0:33 Intro. [Recording date: February 22, 2018.] Russ Roberts: Today we're going to be talking about the economics of the 21st century using a recent essay Arnold wrote on the topic at Medium.com, which we will link to.... The premise of your essay is that the world has changed; economic reality has changed; the economy has changed; but the discipline of economics--the way that we as economists approach the world--hasn't changed sufficiently, if at all. So, I'd like us to start off with the idea that your claim, that the economy is different, somehow, from the economy that economists talked about in the past. What's different, and why is it important? Arnold Kling: Well, let me start by saying that, you know, an economy is embedded in a culture. And culture changes. If you just look at what's happened to music in the last 200 years, or look what's happened to beliefs about sexual conduct, which are still being heavily contested as we speak, you see that culture has evolved very rapidly. And my claim is that, you know, the economy is embedded in a culture; and the economy is embedded rapidly. So, that's different for something like in the physical sciences, where the subject matter isn't changing as you speak. The physicist is investigating the same physical world that they were investigating a couple hundred years ago. The economist is not. So, my metaphor would be, like, you know, think of economists like us being detectives trying to chase a suspect. And, if your approach to chasing a suspect is to sort of look at where the suspect, where you last saw the suspect and then move a couple of feet closer, meanwhile the suspect is moving a mile; and then you move a couple of feet more in the direction of where you last saw the suspect, and the suspect moves another mile--you keep that up after a while and the suspect is just nowhere near where you are looking. Russ Roberts: Well, you know, my job here, as host of EconTalk is to give my guests a hard time, from time to time. My other job is to help the listeners and myself understand what the guest is saying. So, I'm going to be giving you a hard time in this, mostly--as well as, I hope, trying to clarify. But let me start with the argument against that point. Which is: Okay. So, the physical world, the underlying physical world, presumably hasn't changed. The world of quarks, neutrinos, atoms, stars, etc. That's the physics world. The biology world hasn't changed so much. We're still comprised of cells and skin and bone. And you are arguing that the economic world has changed because the culture that it's embedded in has changed. But, I would counter by arguing that human nature hasn't changed. The economist's vision of what motivates human behavior, that goes back, let's say, you could say it goes back to Adam Smith but you could say more recently it goes back to Alfred Marshall, which was late 19th, early 20th century. Marshall was a British economist; wrote the classic Principles of Economics text of his day. And, not that much has changed since then about human nature. And, isn't that all that we really are trying to understand about what motivates people and how they interact? What's so important about culture? Why should it matter when I'm trying to understand, say, interest rates, or the market for bread, or tax policy? Arnold Kling: Okay. I'll say a couple of things about that. First of all, there are some economic concepts that--put it this way. Suppose you were to completely have amnesia about all the economics that was built up from Marshall, Smith, whatever. And you had to start all over. And you looked out in the world. And, which concepts, if you looked at the world today, if you had, sort of the same insight that those great economists had but you didn't know what they already knew, which insights would come back? Which principles would show up again? And which principles would never occur to you, because they are irrelevant? And that's one way to think about this issue. And so, I think we can get into that later. Russ Roberts: Oh, I like that. Arnold Kling: Let me give you a specific reason to not think that everything in economics, you know, can be deduced from Adam Smith, and so on. Look at the Financial Crisis. A lot of people looked at that and said, 'Gosh. Why didn't anyone see that coming?' And I looked at that and said, 'How could any economist possibly have seen that coming, given the primitive view of finance that economists had?' All these financial instruments are--you don't even learn about. Like, when you and I were in graduate school--and I bet it's even still true today--we didn't learn what a repurchase agreement was. And maybe we can put up a link to what a repurchase agreement is. Russ Roberts: I think we can. Arnold Kling: But really, for many years it's been the centerpiece of monetary policy. We've been learning and teaching the wrong way that monetary policy was executed, for many years. We've been saying an open market operation--the Federal Reserve creates money and buys bonds. That's actually not what they've done. They've intervened--the way they've intervened, at least up until 2008--they've been doing lots of weird things since--is that they intervened in this Repurchase market. They intervened in the Repo market. They make Repo loans, or they do Reverse Repo. So, we didn't even understand the mechanics of the Federal Reserve operation, much less the exotic financial instruments that were going on. So, that's an example of the cost of thinking that, 'Well, everything is pretty much the same as it was 200 years ago.' Russ Roberts: Well, I agree with that. And I'd push it, I think, quite a bit further, which is--and I've spoken about this, although not so recently on EconTalk--but, I didn't learn anything about finance at all, in graduate school. I didn't take finance. And I remember when job candidates came through, when I was an Assistant Professor, who had studied finance, I was mystified by them. I thought they were doing this weird, arcane, strange specialization that I--that had something to do with the stock market or Wall Street. And I think the bigger thing that we failed at as economists is that we didn't understand--macroeconomists--struggled to integrate the role of debt and leverage into their models. And, as a result, I think that's the biggest reason we were sandbagged by the Financial Crisis of 2008. I say that--I'm not a technical--I'm not really a macroeconomist. But the macroeconomics I learned had nothing to do with finance. And I suspect that was generally true also until very recently. Maybe still true, as you point out. Arnold Kling: And it's even worse than that, in that even these finance guys who were walking through--they don't understand the purpose of finance. Of financial intermediaries. You know, they know how to relate different prices of different assets. And they [?], 'If the underlying stock is this, the option value should be that.' Or, 'This portfolio ought to perform this way.' But they don't really understand: What is the purpose of financial intermediation? What do financial intermediaries accomplish? I think that's one of the big unknowns in economics, is exactly what they do. Russ Roberts: Explain what you mean by financial intermediation. And what you mean by financial intermediaries. Arnold Kling: Okay. So, financial intermediaries--you can think of it as any institution that issues debt. So, you know, Amazon issues debt. It's a financial intermediary. The more standard financial intermediaries, of course, are banks and investment banks. And, so, Wall Street firms; things like that. But, there's an awful lot of financial intermediation that goes on, and economists don't understand it. Economists tend to think in terms of the material world. And, if you just think--so, there are resources, and then there's the output that you get by assembling these resources and using these resources. That's the materialistic way of looking at things. And, when you look at things that way, what economists tend to derive are what I call irrelevance theorems. In fact, they are known as irrelevance theorems. Which basically say that finance is irrelevant, because finance is not material. There's no material production going on in the financial industry. It's all intangible. But, just because it is intangible doesn't mean it's not real. It just means that economists have a hard time understanding it and a hard time articulating what it does. But it's really important if we're going to understand what's going on in the economy to be able to articulate that and to understand it.

10:56 Russ Roberts: Yeah. I just want to make an aside here, because I think it's important. And it may or may not come up as we go through our conversation. But, when I read--let me say it this way. I think you're a heterodox economist in some dimension, Arnold. And I think I am, as well. Meaning, slightly, if not very much outside the mainstream of what's considered the normal ways that successful economists think about their profession and about the world. And when I read complaints about economics, they usually drive me crazy. So, even though I'm a heterodox economist, I usually don't like most critiques of economics. And one of those critiques which drives me crazy, sometimes, which you've made a version of here, is that economics is unrealistic. You know: We didn't accurately convey, say, what monetary policy was really doing. Or: We abstract from the importance of the financial sector. And, of course, by definition, every field is--almost every field--is unrealistic. We have to abstract from lots of things, otherwise we make no progress. So, in some dimension, I think those kind of complaints are cheap shots. So, I think the burden is on the complainer to explain why that particular complaint is relevant. Not that it's accurate. It is accurate. Economics is not realistic. We ignore lots of things. But that by itself is uninteresting. So, your claim here, which I think is interesting, is that the financial sector's role in the economy is--the way I would describe it is it's sort of a black box role. It has something to do with growth and successful economic performance for an economy. You need to have the ability to borrow and lend money and to invest, otherwise you can't grow. But we don't have much beyond that to say until, I'd say, recently. Would that be an accurate way to frame your complaint? Arnold Kling: Up until the point where you said, 'Until recently,' because that makes it sound like we actually have made a lot of progress. And I don't believe we have. Russ Roberts: I was trying to be generous. Arnold Kling: Yeah. No, I think that--again, I think the role is intangible. It's in how it affects people's perceptions about risk and time. So, what people want is to issue risky liabilities. Like, I'd like to borrow money and there's some risk that I won't pay it back, and that could be me as an individual or me as an entrepreneur, as a firm. Risky long-term liabilities: that is, I want to have a long time to pay it back. Let's say if I'm a real estate developer, I don't want you coming back in two months telling me to pay back money. It might take years for me to develop this property. And yet, what we'd like to hold as assets are riskless, short-term assets. We want something that we can spend like a checking account. So, what the financial intermediary does is it holds the opposite portfolio. So, the bank that holds loans made to real estate developers and somehow issues you checking accounts where you can spend the money tomorrow and it's riskless to you--that's clearly some kind of magic going on in terms of changing the perception of the underlying risk. If the underlying risk is a real estate project that's going to take 5 years and that may or may not pay off, and yet you are experiencing that as a checking account where you can spend it risklessly tomorrow, that's a major achievement. We need to understand more about it. And, I think it raises all sorts of questions that can come to your mind about how that works or is that a Ponzi scheme, or, what are they accomplishing? And those questions are questions that we ought to be asking and doing research about. Russ Roberts: Do you think in an undergraduate macroeconomics class, or microeconomics class, that-- Arnold Kling: Yeah, can we forget macroeconomics? I'm ready to dismiss those--going back to the question of which concepts would you rediscover and which concepts would you never think of, because they don't work at all, I would put most of macroeconomics in the 'you would never come back to those.' So, let's just talk about micro. Russ Roberts: Well, I'm not going to let you get away with that. It's a lovely thought. I'm sympathetic to it. But, you are arguing then that, let's say, stabilization policy, worries about business cycles--we shouldn't think about those things, and the role that, say, the financial sector plays in that? Arnold Kling: Okay. So, first of all, the term 'business cycle,' I don't think that would come back, because the business cycle sounds like things moving up and down. Back and forth. Now, in, you know, in an agricultural economy, you can sort of see that. You get good harvests and bad harvests, good weather, bad weather. There's a reason to believe it's cyclical. There's no reason at all to believe the economy now is cyclical. It's evolving so quickly that what you have are industries that are expanding while other industries contract, and somehow the net effect of that is something you look at for overall economic performance. But I wouldn't call it a business cycle. So, I am going to be super-heterodox here. I'm going to be militantly anti-orthodox. Russ Roberts: Well, that's fun. I like that.

16:46 Russ Roberts: But, let's go back to your--so, back to my question. Forgetting the nomenclature, do you think undergraduates--or graduate--students should learn about financial intermediation as part of their basic economic instruction? Do you think it's a central piece of the economy. For example we would often teach, say, about how the labor market worked, the role of unemployment, search theory, information theory, we might teach folks about the desire to save. We teach them about risk preference, perhaps. Do you think the role of financial intermediation is a central piece, should be a central part of economic education? Arnold Kling: If I had to guess, sort of what created the steep recession that we experienced, my guess is that something to do with financial intermediation probably played a role. I don't think we have a great understanding of it. But, there's a whole bunch of stuff that I would throw out: like the whole notions of aggregate supply and aggregate demand, I think they obscure more than they help. But, the issue of exactly what transpired that--you know, a lot of people intuitively thought there would be a recession after the Financial Crisis. There's actually some--your most basic macroeconomic theory would have said it's unnecessary. That the government could have been able to stabilize the economy and that the things that government did were the things that should have stabilized the economy. And of course, what economists say in apologizing for the fact that it didn't is, 'Well, they just didn't do enough. They didn't realize how bad it was.' But I'm not sure that those tools did anything. And I don't think we really deeply understand what it was that created a recession following that Financial Crisis. Russ Roberts: Okay. I'm going to play Keynesian. Which is not easy for me, but I think I can manage it. I want to make, actually, a point before I do that, which is: I think you could argue that, as a different way of agreeing with your point, a different angle on it, I'd say, which is: If remember correctly, the recession started in-- Arnold Kling: Before the Crisis. Russ Roberts: Yeah. December 2007, I think; fourth quarter 2007 is the official dating of it. We certainly didn't know we were in a recession at the time. Literally we didn't know. Some people may have suspected. Things were troubled. There were some troubling signs. But I think one way to think about the problem of macroeconomic policy, if I may use the term, or stabilization policy, is we're a little bit like the general in the battlefield getting the report too late that this particular flank is under attack. So, we send some sort of reinforcement; and by the time it gets there, that flank is doing fine--or it's already lost, in which case it's a waste. It's just not just ineffective but counterproductive. So, I think there's an information problem. You're arguing more than that--of course, your argument is a conceptual issue of how to think about it. So, let me play the Keynesian role, now. Which is: 'I don't really need to know the cause. You're talking about all the--again, you're worrying about what the precise causal relationship is between these financial intermediaries and an economic downturn. I don't need to know that. All I need to know is, when things are going badly, all I need to do is spend more money if I'm the government. Or, I have to change interest rates through monetary policy. The cause of it is not important. It might be important for trying to avoid it in the future, but for fixing it once it's underway, I just need to intervene in these time-, well-tested methods for avoiding this thing persisting. Arnold Kling: Yeah. I don't really want to spend time arguing that. I think I'd just refer people to the Specialization and Trade book for sort of my alternative thinking on macro. I'm actually-- Russ Roberts: Or the EconTalk episode-- Arnold Kling: Yeah. I want to go after tougher challenges. I want to go after micro. And productivity. And the marginal productivity theory. And all of that stuff.

21:13 Russ Roberts: Okay. Then let me ask you a different question. I want to try to give a different version of your culture argument, because I don't think the example you gave--which I've now forgotten--but it didn't seem to me to be a cultural issue. Let's suppose, as many people are concerned about today--let's suppose that we're worried about the wellbeing of people in depressed parts of the United States, places that are not doing well economically. Rural areas in, say, West Virginia, Kentucky, and Ohio. And, we're trying to think about how to help those areas, or more importantly, how to help the people that are there. And one of the things that we talk about a lot on this program is, 'Well, why aren't they moving? If economic opportunity is so sparse there or so mediocre, why don't they move?' And then the standard answer--the economist's answer--would normally be something like, 'Well, if they move to the larger cities, rents are very high there. And so it's not as appealing as it used to be. And the way to fix this problem is to improve housing policy.' And, of course, I'm a big fan of that. I'm a big opponent of over-zoning and some of the things we've done to make housing expensive in major cities. But a different answer, which would be, 'Well, you don't understand. There's cultural reasons they don't want to move. They like where they live. They were raised there. They have emotional ties there. And, if you are just looking at the financial aspects of the decision, you are missing out what's really going on.' And similarly, 'If you think the only problem is that they have low skills, you are missing out on the fact that they have despair.' And so, a lot of people, I think, are arguing that economics is missing these cultural elements--the role, literally, of culture, what we would call culture and family and[in?] decisions of where to live. The role of meaning in life, which a lot of people are starting to write about and wondering whether we've got some issues about that. Those are what I think of when I think of the cultural aspects of economics that we might be missing. Does that hit the mark for you? Arnold Kling: I'm going to say no. I'm going to say that I want something broader, that, the cultural changes include, and these include economic changes. For example, changes in our tools of communication. So, historically, the printing press had a big impact. Mass media had a big impact. We're doing a podcast. Paul Samuelson never did a podcast. Mises never did a podcast. Marx never did a podcast. So, you know, we are living in a different world. And some of it's technology. Some of it's habits. A lot more of what we deal with is intangible. And that's a point I really want to emphasize. We've already talked about how finance is intangible. But, you know, Google Maps is intangible in a way that a physical map is not. And there are some important differences that we can talk about, and that I'm sure have been talked about on this show before.

24:28 Russ Roberts: Are you talking about the excludability issue? Because I think that's what--let's talk about that. Because I think that's important-- Arnold Kling: Yeah. Russ Roberts: Because my first thought is: Why do I care? So, Marx was never on a podcast. He wrote a book, called Das Capital, say. Why is that important? Why is it important that, say, in the old days, I wanted to have some fun, I'd go buy an ice cream cone and go to the amusement park, but I'd also look out into the distance at the beach, when I was on the boardwalk of a seaboard coastal city. So, now I look at my phone. It's not tangible. Neither was looking at the ocean. Why is that important? Arnold Kling: Because, well, first of all, the ocean is, you know, no one needs to be paid for there to be the ocean. But somebody, somewhere along the line, needs to be paid if there's going to be Google Maps, if there's going to be Spotify music, and so on. So, with these intangible goods, you said the magic word, 'Excludability.' So, with a physical good, the default setting is, if you've produced the good you can exclude someone from getting hold of it unless they pay you. On the Internet, the default setting is they can get it without your knowing it or being able to stop them. So, it's the complete opposite: Not excludable. And the other issue is rivalry--the technical term. So, with a hamburger, it's rivalrous. If I eat the hamburger, you can't eat the hamburger. But with this podcast, it's not rivalrous. If one person is listening to it, it doesn't interfere in any way with anyone else listening to it. And, when things are not rivalrous and not excludable, the traditional economic story is, 'Ah! That's a public good. There's no way it can be provided by the private sector.' But they are being provided by the private sector all over the place. And, you know, sometimes they are being financed by advertising; sometimes by patronage; sometimes they are putting up pay-walls to try to exclude people. There's a whole menu of options that came out in Carl Shapiro and Hal Varian's book, Information Rules--bundling, versioning. There is a whole menu of things. And these are very important. And, it's not in the traditional mainstream economics. There are economists like Varian and Shapiro and others who have looked at them. And I think that's an exciting area of research.

27:03 Russ Roberts: So, the question is, for me: let's bring this down to a policy issue. So, what Google and Facebook, Apple and Amazon to some extent, but let's stick with Google, Facebook and Apple and Twitter, for example. What they're doing is, they are adding folks: More and more people searching on Google; more and more people on Facebook; more and more people on Twitter. At least for now. They are adding all kinds of folks. They are building what's effectively an online community of people's ability to interact with each other, share information. And, as you point out, excludability is--different in that marketplace than it is in, say, the market for apples. How does that change how we think about antitrust policy? So, a lot of people that you and I are friends with who like competition and think competition is powerful, free-marketer-types, we tend to argue, 'Well, things will sort themselves out. Sure, Google is on top now, but in 10 years, 5 years, 3 years, there will be somebody else. People were worried about Microsoft, now they were wrong. They were worried about IBM [International Business Machines]. They were wrong.' Is Google different simply because it is this nonexcludable, intangible thing? Or is it different for another reason? Or is it not different at all? Arnold Kling: Well, I think it's different. And I think--as Tyler Cowen would point out, your traditional problem with monopoly is that they have an incentive to restrict their consumer base, their user base. By holding that back, they can raise prices. With Google and Facebook, as a first approximation, they have the opposite incentive, which is to have as many people as possible so that they can grab your data. So, right away, you don't want to just fall back on traditional antitrust. That isn't to say that there isn't some kind of abuse going on. And the concern is actually an abuse on the other hand. There's the cliché that, you know, 'You're not the customer. You're the product.' And if that's the case, then you have to rethink it from that perspective. But I--it's a great issue to think about from an economic point of view and to do research on. But again, you don't want to fall--if you try to fall back on the way you thought about traditional industrial firms, I think you get the wrong answer.

29:47 Russ Roberts: Well, I think that's a great point. And I think--I've made the mistake in the past of arguing, 'Well, Google's great, because it's free.' Right? I don't have to pay to search; look how fantastic it is; they provide this great service. Of course, what I'm paying for, indirectly, is through the price of the products that are tangible, that I do buy, that are advertised on Google. If Google is taking an increasingly large share of the profitability of those industries because it has a choke-hold on advertising, I'm going to pay in the form of higher prices of those products. Or there could be monopoly, non-competitive aspects of that, as well. Arnold Kling: Maybe. But I don't think we know. Russ Roberts: I agree with that. Arnold Kling: I mean, it would be interesting just to work out: What is their source of value? For example, with the news industry, the complaint is that--let's say, if you are just going to Google News, and Google News, and Google, is siphoning off the advertising, does that mean that the production of news that the people doing the reporting is going to suffer or be higher cost? I mean, those are great issues to explore. I don't have the answers to those. But those--the economic effects of Google and Facebook on other industries, because they are relying on advertising. I mean, maybe they are just making things wonderful--wonderfully efficient--by the way they advertise. And then it's great. Or maybe they are undermining other industries in a way that's bad. And that's a high-priority issue to explore. Russ Roberts: Yeah. It's not obvious how you explore it. But I do take your point that our standard methods, [?] thinking about that, may not be so useful. Arnold Kling: And I think--I listed, in the essay, four key research areas. And one of them is what I call Firm Interaction. And this question of how the ecosystem operates now, in these various industries, is a really important question. As is what the traditional boundaries of the firm question: what should be done inside the firm and outside the firm? I mean, I'm shocked at the breadth of Amazon. I mean, it's incredible, the breadth of that firm. I don't think any theory of the firm that economists--economists haven't done much with their theories of the firm, because again it becomes an intangible issue of, you know, what should you do inside the firm and outside the firm. It all depends on intangible things, and economists don't do well with intangible things. But, I don't think anybody, from Coase, or Williamson, or anyone who has looked at that would have told you that something with the breadth of Amazon would have emerged. Russ Roberts: Yeah. I like to point out, we came up in a recent episode with Matthew Stoller on this issue. It's not obvious that Amazon is that successful. Most of its profits come from its cloud services-- Arnold Kling: Right. Russ Roberts: When you say--you wouldn't have predicted it. Maybe it won't last. Maybe it's going to struggle. But it doesn't seem to be. It does seem to be a pretty successful, going concern. And the breadth of it is extraordinary. Rather incredible. Arnold Kling: And again--just the opportunities to research it are there. You just have to open yourself up to looking at things from the standpoint of intangibles. And it just--you know, using the standard economic approach of, 'Well, they are allocating labor and capital,'--I mean, come on. Russ Roberts: Well, the standard approach is, you combine 'stuff'--workers, raw materials, machines--and you produce stuff, then. So, you have inputs and outputs. And then, what we teach, a lot of what we teach, is the firm's decision is how much to make. And this always bothered me. It's a rather strange, incredibly[?] narrow, unrealistic description of what firms are struggling with. I mean, firms are trying to figure out--to me, the biggest flaw in these types of methodological[?] problems are, is that the firm's trying to figure out what market it's in. Who are its competitors? That's really tricky. And they are trying, they are going to decide, based on what they produce--they choose who their competitors are. It's really what your biggest choice is, as a firm. By deciding what the nature of your product is, and its components, and its price--that's your choice. Arnold Kling: Well, that's all very important, managing the external environment. And it's also very important managing the internal environment. If somebody could figure out how to make good use--go back to your people in depressed areas, West Virginia, rural Ohio, and whatever--if entrepreneurs could figure out how to make good use of those people, that problem would obviously be a lot less. And so, the question is: Why can't they do that? The whole challenge of managing human beings in today's environment is a big, big issue. Just as a random example: Recently Google fired an engineer, James Damore, for writing a memo about policies related to, or issues related to women engineers--whether Google--actually, I don't want to get into big details about it. But there's something where, that had nothing to do with Damore's productivity, his marginal product, his wage rate. Just the fact that management is dealing with that kind of an issue of the sensitivity of descriptions, of trying to explain why there are not more female engineers at the company, tells you how complex and, once again, intangible things have become for management. But studies are showing that differences in management skills and approaches are a huge factor in differences across firms, across locations, across countries.

36:54 Russ Roberts: So, let me pick a particular example that I think that's true. So, Steve Jobs passes away, and he's replaced by Tim Cook as CEO [Chief Executive Officer] of Apple. Is that important or not? And, I think most economists understand that it is important: that Steve Jobs provided something unique in both his insights and his ability to create a particular kind of culture at Apple. And that's not a cookbook. It's not a recipe. Tim Cook can't--bad pun there, didn't mean that; sorry--as the chief cook, he can't step in there and replicate that, because it's not written down. And if you said, 'I'm going to create a model of why Apple was successful under Steve Jobs,' you'd struggle, because, first of all, they weren't always successful. They had a lot of failure under Steve Jobs. And I think people then were trying to figure out why he was successful. I've probably mentioned this before, but I always find it interesting: Steve Jobs was obsessed with the inside of the computer, not just the outside. He wanted the inside to be aesthetically pleasing. So, people decide, 'Well, that's a good thing then,' because they are successful. Well, it could be that it's just a weird, neurotic aspect of Steve Jobs's personality that would best be avoided, and a successful CEO in his aftermath should ignore that, and save money, and not make the inside look as good as the outside. On the other hand, maybe it had a cultural impact on excellence that you and I have no understanding of. So, I think corporate culture and motivation, to come back to the Damore example--I think companies care a lot about how people feel about where they work. Because, people do care about that. And companies, therefore, are going to pay attention to that. And, as economists, I don't think we have anything--we have nothing to say about that, as far as I'm concerned. And I'm not sure we ever will, by the way. So, I'm not sure you're right that we should be thinking about it. Maybe we shouldn't. Arnold Kling: Well, but it is true that getting teamwork and getting alignment is very important. And economists do step in on the subject of incentives: How do you build in the right incentive structure within a corporation so that there's alignment? So, I don't think it's an avoidable subject. Russ Roberts: Well, I think--let's take that as an example. I think if we think about Charlie Chaplin's Modern Times or Adam Smith's pin factory--an assembly line is essentially the one model of economic production that economists have looked at in various ways. It goes back to my example, which I got from you: We take people and machines and raw materials and we combine them, and then we get an output. And, I think anybody who has ever worked on a group project, even in school, understands that that process is very hard to describe--how group activities get done. At one extreme, one person does all the work and the other people free-ride; at the other extreme, there's this incredible synergy. And, as economists, I don't think we've figured out much that's useful about understanding that. But we do understand that it matters. Arnold Kling: And, if nothing else, it means that the neoclassical theory of income distribution that says, 'Oh, you can figure out what a person's wage is going to be, because it's going to be their marginal product.' Or, the other way around, 'You can figure out what a person's marginal product is because it's bound to be close to their wage.' When you're in some situation where you have potential for this huge synergy of the team, you can't rely on that. When you're in a situation where business strategy is really important, and the same skills as an engineer can be used much better at Google than at another company, you can't rely on this marginal productivity theory. So, that's another example where I think we do need to be willing to try for new economic thinking. Russ Roberts: And marginal product means the addition to the product when you add a little more of, say, my time-- Arnold Kling: Additional worker. So you can think of it really well in terms of if you had a big field of berries and you had berry pickers, and you said, all right, you add another berry picker, how many berries do they pick? And you can say generically the typical berry picker would pick this much and here's somebody who is really good at it, and they pick more. When you-- Russ Roberts: Or, the field gets crowded after a while and an extra person doesn't add as much. We understand that, too. Arnold Kling: Yeah. But, when you are talking about something like creating the iPhone 10 and coming up with a strategy for it and a price for it and the features for it, and then building those; and everything that goes with it, and the supply chain for that--I just don't think the marginal productivity story tells you much. Russ Roberts: Well, I agree with that. And I think a great manager--it's impossible, I would argue, to measure with any precision in a product like that, who made the biggest or most important, or how much they contributed. Right? That's your point, to some extent. And I think a good manager understands, however, even though they can't measure it, they have an idea of who works well in teams, who adds to the creative process. Of course, a lot of what--for those of you who are listening in large corporations who tend to work in these teams--you know that there's a lot of political maneuvering about who gets credit and how they get credit. And there's a lot of inaccuracy. Somebody who is just really good at schmoozing the boss might get more credit than they deserve. The quiet, more introverted person might get left behind and ignored, who doesn't play the office politics game. These are all interesting things that I think of as being the subject of a thoughtful, provocative business article in a good business publication. Again, I'd argue that outside of some very broad arguments by people like, say, Alchian and Demsetz on team production, economists know something about this; they recognize this challenge. It's not clear that we have anything to contribute other than a few descriptive, stylized images. I don't know. Do you think we can make some progress here? Arnold Kling: I think we can. And, yeah, I do. I certainly hope so, because otherwise, then what you'd be saying is, 'Well, sorry, we have to stick with what we got from Karl Marx about capital and labor, and then what was updated about that with neoclassical marginal productivity theory, and we have to use these hundred year old, two hundred year old concepts in the 21st century world. We don't have a choice.' I do believe we have a choice. It may be difficult and intangible stuff may be harder to deal with; and rapid evolution is going to be hard to deal with; and business strategy is complex. But let's at least try.'

44:37 Russ Roberts: Well, I'll come back to the episode we did recently with Bill James, where he argued that, very similar to your point, and my point, or at least the issue is the same. We were discussing whether, why some baseball managers are more successful than others. And Bill James argued in that conversation that there are differences in the abilities of managers to motivate players--the so-called culture of the clubhouse. And that he believes we can make progress on understanding it, and get better at that. My view, until I see the data, is that these things are--we tend to look where the light is. We're under the lamppost looking for the lost keys. And so, we tend as economists to look at things that can be measured. Those tangible things. Now, there's things that can be measured about intangible things: You can survey people about how hard they try, or you can survey people about their job satisfaction; you can survey people about how well a team works ex post. But it's not obvious to me that we're going to make analytical progress. I think we can make some progress in recognizing these things. But I'm going to take the opposite approach. I'm going to argue we shouldn't be doing these things, in that, I think the main reason we do them, the main reason we try to model them and think about them using the analytical toolkit of economics is often so that we can make policy judgments. And I'd argue that, in a world where things are largely intangible, those policy judgments are going to be way off the mark. Because we can't measure those things very precisely. We're going to mis-state what makes people's lives--excuse me, what makes people better off. For example, I think to a large extent we have used financial measures--income--as our measure of wellbeing. And that's not a bad place to start; but it's a very bad place to finish. And I think our inevitable focus on tangible things is going to make the most important things in life, which are intangible, outside of our purview. And I think they probably have to stay that way. Arnold Kling: What I'm nervous about, if we stick to tangibles, is that, you know, 200 years ago if you knew how many bushels of wheat were being produced and how many railroad cars, or how many miles of railroad track were being laid, you knew a lot. Now, we don't know what the value is to people of Google Maps. We really don't know--anything. And you can say, 'Well, we'll never know.' But, I don't want to give up quite that much. I think if we take some creative effort to try to figure out what the value is of Google Maps. But I think it's worth some effort. And we certainly have--these companies are collecting all sorts of data that people can creatively use to try to answer some of these questions. So, I think we ought to be looking there.

47:49 Russ Roberts: What do you think about the typical economist's focus on so-called rationality and the behavioral economics critique that says people aren't rational? And this is related to what you said earlier--their decisions aren't just based on self-interest, say: they can be embedded in cultural issues and other motivations? Do you think that's an important area that economists should be more open-minded about? Arnold Kling: My initial view is that if you gave me an under-rated/over-rated, I'd say behavioral economics is a bit over-rated. I think the most important thing, the most important challenge we face isn't that we need to drop the rationality assumption. I think that we have to drop the tangibility assumption--that things are tangible. And we have to drop the notion that capital is all physical. There's a lot of intangible capital as well as intangible output. We haven't discussed the intangible capital, although we've kind of alluded to it. I think there are more important problems with mainstream economics than the rationality assumption. I guess that's the way I'd put it. Russ Roberts: When you say that we need to look at intangible capital or the nature of modern economic activity by firms being less tangible, talking about, say, Google Maps, what's in your toolkit? What does economics--what do you think of when you think economics should look at more of this? What comes to your mind when you say that? You say, for example, in your essay: These are areas that economists should do research on. Are you bringing--you don't want to bring some of the traditional toolkit because you think it's outdated. What do we have to offer? Arnold Kling: Okay. So, that brings up this question of: Which concepts do I think would come back if we were to start over, and which would not? That book, Specialization and Trade, I think the concept of specialization would come back big time. I mean, the economy is way more specialized. Marx described these interchangeable workers--the working class. We still talk about the 'working class.' If you took somebody here from Mars in to observe our economy, they would not come up with a concept of 'working class' at all. They'd see this great variety of skill sets, locations, temperaments--all sorts of things in people who are employed. And they would, I think they would start looking at things in those terms: How do these temperaments and how do their locations and how does their skillset and their training and their ability--how do all these things come together to determine, you know, their income and their quality of life and their standard of living? That's--I think that's where people would go. So, specialization would be an even more important issue. Substitutability would be a more important issue. So those are the things that would come back. The law of supply and demand still holds. I think that's still very useful, maybe even more useful. The issue of price discrimination, which was typically talked about in the context of monopoly, is way more important in the economy than people give it credit for. And it's certainly not just monopolists that use price discrimination. Just about everyone has to use price discrimination as a competitive strategy. And, if you do a sort of a natural economics question, you know, 'Why does this happen? Why do movie theaters price this way? Why does popcorn cost so much? Why do cable bundles work?' The answer to most of these questions boils down to price discrimination. So, there's another concept that we'd be using more if we were trying to look at 21st century economics. Russ Roberts: Well, I'm going to push back a little bit on supply and demand, in that: It's my favorite insight in economics, probably, that you can draw on a blackboard. It's for me a crude version of emergent order. It's a way of capturing the complexity of interactions that are at the heart of economic life. And yet, you've also argued that intangibility is growing increasingly important. Does supply and demand have anything to tell us about these intangible things, where output is nonrivalrous and where price is often zero? Arnold Kling: Well, that's a fair pushback. But, I think there still is--people still need to get paid. And things need to get priced. They're not, maybe not, the prices are showing up in different places. So, in the case of Google and Facebook, the prices are showing up in advertising. Or as you suggested the prices may be showing up indirectly in the prices of other goods and services. So, there's still prices going on. It's just they're not maybe in the places you expect them. And, there's a lot more strategy involved in getting people, in getting money to the people who are producing these public goods that we call information. So, somebody is producing these maps. Somebody is doing this mapping technology and the software to present Google Maps to you. So, there's still some people that need to be paid. But you're right that the supply and demand story for Google Maps as a product is not as easy to tell as a supply and demand story somewhere along the line for the process of getting it done.

54:44 Russ Roberts: Well, I'm going to leapfrog over you and get maybe more extreme. Which is: Your basic point that someone needs to get paid is mostly true. But it's also true that a lot of things that are part of the modern economy, no one's getting paid at all. Or, they are getting paid in strange and very different ways. I don't know how many hours we spend on YouTube a day. It's a really large number. I saw it recently; it's frighteningly large. A lot of what people are watching is just put up there by people for fun. They are not making--some people are making a living on YouTube; some are using it to drive traffic to other places. Some are using it to establish a reputation. A lot of it is produced during leisure time. And I--I want to try to make your point a different way; then you can respond. Your critique about tangibility, I would think of it this way: The manufacturing sector as a source of employment is really small in America right now. And certainly small in historical terms. It's been falling steadily as a proportion of total employment now; in recent years, absolutely falling. And yet, it gets a lot of attention. And I think it gets a lot of attention partly because of the nature of electoral politics, and the geographical concentration of some of those people, perhaps, is part of that story. The intangible economy you are talking about, the non-manufacturing part, the Google Maps, YouTube, Spotify part--Spotify is a little different, but YouTube, let's call it YouTube and Google Maps--those are parts of the "economy," they are parts of our lives that don't have so many people employed, producing them. And people bemoan that. I, of course, see that as mainly a feature, not a bug. It's a great thing that we can get these glorious things without a huge portion of human time and effort devoted to them. That Google doesn't have a lot of employees seems to me to be a wonderful thing. Or Amazon. And--I don't know. What do you think? Arnold Kling: Well, that gets to one of my other research agenda items, which is: How do you measure economic performance? Because, it could very well be that, not just the amount of leisure is going up, but, what I might call the intensity of leisure is going up. So, I like to say that, nowadays, there's very few social bridge players. Bridge is a card game. There are mostly tournament bridge players. What that--one possibility is that a lot of those people who used to play social bridge didn't like it that much, but they settled for it because there wasn't anything else for them to do. So, now you've got the tournament bridge players, who love playing bridge. And the social bridge players have found something else that they really enjoy. And I think, sort of, YouTube and what Tyler Cowen calls 'matching technology' of the Internet has kind of enabled that. So, in some sense, leisure intensity has gone up. And people are having more fun with their leisure time. And how do you include that in economic performance? Russ Roberts: And so, one argument would be--and I know you're somewhat sympathetic to this--would be: Who cares? So, it's really hard to measure the sum of this stuff. We shouldn't be measuring it anyway. Our attempts to measure it aggregate across all kinds of things--you complained earlier in passing about "aggregate supply." And I know you've complained on this program and written in negative ways about the GDP [Gross Domestic Product] factory as if somehow the outputs of our economy are produced in a 19th century way by combining capital, labor, and raw materials. And I think--I think that point's really well-taken. Most people would say--and this is one of your themes, 'Well, we just need to measure it better.' And other people would say it's kind of a fool's game. And it's particularly a fool's game when we are trying to measure using output as a surrogate for wellbeing, is the way, where I would fall on that. Arnold Kling: Well, I mean, I'm probably agreeing with you, but I just want to say, if it's a fool's game to try to incorporate into your thoughts about economic performance the intangible things that are hard to measure and are very subjective, then it's even more of a fool's game to base policy on measures of economic performance that totally ignore that. Russ Roberts: Yeah. That's an a fortiori argument there. I think that's correct. I guess part of my underlying agreement with you on these issues is that economists like being important. And part of our importance is the implication that we can, that we often push: that we can save the world with the right--give me the right levers and I can save the world. And one way to take your critique is to say, 'We don't know what the levers are connected to. We hardly know whether the world needs saving. And we should try to figure it out--in the meanwhile, at least, make some effort to do that.' Arnold Kling: Yeah. My shorthand phrase is: Stare at the world, not at your models. Economists have great pride in deriving powerful insights from simple models. And maybe up to a point that's helpful. But I think we're at a point where the evolution of the economy has been so great, the importance of intangible factors is now so high, that this staring-at-the-models approach has been at best sort of not producing much in insight, and at worst is kind of telling us the wrong, giving us the wrong ideas about how the economy is working and about policy.