|May 7, 2006
'Knowledge and the Wealth of Nations,' by David Warsh
The Pin Factory Mystery
Review by PAUL KRUGMAN
ECONOMIC ideas play a large role in shaping the world. "Practical men,
who believe themselves to be quite exempt from any intellectual
influences," John Maynard Keynes said, "are usually the slaves of some
defunct economist." So it's odd how few popular books have been
written describing the social and personal matrix from which economic
ideas actually emerge. There have been no economics equivalents of,
say, James Watson's book "The Double Helix," or James Gleick's
biography of Richard Feynman.
David Warsh has now made a major effort to fill that gap. "Knowledge
and the Wealth of Nations" is the story of an intellectual revolution,
largely invisible to the general public, that swept through the
economics profession between the late 1970's and the late 1980's. I'll
come back to the question of how important that revolution really was.
But whatever one thinks of the destination, Warsh, a former columnist
for The Boston Globe who writes the online newsletter Economic
Principals, takes us on a fascinating journey through the world of
economic thought — and the lives of economists — from Adam Smith to
the present day.
I should mention here that I was a prominent player in some of the
events Warsh describes. My closeness to it all makes me aware of, and
perhaps oversensitive to, the things Warsh doesn't get quite right.
But let me focus on the book's virtues before I talk about its minor
Warsh tells the tale of a great contradiction that has lain at the
heart of economic theory ever since 1776, the year in which Adam Smith
published "The Wealth of Nations." Warsh calls it the struggle between
the Pin Factory and the Invisible Hand. On one side, Smith emphasized
the huge increases in productivity that could be achieved through the
division of labor, as illustrated by his famous example of a pin
factory whose employees, by specializing on narrow tasks, produce far
more than they could if each worked independently. On the other side,
he was the first to recognize how a market economy can harness
self-interest to the common good, leading each individual as though
"by an invisible hand to promote an end which was no part of his
What may not be obvious is the way these two concepts stand in
opposition to each other. The parable of the pin factory says that
there are increasing returns to scale — the bigger the pin factory,
the more specialized its workers can be, and therefore the more pins
the factory can produce per worker. But increasing returns create a
natural tendency toward monopoly, because a large business can achieve
larger scale and hence lower costs than a small business. So in a
world of increasing returns, bigger firms tend to drive smaller firms
out of business, until each industry is dominated by just a few players.
But for the invisible hand to work properly, there must be many
competitors in each industry, so that nobody is in a position to exert
monopoly power. Therefore, the idea that free markets always get it
right depends on the assumption that returns to scale are diminishing,
For almost two centuries, economic thinking was dominated by the
assumption of diminishing returns, with the Pin Factory pushed into
the background. Why? As Warsh explains, it wasn't about ideology; it
was about following the line of least mathematical resistance.
Economics has always been a discipline with scientific aspirations;
economists have always sought the rigor and clarity that comes from
using numbers and equations to represent their ideas. And the
economics of diminishing returns lend themselves readily to elegant
formalism, while those of increasing returns — the Pin Factory — are
notoriously hard to represent in the form of a mathematical model.
Yet the fact of increasing returns was always a conspicuous part of
reality, and became more so as the decades went by. Railroads, for
example, were obviously characterized by increasing returns. And so
economists tried, again and again, to bring the Pin Factory into the
mainstream of economic thought. Yet again and again they failed,
defeated by their inability to state their ideas with sufficient
rigor. Warsh quotes Kenneth Arrow, who received a Nobel in economic
science for work that is firmly in the Invisible Hand tradition:
increasing returns were an "underground river" in economic thought,
always there, yet rarely seeing the light of day.
The first half of "Knowledge and the Wealth of Nations" is a history
of economic thought from the vantage point of that underground river.
It describes how great economists chose to exclude increasing returns
from their analyses, even though many of them understood quite well
that they were leaving out an important part of the story. It also
tells the tale of economists, most notably Joseph Schumpeter, who
decided that if increasing returns couldn't be modeled rigorously, so
much the worse for rigor — and who found their literary,
nonmathematical versions of economics simply ignored. (Schumpeter was
a sad figure in his later years; his canonization as a patron saint of
economic growth — based largely on his famous phrase, "creative
destruction" — came long after his death.) The second half of the book
describes how the underground river finally fountained to the surface.
I've never seen anyone write as well as Warsh about the social world
of economic research, a world of brilliant, often eccentric people who
bear no resemblance to the dreary suits you see discussing the economy
on CNBC. It's a world of informal manners yet intense status
competition, in which a single seminar presentation can suddenly
transform a young man or woman into an academic star.
For about a decade, starting in the late 1970's, many of those star
turns involved increasing returns. Economists had finally found ways
to talk about the Pin Factory with the rigor needed to make it
respectable. One after another, fields from industrial organization to
international trade to economic development and urban economics were
Warsh does a superb job of conveying the drama of it all. He also
tells us about a number of remarkable people and what they did later
in their lives — because many of the once-young men (alas, there are
few women in the story) who made that revolution have had very
interesting second acts.
There are some flaws. The work of the economists who brought
increasing returns to international trade, a group that included yours
truly, receives flattering treatment, yet Warsh's account
misrepresents that work in subtle but important ways.
Maybe that slight sloppiness reflects Warsh's relative lack of
interest in applications of increasing returns other than the one he
believes to be most crucial: as an explanation of economic growth. He
portrays a famous 1990 paper about increasing returns and growth by
Paul Romer of Stanford University as a sort of pivot around which the
whole way economists see the world changed.
Now "Romer 1990" is a terrific paper — I wish I had written it, which
is the highest praise one economist can give to another. Yet I don't
think it can bear the weight Warsh places on it. Nor is it clear that
increasing returns really did transform our understanding of economic
growth. In fact, Warsh seems to concede as much. "So there is a new
economics of knowledge. What has changed as a result? The answer, it
seems to me, is not much."
Never mind. If you like reading stories of high intellectual drama, if
you want to know the origin of ideas that, as Keynes said, "are
dangerous for good or evil," this book is for you.
Paul Krugman is an Op-Ed columnist for The Times.
Copyright 2006 The New York Times Company