Will everyone be worse off if the United States turns social democratic?

September 29, 2012

Daron Acemoglu, James Robinson, and Thierry Verdier have a new paper that asks “Can’t We All Be More Like Scandinavians?” Their answer is no. The answer follows from a model they develop in which

  1. Countries choose between two types of capitalism. “Cutthroat” capitalism provides large financial rewards to successful entrepreneurship. This yields high income inequality, but it stimulates lots of entrepreneurial effort and hence is conducive to innovation. “Cuddly” capitalism features less financial payoff to entrepreneurs and more generous cushions against risk. This yields modest income inequality but less innovation.
  2. Because of the difference in innovation, economic growth initially is faster in cutthroat-capitalism nations. But technological advance spills over from cutthroat nations to cuddly ones, so growth rates then equalize. Over the long run, GDP per capita is higher in cutthroat-capitalism nations (due to the initial burst) while economic growth rates are similar across the two types.
  3. Average well-being may be higher in cuddly countries because the more egalitarian distribution of economic output more than compensates for the lower level of output.
  4. Nevertheless, it would be bad for all countries if cutthroat-capitalism nations switched to cuddly capitalism. That would reduce innovation in the (formerly) cutthroat nations, which would reduce economic growth in all nations.

Acemoglu, Robinson, and Verdier say the model might help us understand patterns of economic growth and well-being in the United States and the Nordic countries — Denmark, Finland, Norway, and Sweden. The United States chose cutthroat capitalism, while the Nordics chose cuddly capitalism. The U.S. grew faster for a short time, but since then all five countries have grown at the roughly same pace. America’s high inequality encourages innovation. The Nordics can be cuddly and still grow rapidly because of technological spillover. If the U.S. were to decide to go cuddly, innovation would slow. Both sets of nations would grow less rapidly.

Incentives, innovation, and economic growth in the U.S. and Sweden

I won’t provide the “detailed empirical study of these issues” that Acemoglu and colleagues say they hope their paper will inspire, but I can offer a little data. To keep things simple, I’ll compare the United States with just one of the Nordic countries: Sweden.

An indicator of financial incentives for entrepreneurs is the top 1%’s share of household income. An indicator of the extent of cushions against risk is government expenditures’ share of GDP. What we see in the data is a lot of similarity between the U.S. and Sweden until the second half of the twentieth century. Government spending begins to diverge in the 1960s, income inequality in the 1970s.

Though Sweden’s top 1% get a smaller share of the total income than their American counterparts, are incentives for entrepreneurs really much weaker in Sweden? Swedish CEOs and financial players don’t pull in American-style paychecks and bonuses in the tens of millions, but there is little to prevent an entrepreneur from accumulating large sums. In the 1990s Sweden undertook a significant tax reform, reducing marginal rates and eliminating loopholes and deductions. Corporate income and capital gains tax rates were lowered to 30%, and the personal income tax rate to 50%. Later the wealth tax was done away with. In the early 2000s a writer for Forbes magazine mused that Sweden had transformed itself from a “bloated welfare state” into a “people’s republic of entrepreneurs.”

But set this aside for the moment. Suppose the incentives for entrepreneurs did begin to differ in the two countries around 1960 or 1970. The model predicts innovation will subsequently diverge. Acemoglu, Robinson, and Verdier refer to one measure of patent applications per capita that has the U.S. leading Sweden beginning in the late 1990s. That timing perhaps is consistent with the model’s prediction if we allow a substantial lag. But they cite another measure that is available starting in 1980 and has the U.S. well ahead of Sweden already by then. This suggests America’s innovation advantage might have preceded rather than followed the two countries’ type-of-capitalism choice.

The final outcome is GDP per capita. Here the model stumbles. The gap between the two countries isn’t recent; it dates back to more than a century ago. Apart from a few hiccups, each country has stayed on its long-run growth path throughout the past 100 years, with Sweden slowly catching up to the United States.

So the U.S. and Sweden have chosen different styles of capitalism, at least as measured by income inequality and public spending. That choice looks to have occurred around 1960 at the earliest. The U.S. may be the more innovative of the two nations, and that advantage may have come after the type-of-capitalism choice. But the model doesn’t seem to help in explaining the gap between the two countries in per capita GDP.

Will American innovation slow if we go “cuddly”?

The really interesting question posed by Acemoglu, Robinson, and Verdier is whether innovation would slow in the United States if we strengthened our safety net and/or reduced the relative financial payoff to entrepreneurial success. I’m skeptical, for three reasons.

The first flows from America’s past experience. According to Acemoglu et al’s logic, incentives for innovation in the U.S. were weakest in the 1960s and 1970s. In 1960 the top 1%’s share of pretax income had been falling steadily for several decades and had nearly reached its low point. Government spending, meanwhile, had been rising steadily and was close to its peak level. Yet there was plenty of innovation in the 1960s and 1970s, including notable advances in computers, medical technology, and other fields.

Second, the Nordic countries, with their low income inequality and generous safety nets, currently are among the world’s most innovative countries. The World Economic Forum’s Global Competitiveness Index has consistently ranked them close to the United States in innovation. The most recent report, for 2012-13, rates Sweden as the world’s most innovative nation, followed by Finland. The U.S. ranks sixth. The 2012 WIPO-Insead Global Innovation Index ranks Sweden second and the United States tenth. Whether or not this lasts, it suggests reason to doubt that modest inequality and generous cushions are significant obstacles to innovation.

Third, if Acemoglu and colleagues are correct about the value of financial incentives in spurring innovation, we should see this reflected not only in the United States but also in other nations with relatively high income inequality and low-to-moderate government spending, such as Australia, Canada, Ireland, New Zealand, and the United Kingdom. But we don’t.

There’s one additional possibility worth considering. If financial incentives truly are critical for spurring innovation, it could be the opportunity for large gains that matters, rather than the absence of cushions. Suppose we were to increase government revenues in the United States via higher taxes on everyone — steeper income taxes on the top 1% or 5% plus a new national consumption tax. And imagine we used those revenues to expand public insurance and services — fully universal health insurance, universal early education, a beefed-up Earned Income Tax Credit, a new wage insurance program, more individualized assistance with training and job placement. These changes wouldn’t alter income inequality much, but they would enhance economic security and opportunity. Would innovation decline? I doubt it.

We may get a test of this moderate-to-high inequality with generous cushions scenario at some point. I suspect this is where America is heading, albeit slowly. Interestingly, the Nordic countries, where the top 1%’s income share has been trending upward (see figure 10 here), might end up there first.

16 Responses to “Will everyone be worse off if the United States turns social democratic?”

  1. cfaman Says:

    But we are cuddly! I have a hard time thinking about innovations that have made a big difference since WWII that have not come directly our of government investment or substantially encouraged by government investment.

    And,

    Suppose a cut throat country develops a new body of knowledge and sells it in education for it’s marginal product to the student, you know a really high price with high incomes to follow. Maybe a few make the investment. Meanwhile in a cuddly country their knowledge may not be as advanced, but the investment is subsidized and made available to all students, so a large number become educated. Now, where did the return on investment go? In cut throat, it went to the sellers of education with some spinoff to those who hired the graduates. And most remained uneducated. In cuddly, everyone became somewhat educated but not to the highest level and the returns were broadly shared.

    It seems I need some numbers to work with here but I’d bet that cuddly could end up with greater aggregate wealth than cutthroat in this situation.


  2. There’s just so much too this. At the heart of it is the again and again mistake (or intentional misleading) of doing a benefit-benefit analysis, not a cost-benefit analysis.

    Even if there were a micro benefit to rewarding entrepreneurs with $5 billion instead of $2.5 billion, or $250 million, or even $25 million (How hard would you work for a serious probability of $25 million, especially if $25 million was as rare and prestigious, and attractive to women, as $5 billion is today? Never forget monumental positional externalities), consider the gargantuan cost of way less money for basic scientific and medical research, way less money for advanced infrastructure, way less money to educate workers well, way less money for healthcare to keep workers productive and closer to their potential,…

    The costs are enormous of not developing your people, your basic science, your infrastructure, to get at most a micron more of effort out of entrepreneurs.

    When you actually do a comprehensive cost-benefit analysis (not a benefit-nothing analysis), it makes the right’s argument look ridiculous.

  3. Terje Johan Abrahamson Says:

    For a Scandinavian, it is nice to see how highly the American left holds our systems. At the same time, it is funny to see how little they know of the systems, that they hold so high.

    If you had known Sweden, you would never wanted to trade the American system for the Scandinavian. The cut in livingstandard would just be to high, for everyone except for the bottom….

    For a starter, read this report about the issue… It is written by a Swedish research-institution, and they are focusing on the facts; not an mirage: http://www.timbro.se/bokhandel/pdf/9175665646.pdf

  4. Lasse Aaskoven Says:

    Well there has actually been some empirical research, which seems to back at least some of the claims of Acemoglu et al. In a paper published in 2008 in Public Choice. Working paper version avaible here http://ideas.repec.org/p/aal/abbswp/06-18.html two Danish economist actually finds that size of government (the central feature of cuddly Nordic capitalism) is negatively correlated with entrepeneurial activity.

    That said, you are probably right, that the US could become more cuddly without losing much entrepeneurial activity and that the Scandinavians could becomre more entrepeneurial without changing the central features of the Nordic welfare states. The capital gains tax in Denmark is to make and example the highest in OECD and is according to a report from the European Central Bank actually harmful for Danish tax revenue. A lower capital gains tax could both provide incentive and ressources for more entrepeneurial activity without causing direct cuts in size of government, allthough inequality might rise.

  5. Luke Says:

    Looking at the government spending and GDP per capita graphs on this post, it does look like Sweden’s GDP per capita was converging on the USA’s, until their government spending dramitically rose. Then their GDP per capita starts trending down away from the USA until they reduced their spending and it started converging again.

  6. Tord Steiro Says:

    Inequality is a bad measure of the incentive to innovate. What if the inequality is a result of extractive institutions rather than returns on innovations?

    I am a bit surprised that you use the inequality measure outright without addressing this issue. My bet is that some of the higher inequality in the US is actually the result of extractive institutions rather than compensation to innovators.

    Furthermore, if you read Acemoglu et. al. model in detail, you see that the main theory is that Scandinavian businesses are free-riding on US innovations. If you would want to prove or disprove their theory, why not focus on this particular issue?

    You could do so by looking into which countries the private sector choose to spend the most on R&D. Let’s say the Scandinavians spend less, while still innovate. We could think they may benefited from free-riding, right?

    I would love to see some numbers of private sector R&D spending to GDP, and an analysis of the trends relative to opportunities for free-riding on each others innovations.

    Just some thoughts.

  7. uffthefluff Says:

    As to that silly paper on how much more prosperous the US is compared to Europe:

    In 2010 Sweden (83%) registered the highest share of broadband connections in 2010, followed by Denmark (80%), Finland (76%) and Germany (75%). For the US it is 68%. The US manages to tie Portugal in smartphone ownership and is well behind Scandinavia. Oh and lets not forget about such trivialities as infant mortality or life expectancy.

    Good rebuttal of a shoddy hypothesis and see also http://observationalepidemiology.blogspot.com/2012/10/cutthroat-capitalism-and-5220-club.html


  8. There is a reason that the US innovation is skewed related to government expenditures compared to most other countries. Almost all of the US huge businesses stemmed from the federal governments investment into the Department of Defense through its fight to supplant the USSR. Take for example the internet. After it became open to private investment and the public, the innovations and businesses skyrocketed and people made fast money due to the low tax rate for the rich.

    One has to factor in the amount of money that the US invested into ‘military technology’ to get a clear answer regarding government expenditures. This should fix the skewed issues with the graphs and give a better idea on innovation and why going ‘cuddly’ isn’t such a bad idea.

  9. lark Says:

    For a real world data point, I am a software engineer and I’ve worked in numerous start ups (and I’m familiar with the context and community). One of the entrepreneurs I worked for (long list of brilliant accomplishments omitted) committed suicide after incurring health care debt for which he had no insurance. I’ve heard tech people refer to health insurance from their corporate employers as ‘golden handcuffs’.

    Being an entrepreneur often involves becoming uninsured for a time. This doesn’t work for many talented folks (who may have family responsibilities). This fellow is not the only person I personally know who had a health catastrophe after leaving a secure job with health insurance for an entrepreneurial opportunity.

    This obvious point is the sort of thing that makes innovation easier in countries with a better safety net.

    The fact that this study has been widely discussed and no one has brought up this obvious issue… well let’s just say it does not reflect well on the reality orientation of the economics profession.

    I do think economists who favor a weak social net to encourage entrepreneurship should in fact try out the lifestyle before they preach it. Take the risk, drop your health insurance.

  10. Stefan Siewert Says:

    The authors have a preference for a Scandinavian-like welfare. As the current election campaigns in the US show, this might or might not reflect the opinion of a majority. Whatever the choice, the reward for being the lead or “cutthroat” country is substantial beyond GDP: a global currency, overwhelming military power, dominance in international institution, attractiveness for talent and capital, an outstanding entrepreneurial mentality, and a leading educational sector. Maybe the functioning of the US economy can be explained only as the spearhead of the world economy. During the 20th century the US was the leading country and, even while challenged, it will stay so for the foreseeable future.
    The model assumes only developed country. However, if we reflect on the world economy there are around 1 billion people living in or near subsistence, around 800 million undernourished people, despite the fact that since the industrial revolution both the population and wealth have increased considerable.

    Indeed, the key question might be that if there is an asymmetric equilibrium between a “cutthroat” and a “cuddly” economy there might be also an asymmetric equilibrium between a developed and an underdeveloped country. In this case, both countries generate growth, but they also reproduce their significant differences. In a competitive and innovative global arena, growth it determined in both countries by reward and free ride. Countries maximize growth if they follow these paths; they loose growth if they start experiments that do not fit to the global trade-off between reward and free ride.

    The Acemoglu, Robinson and Verdier model also assumes that the trade off is positive. This is the case for developing countries. They have significant institutional capacity and resources. In the world economy with developing countries it might become negative for some countries. At some point there is a need to adapt to rising standards (new technologies, civilisation and performance standards), but the reward is not offsetting the costs, contributing to fragility, in the end to state failure.

    There are some practical implications if we follow this model:
    1. There are losers on the global arena, which should be compensated beyond the fight against poverty, health and clear water.
    2. The era of receipts like the Washington consensus are gone, the era of individual solutions has started.
    3. Lessons learnt from other countries are limited, as the global economy is changing and the reward from innovation is decreasing. This might be one of the main reasons, development aid does not show significant influence on the growth rate of beneficiary countries.

    The discussion is rewarding and useful.

  11. Cavoyo Says:

    “The United States chose cutthroat capitalism, while the Nordics chose cuddly capitalism. The U.S. grew faster for a short time, but since then all five countries have grown at the roughly same pace.”

    Yeah, it’s not like there was a war in the middle of the century that destroyed Europe’s productive capacity. No, it’s because the US was “cutthroat” when it had the highest levels of taxation and public spending in its history. Sure.

    Also, this claptrap about how innovation comes from profit-seeking entrepreneurs was all debunked by The Entrepreneurial State. Speaking of which, its authors recommended that Great Britain adopt a state investment program like the US’s Department of Defense to foster innovation. So much for the US being “cutthroat” and Europe being “socialist!”

  12. Jane Flemming Says:

    A Norwegian neighbour, who values Norway’s social safety net and egalitarian ethos, nevertheless says that Norwegian culture is not kind to “square pegs” as he put it. People are discouraged from standing out from the culture at large. In this article from Inc. magazine

    http://www.inc.com/magazine/20110201/in-norway-start-ups-say-ja-to-socialism.html

    it is interesting to see how bureaucracy in Norway both supports and stifles innovation. Entrepreneurs, the article suggests, tend to be motivated by a desire to pursue an interesting and challenging project, rather than the financial incentives.

    Also, although few of the successful entrepreneurs interviewed for the article seem to resent Norway’s high taxes, most are frustrated by the bureaucracy that makes them jump through a lot of hoops to get rid of undesirable employees, and most are enthusiastic to get into the exciting American market. I suspect it’s the freewheeling iconclasm that is encouraged in the US that is really behind it’s innovative culture.

    I remember learning that one of the characteristics of traditional Canadian literature is the tendancy of individuals/characters to be punished for standing out. We are rewarded for staying in the group. I believe Northrup Frye said that Canada would never have a truly great literature until we abandoned this ethos. I wonder if the internet and instant access to the whole world won’t eventually result in more innovation everywhere.

    Thank you for this blog. It’s wonderful to find this in Canada

  13. Jane Flemming Says:

    Sorry, found you by way of Miles Corak, who is Canadian, and has a great blog. Lost my place briefly.


  14. It is worthwhile to highlight the “method” employed by Acemoglu et al: They start by formulating a model that suits them ideologically, while not offering any supporting empirical evidence. They then ask for empirical studies to validate their model. The problem is not just that in science, you are supposed to start from observation and then formulate testable hypotheses to explain the data. A problem is also that their model is based on vague, ideologically loaded concepts (“cutthroat”, “cuddly” etc.) that are not actually well suited for empirical validation (although Lane does an admirable job). What these concepts are well suited for is to create model bias, in other words to ideologically frame a debate. Even Lane’s critical treatment might ultimately just promote a flawed model by establishing the model’s dubious concepts as an accepted frame of reference.


  15. Also, the approach is ahistoric to the point of parody. Economies evolve. What we think of as the “Scandinavian model” (or German or French model) was developed after WWII. The US economy dramatically changed during the New Deal and later during Reaganomics, and so on. The idea that economies are forever stuck with a model they have somehow adopted in the distant past is plainly ridiculous. There would be much more to say but hardly worthwhile. This is what gives economics a bad name, and deservedly so.


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