Tuesday, December 23, 2008

Education and Economic Heat Death

A number of economists in the last two centuries have contributed their part to the dismal science by describing new sets of conditions under which the expansion of wealth we've experienced since the industrial revolution must grind to a halt, often terminating in a kind of economic heat death that would persist indefinitely. For example, in The Tragedy of the Commons, Garret Hardin argued that in the end, common resources would necessarily be destroyed by rational actors optimizing individual wealth, using fisheries as an example; today we have already witnessed the collapse of some fisheries in North America as well as Europe. John Maynard Keynes did his part in this tradition when he elaborated the concept of the liquidity trap, which may or may not be the explanation for Japan's 1990s recession, depending on whether you listen to Paul Krugman or the Austrian+Chicago school. Most famously, Thomas Malthus argued that populations of humans - just like any other animal - would, in the absence of predation and disease, eventually out-reproduce their food supply and remain indefinitely in a state of starvation. Food supplies increase geometrically, and population increases exponentially. Here, finally, is a bright spot, at least for the Malthusian brand of economic heat-death: in one of the least-reported good news stories so far this century, the U.N. has projected that by 2030, modern agricultural methods will have spread far enough that calories produced per person will mean that on average, the Earth's population will be adequately fed.

Schumpeter, Growth, and Innovation

There are likely other plausible heat death scenarios for economies that haven't yet been elucidated, and I have been pondering one with particular reference to the writing of Joseph Schumpeter. Schumpeter was perhaps the most iconoclastic member of the Austrian school, best known today for his recognition of the entrepreneur's role in economic growth. Oddly for an Austrian school economist, Schumpeter wrote about what he thought was the inevitable transition from capitalism to socialism, though it must be said that it's unclear to what degree these passages were motivated by rhetorical salesmanship toward a socialist audience. Schumpeter based his economic models on the concept of circular flow. This idea echoes the all-too-common folk-conception of economies as systems of wealth moving through cycles, but not being created. That is, in a theory of folk economics that is regenerated with depressing frequency among otherwise bright people, money changes hands, but is not actually "made"; it just moves around. In point of fact, Schumpeter emphasized that without some method of wealth "injection" into this circular flow, this is exactly the situation that obtains. Not only is wealth not made, but wealth stagnates and class-stratifies. This is the Schumpeterian heat death scenario.

Now, wealth certainly seems to have been growing over the last five centuries, otherwise it's difficult to understand how we're at least as well-fed today as we were two centuries ago when there were only a billion of us. The simple-minded answer is that this too is just wealth moving around, and that the West plundered the rest of the world - when in fact The Wealth of Nations, that founding scripture of capitalism, was written partly as a refutation of mercantilism. Even if wealth production per person remains constant over time, it's hard to see how there could be the same wealth per person in the economies of the developed world than there was one or two centuries ago. Schumpeter's model shows that wealth creation and economic growth is permitted only by innovation. Without innovation - new technology introduced by entrepreneurs and R&D organizations - the same products would continue to compete and margins would race to the bottom; ultimately we end up with zero growth, stagnation, and concentrated wealth passing back and forth between the same players. Among hunter-gatherers this was in fact the normal state of affairs. In European history, this was true until after the end of the Crusades, when the reopened Middle Eastern trade routes gave rise to a merchant class who could generate wealth independent of the constraints of central political or theological power (which looks out not for the material gain of its subjects but for its own perpetuation). This virtuous cycle of innovation exploded during the industrial revolution, when new technology continued to create new wealth, and the process fed on itself. The Austrian economists would likely argue that economic heat death is caused by any process that blocks this process of continual innovation - a typical obstruction is an overbearing central government.

The race-to-zero-margins in a no-innovation environment is easiest to watch with price competition, which is notoriously tough on margins because price is the easiest thing for consumers to compare. I had my zero-innovation price-competition epiphany during a college road trip when I got off I-95 in northern Florida. The exit was in the middle of that kind of flat coastal pine forest in the American Southeast that seems to extend forever when you've been driving for seventeen hours, and the only buildings visible from the top of the ramp were four gas stations, all equidistant from the highway overpass. All of them had exactly the same prices posted for the same fuel grades. That's when it struck me that none of the stations had any incentive to drop the price by another cent. If one did, the rest would have to follow suit immediately or lose all the business; consequently, even the price-dropper would have the advantage only briefly. (Airlines behave the same way with fares.) Of course, from time to time one of the stations would drop their price to get a break, so the price would gradually inch down, but never up, until their fuel margins were very nearly zero.

Of course if there were some innovation in gasoline, the first to market with it would enjoy wider margins - Schumpeterian rents - until that innovation had diffused throughout the market, and everybody had it, and therefore it provided a special advantage to nobody. (At this point you also start to better understand the point of intellectual property protection in industries with long product development cycles - without them, Schumpeterian rents go away.)

It's worth mentioning that of course at one time refined gasoline was a new product, but continued innovation is the only source of non-zero margins. In point of fact, through advertising some of the service station chains would have you believe that such innovation has in fact occurred ("Ours cleans your engine!" "We're environmentally friendly!"). Making consumers think a meaningful innovation has occurred is one of the main strategies in mature industries, whether it not it's accomplished through advertising - I recently took my first Virgin America flight and people were impressed by the pop music and purple cabin lighting while we boarded, but I was underwhelmed - if that's the major industry innovation of the day, the industry is mature. And as in all such industries, gas is gas, and a combustion engine is a combustion engine. That's why service stations are better off trying to lure you in by having a popular fast food chain inside.

Innovation, Labor and Education

Growth industries (like biotechnology) are not mature industries (like petrochemicals) and they typically rely on highly educated workers. As economists beginning with Adam Smith have predicted, labor has become an increasingly important component in adding value to products. Today it's far and away the most important component, although as recently as the mid-eighteenth century mainstream economists were arguing that labor was negligible (to be fair, things have changed quickly; they were more right then than they would be today). Labor is what makes innovation possible at all. That is to say, technological advances are made possible through this highly valuable labor; that labor is expended by extensively trained professionals whose expertise is made possible by years of education. In that sense, education is an upfront investment for a future return. And here we have another possible path to Schumpeterian heat death, a barrier to innovation from the difficulty of educating the next generation of innovators. Although each generation's science rises one notch higher, resting as it does onto the shoulders of the giants that passed before, each generation is born knowing exactly the same amount of science and math and engineering that Adam Smith's and Hammurabi's children were; namely, none. Unfortunately, Lamarckianism doesn't work in the biological realm or in the intellectual one.

It's probably true that I began this speculation as a result of my own station in life. I will be returning to school at the age of 35, and will not be a practicing and fully licensed physician in a specialty until I am 43. Assume only for the sake of illustration (I hope) that I have created no value so far in my career prior to returning to school. Therefore, if I retire at 65, that means I have 22 years to a) make back the value of the resources I consumed throughout my life and b) return to society what was invested in me in scholarships and loans, just to "break even". Otherwise, I will have been a net drain on the economy.

Of course, I have had the luxury of 13 years between my undergraduate degree and my return to school; I could've been practicing by the time I was 30, had I made up my mind earlier. Imagine your great grandchildren in 2108, who want to become nanobiometallic neurodemolecularizationists. Maybe another century science will have generated so much knowledge and the subject matter will require mastery of so much material that they'll have to go to school straight through from age 5 until age 43, without a break, to finally become a licensed NBMNDist. This is only a profitable venture for society as a whole if NBMND generates wealth fast enough in 22 years of career to offset 43 years of consumption (38 of which was expensive NBMND-track education). And what about their great grandchildren, who have to go to school straight through until they're 60? Can they break even in 5 years after 55 years of education? One response to this problem is to state that knowledge has noticeably specialized already in our own time, decreasing the instruction that professionals need to pursue their field. This is true to some extent, and yet the average time spent in education is still increasing. A semiconductor engineer still needs the same physics education that a civil engineer did half a century ago, and then plenty more too. So to assume that this will never become a problem, we have to assume that the improvement in wealth created per year in careers of ever-decreasing length will outpace the wealth consumed during the ever-increasing educational periods required by the greater body of knowledge that has to be mastered. Contribution to economy enabled by education must stay ahead of cost of education. Education will keep getting longer and more expensive; time to recoup the investment will keep getting shorter.

Mathematically (without getting into summation notation)

I = wealth created per year
L = cost of living per year
R = retirement age
E = years required by education
P = years before education begins
T = cost of tuition per year

Therefore, for wealth creation to outstrip education and living costs:

(I - L)(R - E - P) > (T + L)E + LP

Working out the algebra then,

I >RL + ET
R - P - E

This is what the relation must be at any point in time. Over time, the answer for how fast wealth creation per year must change is expressed as the first derivative of this expression with respect to time.

The threat of stasis arises if the increase in wealth-creation per unit time cannot keep pace with the costs of education. By extension: your great-great-great granddaughter turns 65, gets her diploma, goes to work to write an awesome artificially intelligent computer program, the output of which just barely pays off her loans - and then she retires at the end of that one day of work. And her son is doomed, because he would consume more in education than he produces. At that point we are unable to profitably produce technical experts to create innovation, margins drop to zero, and money stagnates and class-stratifies. There is always the temptation here to hand-wave about AI and nanotechnology somehow stopping this trend, but for now we have to make realistic guesses based on the information we have today.

The Good News

We have already seen demographic indications of increasing average education, and I don't think anyone is surprised. Without running numbers my guess is that we will not encounter this problem for generations. To avoid Schumpeter-Caton stasis,* we have three options: put kids in school even earlier (I doubt we have much leeway there) raise the retirement age (that will help some, as lifespans get a little longer), and focus on developing the technology of instruction. I predict that the economically successful societies of the late twenty-first century will focus on this third option.

As a final note, this article is far from an argument against public funding for education. It's exactly the opposite. In any nation in 2008, it should be considered nothing short of a suicidal assault on economic health when political leaders question the value or necessity of a strong educational and research university system. These are the engines of innovation whose role in driving economic growth will only become more prominent.

*If you can come up with a catchier name, by all means leave a comment.

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