GIVE ME A LEVER26

It was a combination of the evidence that many poor countries were not growing and the Solow model’s inability to say something useful about how to affect long-term growth that eventually made economists look elsewhere.

But Lucas had more than just an aspiration to offer. He was also arguing that we are missing something important, and that the reason why India was poor could not all be because of a shortage of skills and capital. He recognized that India had less capital and skills than the United States, maybe because of its colonial history or the caste system. But to explain the enormous difference in GDP per capita between two countries based solely on lack of resources, those resources would have to be extraordinarily scarce. And if they were so scarce they should be very valuable. For example, the one tractor available would be used very intensively on hundreds of fields prepared by thousands of workers; the rental rate on this tractor would be extremely high. Based on this logic, Lucas computed that if the difference in GDP between the United States and India was to be explained by the scarcity of capital in India and nothing else, capital would have to be so scarce that its price (what is paid to the owner of the resources that finance the machines in the economy) would have to be fifty-eight times higher in India than it was in the United States.²⁸ But in that case why wouldn’t all the capital in the United States move to India, he wondered.

Lucas was, perhaps unsurprisingly, being too optimistic about the functioning of markets. We now know that we live in a sticky economy where nothing moves very fast, and certainly not from the United States all the way to India. Nonetheless, some version of his basic insight has been rediscovered by many others who keep hitting up against the TFP puzzle. For one, if you simply try to explain the cross-country variation in GDP by the amount of resources in different countries, you will quickly realize that even though poor countries are indeed desperately short of skills and capital, their GDP per capita is even lower than this lack of resources would predict.²⁹ In other words, poor countries are poor in substantial part because they make less good use of the resources they have, and even within poor countries some do better than others with the same resources. The question is why?

Paul Romer, a PhD student of Lucas’s, was one of the people inspired to respond to Lucas’s passionate plea that we have to find a better way to explain growth. What made it a challenge was that Solow’s answer rested on perhaps the two most basic ideas in economics. First, that capitalists invest in the pursuit of high returns; when and where returns go down, capital accumulation tends to go down as well. Second, that as capitalists as a class accumulate more and more capital, the productivity of capital becomes lower because there are not enough workers to work with it. In economics this is known as diminishing returns. It has a long pedigree. French economist Anne Robert Jacques Turgot, who was briefly France’s finance minister and one of the many experts who tried unsuccessfully to head off France’s headlong descent into the economic chaos that eventually precipitated the French Revolution, wrote about it in 1767.³⁰ Karl Marx took it as a premise.

The assumption of diminishing returns makes a certain amount of intuitive sense. What is the point of acquiring new machines if there are no workers to operate them (or new engineers to program them, or salesmen to sell the products)? Of course, there are also counterexamples. Amazon clearly derives a lot of its ability to cut costs from the volume of its sales. Setting up the kind of storage and delivery systems it is famous for would not make sense if there were not a constant flow of demand for everything it sells, and to finance that it needs lots of capital. Amazon at a hundredth of its size could not possibly make money. In fact, Amazon made little or no money until it grew very large, and then profits soared. In July 2018, Amazon’s profit reached 2.5 billion dollars.³²

Economists of Solow’s generation were aware of the possibility of increasing returns, which is how economists describe the idea that bigger is better (and the source of Amazon’s present dominance). But one obvious implication of increasing returns is that the biggest firms should be the most profitable, and therefore the best situated to undercut the others and push them out of the market. Such markets are doomed to end up with monopolies. This is indeed what is happening with the online retail sector. But while we do see some industries where there are also a small number of dominant players (social networks and hardware stores are both in this category), most important markets—cars, clothes, and chocolate, for example—have many firms. It is for this reason that economists have tended to shy away from theories that rely too heavily on increasing returns.

Romer wanted to stick with the idea that a single firm was still subject to the law of diminishing returns. His insight was that all we need to undo the Solow effect is to be able to assume that as a whole an economy with more capital also has a more productive capital stock. This could be true even if every firm faced diminishing returns and there was therefore no tendency for firms to become monopolistic behemoths. To explain how this might happen, Romer invited us to think of the production of new ideas in a place like Silicon Valley, though his paper was written years before Silicon Valley achieved its iconic status.³³ Firms in Silicon Valley are very similar to the firms in Solow’s world except in one important way: they use less of what we usually think of as capital (machines, buildings) and more of what economists call human capital, essentially specialized skills of different kinds. Many Silicon Valley companies invest in clever people in the hope they will come up with some brilliant and marketable idea, and sometimes this indeed happens.

The usual forces of diminishing returns are present in these companies as well. Too many temperamental geniuses and not enough drudges to manage the cash and make sure the gaming during work hours remains in check, and you have a disaster on your hands. What is different, Romer argues, is the overall environment of the Valley. Ideas can be heard and overheard everywhere, in the coffee shops and wheatgrass bars, in parties and public transport. One stray thought expressed by someone you will never meet again might prompt another, and all of it cumulates into a set of ideas that have remade the world. What matters is not just how many smart people you work with, but also how many smart people you are competing with, or just happen to be around in the Valley as a whole. Silicon Valley, in Romer’s theory, is what it is because it brings together the best minds of the world in an environment where they can cross-pollinate each other.

Romer argues that the same goes for all successful industrial cities: Manchester in the middle of the eighteenth century, New York and London during various periods of financial innovation, Shenzhen or the Bay Area today. In all of these places, he would claim, the force of diminishing returns that comes from the scarcity of land and labor (labor becomes scarce in part because land is scarce and therefore living in these places is so expensive) was defeated by the exuberant energy that comes out of learning from each other and coming up with new ideas. As a result, high growth can keep going forever as more and more high-skilled people come together, even without help from Solow’s mysterious exogenous productivity growth.

Getting rid of diminishing returns at the level of an entire national economy also helps us explain why capital does not flow to India. In Romer’s world, capital earns roughly the same return in India and in the United States, even though there is much less capital in India, because the standard law of diminishing returns helping India in Solow’s model is compensated for by the faster flow of ideas in richer economies. The question is whether this is just a clever intellectual maneuver, a comforting story we tell ourselves, or whether the force Romer emphasizes looms large in the world.