Value of Connections of the United States

It is well-known that who you know and who you are connected to matters greatly for your business success in many countries. This is nicely documented in several papers that show how connections to powerful politicians have a huge value in countries with weak institutions.

For example, in a famous paper Ray Fisman used an event study methodology exploiting rumors about the health of the Indonesian dictator President Suharto to show how close connections to Suharto were greatly valuable: these adverse news reduce the stock market value of the firms connected to him.

Similar results were found, among other places, in Malaysia by Simon Johnson and Todd Mitton and in Pakistan by Asim Khwaja and Atif Mian.

But the consensus view has been that such connections don’t matter in countries with strong institutions such as the United States.

In fact, Larry Summers used this as the basis for his argument for why the response to financial crises should be different in the United States in his Ely Lecture to the American Economic Association: strong US institutions imply that policies that should not be tried in Indonesia or Malaysia because of concerns about cronyism and corruption could be adopted with little worry in the United States.

This view was supported by work that applied similar methodology to the United States. For example, other work by Ray Fisman, together with co-authors, found that the value of connections to Dick Cheney were small or nonexistent.

So US institutions do seem to work as they are supposed to.

Recent work by Daron, Simon Johnson, Amir Kermani, James Kwak and Todd Mitton finds something quite different, however.

Focusing on the announcement of Timothy Geithner as President-elect Obama’s nominee for Treasury Secretary in November 2008, they report robust and large returns to financial firms with connections to Geithner. Connections here are defined either from Timothy Geithner’s meetings with financial firm executives during the previous two years when he was the President of the Federal Reserve Bank of New York, or from his overlap on non-profit boards with these executives. What’s going on?

One possibility is that this just reflects the fact that firms that had such connections are also those that would have actually benefited from the safe pair of hands that Timothy Geithner would bring to the job of Treasury Secretary. Though plausible, this explanation does not receive any support from the data:  controls for characteristics that could capture such benefits do not change the results, and in fact the results hold when comparing firms of very similar size, profitability and leverage, and similar risk and stock market return profiles.

Another possibility is that the same sort of shady dealings that went on in Indonesia, Malaysia or Pakistan are also present in the United States — or at the very least were thought to be present by stock market participants. But this seems very unlikely, and there is no evidence to support this. Timothy Geithner appears to be an honest technocrat, with no interest in doing favors in order to get campaign contributions or financial gain.

Instead, the paper suggests a different hypothesis: “social connections meets the crisis”.

Namely, the excess returns of connected firms may be a reflection of the perception of the market (and likely a correct perception) that during turbulent times there will be both heightened policy discretion and even more of the natural tendency of government officials and politicians to rely on the advice of a small network of confidants. For Timothy Geithner this meant relying on, and appointing to powerful positions, financial executives from the firms he was connected to and felt comfortable with. But then, there is no guarantee that these people would not give advice favoring their firms, knowingly or perhaps subconsciously (for example, they may be under the grips of a worldview that increases the perceived importance of their firm’s survival for the health of the US economy).

So Larry Summers is probably right that strong US institutions preclude the sort of dealings that went on in Indonesia under Suharto or in Malaysia under Mahathir Mohamad. But this does not mean that connections don’t matter or that we should not worry and be vigilant about them, particularly during turbulent times when important decisions have to be made quickly and the usual mechanisms for scrutinizing important policy decisions are weakened or suspended.

Politics and Technology

In our last post, we discussed how government policy can change the direction of technological change and deal with some of the environmental consequences of laissez-faire economic growth.

But of course the fact that the government could do this is no guarantee that it will do it. Whether or not it will comes down to politics.

This is a special case of the more general interaction between politics and technology, a topic that is unfortunately much ignored.

When social scientists think about technology, institutions and politics, regardless of their ideological leanings, their first instinct is to take their cue from Marx who viewed technology as an exogenous driver of history, and institutions and politics as merely parts of “superstructure” adapting to the needs and peculiarities of technology. As we noted in our post about a year ago, Marx famously summarized this perspective by stating:

The hand-mill gives you society with the feudal lord; the steam-mill, society with the industrial capitalist.

We also noted there that this view is seriously at odds with the facts, for example as recounted by historian Marc Bloch in Land and Work in Medieval Europe.

On the contrary, the development of these technologies, as with other technologies, has been endogenous and strongly responded to incentives in part shaped by politics.

History is in fact full of telling examples how technology responds to politics. Roman technology did not stagnate and then disappear in much of Europe after the collapse of the Roman Empire because it had reached some natural technological barrier, but because politics first within the Roman Empire and then among the fragmented European structure of polities that emerged after its collapse created no incentives for technological progress or even the use of existing technologies.

Nor can the phenomenal advances in sailing and ship-building technology starting in the 15th century documented for example by Carlo Cipolla in Guns, Sails and Empires be understood as the exogenous march of technology. Rather, they were a consequence of incentives created by inter-state competition for the capture of overseas trade routes and colonies.

Likewise, government policy and conflict over it is probably a first-order factor in understanding the direction of technological change today. For example, can we understand the types of technologies developed and enthusiastically used in the US health care system, which then rapidly spread to the rest of the advanced world, without considering the distorted incentives that the US health care system creates?

Though this point was made by Burton Weisbrod as early as the 1991 in a very interesting paper in the Journal of Economic Literature, there is curiously very little work on how politics affect endogenous technology, which seems a clearly under-researched area.

Returning to the issue of climate change, though the impact of government policy on the direction of technology may be potent, the politics here is unfortunately particularly challenging.

First, there is the issue of domestic politics. Government policy can be fruitfully used to redirect technological change from fossil fuel-based technologies to cleaner ones, but this will involve a significant redistribution of profits away from some of the most powerful companies in the United States. Not surprisingly, existing oil companies and energy producers relying on coal aren’t the biggest fans of a transition to clean technology.

This domestic dimension of the politics of energy technology is further complicated by the war over the science of climate change. It’s hard to know for sure, but one would imagine that without the involvement of the energy sector, there wouldn’t be so much confusion on what climate science does or does not say about man-made climate change.

Second, there is the issue of international politics. Any country that unilaterally adopts policies to redirect technological change towards cleaner technologies is likely to end up bearing the cost but not benefiting much unless others follow.

In this light, perhaps the defining political struggle over climate change is the one between the United States and China, the two biggest polluters today. Not surprisingly, this looks like a classic game of chicken or war of attrition, each side waiting for the other to make a concession while we get closer to the abyss.

If you thought that politics of technology was something you could ignore, perhaps you should think again.

Directed Technological Change and Resources

In our previous post, we discussed some of the evidence suggesting that technology is indeed endogenous and does respond to scarcities and prices.

Many economists have worked on modeling this type of endogeneity of technology and how it responds to prices. Remember the great economist John Hicks’s assertion, which we quoted in our previous post, about how higher price of a factor will tend to induce technological changes directed at economizing on that factor.

Hicks was not the only major figure to think about these issues. Charles Kennedy, Paul Samuelson, and Drandakis and Edmund Phelps all weighed in in the 1960s with various theoretical models. But in the age before micro-founded models of endogenous technology based on monopolistic competition, they faced a major challenge: how to model technological progress.

(The technical, but also conceptual, problem was this: If the production function of firms exhibited constant returns to scale in capital and labor, then they would have increasing returns to scale with technology being chosen by firms also, and this would make price-taking behavior impossible).

Work by Daron as well as Michael Kiley developed simple models of directed technological change building on the theories of endogenous technological change.

These models turned out to be not just tractable but also quite surprising in some aspects. In particular, as this paper shows, the implications are quite robust but also different from those that Hicks and others conjectured. But this is a topic for another time.

For our focus here, what is more important is the application of these ideas to the issues of resource scarcities and other environmental implications, which were studied in work by Daron, Philippe Aghion, Leonardo Bursztyn and David Hemous. This work does shed quite a different light on the debate between Ehrlich and Simon.

Recall Simon’s most important point: technology will endogenously respond to scarcities.

One of the results in this research provides a clear support for this line of reasoning: if oil gets scarcer over time, then technology will endogenously switch to cleaner sources of energy, reducing our dependence on oil.

So far so good.

But things are not really as rosy as Simon’s view would suggest.

The real problem isn’t the world running out of oil, but the world frying itself with all sorts of fossil fuels — not just oil but also coal. And coal doesn’t look like it will run out anytime soon.

More specifically, as production using fossil-fuel-based energy creates climate change, economic growth can indeed bring the downfall of the world as we know it (though the exact extent of this does depend on how the world will adjust to significant increases in average temperatures and the variability of climate, on which there is some debate).

In the process some sources of energy may become scarcer, but provided that there are other sources of “dirty” energy, such as coal, this won’t change the trajectory of fossil fuel consumption and climate change.

This research and a complementary paper by Daron, Ufuk Akcigit, Doug Hanley and Bill Kerr suggests that directed technological change may actually make things worse. To start with, dirty technologies are more advanced than clean technologies based on wind, solar power or geothermal (and even, more controversially, nuclear power). Given this state, directed technological change implies that private incentives will encourage firms and researchers to invest more in using and improving these dirty technologies  — clean technologies are just too far behind and won’t be competitive, so it wouldn’t make private sense for people to invest much in them.

But in fact, the most important lesson of this work might be a perspective that brings Ehrlich and Simon together. Though the market without intervention fails and fails badly (think environmental disaster), government intervention can be hugely powerful because it leverages the endogeneity of technology and, as Simon posited, the power of the market to generate new technologies.

If the government intervenes and subsidizes clean research, then this can powerfully stave off an environmental disaster. That intervention is necessary comes from the fact that the market, by itself, will not internalize the negative impact it’s creating on the environment (and on future generations).

This is much more powerful than one might have imagined because of an interesting reasoning. Once the government intervenes by subsidizing clean research, this starts making clean technologies better and better over time. As they become sufficiently better and thus competitive with dirty technologies, the tables turn. Now private incentives that previously directed everybody to invest in and do research for dirty technologies start encouraging the advancement of clean technologies.

Perhaps surprisingly, the government does not even need to intervene forever. Temporary (though not short-term) interventions are sufficient to redirect technological change towards clean technologies and slow down adverse climate change.

What about carbon taxes? Carbon taxes would do the same also, but interestingly they are not by themselves sufficient. Unless one is willing to have prohibitively high carbon taxes — enough not just to reduce carbon consumption today but to also change the future path of technological change — subsidies to clean research have an important role. And typically it would be very costly to have such high levels of carbon taxes anyway.

So bringing Ehrlich’s concern about the adverse implications of economic growth together with Simon’s insight that endogenous technology is a powerful force leads to new and somewhat hopeful insights.

But here’s the catch. Will governments actually do it? Will they choose the right levels of subsidies to clean research and carbon taxes to slow down and even stop climate change? Or will they just stick to business-as-usual until it’s too late? That brings us to our next topic: the politics of technology.

Is Endogenous Technology Conservative?

In our previous post, we reviewed the basics of the debate between Paul Ehrlich and Julian Simon over whether economic growth would lead to widespread resource scarcities and demographic catastrophes.

In The Bet: Paul Ehrlich, Julian Simon and Our Gamble over Earth’s Future, Paul Sabin puts this debate, and their famous wager, in context and provides useful and interesting historical details.

Sabin also follows one interpretation of this debate in which Paul Ehrlich is the liberal, voicing left-wing concerns about economic growth, and Julian Simon the conservative, subscribing to a techno-optimistic view.

Though it is true that Paul Ehrlich considered himself to be from the left, and Julian Simon’s views came to be adopted by the right (and Simon himself embraced some American conservatives’ climate-skeptic views), it is wrong to see this debate as pitting liberal vs. conservative views of technology and economic growth.

At the center of the debate are some basic economic questions: is technology endogenous, and can it change enough to overcome scarcities?

There is nothing inherently right or left in the answer to these questions.

To an economist, it is natural to presume that technology is endogenous, and many economists view technological change as a powerful factor capable of overcoming all sorts of scarcities.

John Hicks anticipated this in his Theory of Wages, writing

A change in the relative prices of the factors of production is itself a spur to invention, and to invention of a particular kind—-directed to economizing the use of a factor which has become relatively expensive…

The most famous version of this idea is embedded in the endogenous technological change models every economist encounters in graduate school (and nowadays, many even see in their undergraduate studies).

In the basic neoclassical growth model, as formulated by Robert Solow, long-run economic growth necessitates exogenous technological change (except in some degenerate cases). Without such technological change raining down as mana from heaven, capital accumulation can drive growth for a while, but must ultimately come to an end. One way of understanding the reason for this is that as capital accumulates, the capital-labor ratio increases and this makes labor “more scarce” (relative to capital). This increases wages and reduces the return to capital, discouraging further capital accumulation.

Looked at it from this perspective, what endogenous technological change models do is that they create incentives for technology to also advance. As a result, even though labor does become more expensive (thus more scarce), this does not choke off economic growth. Scarcities are overcome by technological ingenuity.

Nice in theory, but does this have anything to do with reality?

Actually yes. Considerable empirical evidence shows that technology does indeed respond to incentives, including scarcity.

An interesting example comes from David Nye’s  Electrifying America: Social Meanings of a New Technology, 1880-1940, where he argues

Cities grew larger, better transportation was needed, so the [electric] trolley was invented, called into being by the crowded late nineteenth century cities….By the 1870s large cities had ceased to be accessible by foot, or built to the scale of pedestrians, and traffic congestion was terrible.

But crucially, the difficulties that over-congestion created also induced the development and adoption of new technologies in the form of the electric trolley, which ultimately solved the major conundrum that cities were facing at the end of the 19th century.

The famous Habakkuk hypothesis in economic history also amounts to the same thing (with different historical examples to back it up).   

In American and British Technology in the Nineteenth Century Habakkuk argued that technological progress was more rapid in 19th-century United States than in Britain because American labor scarcity induced faster technological progress and mechanization.

Habakkuk, for example, quoted from a contemporary observer of technology, Pelling, who wrote:

… it was scarcity of labor `which laid the foundation for the future continuous progress of American industry, by obliging manufacturers to take every opportunity of installing new types of labor-saving machinery.’

Or in Habakkuk’s own words:

It seems obvious—- it certainly seemed so to contemporaries—- that the dearness and inelasticity of American, compared with British, labour gave the American entrepreneur … a greater inducement than his British counterpart to replace labour by machines.

More recently, economic historian Robert Allen suggested in The British Industrial Revolution in Global Perspective the same mechanism as the reason why Industrial Revolution took place in Britain rather than in continental Europe or elsewhere.

A more contemporary example comes from the work of economists Richard Newell, Adam Jaffee and Robert Stavins. They show with historical data from Sears catalogs that, when energy was abundant and cheap, innovation in air conditioners tended to reduce prices and leave energy efficiency largely unchanged. After the oil price hikes, when energy became more expensive and “scarcer”, the direction of technological progress changed and air conditioners started becoming more energy efficient over time (but not much cheaper).

So the idea that technology is endogenous and responds to prices and scarcities isn’t an ideological belief, but an economic idea with fairly solid empirical backing.

This of course doesn’t mean that technological change is always powerful enough to overcome all scarcities. That’s another empirical question, and one we will discuss more in the next post.

But here, to put it into context, it is perhaps also useful to note that belief in the power of technology to overcome scarcity and create abundance is not under the monopoly of the right.

Many of the early socialist thinkers, including Robert Owen, Henri de Saint-Simon, Charles Fourier and Edward Bellamy, believed in the power of technology to create their utopian societies. Even Karl Marx was fairly optimistic about what technology and scientific knowledge could achieve (even though he was fiercely critical of what technology did under capitalist control, arguing, for example that “all progress in increasing the fertility of the soil for a given time isn’t progress towards winning the more long-lasting sources of that fertility… Capitalist production, therefore, develops technology, and the combining together of various processes into a social whole, only by sapping the original sources of all wealth…”).

Neither is there anything inherently progressive or left-wing in arguing, as Paul Ehrlich did, that the world is overpopulated and population must be controlled at all costs.

Matthew Connelly’s entertaining and troubling Fatal Misconception shows how the obsession to control population (which in practice means international organizations controlling or attempting to control population in poor countries) could acquire an almost fascistic zeal.

In light of all this, it would seem that the debate between Ehrlich and Simon shouldn’t be viewed as the struggle of left and right-wing ideologies, but an economic and empirical debate.

On the economics of it Simon’s position seems right: technology is endogenous and does respond to scarcities and prices.

On the empirics of it, that is, on the question of whether this response of technology is powerful enough to overcome all scarcities and avoid serious negative environmental consequences, the answer is a little more nuanced as we will see next week.

Ehrlich, Simon and Technology

A new book by Paul Sabin, The Bet: Paul Ehrlich, Julian Simon and Our Gamble over Earth’s Future, revisits the famous wager between Ehrlich and Simon.

Many scholars and commentators over the years have publicly, and sometimes very loudly, worried that we will outgrow our planet’s ability to support us. One of the most colorful was the environmentalist Paul Ehrlich, who repeatedly predicted over the 1960s and 70s widespread resource scarcities and consequent demographic catastrophes. He became more than a public intellectual, almost a household name as a result.

But Ehrlich was challenged by economist Julian Simon, who believed that technological ingenuity would overcome any scarcities before these would have much of an impact on human welfare.

Simon challenged Ehrlich to a bet about the prices of a bundle of commodities that Ehrlich would choose.

Ehrlich picked chromium, copper, nickel, tin, and tungsten as five commodities that would experience increases in their inflation-adjusted prices between 1980 and 1990. The wager ended with a victory for Simon when the prices of all five commodities fell.

But as Sabin recounts, the story would have been different if the bet was extended two more decades.

The next figure shows that indeed Simon’s victory may have been premature.

 

Before the Great Recession prices had reached and surpassed their 1980 level.

That of course neither proves nor disproves Simon’s broader point: technology will respond to scarcities.

That being said, revisiting this bet and the preceding and ensuing debate is interesting for several reasons as we will discuss in the next several posts.

To give a preview, in the next post, we will suggest that the oft-drawn interpretation of the wager between Ehrlich and Simon, repeated by Sabin, as the facing off of liberal and conservative views about growth and technology misses the point.

We will then review some of the economics literature on how technology responds to scarcities and the implications of this for climate change.

We will conclude with a final post on the role of politics in technological change.