‘Knowledge and the Wealth of Nations,’ by David Warsh
The Pin Factory Mystery
ECONOMIC ideas play a large role in shaping the world. “Practical men, who believe themselves to be quite exempt from any intellectual influences,” John Maynard Keynes said, “are usually the slaves of some defunct economist.” So it’s odd how few popular books have been written describing the social and personal matrix from which economic ideas actually emerge. There have been no economics equivalents of, say, James Watson’s book “The Double Helix,” or James Gleick’s biography of Richard Feynman.

David Warsh has now made a major effort to fill that gap. “Knowledge and the Wealth of Nations” is the story of an intellectual revolution, largely invisible to the general public, that swept through the economics profession between the late 1970′s and the late 1980′s. I’ll come back to the question of how important that revolution really was. But whatever one thinks of the destination, Warsh, a former columnist for The Boston Globe who writes the online newsletter Economic Principals, takes us on a fascinating journey through the world of economic thought — and the lives of economists — from Adam Smith to the present day.

I should mention here that I was a prominent player in some of the events Warsh describes. My closeness to it all makes me aware of, and perhaps oversensitive to, the things Warsh doesn’t get quite right. But let me focus on the book’s virtues before I talk about its minor flaws.

Warsh tells the tale of a great contradiction that has lain at the heart of economic theory ever since 1776, the year in which Adam Smith published “The Wealth of Nations.” Warsh calls it the struggle between the Pin Factory and the Invisible Hand. On one side, Smith emphasized the huge increases in productivity that could be achieved through the division of labor, as illustrated by his famous example of a pin factory whose employees, by specializing on narrow tasks, produce far more than they could if each worked independently. On the other side, he was the first to recognize how a market economy can harness self-interest to the common good, leading each individual as though “by an invisible hand to promote an end which was no part of his intention.”

What may not be obvious is the way these two concepts stand in opposition to each other. The parable of the pin factory says that there are increasing returns to scale — the bigger the pin factory, the more specialized its workers can be, and therefore the more pins the factory can produce per worker. But increasing returns create a natural tendency toward monopoly, because a large business can achieve larger scale and hence lower costs than a small business. So in a world of increasing returns, bigger firms tend to drive smaller firms out of business, until each industry is dominated by just a few players.

But for the invisible hand to work properly, there must be many competitors in each industry, so that nobody is in a position to exert monopoly power. Therefore, the idea that free markets always get it right depends on the assumption that returns to scale are diminishing, not increasing.

For almost two centuries, economic thinking was dominated by the assumption of diminishing returns, with the Pin Factory pushed into the background. Why? As Warsh explains, it wasn’t about ideology; it was about following the line of least mathematical resistance. Economics has always been a discipline with scientific aspirations; economists have always sought the rigor and clarity that comes from using numbers and equations to represent their ideas. And the economics of diminishing returns lend themselves readily to elegant formalism, while those of increasing returns — the Pin Factory — are notoriously hard to represent in the form of a mathematical model.

Yet the fact of increasing returns was always a conspicuous part of reality, and became more so as the decades went by. Railroads, for example, were obviously characterized by increasing returns. And so economists tried, again and again, to bring the Pin Factory into the mainstream of economic thought. Yet again and again they failed, defeated by their inability to state their ideas with sufficient rigor. Warsh quotes Kenneth Arrow, who received a Nobel in economic science for work that is firmly in the Invisible Hand tradition: increasing returns were an “underground river” in economic thought, always there, yet rarely seeing the light of day.

The first half of “Knowledge and the Wealth of Nations” is a history of economic thought from the vantage point of that underground river. It describes how great economists chose to exclude increasing returns from their analyses, even though many of them understood quite well that they were leaving out an important part of the story. It also tells the tale of economists, most notably Joseph Schumpeter, who decided that if increasing returns couldn’t be modeled rigorously, so much the worse for rigor — and who found their literary, nonmathematical versions of economics simply ignored. (Schumpeter was a sad figure in his later years; his canonization as a patron saint of economic growth — based largely on his famous phrase, “creative destruction” — came long after his death.) The second half of the book describes how the underground river finally fountained to the surface.

I’ve never seen anyone write as well as Warsh about the social world of economic research, a world of brilliant, often eccentric people who bear no resemblance to the dreary suits you see discussing the economy on CNBC. It’s a world of informal manners yet intense status competition, in which a single seminar presentation can suddenly transform a young man or woman into an academic star.

For about a decade, starting in the late 1970′s, many of those star turns involved increasing returns. Economists had finally found ways to talk about the Pin Factory with the rigor needed to make it respectable. One after another, fields from industrial organization to international trade to economic development and urban economics were transformed.

Warsh does a superb job of conveying the drama of it all. He also tells us about a number of remarkable people and what they did later in their lives — because many of the once-young men (alas, there are few women in the story) who made that revolution have had very interesting second acts.

There are some flaws. The work of the economists who brought increasing returns to international trade, a group that included yours truly, receives flattering treatment, yet Warsh’s account misrepresents that work in subtle but important ways.

Maybe that slight sloppiness reflects Warsh’s relative lack of interest in applications of increasing returns other than the one he believes to be most crucial: as an explanation of economic growth. He portrays a famous 1990 paper about increasing returns and growth by Paul Romer of Stanford University as a sort of pivot around which the whole way economists see the world changed.

Now “Romer 1990″ is a terrific paper — I wish I had written it, which is the highest praise one economist can give to another. Yet I don’t think it can bear the weight Warsh places on it. Nor is it clear that increasing returns really did transform our understanding of economic growth. In fact, Warsh seems to concede as much. “So there is a new economics of knowledge. What has changed as a result? The answer, it seems to me, is not much.”

Never mind. If you like reading stories of high intellectual drama, if you want to know the origin of ideas that, as Keynes said, “are dangerous for good or evil,” this book is for you.

Paul Krugman is an Op-Ed columnist for The Times.




Sunday, May 14, 2006; F03

For more than half a century, Robert L. Heilbroner’s “The Worldly Philosophers” has stood as the most concise and insightful history of economic thought. Heilbroner died last year, but were he alive, I’m sure he would consider David Warsh a worthy successor. In Knowledge and the Wealth of Nations (Norton), Warsh, a former economic columnist for the Boston Globe, has surveyed the complex economic breakthroughs of the past 20 years, put them in their historical context and distilled them into a compelling narrative. Warsh organizes his story around Paul Romer, the Stanford University professor whose pioneering and highly mathematical work on economic growth has been at the center of a generation of research into imperfect competition, network externalities, knowledge spillovers and increasing returns to scale. And if you don’t have a clue what those expressions mean, don’t worry — the glory of this elegantly written book is that all you need to bring to it is your curiosity.

– Steven Pearlstein


THE ECONOMIST, Economics Focus

The riddle of technology and prosperity is explored in a fine new book
FIFTY years ago, Robert Solow published the first of two papers on economic growth that eventually won him a Nobel prize. Celebrated and seasoned, he was thus a natural choice to serve on an independent “commission on growth” announced last month by the World Bank. (The commission will weigh and sift what is known about growth, and what might be done to boost it.) Natural, that is, except for anyone who takes his 1956 contribution literally. For, according to the model he laid out in that article, the efforts of policymakers to raise the rate of growth per head are ultimately futile.

A government eager to force the pace of economic advance may be tempted by savings drives, tax cuts, investment subsidies or even population controls. As a result of these measures, each member of the labour force may enjoy more capital to work with. But this process of “capital-deepening”, as economists call it, eventually runs into diminishing returns. Giving a worker a second computer does not double his output.
Accumulation alone cannot yield lasting progress, Mr Solow showed. What can? Anything that allows the economy to add to its output without necessarily adding more labour and capital. Mr Solow labelled this font of wealth “technological progress” in 1956, and measured its importance in 1957. But in neither paper did he explain where it came from or how it could be accelerated. Invention, innovation and ingenuity were all “exogenous” influences, lying outside the remit of his theory. To practical men of action, Mr Solow’s model was thus an impossible tease: what it illuminated did not ultimately matter; and what really mattered, it did little to illuminate.

The law of diminishing returns holds great sway over the economic imagination. But its writ has not gone unchallenged. A fascinating new book, “Knowledge and the Wealth of Nations” by David Warsh, tells the story of the rebel economics of increasing returns. A veteran observer of dismal scientists at work, first at the Boston Globe and now in an online column called Economic Principals, Mr Warsh has written the best book of its kind since Peter Bernstein’s “Capital Ideas”.

Diminishing returns ensure that firms cannot grow too big, preserving competition between them. This, in turn, allows the invisible hand of the market to perform its magic. But, as Mr Warsh makes clear, the fealty economists show to this principle is as much mathematical as philosophical. The topology of diminishing returns is easy for economists to navigate: a landscape of declining gradients and single peaks, free of the treacherous craters and crevasses that might otherwise entrap them.

The hero of the second half of Mr Warsh’s book is Paul Romer, of Stanford University, who took up the challenge ducked by Mr Solow. If technological progress dictates economic growth, what kind of economics governs technological advance? In a series of papers, culminating in an article in the Journal of Political Economy in 1990, Mr Romer tried to make technology “endogenous”, to explain it within the terms of his model. In doing so, he steered growth theory out of the comfortable cul-de-sac in which Mr Solow had so neatly parked it.

The escape required a three-point turn. First, Mr Romer assumed that ideas were goods—of a particular kind. Ideas, unlike things, are “non-rival”: everyone can make use of a single design, recipe or blueprint at the same time. This turn in the argument led to a second: the fabrication of ideas enjoys increasing returns to scale. Expensive to produce, they are cheap, almost costless, to reproduce. Thus the total cost of a design does not change much, whether it is used by one person or by a million.

Blessed with increasing returns, the manufacture of ideas might seem like a good business to go into. Actually, the opposite is true. If the business is free to enter, it is not worth doing so, because competition pares the price of a design down to the negligible cost of reproducing it. Unless idea factories can enjoy some measure of monopoly over their designs—by patenting them, copyrighting them, or just keeping them secret—they will not be able to cover the fixed cost of inventing them. That was the final turn in Mr Romer’s new theory of growth.

As useful as poetry
How much guidance do these theories offer to policymakers, such as those sitting on the World Bank’s commission? In Mr Solow’s model, according to a common caricature, technology falls like “manna from heaven”, leaving the bank’s commissioners with little to do but pray. Mr Romer’s theory, by contrast, calls for a more worldly response: educate people, subsidise their research, import ideas from abroad, carefully gauge the protection offered to intellectual property.

But did policymakers need Mr Romer’s model to reveal the importance of such things? Mr Solow has expressed doubts. Despite the caricature, he did not intend in his 1956 model to deny that innovation is often dearly bought and profit-driven. The question is whether anything useful can be said about that process at the level of the economy as a whole. That question has yet to be answered definitively. In particular, Mr Solow worries that some of the “more powerful conclusions” of the new growth theory are “unearned”, flowing as they do from powerful assumptions.

At one point in Mr Warsh’s book, Mr Romer is quoted comparing the building of economic models to writing poetry. It is a triumph of form as much as content. This creative economist did not discover anything new about the world with his 1990 paper on growth. Rather, he extended the metre and rhyme-scheme of economics to capture a world—the knowledge economy—expressed until then only in the loosest kind of doggerel. That is how economics makes progress. Sadly, it does not, in and of itself, help economies make progress.

The Financial Times

Nerds and saints of economic thought
By Tim Harford
Published: June 25 2006 18:57 |

Knowledge and the Wealth of Nations: A Story of Economic Discovery
By David Warsh
WW Norton, $27.95
Some experts have the kind of obsession with petty detail that seems likely to make for dull dinner-party conversation, but the best intellectual guides win us over to enjoy the nerdy details as much as they do. David Warsh is one of these rare creatures.
Warsh, who wrote for The Boston Globe for many years, has an obsession with economics and economists. He now writes a newsletter called Economic Principals, which deals with the comings and goings of the profession. The first chapter of Knowledge and the Wealth of Nations is an anthropological study of the American Economic Association, which, miraculously, turns out to be perfectly riveting.
In what is, at its heart, an excellent intellectual history, Warsh shows how the ideas of innovation and economic growth began with Adam Smith and bubbled up only to be submerged again and again.
There was a contradiction at the heart of Adam Smith’s work. His two key ideas were the power of specialisation to muster productive forces and the power of competition to turn those productive forces to the benefit of society. Increasing returns to scale are exemplified by the tale of the pin factory. “One man draws out the wire, another straights it, a third cuts it...eighteen distinct operations...are all performed by distinct hands.” Smith calculated that a dozen men could make about 5,000 pins each a day, and that requires a large market for pins. If increasing returns to scale are as important as he believes, businesses need to be very large to be efficient.
Smith also emphasised the importance of competition, which drove prices to their natural levels and prevented the exploitation of workers and customers. When competition worked well, what we now think of as the invisible hand would turn private selfishness into public virtue: the baker bakes us bread not because he loves us but because he wants to make money.
The contradiction between increasing returns and competition was not widely recognised for many years. If larger companies have lower costs then industries will be dominated by very few of them, or perhaps by one. Where then is the competition?
Historically – with some notable exceptions – economists have focused on competition and ignored increasing returns, which they found conceptually and mathematically hard to deal with. That was, perhaps, forgivable in the 18th century where most economies of scale were modest enough to allow competition to thrive. But the economy Smith described is not the one we have today. Microsoft, protected by intellectual property law, is a near-monopolist in the world of desktop operating systems. Ebay is dominant thanks to the economies of scale in bringing together buyers and sellers. The industry for making large aircraft is big enough for only two players, Airbus and Boeing. Competitive pressures do not operate well in a world of increasing returns.
Warsh’s story moves from Smith through Ricardo, Schumpeter, Keynes, Arrow and most of the other key figures in economic thought, before arriving at Paul Romer’s attempts to put increasing returns at the heart of understanding economic growth. Romer, a peripatetic figure who always seemed to be on the verge of dropping out of the profession, is now a Stanford University professor. His work in the 1980s tried to resolve the contradictions inherent in Smith. He was helped by rapid progress in the mathematics of increasing returns that his contemporaries were applying to industrial organisation and international trade.
Economists had long appreciated that economic growth was made possible by a combination of capital investment and technological change. They even recognised that technological change was much the more important of the two. But being unable to analyse it, they focused on models of capital investment instead – looking for the lost keys under the street lamp. Romer fashioned himself a torch and went looking further afield.
Technological change is hard to model in part because it is the most extreme example of increasing returns to scale. An idea – such as Microsoft’s Windows XP, or the formula for a vaccine – can be impossibly expensive to create and impossibly cheap to copy. Ideas have always been vital to economic growth and they are now more important than ever. Thanks to Romer’s modelling, economists have a much better handle on the process of innovation and are even venturing some thoughts as to what governments might do to foster it.
Warsh’s story is not without flaws. His view of Romer’s contribution occasionally verges on hagiography. The book also gives a sense of petering out as it arrives in the present. As Warsh himself concludes: “What has changed as a result? The answer, it seems to me, is not much.” That is obviously a little disappointing. Yet overall this is a fascinating story of discovery, meticulously reported and essential reading for anyone curious as to what makes economics tick. Warsh does a great job of describing the achievements of those who “have changed what it is that economists are able to see”.
The writer is an FT economics ­commentator