Nature’s constraints need not limit innovation and growth – Part 2: Paul Romer

The story of how two economists integrated innovation and climate with long term economic growth and won a Nobel prize.

In the earlier companion of this blog we explored how William Nordhaus integrated climate change into models of economic growth.  The story now continues to how Paul Romer integrated technological progress and the power of ideas into the economic equation.

The question of ‘what explains economic growth’ may sound simple – but developing a comprehensive theory of growth has challenged the economics profession for over 200 years.

Paul Romer credits this single chart, plotting the economic growth of England, as the reason he elected to study economics.

Long term perspectives like this help to reveal why the factors of economic growth are so complex and hard to comprehend.  If society really understood the ingredients for economic prosperity, then it would seem odd that there was none of it for hundreds of years.  A desolate English existence is then followed by a sudden explosion of growth that sees the average UK citizen today earn more in two weeks than a 17th century citizen earned in year.

Ever since this modern growth plant began to flower, economists have been toiling away to try to explain the contributing factors in simple mathematical models.  It had long recognised that technological progress was fundamental to growth, but the models lacked a way to incorporate it – hence is was considered an exogenous factor.

The wonkish element of Romer’s contribution comes from a debate around factors that are exogenous (meaning originating externally and unexplainable by the model) versus endogenous (an internal factor that can be explained within the model).

It was not until Romer’s breakthrough (along with other notable contributors) in the 1980-90s that the power of ideas and technology was able to be internalised into the economic model via endogenous growth theory.

To help explain how growth occurs Romer uses a cooking analogy:

“To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material (see natural resources).”

Every generation in human history has stressed over the limits of physical resources and too many people – see Malthus or the famous Simon–Ehrlich wager.

Romer showed us that the bit that really matters is not the limited resources but the ideas of how we use them.  And these new recipes are essentially limitless.

The work of Romer gives us cause for ‘conditional’ optimism, that human ingenuity combined with the right incentives can really overcome almost any challenge.  In this respect, both he and Nordhaus believe that the only real incentive required to overcome the costs of climate change is a simple carbon tax.

That doesn’t gel well with the natural instinct to direct activity through regulation and technology subsidy, rather than the whims of the market.  Yet as Romer says, we must learn from history:

“Our intuition tells us that solving this problem cannot be so easy. But intuition has also been telling us for two centuries that the price of natural resources has to climb as the rate of resource extraction increases. So what are you going to believe? Your intuition or the logic and the evidence?”

The broader lesson is that scientists, entrepreneurs and firms will produce more ideas to improve human welfare given the right incentives.  Nordhaus finds that 98% of the returns from innovation are distributed to the general public, hence getting conditions right for profitable ideas to flourish is well worth the effort.

Investing in a strong education system allows citizens to harness knowledge and develop ideas.  Nations can also attract the best ideas in the world by providing legal protection through the patent system and allowing free movement of goods and capital across borders.  Romer further suggests that avoiding heavy regulation and high marginal tax rates will ensure that citizens are working in the most productive and well remunerated sectors.

At Faraday Grid, we are focussed on harnessing the knowledge that created the biggest machine in human history – the electric grid.  We take the recipes of James Clerk Maxwell, Michael Faraday and a pinch of Adam Smith, then add our own unique ingredients about how to make systems more resilient and less fragile.  That is the innovation machine in action.  A living embodiment of the power of ideas to feed into Romer’s model of economic growth.

As we deploy the Faraday Grid in coming years, the overwhelming majority of the benefits, as Nordhaus suggests, will flow to citizens through access to cheaper, cleaner and more reliable electricity.

The Nobel Prize to Nordhaus and Romer is an inspired choice that gives us great cause for optimism in uncertain times.