Quotulatiousness

November 25, 2017

Can You Beat the Market?

Filed under: Economics — Tags: , , — Nicholas @ 02:00

Marginal Revolution University
Published on 23 Aug 2016

On average, even professional money managers don’t beat the market. To show you why, here’s a scenario to consider:

Say we advise you to invest in companies serving the aging US population. Since the percentage of elderly will rise over the coming decades, it makes sense to invest now in products and services that the elderly might need. Sounds logical, right? Wrong.

See, the aging of the US population isn’t a secret. It’s public information. Now, say you acted on the information and did buy stock as we advised. The current price of that stock already reflects information known to the market. Thus, it’s hard to systematically outperform the market, given that everyone else tends to have the same information you do. This is also the main idea behind the efficient market hypothesis.

According to the efficient market hypothesis, the prices of traded assets already reflect all publicly available information.

With information available to buyers and sellers alike, no one has any sustainable advantage over anyone else. This is why even the pros tend not to beat the market. And that aside, even if news did pop up to change the price of an asset, it would be at random and would likely be reflected in the asset price almost immediately. So there’s no reliable way to forecast performance.

As proof of that, take the Challenger space shuttle crash of January 28, 1986. Within minutes of the crash, the news hit the Dow Jones wire service. The stock prices of the major contractors who helped build the shuttle fell immediately. Keep in mind: that was in the 80s. At today’s pace, new information can change stock prices within seconds. This is why stock tips often end up obsolete.

So to sum up — it’s hard to beat the market. You have to accept that.

Still, how should you invest? That’s what we’ll discuss in the next video.

November 9, 2017

How Expert Are Expert Stock Pickers?

Filed under: Economics — Tags: , , — Nicholas @ 02:00

Marginal Revolution University
Published on 16 Aug 2016

In this first video in our Personal Finance section of Macroeconomics — and also our new course on Money Skills — we’ll begin to lay out some smart rules for investing.

Today, we’ll tackle Rule 1 — ignore the expert stock pickers.

What’s the basis of that rule? Well, in his 1973 book, A Random Walk Down Wall Street, economist Burton Malkiel made a controversial claim. He claimed that a blindfolded monkey, throwing darts at the financial pages, could select a basket of stocks that would do just as well as a set chosen by the pros.

One of Malkiel’s later students, the journalist John Stossel, set out to test that claim. Stossel did throw darts at the financial pages. The darts landed on 30 companies. Turns out, Malkiel did have it right — the randomly-selected stocks did better than professionally-picked ones.

The point here is, random picking roughly gives you as good results, as trusting the pros. Consider — in most years from 1963-2008, the S&P 500 Index outperformed most of the managed mutual funds. And in a different study, researchers took the top 25% best-performing funds. Two years later, less than 4% of the original set remained in the top quarter. Five years later? Only 1% stuck around.

Basically — past performance doesn’t guarantee future results. Chance often tends to win out.

To show you what we mean, take a hypothetical set of 1000 experts making market predictions. Let those predictions be based on a coin toss. Experts who land heads will say the market will surge this year. Those who land tails say the opposite. At the end of the experiment’s first year, 500 of the 1000 experts will have been right, solely by chance. Now, say the remaining 500 toss again. At the end of the second year, 250 experts will have been right, again by chance. Continue with this logic, and by the end of the fifth year, roughly 32 of the 1000 will have been right, five years running.

Perhaps these 32 will be hailed as geniuses, but remember, they only came about through a coin toss.

So, what’s to conclude from this? Two things.

First, luck and chance matter. In some cases, it can be hard to differentiate luck from skill, as proven by the “genius” 32. Second, no need to spend big bucks on a money manager. After all, the studies prove that random picking often works just as well as professional management.

That said, what if you did have market information? What if you knew something about certain stocks, that made you think they’d do well? Could you beat the market then? That’s what we’ll answer in our next video, when we tackle the efficient market hypothesis. Stay tuned!

October 11, 2017

The Great Recession

Filed under: Economics, Government, USA — Tags: , , , , — Nicholas @ 04:00

Marginal Revolution University
Published on 9 Aug 2016

There’s already been much discussion over what fueled the Great Recession of 2008. In this video, Tyler Cowen focuses on a central theme of the crisis: the failure of financial intermediaries.

By 2008, the economy was in a very fragile state, with both homeowners and banks taking on greater leverage, many ending up “underwater.” Why did managers at financial institutions take on greater and greater risk? We’ll discuss a couple of key reasons, including the role of excess confidence and incentives.

In addition to homeowners’ leverage and bank leverage, a third factor played a major role in tipping the scale toward crisis: securitization. Mortgage securities during this time were very hard to value, riskier than advertised, and filled to the brim with high risk loans. Cowen discusses several reasons this happened, including downright fraud, failure of credit rating agencies, and overconfidence in the American housing market.

Finally, a fourth factor joins homeowners’ leverage, bank leverage, and securitization to inch the economy closer to the edge: the shadow banking system. On the whole, the shadow banking system is made up of investment banks and various other complex financial intermediaries, highly dependent on short term loans.

When housing prices started to fall in 2007, it was the final nudge that pushed the economy over the cliff. There was a run on the shadow banking system. Financial intermediaries came crashing down. We faced a credit crunch, and many businesses stopped growing. Layoffs ensued, increasing unemployment.

What could have been done to prevent all of this? You’ll have to watch the video to find out.

October 5, 2017

Four Reasons Financial Intermediaries Fail

Filed under: Americas, Economics, Japan — Tags: , , , , , — Nicholas @ 02:00

Marginal Revolution University
Published on 26 Jul 2016

As we’ve discussed in previous videos, financial intermediaries bridge savers and borrowers. When these bridges crumble, the effects can be disastrous. For businesses, credit shortages can lead to bankruptcy, or layoffs. For individuals, they rely on credit to invest in education or a new home or car. These negative effects show you how crucial intermediaries are to our lives.

Still, what exactly causes failed intermediation? Four answers:

First, insecure property rights. Simply speaking, when you save money at a bank, you expect the ability to pull out your funds when needed. But what if your deposits are frozen? Or confiscated altogether? For instance, in 2013 amidst a financial crisis, the government in Cyprus confiscated bank deposits to help pay down the country’s budget shortfall. You can see how insecure property rights can scare away potential savers.

Second, controls on interest rates. Interest rates are the price of borrowing. Thus, controls on interest rates, often called usury laws, are effectively price ceilings—they set the interest rate lower than the market equilibrium interest rate. With this forced lowering of interest rates, borrowers will want to borrow more, but lenders won’t want to lend. The effect? A lending shortage.

Third, politicized lending. Banks profit by assessing risk, and then loaning, based on that assessment. Banks that excel at assessment succeed. Those poor at it die out. Problems arise when the government intervenes to prop up failing banks, resulting in what we call “zombie banks.” In such cases, intervention undercuts normal competition, and intervention tends to favor banks that are politically connected. In fact, it’s been shown that there’s an inverse correlation between government ownership in banks and a country’s GDP per capita and productivity growth.

Fourth, you have runs, panics, and scandals. Remember, trust is vital to the financial system. When trust erodes, depositors may rush to withdraw their money from banks, causing what is known as a “bank run.” This can cause banks to fail, as we saw during the Great Depression. Scandals can also depress market confidence. Enron, WorldCom and Bernie Madoff may come to mind.

So, which of these four factors contributed to the Great Recession of 2008?

We’ll discuss that in our next video.

September 30, 2017

Office Hours: The Bond Market

Filed under: Economics — Tags: , — Nicholas @ 02:00

Marginal Revolution University
Published on 19 Jul 2016

In Intro to the Bond Market, you learned the basics about bonds and how they differ from stocks. But what if you’re investing and you’ve got a few possible companies to choose from? How would you evaluate which bond is likely to be the best investment for you?

Let’s look at an example from our bond market practice questions:

Suppose you’d like to invest in a company and you’ve narrowed your choice down to three firms: Company A is offering a zero-coupon bond with a face value of $1000 to be repaid in 1 year for $963. Company B has the same face value and maturity date but sells for $871. And company C also has the same face value and maturity but sells for $985. In which would you rather invest?

If some of the terms have you scratching your head, don’t worry! Go ahead and start this Office Hours video. Mary Clare Peate from the MRU team will cover the jargon and give you the tools you need to master the problem on your own.

September 20, 2017

Intro to the Bond Market

Filed under: Economics — Tags: , , — Nicholas @ 02:00

Published on 12 Jul 2016

Most borrowers borrow through banks. But established and reputable institutions can also borrow from a different intermediary: the bond market. That’s the topic of this video. We’ll discuss what a bond is, what it does, how it’s rated, and what those ratings ultimately mean.

First, though: what’s a bond? It’s essentially an IOU. A bond details who owes what, and when debt repayment will be made. Unlike stocks, bond ownership doesn’t mean owning part of a firm. It simply means being owed a specific sum, which will be paid back at a promised time. Some bonds also entitle holders to “coupon payments,” which are regular installments paid out on a schedule.

Now — what does a bond do? Like stocks, bonds help raise money. Companies and governments issue bonds to finance new ventures. The ROI from these ventures, can then be used to repay bond holders. Speaking of repayments, borrowing through the bond market may mean better terms than borrowing from banks. This is especially the case for highly-rated bonds.

But what determines a bond’s rating?

Bond ratings are issued by agencies like Standard and Poor’s. A rating reflects the default risk of the institution issuing a bond. “Default risk” is the risk that a bond issuer may be unable to make payments when they come due. The higher the issuer’s default risk, the lower the rating of a bond. A lower rating means lenders will demand higher interest before providing money. For lenders, higher ratings mean a safer investment. And for borrowers (the bond issuers), a higher rating means paying a lower interest on debt.

That said, there are other nuances to the bond market—things like the “crowding out” effect, as well as the effect of collateral on a bond’s interest rate. These are things we’ll leave you to discover in the video. Happy learning!

August 23, 2017

Intro to Stock Markets

Filed under: Business, Economics — Tags: , — Nicholas @ 04:00

Published on 5 Jul 2016

Today, we’ll examine a new kind of financial intermediary: stock markets.

As an individual, you participate in the stock market when you buy a company’s shares. This turns you into a part-owner, entitled to some of the company’s profits. Sometimes, profits are paid out directly via dividends. Other times, profits are reinvested for company growth. In this case, you benefit by seeing the value of your shares rise in tandem with this growth.

Still, the buying and selling of stock doesn’t actually create any new investment. Buying and selling only transfers ownership between stockholders. What actually creates investment is when a company offers stock to the public for the first time (known as an Initial Public Offering or IPO), which is when it issues new shares to raise money for key ventures.

This process of turning savings into investment is what makes the stock market an intermediary.

A key caveat, though — buying stock essentially means betting on a company. As with all gambles, sometimes it pays off, sometimes, it doesn’t. For you as a saver, this means some of your stocks will win, and others, not so much.

This volatility makes stock markets more risky than banks. Bank savers typically don’t have to worry about fluctuations in the value of their deposits.

As for the entrepreneurial side, the stock market is a key institution encouraging new businesses. For a founder, the payoff typically comes during the IPO. An IPO allows founders to sell some of their ownership (in a now more-valuable company) so they can diversify their own holdings.

Next time, we’ll look at the third kind of intermediary: bond markets.

August 18, 2017

What Do Banks Do?

Filed under: Business, Economics — Tags: , — Nicholas @ 02:00

Published on 28 Jun 2016

This week: Dive deeper into one type of financial intermediary: Banks.

Next week: Sticking with macroeconomics, we’ll take a look at the next intermediary: Stock Markets.

Some people want to save and invest, others want to borrow. Sometimes, savers and borrowers link up directly. But most times, they don’t know each other. So they rely on institutions that bridge them together. These bridges are called financial intermediaries, and this video will show you one kind—banks.

How do banks operate?

On the savings side, they attract depositors by paying interest on deposits. On the borrowing side, banks make loans, for which they charge interest. The key to a bank’s profit is in charging a higher interest for loans than the interest paid out to depositors. Of course, to make sure that loans are as productive as possible, banks have specialized staff and systems for evaluating loan applications.

That sort of due diligence, and specialization is central to what a bank does. Not only does a bank coordinate the savings of many, but it also undertakes the task of studying borrowers in order to determine the most qualified. And then, to further minimize risk, a bank will spread its money out across a whole portfolio of loans. Thus, if one loan goes bad, the bank won’t go bankrupt.

In this way, you can see how banks provide valuable services—they allow you to earn interest on your savings, while also turning those savings into loans, which help economic growth.

Notice though, that as a depositor, your savings won’t just rest in a vault. But then, what happens when you decide to make a withdrawal? Banks account for that by having reserves. Banks keep an eye on their reserves so they can cover the withdrawals of various depositors. Predictably, problems arise, when there aren’t enough reserves to cover withdrawals. In the words of our previous video, that’s one kind of failed intermediation.

In the next video, we’ll look at a different kind of intermediary — stock markets.

There, we’ll show you how stock markets turn savings into investment. Hang tight, and see you then!

August 13, 2017

Saving and Borrowing

Filed under: Economics — Tags: , , , — Nicholas @ 02:00

Published on 21 Jun 2016

On September 15, 2008, Lehman Brothers filed for bankruptcy, and signaled the start of the Great Recession. One key cause of that recession was a failure of financial intermediaries, or, the institutions that link different kinds of savers to borrowers.

We’ll get to intermediaries in the next video, but for now, we’ll first look at the market intermediaries are involved in.

This market is the combination of savers and borrowers — what we call the “market for loanable funds.”

To start, we’ll represent the market, using two curves you know well—supply and demand. The quantity supplied in the market comes from savings, and the quantity demanded comes from loans. But as you know, we have to factor in price. In the case of the market for loanable funds, the price is the current interest rate.

What happens to the supply of savings when the interest rate goes up? When are borrowers compelled to borrow more? Or less? We’ll cover these scenarios in this video.

One quick note: there’s not really one unified market for loanable funds. Instead, there are many small markets, with different sorts of lenders, lending to different sorts of borrowers. As we said in the beginning, it’s financial intermediaries, like banks, bond markets, and stock markets, which link these different sides of the market.

We’ll get a better understanding of these intermediaries in our next video, so stay tuned!

August 7, 2017

The Idea Equation

Filed under: Economics — Tags: , , — Nicholas @ 02:00

Published on 31 May 2016

Alex Tabarrok’s TED talk showed you that ideas can trump nearly every crisis. Now, since ideas are so important, we have to ask: is the future of ideas a bright one?

To answer that, we’ll look at something we call the Idea Equation.

It goes like this: Ideas = Population x Incentives x Ideas/per hour.

This equation is a useful way to lay out the factors affecting idea production. When we understand the factors behind production, then we can better predict how the future will go.

Now, the first factor in the equation, is population.

Population determines how many possible idea creators we can have. The good news is, not only is world population growing, but a larger percentage of that population is becoming part of the researcher pool. For instance, China now has 1 researcher per thousand people. This seems low, until you remember they had about half a researcher per thousand in the year 2000. This means they’ve doubled their researcher pool, in just about 10 years.

So, on the population front, we’re seeing progress.

But how about the incentives that encourage idea creation? What’s the state of those?

That’s factor 2 in the equation, and again, we have good news here.

See, for the most part, countries are now choosing better institutions. On balance, the world now has more dependable legal systems, and more honest governments. Previously closed-off nations are now opening their markets to competition and trade. Aside from that, the world is generally becoming more politically stable, and property rights are strengthening as well.

As a result of these better institutions, there are now more incentives to produce ideas. Not to mention, we’re still continuing to globalize world markets. Remember what the TED talk said? Larger markets incentivize more R&D, and we’re certainly seeing higher activity in this area.

For example, in 1990, only seven nations accounted for 92% of world research spending. Today, those same 7 countries only account for 56%. Countries like China, Korea, and Brazil have already joined the fray, sharing the burden of idea creation, which benefits us all.

That said, we do still have the third part of the Idea Equation. This is where things get hairy.

You see, the factor “ideas/per hour” is the most mysterious one. Yes, it measures the productivity of idea creators, but we’re still unsure how productive the future will be. For one, there’s evidence that idea creation is becoming more expensive in certain fields. But on the other hand, we’re also seeing new technology that makes idea creation easier—things like the Internet, AI, and online education.

As long as we continue to globalize markets, provide better incentives for idea production, and keep developing technology that makes idea creation easier, then there’s no reason to think that the future can’t be bright. The brightness may not be guaranteed, but at least there’s hope, which is what matters.

July 31, 2017

Patents, Prizes, and Subsidies

Published on 17 May 2016

Growth on the cutting edge is all about the creation of new ideas.

So, we want institutions that incentivize such creation. How do we do this? The answer is somewhat tricky.

The first goal for good ideas is for them to spread as freely as possible. The further the reach, the greater the gains. The problem is, if just anyone can use ideas, then why would we ever pay for them? And without the right incentives, why would innovators create new ideas at all?

Imagine yourself as the creator of a new drug. Typically, it costs about a billion dollars to do this, not counting the time and effort needed to get the drug FDA-approved.

Now, if there were no protections in place, then theoretically, once the formula’s known, everyone could just copy the make-up of your new drug. See, the thing about pharmaceuticals is, once the formula’s known, production is relatively cheap. Given that, let’s assume imitations start flooding the market.

Predictably, the price of your new drug will plummet.

Once prices hit rock-bottom, you’ll have no way to recoup the $1 billion you spent on R&D.

Given that kind of result, we reckon you probably won’t want to develop more good ideas.

The US founding fathers anticipated this problem. Knowing that innovators needed incentives to have good ideas, the founders wrote a protection mechanism into the Constitution.

They gave Congress the ability to grant exclusive rights to inventors — rights to use and sell their inventions, for a limited period of time. This exclusive right, is what we call a patent. Patents grant inventors a temporary monopoly over the use and sale of their intellectual property.

Now, as nice as this is, patents are a thorny subject.

For one, how long should patents last? Also, how much innovation is considered enough to merit a patent grant? Not to mention, are patents the only way to reward good ideas?

The answer is no.

There are two more incentive options here: prizes, and subsidies.

Let’s start with subsidies. University and research subsidies are particularly effective in the basic sciences. Since innovations in this space are rather abstract, subsidies incentivize research without requiring the applications of the research to be explicitly named. The problem is, when we’re incentivizing just research, then researchers might pick directions that are interesting, but not particularly useful.

This is why the third incentive option — prizes — exists.

Prizes reward the output of solving a certain problem. Another plus, is that prizes leave solutions unspecified. They provide a problem to work on, but give quite a lot of leeway as to how the problem is solved.

Now, knowing the complexity inherent in patents, you might think that prizes and subsidies are good enough alternatives. But none of these incentives for ideas, are inherently better than any of the others. Patents, prizes, and subsidies all involve their own tradeoffs and questions.

For example, who decides what gets subsidized? Who decides which goals merit a prize?

It’s hard to determine what mix of institutions, will best incentivize the production of good ideas. Patents, prizes, and subsidies all navigate these conflicting goals, in their own way.

And yes, all this talk of incentives and conflicting goals and tradeoffs might be like walking a tightrope. But, it’s a tightrope we can’t opt out of. Certainly not if we want the economy to keep growing.

In our next release, you’ll watch a TED talk from a certain economist that elaborates further on ideas. And then, we’ll wrap up this course segment with the Idea Equation. Stay tuned!

July 24, 2017

The Economics of Ideas

Filed under: Economics, History — Tags: , , — Nicholas @ 02:00

Published on 10 May 2016

At the end of our last video, we asked, “What spurs the growth of new ideas?”

To answer that, we’ll tell you two stories.

The first is about a man named John Kay.

He created the flying shuttle, one of the key inventions of the Industrial Revolution. His shuttle improved looms, and made it possible to produce clothes quicker and more cheaply. This allowed larger numbers of people to have new, clean clothes, and it made fashion something that was no longer just for the rich. But what did he get for his efforts?

Well, the weavers who were threatened by his invention broke the improved looms and his house was burned down. He eventually fled to France, fearing for his life, and eventually died there, a poor man.

Our second story paints a completely different picture.

It’s about a man almost everyone knows: Steve Jobs.

Like Kay, Steve Jobs was also an innovator, pioneering products like the iPod, iTunes, iPhone, and the iPad. For his efforts, he earned not only money but recognition as well. Unlike John Kay, Steve Jobs became an icon, celebrated for his achievements in the world.

Why such a stark difference between these two men?

When we examine the differences between John Kay and Steve Jobs, we’re also looking at the thing that either dooms an idea or allows it to prosper. This vital factor is institutions, which serve as the soil where ideas are planted.

Depending on the quality of said soil, the ideas either take root, or they shrivel into nothingness.

To understand how this is, think of the institutions in the United States today.

The US has institutions that encourage the germination and growth of ideas. If you’re an entrepreneur, America has incubators and investors, ready to fund your idea if it’s a good one. In the US, you also have recourse to laws that protect your idea, not to mention a culture that celebrates innovators. And, if your idea’s a good one, the market will handsomely reward you.

To tell you the truth, John Kay could only have dreamed of institutions like the ones we have today.

As you can see, good institutions can mean the difference between an idea withering and an idea thriving.

While it may seem like ideas grow at random, the truth is you need a set of key ingredients, or what we call “institutions.”

In the next video, we’ll see how patents affect the growth of ideas, and we’ll examine the trade-offs between protecting and sharing ideas. Last, we’ll also look at the role the government can play, in providing a stable environment where ideas can flourish.

July 18, 2017

The Solow Model and Ideas

Filed under: Economics — Tags: , , — Nicholas @ 02:00

Published on 3 May 2016

More Solow Model from MRU’s Macro course: the power of ideas in driving economic growth.

A deeper dive into what helps spur the creation of ideas.

According to our previous videos in this section, the Solow model seems to predict that we’ll always end up in a steady state with no economic growth.

But, the Solow model still has one variable unaccounted for: ideas.

So, can ideas keep us growing?

Ideas do one thing really well: they give us more bang for our buck.

This means we get more output for the same inputs of capital and labor. Ideas are a way of upping our productivity, increasing output per worker across different industries.

Just how much extra output are we talking about?

Well, imagine changing the A variable of the Solow model from 1 to 2. This means a doubling of our productivity.

This shifts the entire output curve upward. When output doubles, so does investment. Once investment comes in faster than depreciation, we end up accumulating capital once again.Thus, the economy keeps growing, which further boosts output.

Now, think of what would happen, if ideas continually improved. With each improvement, ideas would keep shifting the output curve upward, which will continually increase investment as well, and allow us to keep to the left of the steady state.

And when we stay to the left, that means we keep growing.

What all this means is, growth at the cutting edge is determined by two things.

First, it’s determined by how fast new ideas are formed, and second, by how much those ideas increase productivity.

You now have a complete picture of our simple Solow model. It’s a model that accounts for catching up growth, due to capital accumulation, and cutting edge growth, due to the buildup of ideas.

Now, since ideas foster growth at the cutting edge, we’re left with the question that naturally follows: what factors help spur the accumulation of ideas?

That’s what we’ll discuss in the next video, so hang tight!

July 15, 2017

Office Hours: The Solow Model: Investments vs. Ideas

Filed under: Economics — Tags: , , , — Nicholas @ 04:00

Published on 7 Jun 2016

Ideas are a major factor in economic growth. But so are saving and investing. If you were given the choice between living in an inventive (more ideas) or a thrifty (more savings) country, which would you choose?

The Solow model of economic growth, which we recently covered in Principles of Macroeconomics, can help you make the choice. In this Office Hours video, Mary Clare Peate will use our simplified version of the Solow model to show you an easy way to work out each country’s economic prospects, and then compare them to see where you’d rather be.

June 26, 2017

Human Capital & Conditional Convergence

Filed under: Economics — Tags: , — Nicholas @ 14:33

Published on 26 Apr 2016

In our previous macroeconomics video, we said that the accumulation of physical capital only provides a temporary boost to economic growth. Does the same apply to human capital?

To answer that, consider this: what happens to all new graduates, in the end?

For a while, they’re productive members of the economy. Then age takes its toll, retirement rolls around, and eventually, the old workforce is replaced with a new infusion of people. But then, the cycle restarts. You get a new workforce, everyone’s productive for a while, and then they too retire.

Does this ring a bell?

It should, because this is similar to the depreciation faced by physical capital.

Similarly, are there diminishing returns to education? It likely wouldn’t pay off for everyone to have a PhD, or for everyone to master Einstein’s great theories.

That means the logic of diminishing returns, and the idea of a steady state, also applies to human capital.

So, now we can revise our earlier statement.

Now we can say that the accumulation of any kind of capital, only provides a temporary boost in economic growth. This is because all kinds of capital rust. So, one way or another, we’ll reach a point where new investments can only offset depreciation.

It’s the steady state, all over again.

However, what does the journey to steady state look like?

The Solow model predicts that poor countries should eventually catch up to rich countries, especially since they’re growing from a lower base. And given their quicker accumulation of capital, poorer nations should also grow faster, than their more developed neighbors.

And eventually, every country should reach similar steady states.

In other words, we would see growth tracks that all eventually converge.

So, why isn’t this always the case? Why, in some cases, are we seeing “Divergence, Big time,” as coined by economist Lant Pritchett?

The answer to these questions, lies in the institutions of different countries and the incentives they create.

Assuming that a certain set of countries do have similar institutions, that’s where we see the convergence predicted by the Solow model. We see that poorer countries do grow faster than their richer counterparts. And conditional on having similar institutions, eventually, even poorer countries will reach a similar steady state of output as more developed nations. We call this phenomenon conditional convergence.

You can think of it as a national game of catch-up, with catch-up only happening if institutions don’t differ.

What happens though, once all this catching up is done?

Let’s not forget that there’s still another variable in the Solow model. This is variable A: ideas — the subject of our next video.

There, we’ll show you how ideas can keep a country moving along the cutting edge of growth.

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