Readers & Thinkers: The 2018 Nobel Prize in Economics. Ideas and Hot Air

Dear All:

Well, who won?

The Nobel prize for economic sciences for 2018 was announced today, October 8, 2018. It went to Paul Romer and William Nordhaus.

Romer is 62 years old and was born in Denver, Colorado.   He obtained his BA, MA, and Ph.D. from the University of Chicago.  The work that launched his career in growth theory was started as a Ph.D. student at Chicago and was completed while an Assistant Professor at the University of Rochester.  He is now a Professor at New York’s Stern’s School of Business.

Nordhaus is 77 years old and was born in Albuquerque, New Mexico.  He obtained his BA from Yale University and his Ph.D. from the Massachusetts Institute of Technology.  He spent most of his career working on ideas related to climate change starting around 1973.  It’s hard to point to one specific contribution of his work in this area, however, he did all of his work at Yale University, where he has been since 1967.

In my 2017 prediction of the Nobel Prize, I mentioned both Romer and Nordhaus.  Nordhaus mainly because of his association with environmental economics, which is important, but also a political statement for the committee.  Romer was widely expected to the win the Nobel Prize one day. 

I also mentioned environmental economics this year – and he would have been the obvious candidate along with Weitzman.

So what did these guys do to make them so Noble?

Paul Romer: Endogenous Growth

The Nobel committee wrote that Romer received the prize “for integrating technological innovations into long-run macroeconomic analysis”, while Nordhaus received the prize “for integrating climate change into long-run macroeconomic analysis.”

In some sense, growth theory is one of the most important areas economists ever study.  If a country grows in output per worker, it means that, in theory, everyone could be better off.  That is, we could work less and consume the same or work the same and consume more or some combination of the two.

For example, in 1990, China’s per capita income was $986 per person per year.  That is, an average Chinese citizen made $986 per year.  In 1990, the average American made $23,954.  Thus, the average American was 24 times richer than the average Chinese.  If Chinese economists could understand policy choices that would lead to higher growth for China, wouldn’t they want to do this?  From 1990 to 2017, the Chinese economy grew by 15.88% per year compared to the U.S. economy of 3.88%.  Today, the average Chinese citizen has an income of $16,806 compared to the average US citizen of $59,531 — only 3 ½ times as large.

In fact, growth is so important for economic well-being, it led Nobel prize economist, Robert Lucas, to write that “The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.”

Economists have spent a great deal of time attempting to document and understand the difference in growth rates between countries, as well as think about how policy might affect growth.

One of the earliest enlightenments in this area came from a paper written by Nobel prize winner, Robert Solow, in 1957.  He wanted to understand what caused the United States output-per-hour to double from 1909 to 1949.  One way this could have happened is if every worker had more tools (economists call this capital) to work with.  For example, if you’re baking cookies and I give you 2 ovens versus 1, presumably you can make more cookies per hour.  He discovered that from 1909 to 1949 only a very little of this growth could be explained by more tools; the majority (87.5%) of it was explained by technical change.

Solow went on to develop one of the earliest models to understand an economy’s growth.  One of the key implications of his model was that growth rates across countries would converge.  That is, a poor country should grow faster than a rich country and thus the incomes-per-capita would converge to one another.  We would all be economically the same in the long-run.

There was a problem with this theory, however.  If one looks at a simple graph of country growth and the current level of wealth of countries, one does not see a convergence pattern.  That is, it’s not clear that poor countries grow faster than rich countries.  

Solow’s model assumed that technology was exogenous (i.e. society didn’t have control over it), so Romer wanted to make a model where society had control over technology.  That is, Romer added “ideas” to the model.  That is, if humans are doing research and development, then they are trying to create new ideas.  So, in his model, society can decide to spend more time trying to find ideas.  This is why his model and the research along these lines is called endogenous growth theory.  The other key piece of his model is that technological innovation through new ideas can be shared without diminishing its value.

That is, the big difference between “idea” creation in Romer’s model and something like capital in the Solow model is the following.  If you want to increase cookie production and I give you an extra oven, then you will be able to produce more cookies per hour, however, no one else will.  If I can give you an “idea” of how to make more cookies per hour, then you can use the idea, but so can anyone else.  Thus, output per person in the economy will be tied to the total knowledge base, since ideas and knowledge can be shared almost costlessly.  In economics, we say that it’s the non-rivalrous nature of “ideas” that makes them so special. This new model could explain the lack of convergence in the data.

The endogenous growth model of Romer was accompanied by another paper by his advisor, Robert Lucas, which assumed that human capital (i.e. how knowledgeable or skilled workers are) had externalities on the production possibilities of the entire economy. 

With the release of those papers, growth theory became a popular topic in academic economic circles again.

William Nordhaus: Climate Change & Growth

William Nordhaus began first writing about the environment in 1973.  In his work, he didn’t provide us with any novel model or unique insight, rather he incorporated the environment in a general model of economic decision making.

For example, his early work focused on the idea that natural resources were finite and thus he wondered how we might optimize the production and use of finite resources so that we benefited society over the long-run.  In 1977, he wrote his first piece on carbon dioxide emissions and economic activity.  That is, he considered an optimization problem where we maximize output, but subject to limitations on carbon dioxide emissions.  He elevated his work on these topics after the 1990s.

In one of his studies in 1996, he highlighted some important points.  First, coordination of world policy is important and means that some countries, like China and the Soviet Union would have larger reduction obligations than the rest of the world.  Second, a tax on carbon might be one way to efficiently reduce emissions world-wide.  Third, the uncooperative case (i.e. where every country does what they want) will be substantially less efficient from the coordinated case.  Of course, world coordination isn’t easy.  Finally, the costs in controlling world output would be small at about 1-2 percent of global income in the next century.

Most of us measure economic success by looking at how many goods and services we can purchase or as stated earlier real income per capita, which is a proxy for what we can buy.  Nordhaus wanted to look at how the growth in that real income per capita came about when it might deplete resources that future generations would not have and how externalities from production, like CO2 gases, might affect future economic output and well-being. A key point of his work is that one must consider the costs to any environmental actions (e.g. loss of output) versus gains from the decisions. Oftentimes politicians and rule-makers only consider one side of the issue.

So what about the Nobel choice?

One of my favorite classes at MIT was given on growth theory by Robert Solow.  In fact, it was a period when growth was getting hot again.  Many new growth models were being developed and even classmates of mine were doing lots of empirical research on growth.  One of my peers, Chad Jones, began testing the ideas of Romer and Lucas is his Ph.D. dissertation.  He’s now a macroeconomics Professor at Stanford.

Robert Barro and Xavier Sala-i-Martin were also big contributors to the empirical testing of all sorts of growth models.  In fact, their work finds that conditional convergence works quite well.  That is, when you control for institutions and the quality of human capital, countries are converging in real per capita income at about 2% per year.  That means it takes about 35 years for 50% of the per-capita-income gap to disappear.  A simple way to see this conditional convergence is to remove African countries from the sample and then the convergence graph looks pretty good.

Maybe there’s room for both theories.  Endogenous growth is really about the very long-run, since it does take a long time for ideas or human capital to alter at the world level.  Another teacher of mine, Michael Kremer, did a very interesting study.  He asked, “If more people are likely to lead to more ideas and more ideas are likely to lead to greater growth, has that been true over the last one million years?”  He found it was (by the way, don’t ask about the data quality).

As for William Nordhaus, I think the selection was both a statement about environmental economics and climate change and about a specific contribution.  However, someone else might disagree with me and argue that Nordhaus was the first or one of the first to explicitly build a quantitative model that integrated climate effects with economic events.  

Regardless of the reason, I think it is extremely important for economists to consider the real value of production in all its senses.  This includes dollar damage, as well as health damages, and psychological damages.  Of course, the latter damages are harder to estimate.  For example, Nordhaus estimates that a planned path versus an uncontrolled path for the world economy might be a difference of $270 billion present discounted dollars. However, it should be remembered that one of the problems with simulation models, such as that of Nordhaus, is that the uncertainty in the input estimates and the projections are very high.

And did you know that one of Nordhaus’s undergraduate assistants was Nobel Prize winner Paul Krugman?

So is that it?

Well, not so fast. Could have Robert Barro been added to the award? Or maybe Karl Shell?

It should always be remembered that even though Paul Romer and Robert Lucas revitalized our interest in growth theory, there were armies of researchers who contributed to this field.  Just a few of the names include Harrod, Domar, Solow, Swan, Ramsey, Maddison Denison, Barro, Xavier Sali-i-Martin, Chad Jones, Aghion and Howitt, Rebelo, Michael Kremer, and many others

I spoke today with Robert Solow, one of the main contributors to the neoclassical growth model.  He said that he was very delighted about William Nordhaus, since Nordhaus was one of his favorite thesis students at MIT.  He also was happy about Paul Romer.  I asked him which he believed explained growth more – the Solow model or the new endogenous growth theory.  “When I did this 60 years ago, I understood that technological change was not entirely exogenous, but I had no clear idea of how to proceed.  I think the cause of growth is inherently a very difficult thing to pin down.  I think there still remains an exogenous element to technological progress.  Oftentimes, you start working on idea A, but end up with idea B.  But it is still worthwhile to try and understand the process.”

For more information on the winners:

From Yale University:

From MIT:

From University of Chicago:

Congratulations to William Nordhaus and Paul Romer and their pursuit of knowledge, and the armies of other researchers who walked with them!



P.S. Feel free to email me your thoughts and indicate whether you wish them to remain anonymous or not.

October 8, 2018