By: Diego Maguina

A long-awaited and well-deserved award for a great man.

On October 8th, the Royal Swedish Academy of Sciences announced that the Nobel Memorial Prize in Economic Sciences of 2018 would be awarded to William Nordhaus and Paul Romer. While both economists deserve the same credit given their enormous contribution to the discipline, Paul Romer was a particularly special choice for New York University, provided that he is a member of our educational community. Romer joined the Leonard N. Stern School of Business in 2010, where he has served as a Professor of Economics and the Founding Director of the Marron Institute of Urban Management.

The Swedish Academy awarded the prize to Paul Romer ‘for integrating technological innovations into long-run macroeconomic analysis’. Economic growth has been an extremely important —if not the most important question— in economics. The implications of economic growth swamp those of business cycles and determine the standards of living of several generations to come. As a matter of fact, Robert Lucas —who received the Nobel Prize in 1995— famously stated: ‘Once one starts to think about [questions involving economic growth], it is hard to think about anything else’.

Yet, economic growth still remains puzzling. Why do some countries grow faster than others? And even more fundamentally, how do countries grow? These have been questions economists have tried to answer for more than half of a century, and while we might not have a clear and straightforward answer, Paul Romer certainly helped us move in that direction.

From Solow to Romer

All economics students have studied the pioneering work by Robert Solow —who also received the Nobel Prize in 1987 for his work on economic growth. In simple terms, the Solow growth model —which was developed in the 1950s— proposes that output per capita growth in the long run is only determined by technological growth.

Solow uses a neoclassical production function. Given the diminishing marginal returns to capital, investment —through saving— is able to increase output per capita in the short run. As each additional unit of capital contributes a smaller amount of output but adds constantly to breakeven investment (composed by the rates of depreciation, population growth and technology growth), the growth effect peters out. Savings can increase constantly, but there is a limit —evidently, a country cannot save more than what it produces. However, this does not happen with technology: it can exogenously increase without bounds over time and, hence, sustain growth in the long run.

This is a very condensed explanation of the Solow model. While it was revolutionary in its time, there are some problems with it. The most important one is that it does not explain growth! This model explains the dynamics of growth given an exogenous increase in technology. The word exogenous is extremely important: technology grows because we assume it grows, and as we assume technology grows the economy grows. But, how is this possible?

This is when endogenous growth theory comes in. Economists including Paul Romer, Robert Barro, Robert Lucas, among others started to develop growth models in the 1980s that could explain —by themselves— why economies grow. Following Romer’s words: ‘this work distinguishes itself (…) by emphasizing that economic growth is an endogenous outcome of an economic system, not the result of forces that impinge from outside’.

Moreover, Romer states that the origins of endogenous growth follow two motivations. First, it was necessary to develop models that could break with the ‘convergence controversy’. A prediction of previous models is that different economies would converge over time. Nevertheless cross-country data over decades shows that this does not necessarily hold: while some countries seemed to have closed the gap, some developing countries have fallen behind.

Second, it was necessary to develop models at the aggregate level that embody microeconomic principles of how firms operate and individuals behave. Romer further states that it is a dilemma for growth economists to introduce several distilled facts at the same time in a comprehensive model, but this is what endogenous growth theory attempted to do.

Romer developed a pioneering endogenous growth model. In 1986, he published one of his most famous papers: ‘Increasing returns and long-run growth’. There are two crucial concepts underlying the model that arises from it. First, the learning-by-doing principle: following Kenneth Arrow’s ideas, productivity augments with experience, which is in turn related to gains in knowledge that occur as firms invest in physical capital. Second, knowledge spillovers: when knowledge is created, it generates positive externalities for the entire economy because it cannot be kept undisclosed. In other words, when firms invest in physical capital, their productivity will increase as their knowledge increases through experience, but this knowledge will also spread across the entire economy, which will ultimately foster growth. All of this allowed Romer to abandon the diminishing marginal returns assumption and to develop a model that could explain growth in the long run by itself.

It is true that endogenous growth models have received further criticism. Nevertheless, it is important to recognise —and it would be ungrateful to forget— that the economists who worked on them, such as Paul Romer, have helped us better understand economic growth.

Thank you, Professor Romer

Paul Romer continued to produce more research since he published his 1986 groundbreaking paper. In addition to growth, he has explored other topics such as entitlement and urbanisation. Furthermore, and leaving research aside, in 2000 he founded Aplia —an online educational platform that college professors of different subjects can use to assign homework to students. Although it was acquired by a different company some years ago, it represents Romer’s interest in entrepreneurship and, more importantly, his commitment to education.

Finally, and from a very personal perspective, I am glad to mention that I was able to meet him at a press conference in New York University on the day the Nobel Prize was announced. Far from being a distant person who would not talk to an undergraduate student who congratulated him as he was leaving the premises, he proved to be a kind and humble man in the brief exchange we had. He is an inspiration for me and for many other students around the world.

Sources:

Photo credit: Sapna Parikh, NYU http://www.stern.nyu.edu/experience-stern/news-events/media-advisory-press-conference-nyu-stern-with-paul-romer-2018-nobel-laureate-economics

Lucas, R. E., Jr. (1988). On the Mechanics of Economic Development. Journal of Monetary Economics, 22(1), 3-42.

NYU Stern. (n.d.). Paul Romer. Retrieved November 10, 2018, from http://www.stern.nyu.edu/faculty/bio/paul-romer

Romer, P. (1994). The origins of endogenous growth. Journal of Economic Perspectives, 8(1), 3-22.

Romer, P. M. (1986). Increasing Returns and Long-Run Growth. Journal of Political Economy, 94(5), 1002-1037

Sala-i-Martin, X. (2000). Apuntes de crecimiento ecónomico. Barcelona: A. Bosch.

Solow, R. M. (1956). A Contribution to the Theory of Economic Growth. The Quarterly Journal of Economics, 70(1), 65-94.

The Royal Swedish Academy of Sciences. (2018, October 8). The Prize in Economic Sciences 2018 [Press release]. Retrieved November 10, 2018, from https://www.nobelprize.org/prizes/economic-sciences/2018/press-release/