Of Stagnation and Rejuvenation
Today’s innovation revolution is making the world a wealthier and better place in many ways. So why is it that many ordinary people in developed countries feel that their lives are getting worse? There is even a chorus of experts now arguing that the children born today may be the first generation of Americans to be worse off than their parents.
The explanation for this malaise, which was evident even before the recent financial crisis, is the middle-class squeeze. Thanks to the forces of globalization and Googlization, the elites of Mumbai now lead lives as good as or better than those enjoyed by the elites of Manhattan and Munich. With the transformative power of mobile telephony and microfinance, rural women in Rwanda and slum dwellers in São Paulo’s favelas now have economic opportunities unimaginable just a decade ago. But what about Kansas?
The disruptive forces overturning the old economic order are creating enormous opportunities, but many in the struggling middle classes are not benefiting. There are various explanations for this trend, but it is at least in part because even educated, white-collar workers in many rich countries lack the skills to capitalize on those opportunities. As the broad middle of the developed world watches elites capture much of the gain from the new global order, anger and resentment are growing. Unless leaders from both the public and private sectors take steps to widen access to the economic opportunities made possible by the Great Disruption, a dangerous backlash against globalization, immigration, and innovation looks to be in the cards.
The critics of today’s economic transformation are right in suggesting that there is an indefensible inequity in how the fruits of revolution are being shared. There is even evidence to support the assertion that the United States, long the most dynamic big economy in the world, may be headed for stagnation. However, it is wrong to suggest that such a decline is inevitable or that the disruptive forces behind the global economic rise of recent decades have run out of steam.
The good news is that the new economics of innovation points to a creative set of tools, rules, and social norms to tackle this problem. The road from stagnation to rejuvenation runs through innovation.
Arianna Huffington is an optimist in general and a big believer in the future of the United States in particular. Growing up in Athens, Greece, she walked past a statue of Harry Truman every day and dreamed of moving to the land of opportunity. She had the chance, at the age of sixteen, to spend the summer with American families, and she loved it so much she vowed to come back. When she did, in 1980, she came for good and made the most of her opportunities. The flamboyant and witty migrant has grown her Huffington Post into one of the only financially successful online journals and has become an influential social and political commentator. By any measure, the United States has been good to her, and her faith in the country has been amply rewarded.
So why is she now warning that her adopted homeland is on its way to becoming a third-world country? The reason is simple. She worries that the extraordinary economic squeeze that middle-class Americans have experienced in recent years will turn the country into a place with just two classes—the rich and everybody else. That, after all, is how famously unequal societies such as Brazil and India have long been (at least until the remarkable rise of the middle classes in emerging markets of late). But now, she explains in Third World America, the warning signs are unmissable: “Our industrial base is vanishing, taking with it the kind of jobs that have formed the backbone of our economy for more than a century; our education system is in shambles, making it harder for tomorrow’s workforce to acquire the information and training it needs to land good twenty-first-century jobs; our infrastructure—our roads, our bridges, our sewage and water and transportation and electrical systems—is crumbling.”
Huffington does not want to be a Cassandra. However, she observes sadly, the other Greek woman sounding the alarm was proved right, as the Trojans discovered to their detriment. And so too may be this one, if U.S. leaders do not act. The confluence of economic and political forces squeezing the middle class today in developed countries, not just the United States, is all too real. Huffington worries that the American dream of achieving a better life for one’s children through hard work and discipline is now in peril. Though some dismiss any talk of a middle-class squeeze, many on both sides of the political aisle share her concerns. President Barack Obama declared in 2010 that “the class that made the twentieth century the American century . . . has been under assault for a long time.” And Ronald Haskins, who served as the senior White House advisor on welfare policy to President George W. Bush, stated recently, “We’ve had a dramatic increase in inequality in the country. There’s no question about that. Some people try to argue that point that it isn’t true, and I think that, you know, it’s crazy for anybody to do that. Every data set that I’m aware of shows that there’s huge, increased inequality.”
Consider the evidence. The richest 1 percent of Americans took home less than 9 percent of the country’s income in the late 1970s. By 2007, the richest 1 percent took in 23.5 percent of total national income. The last time income was that concentrated in America was back in the 1920s. Rising inequality does not have to translate automatically into a squeeze on the middle class, of course: it is possible for the very rich to get much richer even as the ordinary Joe makes a wee bit more. But in this case, the squeeze was indeed on. The modest gains in income that average American households saw in the years before the recent financial crash were often more than wiped out in practice by soaring debt payments, rising insurance premiums, out-of-pocket health care charges, and other substantial increases in the cost of living. Alan Greenspan, the former chairman of the Federal Reserve Board of Governors, warned as far back as 2005, “This is not the type of thing which a democratic society—a capitalist democratic society—can really accept without addressing.”
What is more, the squeeze is not a uniquely Yankee phenomenon. Branko Milanovic, a World Bank economist, has crunched the numbers on inequality in and among countries. He makes the important observation that global income distribution was actually made more equal by the extraordinary rise of India and China in recent decades. Indeed, judged on a global scale, the past few decades have produced something of a great leveling across the world—which is surely to be applauded. However, offsetting that were forces that led to greater inequality within important countries. He points out that while the United States is among the most unequal of developed countries, “inequality has risen decisively in Western nations over the past twenty-five years.”
If that were the end of the story, it would be merely a moral outrage. However, while some inequality in income is inevitable and even desirable (most reasonable people will agree that hard work and brilliance should be rewarded more generously than sloth and stupidity), extreme inequality strains the social compact and risks propelling societies into chaos. That is why the bigger worry is the prospect of a backlash sparked by growing inequality, as this could do much to harm the economic outlook for everyone—including the struggling middle classes. There are already signs that the stagnation and malaise seen in the United States and other developed countries is fueling anti-immigration and antitrade sentiments. If the engines of innovation that have produced extraordinary global prosperity (albeit in inequitable form) over the past few decades were to be gummed up by a halt in the flow of ideas, people, and goods, then the result may well be much slower economic growth or worse for all of society. And history shows that the battle over how big a slice of pie one gets becomes much uglier when the pie is shrinking rather than growing.
The challenge of yawning income gaps within countries threatens to undermine the innovation-driven transformation that has done so much good for so many in the global economy. A backlash is already under way in various countries, as seen in the local resentments against job-grabbing immigrants, rapacious capitalists, “socialist” big government, and other presumed enemies of the middle class—as well as the global difficulties encountered by the Doha round of trade liberalization and the latest negotiations under the UN’s Kyoto treaty on climate change. Robert Reich, a former Clinton administration official who is now at the University of California at Berkeley, argues that change is coming, for good or ill: “The question is not whether the pendulum will swing back. It surely will. The question is how it will swing—whether with reforms that widen the circle of prosperity, or with demagoguery that turns America away from the rest of the world, shrinks the economy, and sets Americans against one another.”
So what to do? Most of the explanations for the middle class squeeze involve distributional arguments: yes, the pie is growing, say critics, but greedy or well-connected elites are grabbing unfairly large shares of that pie. There is certainly truth to this argument, as Jacob Hacker and Paul Pierson show in their book Winner-Take-All Politics. Whether it is by securing income tax cuts that benefit mostly the very wealthy, lobbying for federal funding for pork-barrel projects in favored industries, or keeping in place tax breaks for employer-provided health care (which subsidizes the privileged while forcing higher insurance rates and out-of-pocket health costs on poorer working people), American elites have clearly managed to gobble up an ever bigger piece of the economic pie.
Indefensible as these are, at least such distributional problems can be addressed by the political system, if and when the two political parties in Washington decide to get serious about the country’s future. For example, one of the biggest reasons ordinary families feel poorer is the fact that an ever-increasing share of their monthly compensation (which, put simply, is a mix of cash income and health benefits) is going to pay for rising health premiums. Big business often huffs and puffs about health care inflation, which is roaring at rates much higher than the overall inflation rate for the economy, but here’s the dirty little secret: companies do not actually care too much about this issue. The federal tax code allows them to write off the total compensation paid to workers, regardless of the split between health benefits and cash income. The sharp rise in health insurance costs in recent years has not put individual companies (especially those in sectors, such as retail, that do not face foreign competition) at much of a competitive disadvantage. However, it has been a big factor behind the stagnation in the level of inflation-adjusted wages paid to the ordinary worker. That is why meaningful health reforms, going beyond President Obama’s recent efforts, that check the inflation in health care costs could help alleviate the middle-class squeeze.
This may seem difficult, but it is actually easier to carry out such reforms, which rejigger how the economic pie is divided, than it is to address another possible cause for the middle-class squeeze: that the pie has stopped growing altogether.
Is the Low-Hanging Fruit Gone?
Tyler Cowen, an iconoclastic economist at George Mason University, makes this much more disturbing argument in The Great Stagnation, the most talked-about book on economics in many years. Looking at shrinking real wages and weakening purchasing power for ordinary Americans, he observes that typical individuals in earlier generations saw a doubling of living standards every few decades. Americans today, he argues, are sinking into a great stagnation and must get ready for an era of diminished expectations. The reason, he argues, is not just because the elites are taking the biggest pieces of pie. It is, he argues controversially, because the pie itself is no longer growing as it used to. And, he adds for good measure, none of the tricks in today’s innovation tool kit described in this book will come to the rescue of the current generation of middle-class families.
That is an astonishing claim, and one that is worth scrutinizing. His central proposition is that the United States has been “living off low-hanging fruit for at least three hundred years.” Whether this was cheap immigrant labor, free land (though the Native Americans would bristle at that notion), or powerful new technologies, the country’s economic rise can be explained in large part by such gifts. Rates of economic growth in the United States have slowed down since about 1970, he thinks, because the benefits of the previous momentum were exhausted before new sources of growth were discovered.
That assertion seems to fly in the face of conventional wisdom and everyday experience, which suggest that the world is living through an extraordinary economic boom fueled by new information and communication technologies. After all, is this not the age of the personal computer, the Internet, mobile telephony, and other marvels that have done so much to improve lives and propel economic growth? His stunning answer is no: “Apart from the seemingly magical Internet, life in broad material terms isn’t so different from 1953.” He argues that earlier technologies such as electricity and railroads were much more transformative than today’s. The Internet, he claims, is a marvelous invention that has dramatically improved the quality of people’s lives—but, he insists, it has yet to make much of a contribution to jobs, productivity growth, or economic output. Many Internet products are free and Internet firms profitless; even goliaths of the sector such as Facebook and Groupon employ pitifully few people compared, say, to the automobile industry a century ago. Worse yet, he argues, these technologies will not do much to revive growth or help ease the middle-class squeeze: “We are at a technology plateau and the trees are more bare than we would like to think.” In short, innovation will not ride to the rescue anytime soon.
What should one make of this extraordinary, if deeply distressing, assessment of the future? Cowen is certainly right about a few things. The big Western economies could stay stuck in a quagmire for some years even as developing economies boom, for a couple of reasons. In the short term, the overhang of the financial crisis will keep the middle class squeezed for a while yet. High levels of unemployment and recessionary cutbacks mean that lots of workers and factories are idle. It may be difficult for many of those now unemployed to find new jobs, as evidence suggests long-term unemployment leads to the degradation of skills, creditworthiness, motivation, and marketability. The OECD estimates that just closing this “output gap” and putting the rich world back where it was before the financial crisis, never mind put the great stagnation behind, could take till 2015.
A longer-term factor is demographics. Most developed economies are aging rapidly, so the supply of new workers is about to decline just as the number of retirees (whose benefits are usually paid for by working people) is about to surge. Unless countries embrace more liberal policies on working-age immigrants from developing countries, this will precipitate a pension crisis and also lower the potential economic growth rate. Other ways out of this problem would be for workers to toil until later in life or for lots of new native-born workers to enter the workforce after receiving a decent education, but those factors seem unlikely to ease the squeeze soon. Any whisper of pushing back the age of eligibility for Social Security or government pensions prompts ugly public rows in the United States and Europe, while the biggest potential pool of unpaid workers in recent history—women—has already entered the workforce of wealthy countries in droves over the past few decades.
In addition to battling those headwinds, the economies of the developed world have a problem with productivity growth. This matters for several reasons. First and foremost, it matters because economic growth is driven by two chief factors: population and productivity. In emerging economies, the first factor can play a big role, as populations are often young and labor forces are expanding rapidly. But that is unlikely in mature economies, which tend to have stable and aging workforces. That is why in the advanced world, improving productivity—that is, producing ever more valuable goods and services with each unit of labor—is the most powerful way to grow faster. The arrival of information technology fueled a productivity boom in the late 1990s in the United States, as did the wider adoption and diffusion throughout the economy of related software and productivity tools in the early 2000s. Europe also improved, but not nearly as much as the United States, perhaps because its markets are less competitive. So companies there invested less in improving services and business processes in such sectors as retailing. The upshot is that productivity growth was losing steam in developed countries before the global financial debacle.
So Cowen is right to sound the alarm about the productivity engine sputtering, as this engine is the closest thing governments have to a silver bullet when it comes to revving up economic growth and creating the good jobs that will end the middle-class squeeze. But he goes further, postulating that no new productivity miracle is in the offing. The 30 percent or so of workers that benefit directly or indirectly from the rise of the Internet and computing (be they Google software engineers and high-end content providers, Geek Squad technicians who install high-tech equipment in the homes of the technologically challenged, or artists who design funky iPad cases) will thrive, he guesstimates, while the rest of society will be relegated to an underclass that will fall ever further behind.
Is he really right in suggesting that rapid productivity growth will become impossibly difficult because the low-hanging fruit is gone? More to the point, is he right in arguing that today’s remarkable innovation revolution will do little to ease the middle-class squeeze anytime soon? Only time will tell for sure, but there are good reasons to be more optimistic if—and this is a very big if—governments take the right steps to kick-start growth and fuel innovation.
The Only Silver Bullet
The New Yorker ran a lovely cartoon in 2011 that captured thousands of years of economic history in a snapshot. The artist sketched a Stone Age scene, with a small family huddled together around a big rock. The only material possession in sight is a stick held by a child. The father looks at his son and says somberly, “When I was your age, things were exactly the way they are now.”
It is hard for people in the developed world to believe this, but through almost all of mankind’s history, economic stagnation was the norm, not the exception. Until about three hundred years ago, the per capita income of all but the very elite (think pharaohs and kings) remained grindingly small. That is why the lives of sons were remarkably similar to those of their fathers. But the industrial revolution sparked a surge in economic growth that raised living standards and disposable income dramatically. Angus Maddison, an economic historian, has calculated that the average European was four times richer in the middle of the twentieth century as his counterpart was in the early part of the nineteenth century. Revealingly, the average American got eight times richer over that same period but—thanks to government policies of the day that were hostile to the diffusion and adoption of new technologies and ideas (in other words, the essence of innovation)—the average Chinese person actually got poorer.
So could the past turn out to be prelude for the middle class? First consider the notion that the days of rapid productivity growth are gone. The McKinsey Global Institute (MGI) has done a detailed investigation of the matter. Asked if Cowen is right, James Manyika, a director at MGI, replies yes and no. Without a productivity boost, today’s younger generation will see slower increases in living standards. By his group’s calculations, Americans born in 1960 saw their GDP per head grow 2.5 times by the age of forty; those born in 2000 can expect to see it grow only 1.6 times by that age on current trends. That is hardly stagnation, but it is fair to say America may be entering an age of diminished expectations unless productivity growth speeds up. And that will not be easy: MGI estimates that U.S. productivity growth needs to accelerate by nearly a third from current levels to sustain past GDP growth rates over the next decade, assuming no increase in labor inputs.
Nevertheless, there is reason to think productivity growth can pick up. For one thing, the argument that there is no low-hanging fruit may be wrong. The United States may have one of the most efficient big economies in the world, but there are still plenty of corners of inefficiency and waste. For example, health care gobbles up some 18 percent of U.S. GDP, far and away more than what any other rich country spends on this, but international comparisons show that the country gets only mediocre health outcomes. There is plenty of evidence that money is wasted, inventions are needlessly gold-plated, and costs are merely shifted around from one part of the sector to another. Similar arguments can be made about the U.S. public education sector, which is crying out for innovation and efficiency gains.
MGI has scrutinized the American economy and found that there is “plenty of headroom” for future productivity improvements. About three-quarters of those gains look to come from the private sector, and a quarter from government and quasi-public sectors such as health care. Even if Cowen is right that the lowest-hanging fruit is gone, there are surely plenty of lowish fruits that can be reached, albeit with a bit more effort. That suggests the tree is not bare. What is more, the MGI work debunks the perception held by some that productivity gains inevitably come with massive job losses—an understandable sentiment given the mass layoffs undertaken by employers during the recent financial crisis under the guise of productivity enhancement. The think tank looked back across the past century and found that for every rolling ten-year period but one, productivity improvement went hand in hand with rises in employment.
Ah, but what about Cowen’s bolder claim—that technology has run out of steam and that innovation will not come to the rescue of the United States anytime soon? If that were true, that would cast doubt on the central arguments of this book: that the world’s grand challenges, as well as the middle-class squeeze, could be tackled by a wave of socially useful innovation. One pillar in his argument is his assessment that Internet companies, which are giving many things away for free, are not producing much economic value. That is a questionable assertion. While it is true that lots of things appear free at the point of use—think of Google searches or coupons from Groupon—in fact there is value being created discreetly. The personal data that Google collects from searches allow it to tailor its lucrative online advertising, just as the “vapor trail” of data left by (mostly unwitting) users of location-based services such as Foursquare allows such firms to profile users and create data analytics that investors believe to be hugely valuable. And this Big Data goldmine is unlikely to be tapped out anytime soon: astonishingly, Google estimates that some 15 percent of the search requests it receives every day are new and unique.
Another pillar in Cowen’s argument is that previous revolutionary technologies have taken many decades to transform societies. Since the Internet is relatively young, he argues, this means that any big economic dividends are a long way off—and therefore innovation will not save the middle class anytime soon. He points to deep economic analysis done by Alexander Field in A Great Leap Forward, a book that overturns conventional wisdom by demonstrating that the decade that saw the greatest productivity advance in the twentieth century was the 1930s. (Previously, many argued that it was the wartime efforts at resource mobilization that kick-started the golden economic era of the 1950s and 1960s.) Field shows that during the Great Depression, companies adopted dramatically better processes and technologies that eventually led to such marvels as streamlined cars with automatic transmissions, diesel locomotives, and a world-beating film industry in Hollywood. The point about the long cycles of innovation is surely right: invention often comes in a fast and furious flurry, but the real economic gains are usually realized only decades later as those inventions are adopted and adapted throughout society.
But this argument ignores the fact that lots of money has been invested in fields other than the Internet over the past few decades and it is quite possible that those long-term investments will pay dividends in the next decade or two. Bill Gates has little time for talk of stagnation: “Bah—would you rather live in the 1950s?” Thanks to those decades of investments in research and development, Gates says, he sees extraordinary progress coming soon in fields ranging from energy storage to advanced materials to genomics. The first problem with the techno-pessimistic view, he argues, is one of time horizons. If one speaks of just a few years, the view may be right, but if one speaks of the long term, it is surely wrong, he thinks. The second problem, he argues, has to do with the inadequacy of metrics such as productivity and GDP, which do not capture many ways in which technology is improving lives. For example, how does one calculate how much humanity’s lot has improved because of the arrival of Wikipedia, which puts more information into the hands of schoolchildren in the world’s poorest villages than the American president commanded just a few decades ago? And, asks Gates mischievously, “who changes flat tires anymore?”
Beyond Stagnation
This debate is likely to rage for some time yet, and eyes are sure to glaze over as the economists and technologists clash, but here is why everyone needs to pay attention. The concerns voiced today by Tyler Cowen about the United States may soon ring true for other countries too if governments fail to fix bad policies that retard innovation and implement good ones that boost it (a topic taken up by a later chapter, “The Sputnik Fallacies”). Even before the financial crisis, Europe had a problem with productivity growth worse than that of the United States, and Japan’s lost decade of economic malaise has already produced a lost generation of youth. The Middle East desperately needs to create new jobs too, if the hopes raised by the democratic uprisings of the Arab Spring are not to be cruelly crushed: the World Bank estimates that the region needs to create eighty million more jobs by 2020 just to absorb new entrants into the labor pool without loss of living standards. And even China, the source of much of the dynamism in the world economy of late, will face a crisis in time thanks to its one-child policy. Unlike India, which looks to enjoy a “demographic dividend” as lots of young workers enter the economy soon, China’s workforce is aging and there are not enough children to fill the void.
The surest path from stagnation to rejuvenation runs through innovation. To see why, consider the lessons offered by the new economics of innovation and “intangible” capital. In early 2011, Ben Bernanke, the current chairman of the Federal Reserve Bank’s Board of Governors, gave an important but little-noticed speech at a conference at Georgetown University that sketched out the relationship between innovation and growth: “Innovation and technological change are undoubtedly central to the growth process; over the past 200 years or so, innovation, technical advances, and investment in capital goods embodying new technologies have transformed economies around the world . . . in addition, recent research has highlighted the important role played by intangible capital, such as the knowledge embodied in the workforce, business plans and practices, and brand names. This research suggests that technological progress and the accumulation of intangible capital have together accounted for well over half of the increase in output per hour in the United States during the past several decades.”
Bernanke’s praise for the role of innovation in sparking economic growth heralds the triumph of the new economics of innovation. Traditionally, economists did not think too much about technology and its impacts on economic growth. That began to change as research by a camp of economists, most prominent among them MIT’s Robert Solow (who later won a Nobel Prize for this work), suggested that technical progress dwarfed the role played by labor and capital in determining economic growth in modern economies. That laid the foundation stone for new growth theory, an influential update on Solow’s work that was pioneered by Paul Romer, a longtime Stanford economist who has recently moved to New York University. The essence of this philosophy is the notion that the source of economic progress is ideas.
That is a radical departure from classical economic thinking, which focused on traditional means of production such as land, labor, and capital. But research and elaborate calculations done by economists in Romer’s camp show that growth is driven not merely by physical objects but mostly by smarter ways of manipulating physical objects that create new goods and services that satisfy society’s unmet needs: in short, by innovation. As Romer puts it, “The classical suggestion that we can grow rich by accumulating more and more pieces of physical capital like forklifts is simply wrong . . . any kind of physical capital is ultimately subject to diminishing returns.” In contrast, he observes, knowledge is subject to increasing returns.
That is the essential insight of the age of innovation. Because more than one person can make use of such knowledge-economy goods as software at one time, such goods are tremendous drivers of productivity. After all, though it may cost Microsoft hundreds of millions of dollars to produce the first copy of a new software program, it costs the firm next to nothing to produce the millionth or billionth copy. Romer invokes the analogy of a kitchen to explain his theory. Mixing inexpensive ingredients according to a recipe creates valuable new dishes. Most people believe the limit on growth is the number of ingredients available to cook according to a given set of recipes. Ah, but if ingenious new chefs devise better recipes, then society could generate more economic value per unit of raw material.
The new economics of innovation offers a powerful rebuttal to the notion that resource scarcity limits growth and dooms mankind to stagnation. As Romer puts it: “Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. Possibilities do not add up. They multiply.”
This is not to say that innovation is easy, of course, or that the current pace of progress is unprecedented. The great Victorian age of invention brought the world many marvels, including the telegraph, which lifted productivity at the time and laid the foundations for progress in the century to follow. Hal Varian, the chief economist at Google, has observed that technology changes, “but economic laws do not.” He notes that even in today’s Internet economy such age-old factors as inflation, business cycles, profits, and monopolies all still matter.
Romer himself offers the most powerful note of caution. Ask him about Cowen’s thesis on the great stagnation, and he offers a surprising response at first: “I agree with him that something big has gone wrong in the United States since the 1970s.” He agrees productivity is not growing as fast as it should be, but he strongly disagrees that the reason is the rate of arrival of new technologies. Rather, he argues, the problem is rules: “New technologies absent the right rules can be harmful.” He points to the example of fisheries, where new technologies in netting and trawlers have led not to greater economic value or sustainable productivity gains but to overfishing, declining stocks, and industrial decline. By rules he means more than a static set of regulations or the rule of law; his “rules” can range from bankruptcy codes to government regulations to social norms around corruption. He insists they need constantly to adapt to keep pace with changing technologies, societal mores, and the effects of scale. Intellectual property is another set of rules that influence the pace of innovation. Romer acknowledges the importance of issuing patents as an incentive for inventors, but argues that current rules may need to be softened to allow for greater and more rapid dissemination of ideas.
Societies that get these rules right will benefit more from the invention and adoption of new technologies than will those with rules that are distorted, perverse, or captured by elites. He worries, for example, about the lobbying power of incumbent industries to defend the status quo and win such perks as outsized executive compensation. To help developing countries accelerate their development process by leapfrogging to good rules, he is now campaigning for special charter cities to be carved out of developing countries. Some call it neocolonialism, but he insists these newly created zones would operate independent of local elites under the authority of benevolent foreign overlords applying time-tested rules and good governance (rather as Britain did in Hong Kong). As for the malaise of the United States, Romer believes that the wrong rules allowed such sectors as health care and finance to suck in huge resources without producing much value for society.
The rules that a society adopts influence not just the total amount of effort that goes into innovation, he argues, but also the types of problems that all this innovative effort is trying to solve: “If some of the best minds of the current generation are spending their time trying to figure out innovative ways to engage in rent-seeking instead of creating value, human progress will suffer.” This is what happened as the financial sector in many Western countries, most notably in the United States and Britain, became increasingly disconnected from the real economy. The American financial industry grew dramatically during the bubble years preceding the recent crash, with its size soaring to historical highs of nearly 8.5 percent of U.S. GDP; in 1990 it was under 6 percent and in 1970 roughly 4 percent. But this growth was based on illusory innovations and unsustainable gains, as the collapse later revealed. Worse yet, there is some reason to think that the lure of easy money on Wall Street sucked some of the brightest and most enterprising people away from careers in other fields that have traditionally produced socially useful innovation and entrepreneurship.
That, in sum, is why innovation matters so much at the level of the ordinary person. Today’s middle-class squeeze is not just the result of the Great Disruption of the global economy: it is also the result of countries clinging to the wrong rules for encouraging innovation and sharing its gains. The final section of the book investigates what the right rules are by asking what governments, companies, and individuals can do to encourage innovation in the first place. But before turning to that question it makes sense to consider, as the next section does, the dramatic ways in which innovation itself is changing. After all, as Ben Bernanke pointed out, it is intangibles such as the know-how inside the minds of innovators that are increasingly driving innovation.