Will Thomas and I gave a talk on Austrian Economics at Atlas Summit 2016, where I pointed out that Austrian Business Cycle Theory (ABCT) does not fit the empirical facts. ABCT claims that increasing savings/capital are the cause of economic growth, which is very similar to what classical and neo-classical economics states. I pointed out that in fact it is increasing levels of technology (inventions) that are the cause of economic growth not increases in capital. One of the questioners after the talk stated that inventions (technology) are part of capital.
Many people want to conflate increasing levels of technology with capital, however they are not the same. Capital as used in economics means those durable goods used in production.
In economics, capital goods, real capital, or capital assets are already-produced durable goods or any non-financial asset that is used in production of goods or services.
Adam Smith defines capital as “That part of a man’s stock which he expects to afford him revenue”. https://en.wikipedia.org/wiki/Capital_(economics)
The article goes on to explain how to determine if something as capital.
Classical and neoclassical economics regard capital as one of the factors of production (alongside the other factors: land and labour).
This is what makes it a factor of production:
The good is not used up immediately in the process of production unlike raw materials or intermediate goods. (The significant exception to this is depreciation allowance, which like intermediate goods, is treated as a business expense.)
The good can be produced or increased (in contrast to land and non-renewable resources). https://en.wikipedia.org/wiki/Capital_(economics)
Technological change is not a good, it is the process of inventing. It is true that when these new inventions are reproduced (manufacturing) then when purchased they become capital, but that is several steps removed. If we treat technological change as just part of capital then going out and purchasing capital goods is the same thing as inventing. However, the results are not the same. Purchasing (acquiring) capital without invention results in no real per capita increases in wealth over the long run. As a simple example assume that every farmer in the U.S. has the latest most up to date tractor their land can use. Adding more tractors (capital) does not increase the output of these farms. The same is true for capital in general.
A number of economists have pointed out that increasing levels of capital are not responsible for the tremendous economic growth experienced in the West since the Industrial Revolution. Among these economists are Robert Solow, Paul Romer, and Deirdre McCloskey. They all point to increasing levels of technology as the cause for our increased wealth. Our standard of living is defined by our level of technology.
On the other hand inventing at a faster rate does produce real per capita increases in wealth. Inventions can produce returns that are staggering. For instance, Eli Whitney’s invention of the cotton gin allowed a forty times increase in the output of cotton in the U.S. in one decade.
In science it is important to isolate the factors effecting an experiment. For instance, if you conflate wind resistance and gravity then you end up with the nonsense that heavier objects fall faster than lighter objects. This means you will never be able to create a parachute or an airplane.
In economics if we conflate inventions with capital, we make the mistake that third world countries will become wealthy if we provide them capital. In fact, this is exactly what Development Economics has said for years despite overwhelming evidence to the contrary. Conflating these two concepts will cause us to ignore the role of property rights for invention as being the biggest long term driver of wealth and instead focus on capital gains taxes or increasing the savings rate or increasing comsumption.
Inventions are the cause of real per capita increases in wealth, not capital. Conflating the two is illogical and results in nonsensical economic policies.
This book, Capital in Disequilibrium: The Role of Capital in a Changing World by Peter Lewen, is supposed to be Austrian Economics’ answer to “new growth theory”, which recognizes that new human knowledge is the most important component to economic growth. As opposed to the “old” ideas on growth which claimed economic growth was the result of increases in land, labor, or capital. Old school growth theories focus primarily on increases in capital. Perhaps the two biggest figures in new growth theory are Robert Solow and Paul Romer. Robert Solow won the Nobel Prize in economics for his econometric study showing that technological change was the key driver in the US economy. Sadly he then said technological change was not part of the study of economics, it was like background radiation and beyond our control. Paul Romer takes over from Solow by making technological change part of the study and policy recommendation of economics.
This book suffers from many of the same problems other economists who have explored new growth theory have had. They attempt to graft the findings of new growth theory onto their preconceived ideas about economics. For example, Robert Solow is a Keynesian so he has attempted to just tweak Keynesian ideas to fit this new information, instead of understanding that this new information required a whole new look at and approach to economics. Paul Romer is what I would call a “mathematical Keynesian” and is also trying to fit a square peg into a round hole.
This book attempts to take the finding s of new growth theory and meld them into Austrian Business Cycle Theory (ABCT). ABCT claims that economic growth is the result of increases in capital/savings. There is no evidence that increases in savings or capital in anyway result in economic growth and plenty of evidence to the contrary. Pasting some of the ideas of new growth theory onto ABCT neither solves the problems with ABCT nor adds anything to new growth theory.
The author’s ideas on scientific and technical knowledge come from Karl Popper, who has argued that knowledge is impossible. This is not surprising as it is consistent with Hayek’s ideas of cultural evolution, which argues that reason is limited and it is conceit to suggest that anyone can use reason to determine a correct societal structure. Both Hayek and the author are fans of David Hume (See Lewin’s youtube “Peter Lewin on Austrian Capital Theory – Part 1”). David Hume you will remember said causality was an illusion and brought us the “is ought” problem in ethics. In other words, Hume attacked the very basis of reason, logic, and ethics. Hume is part of the Scottish Enlightenment, which elevated emotions above reason. The Scottish Enlightenment underpins all of Austrian Economics. The other philosophical tradition behind the Austrians is philosopher Franz Brentano who raised the psychology of the person to a primary.
It is not surprising then that the author concludes “The superior performance of capitalist economies cannot be logically ‘proved.’” Under the author’s ‘implications for policy’ section we get this,
“It involves not only, or primarily, the addition of existing capital equipment but rather the introduction of progressively more technically advance equipment, the production of which is made possible by an institutional environment in which the discovery of such technical advances is encouraged.”
Interestingly enough the author never explains what encourages technological advances and he never even mentions property rights for inventions, i.e., patents. Even Solow and Romer realize that they cannot ignore patents, however contrived their arguments are for dismissing them.
One of the reasons the author ignores patents is that he emphasizes what he calls “tacit knowledge.” Tacit knowledge is something we know but cannot prove or of which we are not conscious. This is perfectly consistent with the Austrian ideas that reason is limited or ineffectual. As a result, he talks a lot about innovation and never mentions inventors. He talks about organizations, but never individuals. He talks a lot about production and ignores invention. Austrians like to scream they are capitalist or free market, but they are certainly not pro-individualistic. This is not surprising as this would require a commitment to the power of the individual mind to understand the world. The author further reveals his collectivist ideas when emphasizes that the knowledge that is important to the economy is “social knowledge.” The Austrians are collectivists. They believe central planning interrupts the functioning of the process of gaining “social knowledge.”
This book does not contribute anything to new growth theory. The only reason to read this book is to better understand the underlying principles of Austrian Economics, which are not pro-reason, pro-individual, or pro-capitalism (The economic system that occurs when the government protects individual rights.)
 A Graphical Introduction to the Austrian Business Cycle Theory, Gaurav Mehra, https://mises.ca/posts/articles/a-graphical-introduction-to-the-austrian-business-cycle-theory/, accessed 9/8/15
 [This] technique has been applied to virtually every economy in the world and a common finding is that observed levels of economic growth cannot be explained simply by changes in the stock of capital in the economy or population and labor force growth rates. Hence, technological progress plays a key role in the economic growth of nations, or the lack of it. http://en.wikipedia.org/wiki/Growth_accounting.
This is a multi-part post on the science of economic growth. Standard economic theory has failed miserably to define the source of economic growth, which means it is impossible for it to provide rational policies to restore economic growth. This series of posts defines a scientific theory of the source of economic growth.
Exogenous vs. Endogenous
Robert Solow assumed that inventions were exogenous and therefore the most important factor in economic growth was essentially out of the reach of economic policy. The exogenous model of growth has been refined by Michael Kremer and more recently by Klasen and Nestmann. These models start with the assumption that inventors (brilliant or lucky) are randomly distributed through out population. As a result, high population rates will lead to higher rates of invention, which will lead to increases in population (Malthusian Assumption). This assumption works reasonably well throughout history, until the Industrial Revolution. There have been attempts to refine the exogenous theory by adding population density. However, none of these adjustments to exogenous theory can explain whyEngland was the epicenter of Industrial Revolution. France had a larger population by a factor of three and larger GDP and equally talented scientists. Why did the U.S. overtake England’s GDP by the 1850s or why the overall GDP per capita and level of technology of the West grew so much faster than the East? The one factor that is consistent is the rate of invention.
A number of economists have shown that inventors are motivated by financial return. For instance, Jacob Schmookler, in Invention and Economic Growth, shows that demand or expected return is the biggest factor affecting the number of inventions in a particular industry. He also examined the role of scientific advances in the creation of new inventions and found that these had minimal effect on the number of inventions. His results were echoed by economic Historian Zorina Khan. She provides extensive evidence that the US patent system and economic forces affect both the level and direction of invention. She shows that the US created the first modern patent system and the patent system provided the major incentive that caused the US to grow from an agrarian economy to a world economic and technology power in just 70 years. Note there was very little government sponsored research and development at the time.
Perhaps the best known endogenous growth theory economist is Paul Romer. Romer makes the distinction between physical property, which is rivalrous, and ideas or recipes as he calls them, which are non rivalrous. He claims that:
With ideas, you have this tension: You want high prices to motivate discovery, but you want low prices to achieve efficient widespread use. You can’t with a single price achieve both, so if you push things into the market, you try to compromise between those two, and it’s often an unhappy compromise.
Romer is ambivalent about patents for this reason. He likes the incentive they provide for creating new inventions. However, he believes that it slows down dissemination of new technologies and results in monopolistic competition.
He further states: “Because everybody can use the idea at the same time, there’s no tragedy of the commons in the intellectual sphere. There’s no problem of overuse or overgrazing or overfishing an idea.”
This statement is misleading as applied to inventions and patents. As soon as the invention is realized in a physical form, then the invention is subject to the same scarcity issues as any other good or service. The total market for an invention is limited (scarce) at a particular point in time and the goods and services necessary to realize an invention in its physical form are also scarce. When the infringer of a patent makes the invention, he reduces the market value of the invention to the inventor. Patent law not only recognizes that ideas cannot be overused by too many people knowing about them, patent law actually encourages the spread of ideas. A primary goal of a patent system is the spread of technical information. Before modern patent systems, people and companies kept their inventions trade secrets, which inhibited the spread of information. In theU.S., our patent system created a number of patent depository libraries to encourage the spread of technical information. It is one of the requirements of patents that the information on how to “practice the invention” is part of the quid pro quo for receiving a property right in your invention. Specifically, 35 USC 112 states:
The specification shall contain a written description of the invention, and of the manner and process of making and using it, in such full, clear, concise, and exact terms as to enable any person skilled in the art to which it pertains, or with which it is most nearly connected, to make and use the same, and shall set forth the best mode contemplated by the inventor of carrying out his invention.
Romer’s statement that ideas are not subject to the tragedy of the commons is misleading in another sense also. One of the problems with commons is that when no one owns a resource, no one invests in the resource – or at the least they under-invest in the resource. A system of limited term property rights for inventions is not the unhappy compromise that Romer suggests. It encourages the spread of information about the invention and it provides incentives to both create new inventions and to invest in the dissemination of inventions. Romer implies that it takes no resources to disseminate new inventions and others explicitly state this, but they are incorrect. Inventing the electric light bulb did not allow instantaneous use by people throughout the World. It required investment in manufacturing plants, distribution, an electrical power system, etc. Without secure property rights in the invention, there would have been no incentive for anyone to invest in this dissemination of technology. This was clearly shown in a study by Professor Hughes. The study, British Electrical Industry Lag:1882-1888, examined how limitations on the rights (profits) of British companies attempting to provide electrical lighting resulted in the British lagging significantly behind the United States. Without the incentive of ownership, the British were unable to provide electrical lighting to their country. Lack of strong property rights resulted in under-investment in the electrical industry inBritain. Professor Hughes examines a number of other potential explanations. Differences in technological talent between theU.S. andBritain? The British had more and better trained engineers. The effect of economic downturns? Both countries suffered economic downturn at the same time. Interestingly enough, no other explanation accounts for the difference in the dissemination rates of electrical technology in theU.S. andBritain.
Romer’s emphasis on scarcity and rivalrous vs. non-rivalrous goods, leads to a number of errors. Entropy explains not only why goods are scarce, but why diminishing returns exist and why inventions are how humans overcome entropy and diminishing returns. First, scarcity does not imply diminishing returns. A scarce resource might be as easy to extract the first time as the last. In this case, the resource’s cost would be exactly the same until we ran out of the resource. Scarcity does not explain the ultimate struggle of all life – namely the need to extract more energy than one uses in order to stay alive. Secondly, the nonrivalrous nature of ideas does explain how humans overcome diminishing returns. The emphasis on rivalry leads to the idea that there is some sort of conflict between systems that encourage inventions but supposedly restrict the dissemination of inventions (production). This conflict is also rooted in the idea that we want to maximize the production of goods today (existing inventions). Humans’ long term struggle is to overcome entropy, not to maximize goods today. In order to maximize goods today, we have to devote all resources to production and none to invention. This means we are in a technologically stagnant situation. As explained earlier, this is not sustainable because of diminishing returns and will result in a return to the Malthusian Trap. Our ability to survive and thrive is based on maximizing inventions. This results not only in more of the same goods in the future but a greater diversity of goods. Diversity of goods may be more important than increasing the production of existing goods. For instance, when we find that we are running out of coal we can switch to oil or nuclear power; when we find that one antibiotic is not effective against a new strain of bacteria, we can switch to a different antibiotic. Diversity of goods allows us to withstand external shocks to our economy better than maximizing production of existing goods.
A system that only incentivizes inventions but not dissemination will result in producers that do not focus on either creating or disseminating new inventions. Introducing an invention to the market is a huge risk. Retailers do not know if the product based on the invention will sell. The manufacturer often has to spend money establishing new channels of distribution and investing in new manufacturing facilities. In fact, venture capitalists often estimate the cost of introducing an invention to the marketplace at ten times the cost of inventing. It is always less cost and less time for a manufacturer to simply wait until a product is proven successful and then introduce a copycat product. This allows them to freeload on the marketing, sales, distribution, and inventive efforts of the first mover. There have been a number of business books on this exact point, see Getting to Plan B: Breaking Through to a Better Business Model, by John Mullins and Randy Kosimar see also Copycats: How Smart Companies Use Imitation to Gain a Strategic Edge Without incentives for both creation and dissemination of new technologies, we will have underinvestment in dissemination. Smart companies know that the cost of introducing a new product is expensive and fraught with risk. This is why most large companies focus most of their research and development on line extensions. A Small Business Administration study, An Analysis of Small Business Patents by Industry and Firm Size, found that most emerging technologies are developed by start-ups and individual inventors.
Invention is an endogenous process that is heavily affected by policy decisions. In theUnited States, our unique patent system provided an incentive to invent and to invest in the dissemination of inventions. The patent system also encourages the dissemination of information on which other inventors can build. Because of the high risk of inventing and marketing emerging technologies, most of this effort is undertaken by start-ups and individual inventors. Direct government support for inventive activities in the United Statesin the 19th century was minimal. Despite this, the US went from a mainly agrarian nation at the time of the American Revolution, to the leader of the Industrial Revolution by 1850.
 Kremer, Michael, Population Growth and Technological Change: One Million B.C. to 1990, The Quarterly Journal of Economics, Vol. 108, No. 3. (Aug., 1993), pp. 681-716, http://links.jstor.org/sici?sici=0033-5533%28199308%29108%3A3%3C681%3APGATCO%3E2.0.CO%3B2-A.
 Klasen, Stephan; Nestmann, Thorsten, Population, Population Density, and Technological Change, CESifo Working Paper Series No. 1209, 2004, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=558105.
 Schmookler, Jacob, Inventions and Economic Growth, Harvard Press, 1966, pp 104-164.
 Schmookler, Jacob, Inventions and Economic Growth, Harvard Press, 1966, pp 57-86.
 Khan, Zorina B., The Democratization of Invention: Patents and Copyrights in American Economic Development, 1790-1920, Cambridge University Press, 2005, pp. 50
 Khan, B. Zorina. “Technological Innovations and Endogenous Changes inU.S. Legal Institutions, 1790-1920.” NBER Working Paper No. 10346.Cambridge,MA: March 2004.
 Bailey, Ronald, “Post-Scarcity Prophet: Economist Paul Romer on Growth, Technological Change, and an Unlimited Human Future”, Reason, December 2001.
 Romer prefers the word “recipes” to “inventions” perhaps because he believes the word invention implies all the complex definitions of patent law. However, I believe this leads to confusion. An invention that is never realized in physical form is meaningless. Once it is realized in physical form it has at least some of the rivalrous features of physical property.
 Bailey, Ronald, “Post-Scarcity Prophet: Economist Paul Romer on Growth, Technological Change, and an Unlimited Human Future”, Reason, December 2001.
 Even software inventions are subject to scarcity. It takes energy, transmission capabilities, and computers to recreated a software invention.
 Mullins, John and Kosimar, Randy, Getting to Plan B: Breaking Through to a Better Business Model, Harvard Business Press,BostonMA, 2009.
 Shenkar, Oded, Copycats: How Smart Companies Use Imitation to Gain a Strategic Edge, Harvard Business Press,BostonMA, 2010.
The more fundamental question in economics is whether inventions have any economic impact. There is no role for inventions in classical economics, which focuses mainly on disruptions in supply and demand. Marxist believe that all economic value is a measure of physical labor, so there is no room in the Marxist tent for inventions either. Despite this modern economics has grudgingly admitted that inventions are key factor in economic growth. However, they are torn on whether inventions (advances in technology) are endogenous or exogenous. The exogenous camp believes that inventions occur separate from any incentives or spending on inventions. Economists that fall into the exogenous camp clearly do not see any reason for a patent system, since they believe that inventions occur separate from any market forces.
The first widely acknowledged chink in the Marxist and Classical economics armor against inventions was Joseph Schumpeter who argued that creative destruction, caused by innovation, is the key to economic growth. The hero in Schumpeter’s world was the entrepreneur not the inventor. Despite this Schumpeter also was a determinist who believed in “natural” cycles and believed in the exogenous theory of inventions.
The next step in the economic analysis of invention was by Robert Solow. Dr Solow published a paper in 1956 on economic growth that stated that four fifths of US worker output was due to technological progress (inventions). Robert Solow would go on to win the Nobel Prize in Economics for this point. However, Solow believed that technological progress was exogenous and therefore occurred separate from economic incentives to invent. As a result, he argued that all countries would converge in their economic growth rates and their level of technology. There has been no evidence for Solow exogenous theory of growth. The growth and level of technology, inventions, and economic growth of countries has not converged as Solow predicted. It is not surprising that Solow, in the exogenous camp, is a fan of the anti-patent book Against Intellectual Monopoly, by Michele Boldrin & David K. Levine.
The next big advance in the analysis of inventions and economic progress was the book Invention and Economic Growth by Jacob Schmookler in 1966. Schmookler undertook the most systematic analysis of invention of any economist. He analyzes the issue of whether invention is exogenous, as argued by Solow, or endogenous. He clearly shows that invention is mainly endogenous. Schmookler does not directly address the question of the utility of a patent system in encouraging inventions. However, he hints that attacks on the patent system in the 1930s and 40s was the cause for the decline in the number of patents issued to US inventors during this time.
In general, most economists in this area now acknowledge that invention is endogenous – subject to market forces. If you accept that the invention process is endogenous, then the next question is whether patents encourage invention – are patents relevant?
One of the leading economists in the area endogenous growth is Paul Romer. Romer thinks that the creation of inventions (he would call them recipes) are clearly subject to resource limitation. He points out that researchers and laboratory equipment are not free and therefore we need a system to encourage people to invest in new inventions. However, he believes that once an invention is created it cost virtually nothing to disseminate. The example he uses is oral rehydration therapy. While there are a small number of examples of inventions that are so simple and so easy to understand they can be disseminated at virtually no cost, most new inventions and technology do not fit into this category. For instance, calculus is a very useful branch of mathematics and it has been known for centuries and yet most of us who learned calculus paid someone to teach us. There were no intellectual property laws requiring us to pay a teacher to learn calculus, so if inventions (recipes) can be spread at no cost why did we undertake the irrational step of paying someone to learn calculus. If technological can be disseminated at no cost then there is no reason for professors, doctors, lawyers, engineers, and especially marketers and sale people. Romer is ambivalent about patents. However, his ambivalence is based on the false assumption that technology dissemination is free.
Gregory Clark, an economist at UC Davis, has written an interesting book in this area, entitled A Farewell to Alms. In this book he states that the most important question in economics is explaining why
after millennia of per capita income being stagnant it takes off around 1800 in the West. He provides an interesting answer. The first part of his answer is that rate of technological progress increased at the beginning of the industrial revolution. The second part of the answer is why the rate of technological progress suddenly increased. He suggests that the industrial revolution takes of in Britain because of environmentally induced evolution. Specifically, he suggests that the downwardly mobile society of Britain resulted in thrift and hard work being genetically selected in Britain. These traits resulted in the industrial revolution taking off in Britain. Clark appears to be part of the exogenous camp. As a result, he does not think that patents are important in encouraging advances in technology or economic progress.
B Zorina Khan is another economist who has studied this issue. She is author of the book, The Democratization of Invention: Patents and Copyrights in American Economic Development, 1790-1920. She provides extensive evidence that the US patent system and economic forces affect both the level and direction of invention. She shows that the US created the first modern patent system and the patent system provides the major incentive that causes the US to grow from an agrarian economy to a world economic and technology power in 70 years.
The economic literature on patents is littered with misunderstandings of the basic rules of the US patent system. For instance, many economists do not understand that the patent system is designed to spread information. In the US we did this by setting up patent depository libraries, so that all people could take advantage of the knowledge associated with an invention. You will read many economists that believe patents inhibit the spread of information. This is clearly incorrect. They do inhibit practicing of the invention without the payment of a royalty, but the underlying information is free for all people to learn from.
Economists are also generally ignorant of the history of patents. They do not realize that patents are designed to encourage people to disclose the information associated with their invention. The alternative to patents is trade secrets and no government can force people to disclose their trade secrets. Before patents people protected their economically important inventions by keeping them a secret. This limits the area’s where people will invest in new technologies to those that can be kept a trade secret. It also means that the public does not benefit from the knowledge of the invention. Most economists do not understand the unintended consequences of their anti-patent position.
Economists generally want to model patents as a government granted monopoly instead of a property right. This is logically incorrect. In economics, a government-granted monopoly (also called a “de jure monopoly”) is a form of coercive monopoly by which a government grants exclusive privilege to a private individual or firm to be the sole provider of a good or service. Since a patent does not even provide the holder the right to sell or practice their invention, it clearly does not grant an exclusive privilege to a firm to be the sole provider of a good or service. Most economists do not understand this basic principle of patent law – a patent does not give the holder the right to produce or sell their invention.
It is straightforward economic analysis that investing in new technologies is an economic disadvantage for a company if there is no intellectual property protection. The company’s research and marketing costs in creating a new product and new market clearly increase its cost of doing business over its competitors who do not spend money on new product development. Their competitors just copy the new product and sell it into the markets the inventor created. The inability of economists to grasp this simple point is mind boggling. The only explanation I can come up with is that most of the economists who write about patents have not worked in the technology start-up market. If they had, they would know that incredible additional expenses incurred not only in creating a new product, but in marketing and selling a new product. This is particularly true the more unique the product. It is always easier to sell a me-too product, since you do not have to explain how it works and why someone would want it. This is why invention in most large companies is limited to line extensions.
Economists cannot provide meaningful input or commentary on the patent system unless they actually understand the patent process, the rights obtained with a patent, and the basic history of patent systems. Ms. Khan and Pat Choate are some of the few economists who have a strong understanding of the patent system. Unfortunately, Khan does not differentiate that patents are property rights, not a monopoly.
 However Adam Smith did mention inventions as one of three ways to increase the wealth of a nation. “some addition and improvement to those machines and instruments which facilitate and abridge labor”, Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations, Edited by Edwin Cannan, New York, Modern Library, pp. 373-374.
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