Although economic inefficiency is no virtue, it should not automatically be interpreted as a sign of failure in the functioning of the economy or its individual components. In fact, the pursuit of efficiency often comes at the expense of other values that are no less important.
CAMBRIDGE – Economics has always concerned itself with the efficient allocation of resources. But over a long generation, the quest for efficiency cannibalized the discipline. Now Elon Musk is planning to make the ruthless pursuit of efficiency the guiding principle of the incoming Trump administration. But efficiency in the allocation of resources, in this case government funds, always has the potential to compromise genuine effectiveness in the achievement of goals.
Historically, the discipline of economics was not just about allocation: the distribution of income and wealth and the stability of the system as a whole were also matters of concern. In the models of neoclassical economics, under competitive conditions, the factors of production will earn the marginal contribution that they make to output, rendering the resulting distribution of income fair by construction. And according to the rational expectations hypothesis, with its guarantee that all resources will be fully and efficiently employed (subject only to random external shocks), macroeconomic stabilization becomes irrelevant as a field of study.
By definition, given efficient markets, resources are optimally allocated to satisfy expressed individual preferences; free competition and the price mechanism ensure the absence of waste in a persistent general equilibrium. In 1954, Kenneth Arrow and Gérard Debreu translated this vision into a mathematical model that defines a general equilibrium where the infinity of all possible state-contingent transactions are executed once and for all.
The problem, of course, is that the Arrow-Debreu model describes an economy frozen in time. In principle, achieving such an equilibrium requires an infinite array of markets in which all products and services that ever will exist can be traded, with each transaction contingent on one of all the infinite states of the world that will ever exist. Given this, Arrow and Debreu concluded by disproving the hypothesis that an efficient general equilibrium could be reached in the real world.
The Efficiency Paradox
Pursuing efficiency in the real world entails a fundamental paradox. As the technology researcher Edward Tenner shows, the most efficient allocation for the current state of the world in the short run inevitably exposes some participants to radically inefficient outcomes when the state of the world changes. Hence, many of those who had optimized their balance sheets to maximize returns before 2008 ended up in liquidation after Lehman Brothers failed. Arrangements that had been efficient suddenly became ruinous.
Of course, economic inefficiency is not itself virtuous, and economists have long been aware of market failures. The literature on economic externalities, imperfect competition induced by increasing returns to scale, and diseconomies when increased size only increases costs has been growing and evolving ever since Arthur Pigou published his foundational work on welfare economics over a century ago.
In recent years, the Nobel Prize in Economic Sciences has been awarded to theorists who analyzed the consequences of information failures between market participants (George Akerlof, Michael Spence, and Joseph E. Stiglitz); those who evaluated psychological biases previously excluded from the discipline’s domain (Daniel Kahneman – whose collaborator, Amos Tversky, died before the award – and Richard Thaler); and those who demonstrated that contracts can never cover all the possible contingencies that might matter to the contracting partners (Oliver Hart and Bengt Holmström).
Yet efficiency remains the standard by which economists assess public policies and market outcomes. It drives cost-benefit analyses of government intervention in markets and underpins the credo that corporate managers’ only duty is to maximize shareholder value. As Elizabeth Popp Berman writes in Thinking like an Economist, the dominant “economic style … maintains a deep appreciation of markets as efficient allocators of resources … [and] places a very high value on efficiency as the measure of good policy.”
But public policy is not the only realm where devotion to efficiency prevails. The same excessive focus is apparent across the economy, where it crowds out other virtues and often comes at the expense of innovation, resilience, and fairness.
You Say You Want an Innovation
At the frontier of science and technology, progress is necessarily made by trial and error (with failures far outnumbering successes). The process requires investment in discovery and invention, as well as in experiments seeking to exploit the new economic opportunities created by innovation. Each step generates much waste, from dead-end research programs and useless inventions to failed commercial ventures. And when new entrepreneurial ventures deploy an innovation that displaces established incumbents, previously productive assets are rendered unprofitable and largely worthless.
Secure your copy of PS Quarterly: The Year Ahead 2025
Our annual flagship magazine, PS Quarterly: The Year Ahead 2025, has arrived. To gain digital access to all of the magazine’s content, and receive your print copy, subscribe to PS Digital Plus now.
Subscribe Now
Likewise, the innovations that have transformed the architecture of the market economy – from canals and railroads to electrification and the internet – have required massive investments to construct networks whose use value could not even have been imagined at the outset. At each stage of its evolution, the innovation economy depends on sources of funding that are not exclusively concerned with economic returns.
Historically, there have been two major sources of such funding. Recurrent waves of financial speculation have paid for the development and deployment of new technologies and experiments to find out what commercial benefits they may offer. And a proactive state has underwritten innovation-driven growth, usually in the name of national security and economic competitiveness.
After the late nineteenth century, the great corporations spawned by the Second Industrial Revolution funded much of the mechanical tinkering that unlocked new scientific discoveries, thus creating the basis for more economically meaningful innovation. These corporate giants were variously supported, or at least tolerated, by the state, because they reliably channeled some of their monopoly profits into central research laboratories. Think of America’s former telephone monopoly AT&T, its invention of the transistor, and the origins of the high-tech revolution. Monopoly, an inefficient economic outcome, provided the institutional base for investment in innovation.
Eventually, these corporations’ seemingly unassailable market positions were lost to competition or deregulation (AT&T nowadays is but a shadow of its former self), and surefire returns from share buybacks replaced risky investments in research and development. By then, however, a cadre of American political entrepreneurs had successfully established national security and public health as legitimate grounds for direct state investment in science. While the US Department of Defense sponsored all the foundational technologies that would drive the digital revolution, the National Institutes of Health became the midwife of genetic engineering and biotechnology.
Schumpeterian Waste
The necessary inefficiencies that underpin innovation are what I call “Schumpeterian waste,” in recognition of Joseph Schumpeter, the first economist to explore the economics of innovation extensively and intensively. Ever since Philippe Aghion and Peter Howitt formalized the process Schumpeter called “creative destruction” (in a seminal 1990 paper and later in their 2008 book, The Economics of Growth), empirical research on the topic has been growing.
The original Schumpeterian growth model assumes that aspiring innovators know enough about the future to optimize their investment in R&D; in this limited sense, it embeds the virtue of efficiency from the outset. But the model also recognizes that most of the competitors in an innovation race will fail. The winner will be a transient monopolist who can temporarily reap excess profits – “monopoly rents” – as the reward for the risky upfront investment that was made. Thus, inefficiency relative to the optimal allocation of resources in a static world is essential.
Nor is this the only inefficiency that accompanies Schumpeterian innovation. A few years ago, Aghion and Howitt reviewed their work in light of an American economy suffering from slow productivity growth and an evident decline in dynamism:
“Creative destruction sets up a conflict between the disruptive outsiders who gain from creative destruction and the entrenched incumbents who are threatened by it and therefore try to suppress it. This conflict is further complicated by the fact that the disruptive innovators will, if they succeed, eventually become reactionary incumbents themselves. Indeed, the more successful they are at innovating, the better positioned they will be to suppress future innovations by outsiders. So, the very same rents whose prospect induces innovations and growth can later be used to finance the suppression of innovation and growth.”
For a moment, at least, the rediscovery of industrial policy by US President Joe Biden’s administration mobilized the American state to address these endogenous barriers to investment at the technological frontier. The American Rescue Plan Act, the Bipartisan Infrastructure Law, and the Inflation Reduction Act represented a down payment on the revival of public underwriting of strategically valuable, risky investments. Whether the second Trump administration will support or seek to repeal these initiatives remains a critical “known unknown.”
The Resilience Imperative
The primary metric for assessing the efficiency of a firm’s allocation of capital is the financial returns it generates. Yet increased profits represent only one driver of higher returns on capital employed. Firms can also reduce the amount of committed capital, which results in more certain returns over the short term.
Investments whose benefits are contingent and systemic are the easiest for private firms to reduce. This is a longstanding issue. As Arrow and Richard R. Nelson noted in seminalpapers written more than 60 years ago, firms that fund R&D cannot capture all the possible future returns from it, because useful knowledge becomes public, patents expire, and the innovations become available to entrepreneurs to use to generate their own cashflows.
The reduced incentive to invest in innovation also applies to investment in resilience. The systemic benefits of investment in buffer stocks and second sources can be only partly captured, so they are not fully factored into individual firms’ calculations. As a result, firms consistently under-invest in this strategically critical domain (relative to its social value).
Recall how the COVID-19 pandemic exposed the fragility of highly efficient global supply chains that had been built on the back of information technology. The impetus to minimize short-term costs and maximize returns for the benefit of shareholders and managers meant that minimal capital was allocated to maintain the buffer stocks or redundant secondary sources that could have helped absorb supply shocks.
The economics of resilience also aligns with the economics of innovation on the matter of share buybacks, which were legalized in 1982. The fewer shares a public company has outstanding, the higher the earnings per share and the potential share price. Again, using positive free cashflows to buy back one’s own stock yields a far more certain and immediate return to shareholders (including managers holding stock options) than does any investment in resilience against possible future shocks.
Given these problems, evaluating the resilience of the economic system requires an extension of the discipline of economics – both theoretically and empirically – to encompass the complex, evolving networks that link firms to one another, upstream and downstream, in the space between microeconomics and macroeconomics. Fortunately, as I detailed last spring, research along these lines has been evolving rapidly.
Banishing Fairness
In Thinking like an Economist, Berman traces how the efficiency-centered “economic style” came to dominate public policy, overriding the concerns for fairness that animated the New Deal and (briefly) President Lyndon B. Johnson’s Great Society of the 1960s. Identifying its “subtler” agenda-defining role beyond the content of specific political programs, she writes:
“The economic style … is a framework for decision-making whose influence is closely tied to its ability to claim political neutrality. It portrays itself merely as a technical means of decision-making that can be used with equal effectiveness by people with any political values. This, though, is a ruse: efficiency is a value of its own.”
Under this non-political guise, efficiency informed the neoliberal order that began under Jimmy Carter, was brought to fruition under Ronald Reagan, and persisted through the Clinton and Obama administrations. The spirit of the age was captured in the title of an influential book by Arthur Okun, who had chaired the Johnson administration’s Council of Economic Advisers: Equality and Efficiency: The Big Tradeoff. Just over 15 years later, during the Clinton administration’s failed attempt at health-care reform, the Markle Foundation funded Maxis, the developer of SimCity, to build a health-policy simulation game in which users can toggle a simple slider to choose where they stand between the poles of equality and efficiency.
The core economic principle in this tradeoff is the “Pareto optimum” (often referred to as the First Welfare Theorem), which asserts that an allocation of resources is optimal when no one’s position can be improved without harming that of another. Absent from this definition is any reference to the actual distribution of income and wealth. For example, an increase in Medicaid funding paid for by higher taxes on the richest 0.01% is as much a violation of the principle as funding tax cuts for the rich by cutting Social Security benefits.
In 1939, the economists John Hicks and Nicholas Kaldor sought to account more directly for the question of distribution. Their Second Welfare Theorem states that a change in the allocation of resources remains optimal if the surplus received by the winners is sufficient to compensate the losers. But, of course, the critical question is not whether the winners could compensate the losers; it is whether they actually will do so.
Which Equality?
Whereas “equality of outcomes,” as an alternative to efficiency, is too extreme to withstand political contestation, “equality of opportunity” is a principle that stands at the critical juncture where the distribution of market power meets the distribution of political power. If efficiency is the presiding virtue of economics, the virtue of an open political system is fairness, subjectively evaluated by those with access to the political process.
Years before Musk thought to insert himself into US politics, the Supreme Court had radically altered the tension between the distribution of market and political power by extending the First Amendment’s protection of speech to political contributions, first in Buckley v. Valeo (1976) and then in Citizens United v. Federal Election Commission (2010). As Musk and many others have shown in the years since, when the winners in the marketplace control the political process, fairness is lost.
Ironically, at this moment, when one of the most extreme winners of the market game is demonstrating the ultimate in political hubris, the terms of the tradeoff may be reversed. The chaos that already dominated US politics prior to Donald Trump’s second term demonstrates that there is an even worse alternative to the tug of war between efficiency and fairness. The breakdown of any semblance of coherent governance is the opposite of optimal, no matter how one defines it.
If things get bad enough, perhaps we will see a new broad coalition comprising those who appreciate that a minimal level of efficiency is necessary for the maintenance of any level of fairness. This would be an ironic unintended consequence for those, particularly some of the titans of Big Tech, who aligned themselves with Trump in the hope of restoring the US to the political economy of Calvin Coolidge and Herbert Hoover.
Efficiency vs. Effectiveness
Whether the goal is increased innovation or resilience or fairness, public and private actors can expect to be evaluated on the proven effectiveness of their initiatives. The New Deal, initiated by Franklin D. Roosevelt following the wreckage of the Hoover years, remains the best example of a peacetime public-policy agenda that prioritized effectiveness over efficiency. Notwithstanding the premature declaration of victory before the 1937-38 “Roosevelt Recession,” the New Deal ended America’s greatest-ever financial crisis and put a rising floor under the economic recovery. Along the way, the New Deal’s Works Progress Administration put millions of unemployed people to work while also adding “boondoggle” to the political lexicon as a synonym for government inefficiency.
But the industrial mobilization that came with the onset of World War II was an even more explicit confrontation between efficiency and effectiveness. The most recent examination comes from the eminent economic historian Alexander J. Field. In A Great Leap Forward, he guides readers to the paradoxical conclusion that the years of the Great Depression delivered some of the most rapid productivity growth in American history.
The expansion of electricity-generating capacity and distribution networks during the Roaring Twenties, along with the diffusion of unit drive motors, transformed manufacturing by enabling flexible production at radically lower cost. Supported by the New Deal’s investment in road building, the surge in manufacturing productivity spilled over to the economy overall. No doubt, survivors’ bias played a role as well, since those firms that lacked the managerial capacity or the financial resources to deploy the new manufacturing technology simply disappeared from the scene.
In his recent book, The Economic Consequences of U.S. Mobilization for the Second World War, Field’s unequivocal assessment is that “the decline in manufacturing productivity between 1941 and 1945 almost completely wiped out the gains made between 1939 and 1941. Total factor productivity … declined by 5.05% per year during the War versus the growth of 10.5% during the two prewar years.” Mobilization, as he meticulously documents, was profoundly inefficient.
Field’s framework reflects an affinity for rationalist economic planning and leads him to engage in counterfactual speculation about what an efficient mobilization would have required.
The military’s evolving requirements were the biggest wild card in trying to plan production. In an ideal world, such needs would have been deduced from a careful analysis of military strategy; but this was not possible in 1942. As Field recounts, the Allied strategy was not fully settled until after the Tehran Conference in late November 1943. In fact, by then the tide of war had already shifted decisively in the Allies’ favor.
Set against this historical reality, Field offers a profoundly irrelevant alternative universe in which “[an] agreed-upon and widely understood strategy would have enabled both military and civilian planners to make informed choices about what to manufacture and in what order. Earlier determination of strategy could have helped govern what in the event was a chaotic process of economic mobilization.”
My father, Eliot Janeway, offered an utterly different perspective on the WWII mobilization. His book, The Struggle for Survival, published more than 70 years ago, was written under the shadow of his first-hand experience with the response – political, economic, and social – to what was an existential global crisis. He begins by celebrating FDR’s recognition, before Pearl Harbor, that efficient planning for mobilization would at best be a distraction from the most fundamental requirement:
“To Roosevelt, as the crisis deepened, as our involvement in it came to seem inescapable, as the battle over isolationism grew more embittered, the important question was the involvement of the nation as a whole in its own defense, not the administrative planning for its participation. … His administrative performance was indeed amateurish. But the message he meant to make clear got through to the people in the end and in time: industrial mobilization for defense was necessary, and if war came only America’s industrial mobilization could win it.”
One phrase from my father’s book has entered the language: the war was won on “the momentum of production.” … Was this despite the manifest, multitudinous inefficiencies that Field documents? Or, rather, were those inefficiencies integral to generating the momentum of production?
On May 15, 2020, just as COVID-19 had frozen economies around the world, the Trump administration launched Operation Warp Speed, providing $11 billion to develop vaccines. No fewer than six vaccine programs were funded (Pfizer-BioNTech was not among them, but it did receive large advanced purchase agreements from the US government). The first vaccines were authorized for use by the end of that year.
Of course, Trump refused to take credit for these strong results, and he has since nominated fanatical anti-vaxxers like Robert F. Kennedy, Jr., to his second administration. Regardless, the lesson, again, is that in times of stress and unavoidable uncertainty, the appropriate response is to multiply one’s efforts in the interest of effectiveness. Tolerance of necessary waste is essential to success.
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Ricardo Hausmann
urges the US to issue more H1-B visas, argues that Europe must become a military superpower in its own right, applies the “growth diagnostics” framework to Venezuela, and more.
From cutting taxes to raising tariffs to eroding central-bank independence, US President-elect Donald Trump has made a wide range of economic promises, many of which threaten to blow up the deficit and fuel inflation. But powerful institutional, political, and economic constraints, together with Trump’s capriciousness, have spurred disagreement about how worried we should be.
The Truth About MigrationTimothy Hearsum/Design Pics Editorial/Universal Images Group via Getty Images
CAMBRIDGE – Economics has always concerned itself with the efficient allocation of resources. But over a long generation, the quest for efficiency cannibalized the discipline. Now Elon Musk is planning to make the ruthless pursuit of efficiency the guiding principle of the incoming Trump administration. But efficiency in the allocation of resources, in this case government funds, always has the potential to compromise genuine effectiveness in the achievement of goals.
Historically, the discipline of economics was not just about allocation: the distribution of income and wealth and the stability of the system as a whole were also matters of concern. In the models of neoclassical economics, under competitive conditions, the factors of production will earn the marginal contribution that they make to output, rendering the resulting distribution of income fair by construction. And according to the rational expectations hypothesis, with its guarantee that all resources will be fully and efficiently employed (subject only to random external shocks), macroeconomic stabilization becomes irrelevant as a field of study.
By definition, given efficient markets, resources are optimally allocated to satisfy expressed individual preferences; free competition and the price mechanism ensure the absence of waste in a persistent general equilibrium. In 1954, Kenneth Arrow and Gérard Debreu translated this vision into a mathematical model that defines a general equilibrium where the infinity of all possible state-contingent transactions are executed once and for all.
The problem, of course, is that the Arrow-Debreu model describes an economy frozen in time. In principle, achieving such an equilibrium requires an infinite array of markets in which all products and services that ever will exist can be traded, with each transaction contingent on one of all the infinite states of the world that will ever exist. Given this, Arrow and Debreu concluded by disproving the hypothesis that an efficient general equilibrium could be reached in the real world.
The Efficiency Paradox
Pursuing efficiency in the real world entails a fundamental paradox. As the technology researcher Edward Tenner shows, the most efficient allocation for the current state of the world in the short run inevitably exposes some participants to radically inefficient outcomes when the state of the world changes. Hence, many of those who had optimized their balance sheets to maximize returns before 2008 ended up in liquidation after Lehman Brothers failed. Arrangements that had been efficient suddenly became ruinous.
Of course, economic inefficiency is not itself virtuous, and economists have long been aware of market failures. The literature on economic externalities, imperfect competition induced by increasing returns to scale, and diseconomies when increased size only increases costs has been growing and evolving ever since Arthur Pigou published his foundational work on welfare economics over a century ago.
In recent years, the Nobel Prize in Economic Sciences has been awarded to theorists who analyzed the consequences of information failures between market participants (George Akerlof, Michael Spence, and Joseph E. Stiglitz); those who evaluated psychological biases previously excluded from the discipline’s domain (Daniel Kahneman – whose collaborator, Amos Tversky, died before the award – and Richard Thaler); and those who demonstrated that contracts can never cover all the possible contingencies that might matter to the contracting partners (Oliver Hart and Bengt Holmström).
Yet efficiency remains the standard by which economists assess public policies and market outcomes. It drives cost-benefit analyses of government intervention in markets and underpins the credo that corporate managers’ only duty is to maximize shareholder value. As Elizabeth Popp Berman writes in Thinking like an Economist, the dominant “economic style … maintains a deep appreciation of markets as efficient allocators of resources … [and] places a very high value on efficiency as the measure of good policy.”
But public policy is not the only realm where devotion to efficiency prevails. The same excessive focus is apparent across the economy, where it crowds out other virtues and often comes at the expense of innovation, resilience, and fairness.
You Say You Want an Innovation
At the frontier of science and technology, progress is necessarily made by trial and error (with failures far outnumbering successes). The process requires investment in discovery and invention, as well as in experiments seeking to exploit the new economic opportunities created by innovation. Each step generates much waste, from dead-end research programs and useless inventions to failed commercial ventures. And when new entrepreneurial ventures deploy an innovation that displaces established incumbents, previously productive assets are rendered unprofitable and largely worthless.
Secure your copy of PS Quarterly: The Year Ahead 2025
Our annual flagship magazine, PS Quarterly: The Year Ahead 2025, has arrived. To gain digital access to all of the magazine’s content, and receive your print copy, subscribe to PS Digital Plus now.
Subscribe Now
Likewise, the innovations that have transformed the architecture of the market economy – from canals and railroads to electrification and the internet – have required massive investments to construct networks whose use value could not even have been imagined at the outset. At each stage of its evolution, the innovation economy depends on sources of funding that are not exclusively concerned with economic returns.
Historically, there have been two major sources of such funding. Recurrent waves of financial speculation have paid for the development and deployment of new technologies and experiments to find out what commercial benefits they may offer. And a proactive state has underwritten innovation-driven growth, usually in the name of national security and economic competitiveness.
After the late nineteenth century, the great corporations spawned by the Second Industrial Revolution funded much of the mechanical tinkering that unlocked new scientific discoveries, thus creating the basis for more economically meaningful innovation. These corporate giants were variously supported, or at least tolerated, by the state, because they reliably channeled some of their monopoly profits into central research laboratories. Think of America’s former telephone monopoly AT&T, its invention of the transistor, and the origins of the high-tech revolution. Monopoly, an inefficient economic outcome, provided the institutional base for investment in innovation.
Eventually, these corporations’ seemingly unassailable market positions were lost to competition or deregulation (AT&T nowadays is but a shadow of its former self), and surefire returns from share buybacks replaced risky investments in research and development. By then, however, a cadre of American political entrepreneurs had successfully established national security and public health as legitimate grounds for direct state investment in science. While the US Department of Defense sponsored all the foundational technologies that would drive the digital revolution, the National Institutes of Health became the midwife of genetic engineering and biotechnology.
Schumpeterian Waste
The necessary inefficiencies that underpin innovation are what I call “Schumpeterian waste,” in recognition of Joseph Schumpeter, the first economist to explore the economics of innovation extensively and intensively. Ever since Philippe Aghion and Peter Howitt formalized the process Schumpeter called “creative destruction” (in a seminal 1990 paper and later in their 2008 book, The Economics of Growth), empirical research on the topic has been growing.
The original Schumpeterian growth model assumes that aspiring innovators know enough about the future to optimize their investment in R&D; in this limited sense, it embeds the virtue of efficiency from the outset. But the model also recognizes that most of the competitors in an innovation race will fail. The winner will be a transient monopolist who can temporarily reap excess profits – “monopoly rents” – as the reward for the risky upfront investment that was made. Thus, inefficiency relative to the optimal allocation of resources in a static world is essential.
Nor is this the only inefficiency that accompanies Schumpeterian innovation. A few years ago, Aghion and Howitt reviewed their work in light of an American economy suffering from slow productivity growth and an evident decline in dynamism:
“Creative destruction sets up a conflict between the disruptive outsiders who gain from creative destruction and the entrenched incumbents who are threatened by it and therefore try to suppress it. This conflict is further complicated by the fact that the disruptive innovators will, if they succeed, eventually become reactionary incumbents themselves. Indeed, the more successful they are at innovating, the better positioned they will be to suppress future innovations by outsiders. So, the very same rents whose prospect induces innovations and growth can later be used to finance the suppression of innovation and growth.”
For a moment, at least, the rediscovery of industrial policy by US President Joe Biden’s administration mobilized the American state to address these endogenous barriers to investment at the technological frontier. The American Rescue Plan Act, the Bipartisan Infrastructure Law, and the Inflation Reduction Act represented a down payment on the revival of public underwriting of strategically valuable, risky investments. Whether the second Trump administration will support or seek to repeal these initiatives remains a critical “known unknown.”
The Resilience Imperative
The primary metric for assessing the efficiency of a firm’s allocation of capital is the financial returns it generates. Yet increased profits represent only one driver of higher returns on capital employed. Firms can also reduce the amount of committed capital, which results in more certain returns over the short term.
Investments whose benefits are contingent and systemic are the easiest for private firms to reduce. This is a longstanding issue. As Arrow and Richard R. Nelson noted in seminal papers written more than 60 years ago, firms that fund R&D cannot capture all the possible future returns from it, because useful knowledge becomes public, patents expire, and the innovations become available to entrepreneurs to use to generate their own cashflows.
The reduced incentive to invest in innovation also applies to investment in resilience. The systemic benefits of investment in buffer stocks and second sources can be only partly captured, so they are not fully factored into individual firms’ calculations. As a result, firms consistently under-invest in this strategically critical domain (relative to its social value).
Recall how the COVID-19 pandemic exposed the fragility of highly efficient global supply chains that had been built on the back of information technology. The impetus to minimize short-term costs and maximize returns for the benefit of shareholders and managers meant that minimal capital was allocated to maintain the buffer stocks or redundant secondary sources that could have helped absorb supply shocks.
The economics of resilience also aligns with the economics of innovation on the matter of share buybacks, which were legalized in 1982. The fewer shares a public company has outstanding, the higher the earnings per share and the potential share price. Again, using positive free cashflows to buy back one’s own stock yields a far more certain and immediate return to shareholders (including managers holding stock options) than does any investment in resilience against possible future shocks.
Given these problems, evaluating the resilience of the economic system requires an extension of the discipline of economics – both theoretically and empirically – to encompass the complex, evolving networks that link firms to one another, upstream and downstream, in the space between microeconomics and macroeconomics. Fortunately, as I detailed last spring, research along these lines has been evolving rapidly.
Banishing Fairness
In Thinking like an Economist, Berman traces how the efficiency-centered “economic style” came to dominate public policy, overriding the concerns for fairness that animated the New Deal and (briefly) President Lyndon B. Johnson’s Great Society of the 1960s. Identifying its “subtler” agenda-defining role beyond the content of specific political programs, she writes:
“The economic style … is a framework for decision-making whose influence is closely tied to its ability to claim political neutrality. It portrays itself merely as a technical means of decision-making that can be used with equal effectiveness by people with any political values. This, though, is a ruse: efficiency is a value of its own.”
Under this non-political guise, efficiency informed the neoliberal order that began under Jimmy Carter, was brought to fruition under Ronald Reagan, and persisted through the Clinton and Obama administrations. The spirit of the age was captured in the title of an influential book by Arthur Okun, who had chaired the Johnson administration’s Council of Economic Advisers: Equality and Efficiency: The Big Tradeoff. Just over 15 years later, during the Clinton administration’s failed attempt at health-care reform, the Markle Foundation funded Maxis, the developer of SimCity, to build a health-policy simulation game in which users can toggle a simple slider to choose where they stand between the poles of equality and efficiency.
The core economic principle in this tradeoff is the “Pareto optimum” (often referred to as the First Welfare Theorem), which asserts that an allocation of resources is optimal when no one’s position can be improved without harming that of another. Absent from this definition is any reference to the actual distribution of income and wealth. For example, an increase in Medicaid funding paid for by higher taxes on the richest 0.01% is as much a violation of the principle as funding tax cuts for the rich by cutting Social Security benefits.
In 1939, the economists John Hicks and Nicholas Kaldor sought to account more directly for the question of distribution. Their Second Welfare Theorem states that a change in the allocation of resources remains optimal if the surplus received by the winners is sufficient to compensate the losers. But, of course, the critical question is not whether the winners could compensate the losers; it is whether they actually will do so.
Which Equality?
Whereas “equality of outcomes,” as an alternative to efficiency, is too extreme to withstand political contestation, “equality of opportunity” is a principle that stands at the critical juncture where the distribution of market power meets the distribution of political power. If efficiency is the presiding virtue of economics, the virtue of an open political system is fairness, subjectively evaluated by those with access to the political process.
Years before Musk thought to insert himself into US politics, the Supreme Court had radically altered the tension between the distribution of market and political power by extending the First Amendment’s protection of speech to political contributions, first in Buckley v. Valeo (1976) and then in Citizens United v. Federal Election Commission (2010). As Musk and many others have shown in the years since, when the winners in the marketplace control the political process, fairness is lost.
Ironically, at this moment, when one of the most extreme winners of the market game is demonstrating the ultimate in political hubris, the terms of the tradeoff may be reversed. The chaos that already dominated US politics prior to Donald Trump’s second term demonstrates that there is an even worse alternative to the tug of war between efficiency and fairness. The breakdown of any semblance of coherent governance is the opposite of optimal, no matter how one defines it.
If things get bad enough, perhaps we will see a new broad coalition comprising those who appreciate that a minimal level of efficiency is necessary for the maintenance of any level of fairness. This would be an ironic unintended consequence for those, particularly some of the titans of Big Tech, who aligned themselves with Trump in the hope of restoring the US to the political economy of Calvin Coolidge and Herbert Hoover.
Efficiency vs. Effectiveness
Whether the goal is increased innovation or resilience or fairness, public and private actors can expect to be evaluated on the proven effectiveness of their initiatives. The New Deal, initiated by Franklin D. Roosevelt following the wreckage of the Hoover years, remains the best example of a peacetime public-policy agenda that prioritized effectiveness over efficiency. Notwithstanding the premature declaration of victory before the 1937-38 “Roosevelt Recession,” the New Deal ended America’s greatest-ever financial crisis and put a rising floor under the economic recovery. Along the way, the New Deal’s Works Progress Administration put millions of unemployed people to work while also adding “boondoggle” to the political lexicon as a synonym for government inefficiency.
But the industrial mobilization that came with the onset of World War II was an even more explicit confrontation between efficiency and effectiveness. The most recent examination comes from the eminent economic historian Alexander J. Field. In A Great Leap Forward, he guides readers to the paradoxical conclusion that the years of the Great Depression delivered some of the most rapid productivity growth in American history.
The expansion of electricity-generating capacity and distribution networks during the Roaring Twenties, along with the diffusion of unit drive motors, transformed manufacturing by enabling flexible production at radically lower cost. Supported by the New Deal’s investment in road building, the surge in manufacturing productivity spilled over to the economy overall. No doubt, survivors’ bias played a role as well, since those firms that lacked the managerial capacity or the financial resources to deploy the new manufacturing technology simply disappeared from the scene.
In his recent book, The Economic Consequences of U.S. Mobilization for the Second World War, Field’s unequivocal assessment is that “the decline in manufacturing productivity between 1941 and 1945 almost completely wiped out the gains made between 1939 and 1941. Total factor productivity … declined by 5.05% per year during the War versus the growth of 10.5% during the two prewar years.” Mobilization, as he meticulously documents, was profoundly inefficient.
Field’s framework reflects an affinity for rationalist economic planning and leads him to engage in counterfactual speculation about what an efficient mobilization would have required.
The military’s evolving requirements were the biggest wild card in trying to plan production. In an ideal world, such needs would have been deduced from a careful analysis of military strategy; but this was not possible in 1942. As Field recounts, the Allied strategy was not fully settled until after the Tehran Conference in late November 1943. In fact, by then the tide of war had already shifted decisively in the Allies’ favor.
Set against this historical reality, Field offers a profoundly irrelevant alternative universe in which “[an] agreed-upon and widely understood strategy would have enabled both military and civilian planners to make informed choices about what to manufacture and in what order. Earlier determination of strategy could have helped govern what in the event was a chaotic process of economic mobilization.”
My father, Eliot Janeway, offered an utterly different perspective on the WWII mobilization. His book, The Struggle for Survival, published more than 70 years ago, was written under the shadow of his first-hand experience with the response – political, economic, and social – to what was an existential global crisis. He begins by celebrating FDR’s recognition, before Pearl Harbor, that efficient planning for mobilization would at best be a distraction from the most fundamental requirement:
“To Roosevelt, as the crisis deepened, as our involvement in it came to seem inescapable, as the battle over isolationism grew more embittered, the important question was the involvement of the nation as a whole in its own defense, not the administrative planning for its participation. … His administrative performance was indeed amateurish. But the message he meant to make clear got through to the people in the end and in time: industrial mobilization for defense was necessary, and if war came only America’s industrial mobilization could win it.”
One phrase from my father’s book has entered the language: the war was won on “the momentum of production.” … Was this despite the manifest, multitudinous inefficiencies that Field documents? Or, rather, were those inefficiencies integral to generating the momentum of production?
On May 15, 2020, just as COVID-19 had frozen economies around the world, the Trump administration launched Operation Warp Speed, providing $11 billion to develop vaccines. No fewer than six vaccine programs were funded (Pfizer-BioNTech was not among them, but it did receive large advanced purchase agreements from the US government). The first vaccines were authorized for use by the end of that year.
Of course, Trump refused to take credit for these strong results, and he has since nominated fanatical anti-vaxxers like Robert F. Kennedy, Jr., to his second administration. Regardless, the lesson, again, is that in times of stress and unavoidable uncertainty, the appropriate response is to multiply one’s efforts in the interest of effectiveness. Tolerance of necessary waste is essential to success.