Brynjolfsson and McAfee are not wrong, but I think a better picture emerges if we attempt to reconcile their argument with Cowen’s rather than viewing them as contradictory. As Tyler argues, we have not had the kind of growth we might have expected 40 years ago if we had extrapolated based on the prior 40 years. See this chart on total factor productivity by David Beckworth. I think McJolfsson’s view and Cowen’s view are complementary if viewed from a sufficiently “big picture” perspective; the slowdown in TFP and the speedup in SBTC are, after all, decades-long trends.

Here’s my model. First we need to differentiate between two kinds of innovation and think about their effects. The first kind of innovation is geared toward brute maximization of production. It is typically centralized and makes use of economies of scale. Examples might include an assembly line factory or a big, coal-fired power plant. Because these innovations tend to be centralized, they introduce points of control. The capital is typically fixed and therefore easy to tax and regulate. It’s well known in the development literature that it’s really hard for governments to control rural peasants who live off the grid. Once they move to the cities and plug into centralized services, it is easier to require them to send their children to school, for instance. Because these innovations introduce points of control, I will call them technologies of control.

On the other hand, not all innovations are about brute maximization of production. Some are about producing things that we already know how to produce in ways that have ancillary benefits. An important ancillary benefit is evading control. Examples of these innovations include 3D printers and solar power. The evasion of control that is possible with 3D printers is the subject of Cory Doctorow’s short story Printcrime. And portable solar power cells can make people harder to control by supplying electricity without the need to register an address, have a bank account, stay put, and so on. These are obvious examples, but control can be evaded through more subtle innovations as well. I will call innovations that circumvent points of control that can be used by governments or monopolies to exploit, tax, or regulate technologies of resistance.

Now, postulate some background rate of innovation. How many resources will be devoted to technologies of control and how many to technologies or resistance? The answer is that it depends on how invasive the state (or other monopolies) are. When the state is invasive, at the margin the incentive is to find ways to circumvent the points of control; a greater proportion of resources will go into technologies of resistance. When the state is non-invasive, at the margin the incentive is a purer maximization of production; a greater proportion of resources will go into technologies of control, which results in higher growth.

What determines how invasive the state will be? Call me a cynic, but I think it correlates strongly with the availability of points of control. When factors of production are fixed, when demand for government supplied public goods is inelastic, when there are lots of points of control, the government will exercise more control. When the opposite is true, when there are few points of control, the government is unable to act invasively.

As you can see, there is a system of feedback. But the countervailing forces need not push outcomes to a stationary equilibrium. As we all know, time-to-build can result in cycles. Since technologies take time to change direction and develop, and since politics is slow to adapt, we should expect a non-stationary equilibrium. I think this is consistent with the broad facts. A hundred years ago, at least as it concerns white males living in the US, the government was relatively non-invasive. As a result, they developed centralized technologies that created a lot of growth, technologies of control. As new points of control were introduced, the government became more invasive. The modern state was born. At some point, innovation gradually increased toward technologies of resistance. The low-hanging fruit from the prior era eventually petered out, and sometime around 1974 we began to see lower TFP growth. As technologies of resistance improve relative to technologies of control, I can’t say exactly what will happen. A lot depends on whether government becomes gradually less invasive as points of control disappear or whether it continues to overreach; if the latter, we could observe some kind of interesting political turmoil.

So far, I’ve been pretty general about technologies of resistance, but I want to tie it back into McJolfsson’s story about rapid skill-biased technical change. The key point is that labor is extremely regulated; firms that use labor are subject to intense government control. In part this is because policies that give labor a “bigger piece of the pie” are popular with voters, and in part it is because labor can complain and enforce its rights in a way that machines cannot. If you own a business and you are subject to intense government control, you are going to invest resources in circumventing the points of control. In our economy, that means getting rid of lots of labor as cheaply as possible, which means skill-biased technical change. As Arnold Kling has said, “if a job can be defined, it can be automated or outsourced.” But it’s because there is so much control exercised in the labor market that the incentive to automate and outsource is so high.

On the other side of the labor market, I wonder if post-materialism is not also part of an attempt to evade control. A lot of talented people are scaling back their labor efforts, and while surely not all of this is due to taxes and regulations, some of it may be. And other innovations which seem truly new, such as the development of autonomous vehicles, are the result of control of which we may not even be aware; for instance, how profitable would it be to develop autonomous vehicles if Pareto-improving trade with immigrant drivers were not made impossible by immigration and labor restrictions?

The Internet has been somewhat insulated from the kind of political control that I am claiming leads to the cycle of control and resistance. As a consequence, I think we observe an epicycle there. Internet technologies can be centralized at the company level or standardized at the protocol level. Email is an example of a technology that is standardized at the protocol level, and it was developed in the early days of the Internet, when market power was a serious concern. Today, there are so many competitors in the online messaging field that market power is not a real problem. Consequently, we observe services like Facebook and Twitter, which are centralized and can provide “higher production” by reducing spam, for instance. If Facebook and Twitter ever abuse their market power too much, that is when distributed, protocol-based substitutes such as Diaspora and Status.net will take over. And when the government starts exerting more control over the Internet, we’ll observe the adoption of new technologies to circumvent that control, such as encryption and mesh networking.

In a strange way, this theory is a partial vindication of Ayn Rand; the only problem is that she was too literal. The productive people do not go on strike when they are over-controlled. Instead, they innovate around the points of control. They go on strike at the margin. And it doesn’t take a big, dramatic exit. A little bit cumulatively over decades is sufficient to both be noticeable in the data and to reduce the amount of control that can be exercised.

At the risk of being accused of now-more-than-everism, I’ll point out that the problems associated with a greater focus on technologies of resistance and with skill-biased technical change could be much ameliorated by a government that dramatically reduced its control over its citizens. Stick to supplying public goods and providing a small safety net. It won’t fix everything overnight—technology has momentum—but it will make things better than it otherwise would be. However, I think there is little chance of this happening. It requires out-of-equilibrium political play. Instead, if my theory is correct, we will find out what happens when large, invasive governments overextend and are forced to shrink.

I’m writing this post on Austrian macro because the Austrian school seems to be both en vogue with and poorly understood by Tea Party types. For that matter, it is poorly understood by critics of the Tea Party. I’ll be the first to admit that I am not the most qualified person in the world to write this post. I am not an Austrian or a macroeconomist. Lots of people, including some GMU first-years who are taking the macro prelim this weekend, could do a better job than I will do. Maybe they can comment and refine the post that way. Let’s get started:

What’s right with Austrian macro?

The starting point for modern macroeconomics is what is known as dynamic stochastic general equilibrium (DSGE) models. These models vary depending on the point that the theorist is trying to make, but in the broadest class of them, there is in fact very little economics even going on. Say we start with Long and Plosser’s classic RBC model. How many goods are there in Long and Plosser? One (plus leisure). How many people are there in Long and Plosser? One! How much trade is there in Long and Plosser? Zero. Now, if what you mean by economics is intertemporal optimization in the face of random shocks, then Long and Plosser is an economic model. But as Hayek argues, “This, however, is emphatically not the economic problem which society faces.” DSGE models are poorly suited to evaluating changes in an economy with arbitrarily diverse agents with arbitrarily diverse preferences and arbitrarily diverse information sets. This critique of DSGE-style macro is part of the core of Austrian theory.

Furthermore, in the Austrian view, capital is heterogeneous and multi-specific. If you invest in a pet store, and then decide you want to convert it to a massage parlor, that is costly and time-consuming. This opens the door to malinvestment. In many RBC and New Keynesian models, capital is homogeneous, meaning that it is costless to switch from one investment into another. Kydland and Prescott explicitly assume time-to-build, but this is not the only friction in real-world investment.

According to the Austrians, production functions for the multi-specific capital are discovered over time. In virtually all RBC and New Keynesian models, production functions, the way of transforming the single type of capital into the good or (rarely) goods are specified in advance and do not change. Austrians emphasize competition as a discovery procedure. Entrepreneurs are constantly trying to find new ways to turn existing capital stocks into goods that consumers may want. This discovery procedure is obviously sensitive to policy shocks.

What is wrong with Austrian macro?

The biggest problem with the Austrian school is a legacy of the fact that much (not all!) of the theory was developed before the rational expectations revolution. Even if you think rational expectations is bogus, the fact is that many Austrian models do not explicitly state what is driving expectations. If the monetary authority inflates, everyone is tricked. This is clearly problematic. A better Austrian theory in my opinion would evolve along the lines of the Lucas islands model. I have written before that I think our current situation is one of severe model uncertainty. Some people think money is tight and others think money is loose. If that is the case, then even if people have, say, Bayesian expectations, many of them will be tricked, resulting in monetary distortions.

The other major weakness in Austrian business cycle theory is that it focuses way too much on one particular distortion, monetary policy. Now, the Austrians have an answer to this; they argue that money is one half of every single transaction in the economy, so if money is distorted, then that is a big problem. I don’t think this is true. First, monetary distortions will cause primarily intertemporal distortions. This may be problematic, but as I wrote above, one of the biggest strengths of the Austrian model is that it takes seriously the heterogeneity of goods, capital, and preferences. Focusing primarily on intertemporal investment gives away that huge gain. Austrians should be more open to examining other distortions, such as the subsidization of fixed-value financial claims (FDIC insurance, favoring debt versus equity) and industrial policy. I think Arnold Kling is onto something with his emphasis on Patterns of Sustainable Specialization and Trade.

What is misunderstood about Austrian macro?

The Austrian mantle has been claimed by the Tea Party, but very few Tea Partiers are familiar with modern Austrian scholarship. Michelle Bachmann famously takes Mises with her to the beach, but there is a great deal of Austrian theory that is post-Mises. In particular, most of the modern Austrians I have talked to are not goldbugs. They understand that the most important characteristic of money is not its store-of-value property. In general they favor rules versus discretion in monetary policy, but those rules are ones that non-Austrians can easily get behind. For instance, George Selgin writes, “Scott Sumner’s general views on macroeconomics are so much in harmony with my own that, in commenting on the present essay, I’m hard pressed to steer clear of the Scylla of fulsomeness without being drawn into a Charybdis of pettifoggery.” Furthermore, to the extent that Austrians like gold as currency, they like it because they believe it would “win” in a free-market competition against fiat currency, not because gold is special per se. A simple test would be to get rid of capital gains taxes on gold and other assets and see what wins.

Modern Austrians view policies like NGDP targeting as coming straight out of Hayek, who wrote about the importance of preventing a “secondary deflation.” Consequently, the mainstream accusation that Austrians favor no policy in the face of a financial crisis is misguided. The correct policy, according to many Austrians, is to adopt the most non-distortionary monetary policy there is, which is to keep nominal spending at the expected level. Letting spending collapse is itself a distortionary policy.

The Tea Party is populist, but it seems to be populist for the sake of populism. Austrian theory, on the other hand, is anti-elitist because it believes that neither elites nor anyone else can successfully “manage” the economy. There is consequently a certain populist interpretation of Austrianism; but the theory is not so much about giving the masses what they want as about letting a decentralized process take place. This is the main reason I am skeptical about the political adoption of Austrianism. It is being used as a rhetorical tool in a cultural dispute, not as a way of understanding the nature of the economic problems we face.

The term “liquidity trap” comes from Keynes. He described it as a theoretical possibility under which monetary policy would be ineffective; it would be unable to stimulate an economy in recession. Consequently, fiscal policy would be needed. To my knowledge, Keynes was not claiming that the economy ever has been in a liquidity trap; it’s simply a possibility that occurs under very specific conditions. Those conditions define “liquidity trap,” but there is disagreement over when they hold.

What is at stake here is the status of fiscal policy. If the economy sometimes experiences liquidity traps, then that is perhaps a good reason to keep fiscal policy in our toolbelt. If the economy never experiences a liquidity trap, then monetary policy strictly dominates fiscal policy: it is faster, less wasteful, and does not increase sovereign debt. It’s sometimes hard to say whether advocates and detractors of fiscal policy take those sides because of their position on liquidity traps or vice versa.

Krugman is among those who think that the world does experience liquidity traps, that we are in one now, and that we need more fiscal policy. Why does he think this? Arnold Kling does some of the forensic work and uncovers an old and a recent statement from Krugman on liquidity traps. Arnold says they are inconsistent, but I think they are perfectly consistent. The old statement:

My view … is that the liquidity trap is real: no matter how much the Fed increases the monetary base, it has no effect, because it just substitutes one zero-interest asset for another.

The new statement:

The economy is in a liquidity trap when even a zero nominal interest rate isn’t enough to restore full employment. That’s it.

What Paul is saying is that the economy is in a liquidity trap when the nominal interest rate on short-term Treasuries is zero. When the Fed tries to expand the money supply by buying up short-term Treasuries, it is swapping cash for Treasuries. Normally, cash and Treasuries have different properties: cash has a nominal interest rate of zero and Treasuries bear some positive nominal interest rate. However, when Treasuries bear an interest rate of zero, they are basically the same as cash. They are backed by the US Government and they don’t carry interest. Why should swapping one asset for an identical asset make any real difference in the world? On this narrow point, Krugman is clearly correct: it wouldn’t make a difference at all.

Krugman is wrong, however, that this constitutes a liquidity trap, either in the sense that Keynes meant it or in the looser sense that monetary policy is ineffective, because swapping cash for short-term Treasuries is not the only (or even necessarily the best) way to conduct monetary policy. First of all, it is important to recognize that there is not just one nominal interest rate. There is an infinity of nominal interest rates. If the interest rate on short-term Treasuries is zero, the Fed can swap cash for longer-term Treasuries. It could in theory buy private bonds, or stock, or mortgage-backed securities, or even non-financial assets. In any of these cases, the Fed is increasing the amount of money in circulation, and it is removing less liquid assets. This is expansionary except in extraordinary circumstances I’ll discuss below.

Incidentally, the Fed can also conduct monetary policy by other means. It can simply print money and distribute it, the infamous “helicopter drop.” It can buy foreign currency. It can lower the interest rate or raise the penalty on excess reserves that banks hold at the Fed. It can promise to inflate more in the future. All of these actions are expansionary, again except perhaps in extraordinary circumstances.

What are the extraordinary circumstances in which all monetary policy is ineffective? Keynes got it right. Monetary policy is ineffective when people want to hoard whatever cash they can get their hands on. In technical terms, the demand for money is infinitely elastic. The point is that increasing liquidity in the system (buying illiquid assets with liquid assets, say) does not translate into more spending because people soak up whatever liquidity there is.

When is demand for money infinitely elastic? Basically never. This is what Tyler is saying in his most recent post on liquidity traps. In Tyler’s terminology, there are multiple margins on which people express preferences for liquidity. There is the money-bonds margin, and in fact, there are multiple money-bonds margins. When the nominal interest rate on short-term Treasuries is zero, that is one margin on which people are expressing a preference for liquidity. But as I argued above, there are other bonds, and people are generally willing to sacrifice liquidity for a non-zero rate of return. There is also the money-goods margin. People are generally willing to sacrifice liquidity for stuff. That is, if you give them money, they spend some of it. But since Keynes is all about aggregate spending, you can see how it would be the case that if people infinitely preferred liquidity to goods (they were unwilling to spend even if you gave them more money), then it would be desirable to have the government to engage in direct spending (fiscal policy) to boost aggregate demand.

So why does Krugman fixate on only one interest rate, on only one particular money-bonds margin? I think that it’s just a lack of imagination about what monetary policy consists of. Traditionally, monetary policy in the US has consisted primarily of open market operations on short-term US Treasuries. But there is nothing special about this particular kind of monetary expansion. If Krugman wants to call it a liquidity trap when the nominal interest rate on short-term Treasuries is zero, he needs to abandon the conclusion that fiscal policy is called for in a liquidity trap. I prefer to retain Keynes’s original meaning and conclusions by defining a liquidity trap as an infinitely elastic demand for money.

All of the numbers in play are fundamentally non-economic. Whether we’re talking about growth in measured productivity or median family income, all of the numbers used are calculated by taking some P and multiplying it by some Q. These are modes of accounting, not of doing economic analysis.

What we really want is something that captures changes in total surplus (or utility) per capita: indifference analysis. A basic question that can start off the discussion is the one I asked on Twitter yesterday:

What multiple of your lifetime income would someone have to offer to get you to agree to have been born 20 years earlier?

If you take the 20th root of that multiple and subtract one, you have an estimate of the annual growth rate of your personal economy. If you don’t have a fancy calculator handy, Wolfram Alpha is your friend.

My sense is that Tyler’s multiple is embarrassingly high (it is, after all, the Age of the Infovore). Mine is high too.

If Tyler wants to defend the stagnation hypothesis against this line of reasoning, he has two choices. First, he can say that the multiple would be even higher for earlier 20-year periods. I doubt that he would say this for himself.

Second, he can claim (correctly) that he is not the typical person. The masses are not infovores. But granting that this is the case, it’s difficult to imagine what sort of improvements could be made, even in theory, that would elicit for them the kind of welfare explosion experienced by infovores in recent decades. What do non-infovores want?

The fact is that in wealthy Western countries we’ve hit pretty severe margins of diminishing utility in terms of what we can offer non-infovores, at least those who have not recently come upon some hardship. You can say bigger houses and more leisure, but all I hear, with only slight exaggeration, is “more Muzak and potatoes.”

Tyler makes many good points, but once you accept that for many people (infovores) welfare is surging and for most others (non-infovores) it has comparatively nowhere to go, then it’s hard to call that exactly stagnation. Indeed, you could argue that we have already won the future.

The first scatterplot uses all available data.

It’s clear that there is a strong correlation between inflation means and variances (r=0.77, in fact) and an even stronger one, r=0.92, for means and standard deviations (see how the data appears to be quadratic?). But I don’t observe any evidence of clustering.

Because most of the data appears on the lower left, it may be helpful to zoom in. I repeat the plot for those countries where the mean is less than 150 percent. I also exclude the countries that have less than 15 observations.

Once again, there don’t appear to be discrete clusters. Just to make sure, let’s zoom in one more time on the lower left.

While Caplan’s proposed test does not support the Kling hypothesis, I am not sure that it effectively captures what Kling is postulating. For one, what counts as high and variable in the US is not the same as what counts as high and variable in Israel, Chile, Russia, or Zimbabwe. Secondly, if central banks have a choice between the two regimes as Kling postulates, then countries that spend time in both regimes are going to appear on the scatterplot in between the two hypothetical clusters (is this what we observe?). You can’t use a scatterplot of aggregated data to detect structural breaks. I’ll leave it to someone else (maybe one of my commenters?) to propose a better test.

Update: At Bryan’s request, here are three more graphs, zoomed in further on the lower left.

Kling’s post is particularly frustrating. It begins with the sentence:

I am not a soccer fan.

In my opinion, this should be the end of the post. If Kling does not appreciate soccer, can he not at least leave the several billion of us who do alone? If Kling feels six words is too short for a blog post, he can follow it up with this:

Therefore, I have no opinion on this game that brings joy to countless other people. Value is subjective, and I am happy to respect others’ subjective preferences.

If Epstein believes that his rule changes would improve the game, he should start his own modified soccer league and profit from its success. I would wish him the best of luck. But I am pretty sure he would not succeed, and that is because most of the world is basically happy with the way soccer works now.

As my regular readers know, I despise meddlesomeness. People should basically leave other people alone, particularly if they are not interested in receiving help or advice. However, I cannot resist the urge to engage in some retaliatory sports meddling, offered with my tongue implanted firmly in my cheek.

I am not a baseball fan. It’s too slow and boring. I propose some rule modifications borrowed from basketball and hockey. First, baseball needs something like a shot clock. I propose that no player (especially the pitcher) be allowed to hold the ball for more than five seconds, and that no more than 30 seconds should elapse between pitches under any circumstances. Violations of these rules will result in two minutes in the penalty box, and the defending team plays a man down. These modifications would not only increase the speed of the game, it would result in the elimination of fat people from professional baseball. Let’s face it—the fact that you can be both a fat slob and a successful baseball player is a damning indictment of the game.

Update — Kling, always a class act, tempers his claims: “…I gladly admit that my opinions should not count, since I know nothing about the sport.” He makes other interesting points in this new post, with which I mostly agree, addressing criticisms other than mine.