Making Washington Focus: First, Re-Educate the Economists

From the IT startups of Silicon Valley to the bioengineering labs of the Research Triangle, America is as full of innovators as ever. But the federal government doesn’t do nearly enough to encourage their work. So as we ponder the future of innovation, the key question is increasingly: Why isn’t Washington doing more?

For one, the Capitol is hamstrung by an ideological gridlock that shunts pro-innovation policies to the sidelines. One party is all too often focused on limiting government’s role in the economy, while the other fails to appreciate what one crucial aspect of that role ought to be. For the former, government just gets in the way. The latter think, let business manage innovation; it’s government’s job to help “the little guy.” As a result, both conservatives and liberals leave questions of innovation and productivity to the market.

But perhaps the most fundamental reason is that policymakers take their cues on economic policy from the economics profession, and most Washington economists subscribe to the neoclassical economic doctrine that does not understand the importance of innovation and sees almost no role for government in it. Indeed, while the economy has been transformed by technology, globalization, and entrepreneurship, the doctrines guiding economic policymakers continue to be informed by twentieth-century conceptualizations, models, and theories. Until more economists “get” innovation, it is unlikely that policymakers will get innovation policy right–but all the more likely, alas, that the country will miss out on the next wave of global economic growth.

Let’s start with the second problem first. The limitations of conventional economics were driven home for me recently when I helped my 17-year-old son study for the Advanced Placement Macroeconomics exam. Page one of the test preparation book defined economics as “the study of how to allocate scarce resources among competing ends.” In other words, economists don’t study how societies create new forms of production, products, and business models to expand wealth and quality of life; rather, they study markets to see how commodities are exchanged. But progress doesn’t come from allocating widgets efficiently; it comes from making widgets more efficiently and, even more so, by inventing the next new widget.

The other thing they should study, according to the neoclassical view, is why and how economies fall into recessions. Understanding and responding to business cycle downturns is certainly important, especially in today’s economy. But it ignores the more important issue: how to expand the economy’s supply potential. Conventional economists know little about this issue, and much of what they do know is wrong.

And it doesn’t really matter much whether the economists are Democrats or Republicans; when it comes to spurring productivity growth, the advice is largely the same. Liberal economist and New York Times columnist Paul Krugman states that since we don’t know why productivity slowed down in the 1970s and 80s, “that makes it hard to answer the other question: What can we do to speed it up?’ Greg Mankiw, former director of the Council of Economic Advisors in the Bush Administration, agrees, stating that “the sources of strong productivity growth [in the 1990s] are hard to identify.” With advice like this, no wonder the political dialogue gives scant attention to innovation-led growth and the policies needed to promote it.

To the extent that conventional economics focuses on growth at all, it is based on what is called the Solow growth model, named after MIT economist Robert Solow. In the 1950s, Solow’s model found that capital investment and education levels did little to explain growth. Most of growth was unexplained, and Solow called this residual, “technological and related innovation,” which is wholly separate from things like “capital investment” and “education levels.” In 1956, Stanford University economist Moses Abramovitz famously stated that Solow’s finding represented “a measure of our ignorance”; and that’s basically where conventional thinking has stayed. Conventional economists still look at innovation as if it falls like “manna from heaven.” Or to put it more formally, conventional economics sees innovation as exogenous–or outside its models–and therefore outside of legitimate economic inquiry. Efforts initiated by economist Paul Romer and a few others to define innovation as “endogenous”–within economic models–are still not far along. As Harvard’s Elhanan Helpman notes in The Mystery of Economic Growth, “The subject of growth has proved elusive and many mysteries remain,” and the mystery of economic growth itself “has not been solved.”

It’s bad enough that conventional economists give short shrift to innovation; worse, they give short shrift to the role of government in spurring innovation. Endlessly repeating the mantra “markets are best at allocating resources,” conventional economists see government intervention as likely to hurt growth because it distorts market-based allocation. When such economists acknowledge any role for government, they envision one mostly limited to ensuring a good business climate, including protecting property rights and providing public goods like science and education. And while liberal economists want the government to intervene to spur a fairer allocation than the market will bring, they too see this as coming at price. As Alan Blinder, formerly of Bill Clinton’s Council of Economic Advisors, believes, “policy changes that promoted equity (such as making the tax code more progressive or raising welfare benefits) would often harm efficiency.” But as a liberal economist, he’s willing to sacrifice growth for fairness: “We need not summarily reject a substantial redistributive program just because it inflicts some minor harm to economic efficiency.” In other words, conventional economists like Blinder believe that the pretax marketplace is efficient and that government policies (e.g., taxes, regulation, and spending) distort Adam Smith’s “invisible hand.”

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