefits erode.

Industry Structure and Government

So who is going to invest in learning? These are the alternatives; the first two create market distortions.

1) Through his economic rents (excess profits), the monopolist has sufficient resources to invest for the future. He values R&D because he competes for the market against competitors in related industries. For instance, Bell Telephone funded its world-class scientific research from profits generated by its monopoly telephone business, inventing the transistor and making fundamental advances in communications theory. But to maintain its monopoly, it forbade the connection of “foreign devices” to its network. Such a ban, if continued, would have made impossible the development of the internet. The authors show that monopoly benefits an economy only if, “the learning benefit offsets the adverse effect of monopoly power,” which also relates to the patent system. ¹¹

2) What about a duopoly of two firms in the industry? The rate of innovation could be lower in that industry due to the decreased investment in research. An industry of two competitors will produce more investment only if the cost of that investment is much higher. ¹²

3) Knowledge is a public good that short-term neoclassical markets produce too little of. In fact, we can think of some cases where they produce none at all. Government is a provider of public goods. Since the Enlightenment, its role in almost all advancing societies has been to provide or sponsor education, do scientific research, invest in infrastructure and promote industry. The ideal way to provide industrial subsidy is by a lump sum grant (or providing research rather than development – think of the National Institutes of Health) with no specific tax on the agricultural sector. The amount of industrial subsidy should be higher when:

1) The future income from learning is higher.

2) The effect of learning is to increase productivity.

3) The smaller the industrial sector. ¹³

Since almost all governments promote learning, the neoconservative goal to “minimize government” is essentially a call to minimize the ability of the U.S. economy to learn in a rapidly changing world. This is really not a good idea. The importance of “learning by doing” leads ultimately to trade policy.

Trade Policy

Professors Stiglitz and Greenwald then go on to show that even though a country’s comparative advantage is in agriculture, it can increase its income rather than stagnate because, “The dynamic benefits of learning exceed the static costs.” ¹⁴ For instance, rather than importing Coca-Cola _® from a neighboring country, setting up a local bottler will lead to spillovers like: improved management, better education, a sponsored soccer team, better roads, truck repair businesses, a bottle producer…etc. In developing countries, the local Coca-Cola bottler runs a major business.

1) The developing country allocates a fraction, P, of its labor force to produce industrial goods. The total income, Y = kP + (1- P) where k <1 represents the lower productivity associated with industrial production.

2) Society maximizes the logarithmic utility function, U.

3) Under the static theory of comparative advantage, U is maximized by maximizing Y. Y is maximized at P = 0, because the country is all agriculture and has no comparative advantage in industrial production.

4) Now assume that the country’s rate of productivity increase is g(P), the rate of productivity increases with the industrial sector.

5) Then mathematically it can be shown, “The country should produce the industrial good, even though it is not its comparative advantage…The dynamic benefits of learning exceed the static costs. Industrial policies pay off.” ¹⁵

6) And finally, “In this model with a linear technology, the easiest way to implement the desired level of domestic production is through a quota set at a level which ensures that at the equilibrium price the desired amount of manufactured goods are produced at home. "With increased costs, there exists an optimal tariff, which would result in the desired level of domestic production." ¹⁶

In the interest of a country’s growth, and long-term utility maximization, tariffs or subsidies are justified even under the theory of comparative advantage, and certainly if the theory doesn’t hold - because international economics will then devolve simply into regional economics and absolute advantage. Assuming, “...a social value to the production of manufactured goods,” ¹⁷ the authors also generally advocate broad trade barriers rather than narrow targeted ones, which pick winners and losers. ¹⁸

The practical effect of this book is to justify trade barriers in developing countries as they industrialize their economies.¹⁹ We apply this argument to the United States, which used to protect its manufacturers with tariffs. In 2014, manufacturing accounted for just 12% of U.S. GDP. Low Income Countries had 9%, Upper Middle Income Countries had 22% and High Income Countries had 15%.²⁰ U.S. deindustrialization has gone too far, with obvious social consequences as fewer people have the ability to earn the increasing salaries that come with industry's productivity improvement and its spillovers to the rest of society.

Trade issues are highly technical and subject to intense negotiation. The United States offers access to its markets to achieve important foreign policy goals such as building alliances and maintaining a world order it has defined since W.W. II. Within these constraints, some continuing general tariffs or subsidies could be beneficial, enabling the post-industrial U.S. economy to regain the benefits of industrialization.²¹

The fundamental issue is this: the free market rewards people as consumers; but, in developed countries, less as producers. This book provides a rationale for the tariffs or subsidies that (if used correctly) allow valuable industry to take root and grow in less developed countries. Its argument is now just as applicable to the deindustrialized United States.

"...everyone speaks today of the innovation economy or the knowledge economy...But the full implications of (this) for the neoclassical model have still not been taken on board. And the implications for policy have been even less absorbed into mainstream thinking....We have shown that comparative advantage needs to be examined especially in light of the increasing mobility of skilled labor and capital. A country's long-term comparative advantage is based in part on its comparative learning capabilities." ²²

Footnotes

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It has been suggested that the U.S. could restore economic growth and prosperity to the middle class by:

1) Reducing government regulation.

2) Balancing the budget.

3) Cutting taxes.

4) Leaving economic issues to the states.

These neoclassical market solutions will not restore economic growth because they do not address the deindustrialization that free markets encourage. They do not lead to logical public policy.

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Chris Patten (1999, p. 193) dealt with less developed country economic issues in Margaret Thatcher's Conservative government. He defends the free market system:

"Protectionist policies probably can save some jobs for a time, the length of which will inevitably vary. But the salvation comes with a high price tag, and it is time-limited - it cannot go on forever. It is estimated that protecting a job by shutting out foreign competition costs a protectionist economy between three and eight times the annual wage of that job. How does paying that price make an economy better off?...So if you pay to preserve jobs against foreign competition, what you do in fact is to pin workers down in low-paid, low-skilled jobs instead of helping them move to higher-paid, higher-skilled jobs. Where do the sense and fairness lie in that? What else do you preserve? For a time, maybe, you can keep declining industries going at the exhausted heart of declining communities. It is easy to regard that as an act of benevolence, an act of cultural solidarity, provided you yourself do not have to go on living in community rotting away at the center, with no future save trying to defy markets and consumers for just a little longer?"

Countries can use industry protections to preserve the status quo and stagnate, as did East Germany; or they can use protections to learn how to export, as did East Asia. What then happens depends upon the programs of management, government and the values of society. Reducing a large trade deficit will benefit the U.S. economy, giving it a better chance to evolve in a direction that benefits Americans as producers and to keep its companies competitive.

__

Our 12/1/15 posting discussed the financial consequences of deindustrialization. The 10/1/15 posting asked why there aren't more 15%-20% annual return investment projects in the U.S. This essay discusses why.

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On CBS's 60 Minutes 12/20/15, Tim Cook, Apple's CEO, was asked why the company had 1MM people (sic) making almost all of its products in China through its suppliers. He replied:

China's vast and cheap labor force is not the primary reason for manufacturing there. The reason for manufacturing there is skill. (Charlie Rose immediately says, "They have more skill than American workers?") Cook replies that China's educational system focuses on the vocational skills necessary for manufacturing. In the U.S., every tool and die maker (left) would fit into the room where we're talking. In China, you would have multiple stadiums. (This training) is the focus of their educational system. That is the reality.

To grow its manufacturing should the U.S. improve its educational system? Of course. But, a lot more is required. Manufacturing is a highly disciplined wealth-producing activity that requires a steadiness not provided by short-term Mr. Market and its short-term profit-seeking enterprises who complain that the necessary skills are not found in the U.S.

1) When U.S. industry - as dictated by the free market - moved its plant and equipment abroad, it made redundant a whole generation of skilled U.S. industrial workers who had to do other things.

2) The financial system and its shareholders value an immediate high return of capital rather than a long-term investment in growth. The result is hollowed-out companies that encourage their suppliers to make the necessary investments in plant and equipment, usually abroad.

3) Mr. Market is fickle and volatile. To maximize their wealth, many U.S. CEOs will favor short-term measures that decapitalize their companies over the long-term investments necessary to create real growth. This is the opposite of the steady virtues required in manufacturing and the perceptions required in product development. Technical educations and training require long-term investments in skills, both general and specific.

The bottom line: government must provide the educational opportunities, incentives and predictable trade policies that Mr. Market cannot provide. The economy changes; thus it is never too late to reindustrialize because new opportunities will open up. Reindustrialization could be a policy as an alternative to blind market forces. It might useful to ask, what activities will lead to gainful employment in the U.S. - those may or may not be the same as previous.

__

Restoring wide-spread economic growth is not just a simple matter of negotiating better trade deals or going after the capitalists, who are needed to create more jobs in the U.S.

The late Andrew Grove was a founder of Intel and, for many years, its Chairman and CEO. He was known for his direct style. In 2010, he wrote, "How America Can Create Jobs." We quote extensively from this notable 7/1/10 Bloomberg Businessweek article:

1. The underlying problem isn't simply lower Asian costs. It's our own misplaced faith in startups to create U.S. jobs.

2. What matters for U.S. job growth is what happens after the concept has been developed in the Silicon Valley garage. The technology has to go from prototype to mass production, when companies scale up. They work out design details, figure out how to make things affordable and hire people by the thousands. Scaling is hard work, but necessary to make innovation matter. *

3. The scaling process is no longer happening in the U.S. As long as that's the case, plowing capital into young companies that build their factories elsewhere will continue to yield a bad return in terms of American jobs. Scaling used to work well in Silicon Valley. At Intel, we had to build factories, hire train and retrain employees, establish relationships with suppliers, and sort out a million other things ** before Intel could become a billion-dollar company.

4. Many companies died along the way, but each survivor added to the complex technological ecosystem that came to be called Silicon Valley. (Economic activity is not just individual atoms of self-interest interacting in a market medium. It occurs like a living, complex biological system where structure - "spillovers" and innovation clusters - matters.)

5. (In 2010) manufacturing employment in the U.S. computer industry is about 166,000 lower than it was before the first PC. Meanwhile, a very effective computer manufacturing industry has emerged in Asia, employing about 1.5 million workers. Apple has about 25,000 employees in the U.S. That means for every Apple worker in the U.S., there are 10 people in China working on iMacs, IPods, and iPhones. The roughly 10-to-1 relationship holds for other U.S. tech companies.

6. You can say, as many do, that shipping jobs overseas is no big deal because the high-value work - and much of the profits - remain in the U.S. That may well be so. But what kind of society are we going to have if it consists of highly paid people doing high-value-added work - and masses of unemployed?

7. The job machine breakdown isn't just in computers. Consider alternative energy: photovoltaic panels and advanced batteries. There is more at stake than exported jobs. With some technologies, both scaling and innovation take place overseas.

8. Scaling isn't easy. The investments required are much higher than in the invention phase. And funds need to be committed early. Another example from Intel: The investment to build a silicon manufacturing plant in the '70s was a few million dollars. By the '90s the cost of the factories that would be able to produce the new Pentium chips in volume rose to several billion dollars. The decision to build these plants needed to be made years before we knew whether the Pentium chip would work or whether the market would be interested in it. Lessons we learned from previous missteps helped us. Some years earlier, when Intel's business consisted of making memory chips, we hesitated to add manufacturing capacity...Our Japanese competitors didn't hesitate: They built plants. When the demand for memory chips exploded, the Japanese roared into the U.S. market and Intel began its descent as a memory chip supplier.

(As Keynes wrote, investors' short-term market orientation greatly discourages long-term investment. This is the problem with an economy built mainly around finance. ***)

9. How could the U.S. have forgotten? I believe that answer has to do with a general undervaluing of manufacturing - the idea that as long as "knowledge work" stays in the U.S., it doesn't matter what happens to factory jobs. (Many economists say, export commodity production abroad.) I disagree. Not only did we lose an untold number of jobs, we broke the chain of experience that is so important in technological evolution. As happened with batteries, abandoning today's "commodity" manufacturing can lock you out of tomorrow's emerging industry. (As Elkus put it, "...future technology will find its basis in what exists today - nothing comes out of the ether.")

10. Our fundamental economic beliefs, which we have elevated from a conviction based on observation to an unquestioned truism, is that the free market is the best of all economic systems - the freer the better. Our generation has seen the decisive victory of free-market principles over planned economies. So we stick with this belief, largely oblivious to emerging evidence that while free markets beat planned economies, there may be (is) room for a modification that is even better.

11. (This really matters.) Such evidence stares at us from the performance of several Asian countries in the past decades. These countries seem to understand that job creation must be the No. 1 objective of state economic policy. The government plays a strategic role in setting the priorities and arraying the forces and organization necessary to achieve this goal. (This was also true in the United States when Alexander Hamilton advocated that government policy foster growth and industry. Economics is not only a matter of land, labor and capital - with labor just a factor of production.)

12. By transferring manufacturing and a great deal of engineering out of the country, (we have) hindered our ability to bring innovations to scale at home. Without scaling, we don't just lose jobs - we lose our hold on new technologies. Losing the ability to scale will ultimately damage our capacity to innovate.

13. The first task is to rebuild our industrial commons. We should develop a system of financial incentives; levy an extra tax on the product of offshored labor. If the result is a trade war, treat it like other wars - fight to win. Keep that money separate...make it available to companies that will scale their American operations. Such a system would be a daily reminder that while pursuing our company goals, all of us in business have a responsibility to maintain the industrial base on which we depend and the society whose adaptability - and stability - we may have taken for granted. (Two candidates in the 2016 Presidential campaign now advocate revolution. U.S. economic problems adversely affect the political process.)

14. Growing up in the Soviet bloc, I witnessed first-hand the perils of both government overreach and a stratified population. But, most Americans probably aren't aware that there was a time in this country when tanks and cavalry were massed on Pennsylvania Avenue to chase away the unemployed. It was 1932...Unemployment is corrosive. If what I'm suggesting sounds protectionist, so be it. ***

* In, "Winner Take All," Richard Elkus (2008), former division manager of Ampex, described how the company, which invented video recording, was never able to take advantage of its technology because, "...(it) never created the kind of engineering and manufacturing structure that would enable it to take advantage of the market potential inherent in those technological concepts...it never (assembled)...the resources needed to advance from a small business with limited manufacturing expertise to a corporation that could meet the challenges presented by the potential for audio and video recording." Akio Morita, who co-founded Sony, was obviously able to do this.

** Manufacturing is very detailed.

*** The 4/4/16 Time writes, "Experts including Adair Turner, the former head of financial regulation in the U.K., estimate only about 15% of all capital flows within America's financial system end up making their way into the real economy."

**** For the United States, appropriate tariffs to reduce the trade deficit would be an improvement.

Dartmouth economist Douglas Irwin defends free trade in usual terms, on the 3/8/16 NPR. "...trade does destroy jobs in import-competing sectors, such as apparel and furniture. But so does technological change. And it also has to be pointed out trade creates jobs in export-oriented sectors, such as aircraft and high tech (too general, the article above is by an actual job creator). So trade doesn't affect the number of jobs in the United States so much as it affects the composition of jobs (that is the salaries companies can afford to pay). And unfortunately, some of those jobs are located in Ohio and Michigan, where heavy industry has traditionally been."

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