Review: Knowledge and the Wealth of Nations by David Warsh

26th June, 2006

Financial Times, 26 June 2006

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”.

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