Introduction

When analysing cross-country patterns, growth accounts provide only a partial analysis. It is now widely accepted that understanding the pattern of cross-country growth and productivity requires estimates of relative levels. Models in the technology-gap tradition consider technological effort as the main determinant of income differences between countries and international technology diffusion as the driving force for catch-up. The rate of catch-up of one country with another depends upon the two forces of innovation and imitation. Innovation refers to the creation of new technologies unknown to the world and imitation refers to the spillover of existing technologies from leading to following countries. The larger the distance from the world technology frontier, the higher the rate of diffusion to a follower might be. But the cost of imitation rises as the pool of non-copied ideas becomes smaller and the potential for growth decreases. The effectiveness of educational systems, technology policies and market regulation might thus crucially depend on the distance to the technology frontier (Fagerberg 1994). In the same vein, Aghion and Howitt (2006) suggest that the post-World War II catch-up of European economies to the USA has slowed down as the technology gap with the USA has narrowed. Policies and institutions which facilitated imitation of technologies in the past are not well suited for growth close to the technology frontier. The latter should be based on innovation in a competitive market environment and rooted in a country's own resources such as skilled labour and research and development.

Introduction

In Chapter 2 we analysed the differences in growth performance between the European Union and the USA. While many idiosyncrasies in the growth patterns can be observed, there are also common long-term trends in the structure of the economy. The purpose of this chapter is to look for similarities, rather than for differences, in the process of structural change in the two regions. This will be done by building upon the seminal work of Simon Kuznets and Angus Maddison. More than twenty-five years ago, these two economists established a number of empirical regularities in the structural transformation of advanced economies since the Second World War (Kuznets 1971; Maddison 1980). The best-known facts are the shifts of output and labour from agriculture to industry and later from industry to services. In addition, the services sector is characterised by limited scope for innovation and technical change with productivity growth rates that are much lower than in industry and agriculture. The Kuznets–Maddison stylised patterns of growth have been a crucial ingredient in much work on economic growth, development economics, international trade, business cycles and labour markets. For example, sectoral differences in productivity are an important cornerstone in models of real exchange rates (Obstfeld and Rogoff 1996). They also underpin the hypothesis of the cost disease of the services sector described by Baumol (1967) and motivate the recent surge in multi-sector endogenous growth models, e.g. Ngai and Pissarides (2007) and Restuccia et al. (2008).

Understanding the benefits from international trade has been an important objective of economists for centuries. As each new economic theory was developed, some economists soon applied it to questions about trade. For example, Sir John Hicks had only recently developed general equilibrium models when Bertil Ohlin added an international sector to them to explain why countries specialize in certain exports. And when Keynesian models were still relatively new in the 1950s, James Meade added an international sector to see how it affected macroeconomic policy. His student, Robert Mundell, continued to explore this question in the 1960s. Then, in the late 1970s, Paul Krugman introduced familiar models of monopolistic competition and economies of scale into trade models and created something of a hybrid. Each of these economists was a Nobel Prize winner who helped to draw attention to the importance of international issues.

Economists Sir W. Arthur Lewis and Amartya K. Sen were more interested in the problems of underdevelopment that led to widespread poverty, hunger, and occasionally famine. Many economists either ignored less-developed countries or simply assumed that they operated under the same principles as developed countries. Nobel Prize winners Lewis and Sen were not willing to ignore the plight of these countries. They wanted to understand the problems that made these countries different, problems that they had personally experienced; Lewis was from St. Lucia and Sen from India.

Amartya K. Sen (1998 Prize Winner)

Amartya Sen did not exactly fit the profile for a Nobel Prize winner in economics.

Alfred Nobel was probably the richest man in Europe when he died in 1896. A serious scientist and inventor, he had taken great personal risks in his early experiments with the unstable explosive nitroglycerine. In fact, during a low point in his career, he lost his younger brother in a laboratory explosion and came close to losing his own life. But because of a stubborn dedication to his work and a confidence in his own ability, he persevered, overcoming technical difficulties and ultimately succeeding in creating a more stable and more practical explosive, dynamite. Equally powerful as nitroglycerin but many times more useful, dynamite would revolutionize mining and construction of canals, roads, and railroads. It was one of the great discoveries of the nineteenth century and would open the door to the industrial revolution and the modernization of industry and transportation.

The potential uses for dynamite were almost immediately apparent, creating a huge demand and opening up a great business opportunity. Unlike many inventors, Alfred Nobel easily made the transition to business and found that he was just as good at manufacturing and marketing as he was in the laboratory. He built factories to produce dynamite, fought to protect his patents from rivals, and developed a sales program to sell dynamite across the globe. Like his father, he also dabbled in the development of military explosives, but it was dynamite that made him rich.

Most of what conventional economists know about markets can be found in the field of microeconomics. Adam Smith launched it in the eighteenth century with his description of market behavior, and Alfred Marshall made it popular in the early twentieth century with a more modern representation of supply and demand. Microeconomics has continued to thrive in universities, and the Nobel Prize has been awarded to one group of economists who translated the basic concepts into higher levels of mathematical abstraction, and to a second group who applied the concepts to problems unrelated to formal markets. This chapter is about the latter, those economists who have won Nobel Prizes by discovering new applications for microeconomics.

Supply and demand, a simple notion, informs many economic models. It easily explains all kinds of basic economic behaviors in all kinds of situations. But microeconomics, especially the perfect competition version, went far beyond that, providing a mathematically precise description of idealized market behavior. Perfect competition relied on simple, but highly abstract, assumptions, namely, a very large number of firms and consumers who act rationally with perfect information. Even firms entering new markets are assumed to know exactly what to do. Under these ideal conditions, it was possible to derive mathematical conclusions about the economy. But what did they actually mean? If the models weren't based on reality, what insights could they provide about the real world?

After completing its fortieth year, what can we say about the success of the Nobel Prize in economics? Has it fulfilled its mission of honoring those economists who, during the previous year, have rendered the greatest service to mankind? Have Nobel Prize–winning economists – the financial economists, the libertarians, the micro minds, the behaviorists, the Keynesians, the Chicago School, the inventors, the statisticians, the historians, and all the others – made this world a better place?

Some Nobel Prize winners invented planning tools that have certainly enriched our lives. With national income accounts we have a much clearer understanding about how well the economy is performing at any given time, and with input-output models and linear programming we can answer interesting and important questions. In other cases, Nobel Prize winners have proposed ideas that reinforce and sometimes challenge our understanding of economics. Right or wrong, these ideas force us to think about important social issues. But do we agree with Gary Becker that criminals are rational human beings who methodically calculate the costs and benefits of crime? Is James Buchanan correct when he claims that government officials are unlikely to act in the public interest? And what about Daniel Kahneman: Are human beings easily misled by context when making decisions? Are these ideas consistent with our own experiences and what we observe around us? Are they right most of the time or just some of the time?

The conversion of economic concepts into formulas dominated the development of economic theory in the post–World War II era. This was a great opportunity for mathematically inclined economists even though much of the work was fairly inconclusive. As soon as one group derived an economic principle, another group proved the opposite. What economists needed were actual numbers to determine whose theory was better. They hoped to find truth in statistics.

In the 1920s, statisticians borrowed techniques from physics and other disciplines to calibrate equations with actual economic data. The field of study became known as econometrics and involved general statistical techniques refined for use with economic data and models. The name econometrics implies its meaning, a combination of economics and statistics or metrics. Nobel Prize winner Ragnar Frisch is credited with coining the term and defined it as “the statistical verification of the laws of pure economics.” Frisch and his student, Trygve Haavelmo, developed the basic framework for econometrics while another Nobel Prize winner, Jan Tinbergen, started applying the techniques to systems of equations. The goal was to provide compelling explanations of economic events and more accurate predictions of the future.

A later generation of Nobel Prize–winning statisticians concentrated on problems of particular interest to economists. Sir Clive W. J. Granger and Robert F. Engle, III developed new methods to analyze data collected over time, Daniel L. McFadden created a better method to study choices made between discrete alternatives, such as buying a Honda Accord or a Toyota Camry, and James J. Heckman explored some of the problems of using groups of individuals to test economic hypotheses.

In classical economics, unemployment only occurs when wages are held unnaturally high, for example, by a minimum wage or unions. This theory was often a tough sell when applied to the entire U.S. economy, but it was never tougher than during the Great Depression. At the start of the Depression, the minimum wage didn't even exist, unions were hardly significant, and unemployment still soared to 25 percent. Classical economics wasn't just wrong, it was spectacularly wrong, making it easier for Keynesian economics to replace it. Classical economics was dethroned but managed to survive largely intact by retreating to the more limited domain of microeconomics. It was acceptable to use classical theory to explain individual markets but not necessarily the entire economy.

Not all classical economists accepted this demotion willingly. The Chicago School led by Milton Friedman never surrendered although the real economy didn't help their cause. If the minimum wage and unions caused unemployment, then the economy had a strange way of proving it. By the time a minimum wage was passed and union membership began to soar in the 1950s, unemployment fell to historic lows. With so much actual evidence contradicting their theory, it was a tough time to be a classical economist.

The University of Chicago provided a safe haven for classical economists and maintained somewhat of training camp for their assaults on the dominant Keynesian theory. They made relatively little progress until the 1970s when oil price shocks temporarily surprised all economists, including Keynesians.

On October 14, 1997, the Swedish Academy of Sciences announced the winners of the Nobel Prize in economics, Myron S. Scholes and Robert K. Merton. They were honored for developing ingenious formulas for calculating the value of financial instruments, including options, a simple but difficult contract to value.

Less than one year later, however, there was a sudden turn of events. The Federal Reserve Bank of New York quietly convened high-level negotiations to avoid one of the largest bankruptcies to ever threaten Wall Street involving the same two Nobel Prize winners. The company causing the trouble was Long-Term Capital Management (LTCM), which not only applied the theories of laureates Scholes and Merton, but also counted them among the company's principals. In less than a year, they became famous for winning the Nobel Prize and then infamous for one of the most spectacular business failures in history. The Nobel laureates at LTCM looked like geniuses until the market destroyed them financially. Why did Merton and Scholes receive a Nobel Prize? And why did their ideas fail so miserably in the real world?

The stock market has always attracted the attention of economists as both an essential economic institution and as a testing ground for new ideas. Although you might think that familiarity with the great theories of economics would be an advantage in the market, the actual track record of economists has been mixed.

A number of Nobel economists came of age during the coincidence of two powerful movements: the Keynesian revolution and the quantification of economics. Keynes had rewritten economic theory and challenged the principles of the old guard from Adam Smith to Alfred Marshall. He explained why free markets didn't always work, and, if there were any doubt, the Great Depression proved it. Gunnar Myrdal, a Swedish socialist and Nobel Prize winner, articulated a similar thesis in the 1930s.

Most of the new Keynesians, however, were in graduate school when they first heard the radical ideas coming out of Cambridge University in the 1930s and from Harvard University in the 1940s. Armed with their new theory, young economists like Robert M. Solow, James Tobin, Franco Modigliani, and K. Gunnar Myrdal set out to change the world. They summarized, refined, and extended Keynesian economics while Lawrence R. Klein tried to program it into his big economic models with mountains of data.

The Keynesians were also part of the generation that believed that economics was a lot like physics. They saw little difference between calculating the maximum trajectory of a rocket and the maximum welfare of a nation. Almost immediately they translated Keynesian economics into variables and formulas, but they didn't stop there. Any economic idea that could be represented by an equation was fair game, including business and household behavior, economic growth, and international trade. For the most part, this work did not require original economic ideas, just really good math skills.

There were probably no more than twenty Nobel Prize winners in economics when I first started thinking about this book. Trying to find my way around the catacombs of the University of Illinois library stacks, I came across speeches of the first Nobel Prize winners in economics. Here was a fascinating attempt by the laureates themselves to explain their own contributions to a more general, highly educated audience without the aid of mathematics. While not all the laureates fully succeeded in conveying the significance of their accomplishments, they often revealed much about the state of economics as well as their own character and motivation. I started a file about Nobel Prize winners that accumulated over the next twenty years. A lot has changed over this time, including the fact that source documents, once only available in a restricted area of a university library, became widely available on the internet.

The concept for the book finally took shape after I read something totally unrelated to economics, A Brief History of Time by Stephen Hawking. This extraordinary book explained scientific theories without mathematics and included lucid explanations of the achievements of Nobel Prize winners in physics. If it was possible to explain the great ideas of physics, the general theory of relativity, and quantum mechanics, then surely it was possible to explain the great ideas of economics.

In 1947, Friedrich A. von Hayek convened a meeting of fellow economists and academics in Montreux, Switzerland to discuss what they feared most in postwar Europe and America. It was not hunger, or unemployment, or even communism. It was government. They all took great pride in their individual points of view but they collectively agreed that the increasing role of government posed the greatest threat and that “The central values of civilization are in danger.” They complained that “Over large stretches of the earth's surface the essential conditions of human dignity and freedom have already disappeared….” The reason for their pessimism was “a decline of belief in private property and the competitive market; for without the diffused power and initiative associated with these institutions it is difficult to imagine a society in which freedom may be effectively preserved.”

With these words, the Mont Pelerin Society was born and promptly elected its first president, Hayek. The society insisted on personal liberty and saw “danger in the expansion of government, not least in state welfare, in the power of trade unions and business monopoly, and in the continuing threat and reality of inflation.” The philosophy that united Pelerinists was classical liberalism (almost the opposite of modern liberalism), a philosophy more commonly referred to today as libertarianism. Named after the mountain near its first meeting, the society continues to meet in various locations around the world to share stories and research about individual freedom.

Not all Nobel Prize–winning microeconomists were part of the Chicago School of Economics or were focused on the stock market. Some, like Sir John R. Hicks, simply applied the microeconomics that they learned in doctoral programs to interesting problems. Microeconomics is a standard part of all advanced studies in economics, and like mathematics or physics, it has a certain appeal because of its well-defined problems and solutions. Hicks was initially attracted to this work and made significant contributions to some of the subfield's basic concepts. While he was never a great mathematician, he had a talent for translating his ideas into simple equations and graphs, providing important tools for other economists. His contributions were not limited to this one field, however, and he was properly recognized by the Nobel Prize committee for equally important contributions to Keynesian economics and general equilibrium.

Another example of a Nobel economist with strong microeconomic skills was William S. Vickrey who used these tools to explore the nature of auctions. He made the surprising discovery that very different auctions will, on average, result in the same revenue. This is a very interesting result and would also be very useful if it were true, but unfortunately the idealized world assumed in microeconomics does not always apply perfectly to the real world. Vickrey also believed that microeconomic analysis could identify the optimum tax, the one that would benefit the most people and do the least damage to the economy.

Economics and mathematics have become increasingly intertwined during the past few decades, a development that has been encouraged and rewarded by the Nobel Prize in economics. As a consequence it is sometimes difficult to identify a true economic idea among the accomplishments honored by the Nobel committee. Are these really economic insights or merely exercises in applied mathematics? Nowhere is this more evident than in the development of general equilibrium theory. What started with Adam Smith's description of market mechanisms has evolved into abstract proofs that are more likely to be described as elegant or robust than relevant.

Economics and mathematics are different in many ways. Mathematicians value abstract problems and solutions, while economics is ultimately about the real world. A good economic theory can explain and forecast economic events and contribute to better economic policies. But as economics evolved into more of a mathematical discipline, this practical purpose has faded. An early generation of economists translated economic theory into equations while the next generation formulated increasingly complex problems and solutions. The final result is sometimes barely recognizable as economics.

General equilibrium theory followed this evolutionary path. From Adam Smith and the classical economists to Nobel laureates Kenneth J. Arrow and Gerard Debreu, the description of a market economy has evolved from text to topology. Sir John R. Hicks played an important role in this evolution, as did Maurice F. Allais, a Nobel Prize winner who pioneered mathematical economics in France and was belatedly discovered by other economists and the Nobel Prize committee.

Eight Nobel Prizes have been awarded for contributions to game theory, although the father of game theory, the brilliant Princeton mathematician John von Neumann, was not among them. He died at the age of fifty-four, twelve years before the first economic prize was awarded. What von Neumann did was to apply the concepts of mathematics with its formal axioms and proofs to the analysis of simple but abstract games. In mathematics, games have a very precise definition. They are presumed to involve players, two or more, and a payoff, gains or losses, with some choice over possible actions. One of von Neumann's first proofs, published in 1928, involved finding a solution to the problem of two players trying to minimize their maximum losses. In this game, players review all of their options with the objective of choosing the strategy that has the smallest possible loss. Von Neumann was able to “prove” mathematically the conditions necessary for a solution to exist, the so-called minimax theorem.

From this initial insight, von Neumann explored other variations with more players and less certainty until he had enough different examples to write a book, The Theory of Games (1944), co-authored with Princeton economist, Oskar Morgenstern. With that publication, modern game theory was born, setting the stage for other mathematicians to explore variations of these simple games.

If anyone else had invented game theory they would have been celebrated for this single, impressive achievement.

The Nobel committee has been so focused on rewarding economics that projects a scientific and mathematical image that it has often ignored more practical, historical, or institutional approaches. There have been exceptions, including two economists who focused on an institutional topic called economic governance. Oliver E. Williamson, a co-winner in 2009, explored the narrow question of why some activities are included within a firm and others are not. The answer to this question requires a deeper understanding of transaction costs.

An entirely different issue caught the attention of his co-winner, Elinor Ostrom, the first woman Nobel laureate in economics. Ostrom was interested in solutions to environmental problems known as common-pool resources. Economists had previously suggested solutions to this problem but they had largely overlooked the role of voluntary cooperative organizations. She found that cooperation, not competition, could sometimes provide a reasonably efficient outcome. Both of these Nobel laureates were more interested in institutional arrangements either within firms or within cooperative organizations, and both were linked to the prior work of Nobel laureate Ronald Coase.

The other two Nobel Prize winners in this category, Robert W. Fogel and Douglass C. North, won Nobel Prizes in 1993 for their work in economic history. Both used economic theory and techniques they learned from Nobel laureate Simon Kuznets to explore unsettled historical questions. The answers they found often surprised other economists and historians. In other respects, the two economic historians had different ideas and sometimes reached different conclusions.