For Economist Paul Romer,
Prosperity Depends on Ideas

By BERNARD WYSOCKI JR.
Staff Reporter of THE WALL STREET JOURNAL

PALO ALTO, Calif. -- More than 220 years after Adam Smith wrote "The Wealth of Nations," economists are still arguing about what makes nations wealthy. They really don't know.

Paul M. Romer is sure he does.

Mr. Romer, a 41-year-old professor at Stanford University, says ideas and technological discoveries are the driving engines of economic growth -- especially ideas that can be codified in a chemical formula, or used to improve organization of an assembly line, or embodied in a piece of computer software.

"Ideas are different. Ideas have special properties," he says. While things such as land, machinery and capital are scarce, Mr. Romer argues that ideas and knowledge are abundant and that they build on each other and can be reproduced cheaply or at no cost at all. In other words, ideas don't obey the law of diminishing returns, where adding more labor, machinery or money eventually delivers less and less additional output.

You might be tempted to say "big deal." Everybody knows ideas are important. But in economics, saying you have found the way around diminishing returns is akin to saying you have discovered the Fountain of Youth.

While this has brought the soft-spoken, tenacious Mr. Romer praise and publicity, it has also subjected him to plenty of analytical barbs from fellow economists. His ideas go by the name of "New Growth Theory," but to some, the theory is still "so-called new growth theory."

The critics say, for example, that if the U.S. has the most ideas and greatest engines of discovery, then it should be the fastest-growing economy, right? But "the richest country is never the fastest growing and never will be," says Mancur Olson Jr., professor of economics at the University of Maryland at College Park.

Nevertheless, in the decade since he first started publishing his thoughts, Mr. Romer has become ever more convinced that he has unlocked the main mystery of growth. He has moved from writing in the dense notations of algebra and Greek letters to putting things in plain English for a wider audience. Because computers, networks and software serve as his best illustrations of how ideas create prosperity, the techie community has returned the compliment by treating him like a rock star. Wired magazine, a bible of the digerati, has featured him in an article.

Bankers Sign On

Bankers have turned to him for insight, as they try to become more like venture capitalists but worry about the risks of financing ideas as opposed to making loans against conventional assets -- bricks and mortar and machinery. Royal Bank of Canada, for instance, has sponsored Mr. Romer at a Canadian think tank and repeatedly has called him in for talks.

"Paul's advantage is in opening the mind," says Gordon Feeney, vice chairman of Royal Bank, which also is opening its wallet. Last month, the bank increased its capital in a venture-financing arm devoted to "knowledge-based" industries such as computing and bioscience to $350 million, from $150 million. Royal Bank also has taken partial ownership stakes in some of these high-tech companies.

Politicians also sometimes latch onto the New Growth Theory as the launching pad for huge government-funded projects, such as magnetic levitating trains. Mr. Romer, son of Colorado Gov. Roy Romer, practically goes ballistic over the way he says liberal-leaning members of the first Clinton administration twisted his ideas.

Former Libertarian

"There have been repeated attempts to kind of suck me in by people who want to use New Growth Theory to justify big government. I think it's intellectually wrong and politically naive," Mr. Romer says. He says that he is all for greater spending on research and development but that public megaprojects leave him cold.

Mr. Romer, who received his doctorate in economics from the University of Chicago in 1983, says that he was a libertarian in earlier days but that he has mellowed somewhat and sees a role for government in innovation. But he thinks the bailout of Chrysler Corp. in the early 1980s was a big mistake, saying Ford Motor Co. and General Motors Corp. would have responded faster to competitive pressure if Chrysler had been allowed to sink.

And he takes a Darwinian view of International Business Machines Corp., which was in deep trouble a few years ago. "I'd like to think -- although I'm not sure it's true -- that we'd be able to stand by and let IBM fail," he says. When the established order is protected, he says, the nimble innovators don't get their chance.

Within the economics profession, Mr. Romer remains a maverick: influential, to be sure, but outside the mainstream. By all accounts, he has helped reignite interest in the causes of long-term economic growth, an area that enjoyed a boom in the 1960s and then went dormant. In so doing, the work has called renewed attention to an earlier generation of growth economists, such as Robert Solow of Massachusetts Institute of Technology. The growth boom also has called forth a blizzard of research and doctoral dissertations. Some outside the economics field have rated Mr. Romer a shoo-in for a Nobel prize someday, a thought that makes him wince. He believes such talk is foolish.

Today, Mr. Romer's New Growth Theory is getting pushed through the gantlet of academic scrutiny, debate and critique: a tantalizing idea, some say, but does it deliver on its promise of increasing returns?

"New Growth Theory -- some of Paul's work in the 1980s -- offered that promise. But it is still, to a large extent, a promise," says Paul Krugman, a star economist who has taught at Massachusetts Institute of Technology and at Stanford.

The jury is still out on Mr. Romer's work because many economists haven't seen convincing evidence that big investments in ideas lead to higher growth rates. Given that the U.S. does 44% of the world's total research and development, far more than any other nation, then, critics ask, shouldn't it enjoy much faster growth than the 2.5% annual rate or so of recent years?

Apples and Apples

Mr. Romer acknowledges that some once-poor countries such as South Korea have grown much faster than the U.S., but he believes the best test is the U.S. against other advanced countries. He says, for example, that the U.S. economy has grown slightly faster than Britain's for about 100 years, resulting in a significant difference in the two nations' gross domestic product per capita today. Mr. Romer says greater U.S. investment in knowledge and discovery is the key.

Mr. Romer's ideas have an almost emotional pull for some economists, Mr. Krugman added, because the world Mr. Romer describes is more interesting than the world of the classical economic models, where the laws of diminishing returns are pervasive. His theories offer a promise of "increasing returns" as knowledge feeds on itself and compounds, and as the rate of economic growth actually accelerates over time. While Mr. Solow pointed out the role of technology in growth -- and won the Nobel Prize for it -- he considered technology something like manna from heaven. It just dropped out of the sky.

Mr. Romer's theories set technology right inside the economic model. One illustration: It might have taken Microsoft Corp. hundreds of millions of dollars to develop the first copy of a Windows software release. But the second copy costs next to nothing. It isn't distributed freely, but it does get replicated very cheaply. Moreover, your use of the "knowledge" embedded in Windows doesn't interfere with my ability to use it at the same time. It isn't "scarce" like money, machinery or even labor.

One real-world lesson is that getting prices right is one of the trickiest problems in the new economy. To Mr. Romer, that usually means low prices. He points out that Xerox Corp. developed a mouse-windows-icon workstation in the 1970s but set the prices exorbitantly high. Apple Computer Inc. adapted the idea and brought the friendly world of point-and-click to a mass audience. So have Microsoft and Intel Corp., at even lower prices.

'Creative Destruction'

Yes, Mr. Romer says, the knowledge-based economy spawns quasimonopolies such as Microsoft, but if we keep patents and copyrights limited, the Microsofts get their inevitable comeuppance. They get overtaken by somebody else in a process of "creative destruction" -- a phrase of the late economist Joseph Schumpeter that is often invoked by Mr. Romer to describe the process and the promise of growth.

It is the spread of this knowledge, and its almost infinite variation and refinement, that is the key to economic growth, he says.

What does all this mean to noneconomists? In the developing world, Mr. Romer says, his theory would mean it makes more sense to put more emphasis on transferring ideas, especially via multinational corporations, and less emphasis on building roads and factories -- traditional capital-spending solutions. In the U.S., he thinks huge government infrastructure projects tend to be pork barrels for politicians. Better to get industries to self-finance the development of knowledge.

Not everybody buys Mr. Romer's ideas. But few doubt that he has helped trigger an important and continuing debate. After all, fostering economic growth and boosting living standards is the ultimate goal of much economics and most government economic policies. And the growth issue has huge importance in developing countries, particularly the dozens of poor nations where per-capita income growth is just a hope and a dream.

But economists can't agree.

"Economists' views on the nature and causes of the wealth of nations are, today, more than usually divergent," says J. Bradford De Long, professor of economics at the University of California at Berkeley. "The theory of economic growth today is up for grabs."

No Simple Answers

A huge stack of literature has poured forth on long-term growth, some by Young Turks, some by an older generation of growth theorists. One of the latter is Mr. Olson of the University of Maryland, who sees "market augmenting" government as the most important factor in long-run growth. Other economists see levels of investment, high levels of primary-school enrollment, the widespread use of an international language or the openness to international trade as the key.

They eschew the simple answers popular in political campaigns -- either lower interest rates or lower marginal tax rates -- as too facile and unlikely to make a big difference in long-run growth.

As the growth debate has heated up, economists have pored over a huge array of cross-country data, searching for the smoking gun, or perhaps the magic bullet of growth. But this sort of analysis has a problem: It is hard to isolate and test any factor.

"This isn't like testing fertilizer," says N. Gregory Mankiw, professor of economics at Harvard University. "We know that the high-investment country tends to grow faster, but what does that mean?" he asks. Maybe it means investment causes growth. But maybe it means just the opposite, that fast-growing countries decide to invest more.

Mr. Romer has heard the arguments and debated them with Mr. Mankiw and others. But on a recent morning, the trim, boyish-looking Mr. Romer brings his arguments to the classroom. Mr. Romer is about to start his third lecture as a professor at the Graduate School of Business at Stanford University.

In the class of nearly 50 students, Mr. Romer is trying to get across the guts of his theories without complex equations and Greek letters. Instead, he is searching for analogies, for plain English, for examples from everyday life.

"So what's the sense in which ideas lead to economic growth?" he asks.

There is a pause. One student says something incoherent. Silence. Then another mumbles that ideas are like recipes.

"Did you say 'recipes'? That's exactly the word I was thinking of," Mr. Romer says excitedly. "Yeah, you need ingredients, you need some capital like an oven, and some human capital, the skill of the cook," he says. "But what we have are very sophisticated recipes that help us transform raw materials -- stuff that isn't terribly valuable -- into things that we value a lot."

The Key Difference

It sounds tame enough, but this is where Mr. Romer differs from many of his colleagues. Is the recipe really more important than the oven? Mr. Romer says absolutely yes. Or how about the skill of the cook? That is human capital, one of the M.B.A. students says. Isn't that the key?

Mr. Romer says no. It isn't savings, or capital spending, or the addition of labor, or even "human capital" -- a fancy name for education. "If you try and install more and more blast furnaces and more and more fork-lift trucks, diminishing returns to the existing stock of physical capital eventually kicks in so hard that you don't get any long run benefits out of it. It's the underlying rate of technological change that determines the growth rate."

As for human capital, he says that is like learning a foreign language. Once you die, it is gone. Research and development is crucial, he believes, but subsidizing companies to perform them is the wrong way to go. Better for companies to match wits in the market and to match up their research with the needs of their business units, without making either one the slave of the other.

Mr. Romer doesn't think having the federal government carry out massive high-technology projects is very smart, either. He believes subsidizing graduate studies in science and engineering is a better use of the money -- that may be a professor's bias -- because it will increase the supply of idea generators, and perhaps cut their salaries in the market, allowing companies to create breakthrough innovations at lower cost.

To him, it is another aspect of "increasing returns," as the steady accumulation of knowledge brings forth new entrants with better ideas. "Science is cumulative," he says. "That's why I'm optimistic."

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