Understanding economic development is the Holy Grail of all economic studies. No theory has yet explained the rise of real incomes per capita in Britain by a factor of about 16 from the 18th century to the present and, in contrast, the remarkable increase in China by a factor of 6 within a span of just 30 years. If China continues at this rate then it will have achieved in 50 years what took Britain 200 years to accomplish. And if we can understand the mechanisms for this development then maybe it can be duplicated elsewhere, in countries still on the brink of economic development.
Economic Role of the City
According to an old story, a servant asked his lord to be paid by placing a penny on the first square of a chess board, two pennies on the second square, four on the third, etc. If the servant had requested the use of the white squares only, the initial penny would have doubled in value thirty one times, leaving $21.5 million on the last white square. Using both the black and the white squares would have grown the penny to $92,000,000 billion. This is the beauty of compounding operations – they are simply astounding! The choice between a payment that doubles with every square on the chess board and one that doubles with every other square is more important than any other part of the agreement between the servant and his lord. For an economy, the choices that determine whether incomes double with every generation, or instead with every other generation, dwarf all other economic policy concerns.
In this article I shall emphasize the common elements in the works of Jane Jacobs and Professor Robert Lucas on economic development and in the process hopefully help fix ideas about Hong Kong as a city.
In The Death and Life of Great American Cities (1961), Jane Jacobs gained a formidable reputation as a defender of the city against the planners and architects who promoted urban renewal in the form of sterile housing projects. She contemptuously cast aside contemporary urban planning and promoted the dynamic qualities of city neighborhoods. She then went on to write several books that dealt primarily with economics. In The Economy of Cities (1969) and Cities and the Wealth of Nations (1984) she advanced a thesis on economic development that is remarkably fresh and provocative.
For Jacobs, cities rather than nations are the originators of wealth creation. The unit of “macroeconomic” analysis should be the city not the nation-state. She says: “It affronts common sense, if nothing else, to think of units as disparate as, say, Singapore and the United States, or Ecuador and the Soviet Union, or the Netherlands and Canada, as economic common denominators. All they really have in common is the political fact of sovereignty.” And she chided economists for drawing the assumption that economies could be analyzed as national aggregates.
Jacobs established the primacy of cities over the rural economies. Cities do not develop because of a pre-existing rural economic base that eventually becomes wealthy enough to support parasitic urban growth. Instead, she argues, cities drive rural economies by providing an urban market for rural products. Enterprises in rural economies produce goods that are already in demand in the established urban centers. These rural enterprises depend heavily on the services based in cities for loans and supplies. Developing the urban economy benefits rural economies because most rural economies are inevitably and inextricably linked to the urban economy, but doing the opposite can have no significant long term effect if the larger urban economy continues to stagnate. It is the rural economy that depends on the city, not the reverse. For the same reason, Jacobs sees large housing projects that create satellite towns on the outskirts of the urban city as akin to rural economies that can never become self-sustaining.
Jacobs’s central theme is that economic development is a process by which a group of cities that engaged in trade with each other create “new work” to add to the work already underway. Cities grow by gradually diversifying and differentiating their economies. The process starts with exports and their suppliers, and later as “import-replacement” – a process of producing locally those goods and services that were previously imported.
Free Lunches in Knowledge
City economies are sustained by their position as the source of innovative economic change. Progress depends on having a large number of individuals and enterprises whose diversities and interactions generate a highly valuable spillover effect. The process of creating new things, or reinventing old things, demands the solution of two problems. First, the innovator must gather information and with experience and intelligence see it in a novel and useful way; in a word, innovate. This may require of lot of work or a lot of luck or a bit of both. But that is not always necessary if the person is placed in an environment that provides ample information and stimulation.
Jacobs’s favorite example of innovation is the story on the invention of the brassiere. New York custom seamstress Mrs. Ida Rosenthal invented the brassiere to solve a problem she had encountered with customers. She found that her dresses did not fit well over her customers’ existing undergarments. The invention was based on the same available technological skills and components that she had employed as a seamstress and were easily found in the city. It is significant that the brassiere was not invented by the lingerie industry and this shows how ideas can flow across industry boundaries.
Second, the city environment facilitates the commercialization of discovered knowledge. This means those who discover the knowledge and those who can make profitable use of it must first find each other; in a word, diffusion. A major source of new economic activity and wealth lies in finding new uses for existing technology. Employees at existing enterprises will learn how those enterprises work, and over time some will have great ideas about how to produce a new product or service based on their existing knowledge. Some of them will leave to start their own companies and implement those ideas. The ability to break away is an essential part of developing new economic activities.
What Jacobs sees in innovative economic changes is what economists call dynamic externalities. These are spillover effects that allow aggregate social returns to become greater than the sum of all individual private returns. For Jacobs innovation is always city-generated and is stimulated by the proximity of people, industry and information in the urban setting.
Existing employers may see the breakaways as employee free-riding behavior. They may try to prevent potential competitors from breaking away through binding contractual arrangements. Preventing free-riding on discoveries is necessary to encourage innovators to make discoveries. At the same time a great deal of economic development springs from word-of-mouth, imitation, and various kinds of free riding behavior. Encouraging the discovery and diffusion of knowledge for promoting economic activities is a complex process with many conflicting interests and incentives. Jacobs is aware of the conflicts between avoiding free-riding and fostering dynamic externalities, but believes the city presents the best competitive environment for mediating this perpetual tension. The fact that Mrs. Rosenthal was a seamstress and was not employed by the lingerie industry may have actually worked in her favor and in the favor of her present and future customers.
But once again, Jacobs identifies a catch: That the most effective way of developing successful innovations is based initially on small, often individual, effort, which is usually chaotic, inefficient, highly risky, and subject to high rates of failure – factors that appear just plain ridiculous. However, most existing private and public loan and economic development programs focus their efforts and resources on enterprises that can prove, under the existing conditions, that they are feasible, efficient, have a high chance of success, and so on. But if one has just invented a brassiere, how can one prove it will be widely marketable? There is no past experience with brassiere marketing to turn to; it is simply a good idea that Mrs. Rosenthal believes will catch on if she is able to produce them in quantity, and that a few of her pre-existing customers happen to like. This is rarely enough for a bank or government loan program, even one ostensibly oriented towards rewarding innovation.
A most telling example is Boston and its surrounding region. In its very early days the city was a creative metropolis. But its citizens lost their drive as the local third and fourth generation rich limited their energies to minding safe financial investments. The popular explanation for the stagnating Boston economy was that cheaper labor in Georgia and elsewhere in the American South had made New England permanently uncompetitive. The explanation seemed entirely too defeatist to Ralph Flanders. In 1946 he and a few of his moneyed friends formed a venture capital company to make $4 million available to small Boston enterprises. The Flanders group had no preconceived ideas of what they were doing. They were quite surprised when the first applicants for capital were three young scientists who, using their relatives’ savings, sought to start a high technology enterprise. The presence of universities such as Harvard, M.I.T., and Tufts guaranteed the supply of personnel for the growth of high tech companies that followed, and new enterprises moved out of Boston proper to take advantage of cheap rental space along the now fabled Route 128.
Failures of the Neoclassical Growth Model
For almost 20 years Jacobs’s work had no perceptible impact on the economics profession until they were cited in Robert Lucas’s “On the Mechanics of Economic Development” (1988). Lucas went on to win the 1995 Nobel Prize in Economics. An earlier version of his paper had been in circulation since 1985 when it was first delivered as a Marshall Lecture at Cambridge University. This was more than a decade after I had heard Lucas discuss Jacobs’s ideas in a class in 1975. Lucas used as illustration the intense arguments faculty members often have over the recruitment of new hires as reflecting the importance of spillover benefit effects arising from potential complementarities in the hires. It was obvious even then that Lucas was intrigued by Jacobs’s ideas of the interactions among persons and enterprises as a source of dynamic externality to construct a model of economic growth.
Lucas’s 1988 paper successfully addressed two very important failures of the standard neoclassical model of economic growth. First, the standard model predicted that poor countries should grow faster than rich countries. This unfortunately was false as the majority of poor nations had remained poor relative to rich countries throughout the post-World War II era. No, or little, convergence had taken place. Second, in the absence of technological progress per capita income would cease growing after reaching the steady state level. But there was no explanation as to how technological progress would take place, other than by assertion, for otherwise it would be impossible to explain why rich countries continue to grow.
Lucas showed how the standard model of economic growth can be extended and altered to explain better the observed patterns of economic growth among nations. He introduced human capital into the standard model. First, he assumed that with effort human capital can be acquired without limit. This very plausible assumption is well supported by numerous studies of schooling, health care and on-the-job training. Introducing this feature allows economies to grow without slowing as they become richer, a possibility that the standard model denied.
Second, he assumed that higher average levels of human capital in an economy raise the level of productivity of everybody in that economy, not just the productivity of those whose human capital is higher. In other words, human capital skills are considered to be complementary and this introduces a dynamic externality into the model.
Testing for Dynamic Externalities
The dynamic externality arising from human capital emerges in the following manner. A person can exert effort, pay some cost, and acquire more human capital. With a higher level of human capital this person’s personal productivity increases and so will his earnings. In addition, the average level of human capital in the economy is also increased and it causes everybody’s productivity to rise. This productivity-enhancing effect is not reflected in increases to their personal earnings and is therefore an externality effect. Allowing economies to have different levels of human capital means those economies that are initially poor will remain poor relative to the initially rich economies. This is because rich economies can gain more from the externality effect than poor economies can. Catching up is therefore not implied in the new growth model.
Lucas recognized that just building externality effects into a model is a black box explanation and does not reveal anything about the actual channels or mechanisms by which they occur in the real world. In Jacobs’s work he already had the answer. He says: “I will be following very closely the lead of Jane Jacobs, whose remarkable book The Economy of Cities seems to me mainly and convincingly concerned (although she does not use this terminology) with the external effects of human capital.”
Lucas’s ringing endorsement of Jacobs’s idea led finally to her discovery by economists. The presence of dynamic externalities was tested in the paper “Growth in Cities” (1991) using US data for the six most important industries in 170 metropolitan areas between 1956 and 1987. The paper tested three theories. One theory was Michael Porter’s thesis The Competitive Advantage of Nations (1990) which suggested that competitive firms within a concentrated single-industry cluster provided the best structure for successful growth. Another theory associated with Paul Romer (1986) suggested that while single-industry clusters were most conducive to the spread of knowledge the incentives to produce knowledge were less among competitive firms than among monopolists or near-monopolists. The third theory was Jane Jacobs’s notion that new ideas and knowledge spread about most readily in cities with competitive, not monopolistic, businesses and with a diversity of business. Unlike Porter or Romer, diversity, not single-industry clusters, was important. The results of the study showed that competition was more conducive to growth than monopoly and that a diverse city economy was better than one with a concentration of a few industries. The evidence is thus negative on Romer, mixed on Porter, and consistent with Jacobs.
Lucas has reaffirmed in a subsequent article “Ideas and Growth” (2009) his belief in the Jacobs idea. He states: “But my own sense is that patents and ‘intellectual property’ more generally play a very modest role in the overall growth of production-related knowledge. I have sought a formulation that emphasizes individual contributions of large numbers of people, in which the role of market power is minimized.”
Jacobs’s and Lucas’s arguments contain deep truths and wisdom for rejuvenating a city that is full of possibilities, but is growing tired and susceptible to living on handouts.
Some Policy Implications for Hong Kong
A population policy that seeks to attract more talent to Hong Kong can only be beneficial for all if economic growth results from dynamic externalities produced by human capital. To date this has been more talk than substance. With the ageing population knocking on the door we clearly should be planning for a much larger and better population mix. To attract migrants and contracted non-local workers based on their capacity to produce and innovate, rather than merely the assets or spending power they command.
The latest policy insanity is to slow down the flow of Mainland mothers giving birth in Hong Kong just when the education standards of these mothers have finally approached the equivalent of those in Hong Kong. Children born today will join the labor force in twenty years when Hong Kong’s ageing problem has reached its peak.
Hong Kong has experienced over 50 years of rapid economic growth. Many of our retiring entrepreneurs and executives are in a great position to follow Ralph Flanders’s lead in Boston by creating the equivalent of a Route 128 here in Hong Kong. There is no lack of scientific and engineering manpower in our universities to support this; almost a third of our graduates come from the disciplines of science and engineering. The last thing we should expect is government funding in this area. Its committees will not choose the right companies, and the gifted or promising enterprises that need support will not apply thanks to the cumbersome procedures and endless application forms.
Government too has an important role to play in facilitating the conversion of old factory space in the community so as to make it more available to and affordable for start-ups and small businesses. For all practical purposes zoning restriction by use is already obsolete. The current application and approval process is still too cumbersome and the outcomes too uncertain.
Yes, investments in education and health are obviously relevant, but I shall save this for another article.
An examination of the institutions that have existed for 1000 years results in essentially three types: religion, universities and cities. The list does not include any governments or businesses. Cities have enormous vitality. Their lights are difficult to switch off, but this does not mean their needs should be ignored.
Edward Glaeser, Hedi Kallal, Jose Scheinkman, Andrei Shleifer, “Growth in Cities”, Journal of Political Economy, December 1992
Robert E Lucas, Jr. “On the Mechanics of Economic Development”, Journal of Monetary Economics, July, 1988
Robert E Lucas, Jr. “Ideas and Growth”, Economica, February, 2009
Paul Romer, “Increasing Returns and Long-Run Growth”, Journal of Political Economy, October, 1986