Back in the U.S.S.R.

Are we more similar than we're comfortable to admit? David Leonhardt:

Richard Freeman, a Harvard economist, argues that our bubble economy had something in common with the old Soviet economy. The Soviet Union’s growth was artificially raised by massive industrial output that ended up having little use. Ours was artificially raised by mortgage-backed securities, collateralized debt obligations and even the occasional Ponzi scheme.

The boys at FreeExchange (The Economist) follow-up with:

There are three sources of economic growth—labour, capital, and productivity—but there exist diminishing returns to labour and capital, at least in the short and medium run. Thus, a sustained level of growth comes only from increases in productivity, brought on by innovation. Russia experienced so much growth in the postwar era because it acquired lots of capital, but it ultimately could not sustain prosperity because the marginal value of adding more capital diminished after a certain point. Increased capital and labour also explain the impressive growth rates of the Asian tigers.

The mortgage backed securities in Mr Leonhardt’s example constitute innovation, not capital. Much of the financial innovation of recent years did facilitate sustained growth. It gave firms the means to acquire productive capital. But the innovation outpaced the necessary regulation and capital was misallocated. That doesn't mean we are fundamentally doomed to economic failure.

Mr Leonhardt goes on to say that growth comes from investment, which is correct. But, as the Russian example illustrates, the simple addition of more capital cannot provide growth indefinitely. Investment that leads to sustainable growth targets things that enhance productivity. The market ultimately determines which innovations are useful and can be successfully adopted.

Mr Leonhardt believes government investment is the way forward. He cites the infrastructure projects of the 1950s and 1960s as examples. That was productive capital accumulation and it provided the institutions necessary to let market based innovations thrive. It certainly contributed to growth, but was not solely responsible for it. As we learned from command economies, government spending on capital does not provide long term prosperity. Government investment is often necessary, but not sufficient, for growth. The investment must provide incentives and support for innovation in the marketplace, which is why investments in education (which he mentions), infrastructure, and R&D are so important.

Mr Leonhardt is critical of the flagrant consumption habits of Americans. But according to Amar Bhide the appetite for new and better goods actually gives Americans a comparative advantage. It means that new innovations (developed at home or abroad) can thrive in America moreso than elsewhere—innovation can't spur growth if there is not a market for it. But too much consumption can indeed harm growth, via reduced saving and eventually less capital accumulation. American consumers need to save more, but their “venturesome consumption habits” should be encouraged

It is dangerous to presume that government investment is generally a better engine of growth than the private sector. Government investment can lead to high rates of sustainable growth, but that investment must enhance a market place where private investment thrives as well.

Before you take a sigh of relief, remember that The Economist is full of "very serious people" who were dead certain there was no housing bubble in 2005. FreeExchange rests their entire argument upon the presumption that we were making financial innovations. What isn't addressed in their response is that these so called "financial innovations" worked by distorting risk valuations, scrupulously avoiding regulation, and were poorly understood by the investors who purchased them. And when you look at it that way it seems a lot less like a "financial innovation" and more like a 21st century mega-scam. And indeed, it was.

Think of it this way: Is it innovation to take a group of 9,000 subprime mortgages and turn it into a capital structure pyramid where even the equity trenches are sometimes given AAA ratings?

Not innovation we can believe in.