Over at Free Exchange, I write about the new ebook by Erik Brynjolfsson and Andrew McAfee titled Race Against the Machine. The authors argue that many of America’s recent economic troubles can be ascribed to the enormous rapidity of technological change in information and communication technologies, and that the answer to this challenge lies in investing in human capital and “fostering organizational innovation”. On the latter, they write:

How can we implement a “race with machines” strategy? the solution is organizational innovation: co-inventing new organizational structures, processes, and business models that leverage ever-advancing technology and human skills. Joseph Schumpeter, the economist, described this as a process of “creative destruction” and gave the entrepreneurs the central role in the development and propagation of the necessary innovations. Entrepreneurs reap rich rewards because what they do, when they do it well, is both incredibly valuable and far too rare…

Because the process of innovation often relies heavily on the combining and recombining of previous innovations, the broader and deeper the pool of accessible ideas and individuals, the more opportunities there are for innovation…

We are in no danger of running out of new combinations to try. Even if technology froze today, we have more possible ways of configuring the different applications, machines, tasks, and distribution channels to create new processes and products than we could ever exhaust…

Most of the combinations may be no better than what we already have, but some surely will be, and a few will be “home runs” that are vast improvements. The trick is finding the ones that make a positive difference. Parallel experimentation by millions of entrepreneurs is the best and fastest way to do that. As Thomas Edison once said when trying to find the right combination of materials for a working lightbulb: “I have not failed. I’ve just found 10,000 ways that won’t work.”

I kept waiting for some mention of the geographic component of innovation, but it never came, even as the authors name-checked innovative tech company after innovative tech company located in Silicon Valley. I kept waiting for the famous Alfred Marshall quote:

When an industry has thus chosen a locality for itself, it is likely to stay there long: so great are the advantages which people following the same skilled trade get from near neighbourhood to one another. The mysteries of the trade become no mysteries; but are as it were in the air, and children learn many of them unconsciously. Good work is rightly appreciated, inventions and improvements in machinery, in processes and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas. And presently subsidiary trades grow up in the neighbourhood, supplying it with implements and materials, organizing its traffic, and in many ways conducing to the economy of its material.

I think that the authors have basically gotten the state of innovation right: we are approaching a critical point at which impressive progress in information technology becomes explosive progress. And I think that the authors are right that the extent to which we are able to take advantage of these technological developments will hinge on how successful America’s tinkerers are at experimenting with new business models and turning them into new businesses. But I also think that there is a critical geographic component to that process of experimentation and entrepreneurship and, as I wrote in my book, I think we are systematically constraining the operation of that component.

High housing costs constitute a substantial regulatory tax burden on residence in many high productivity areas. These are the places where the tinkerers are having their ongoing innovative conversation. But if the tinkerers are driven away, the conversation loses depth and breadth, and we lose many of the combinations that might go on to be the next big company — the next big employer. That, to me, is a very worrying idea.

Is here:

We study the location and productivity of more than 1,000 research and development (R&D) labs located in the Northeast corridor of the U.S. Using a variety of spatial econometric techniques, we find that these labs are substantially more concentrated in space than the underlying distribution of manufacturing activity. Ripley’s K-function tests over a variety of spatial scales reveal that the strongest evidence of concentration occurs at two discrete distances: one at about one-quarter of a mile and another at about 40 miles. These findings are consistent with empirical research that suggests that some spillovers depreciate very rapidly with distance, while others operate at the spatial scale of labor markets. We also find that R&D labs in some industries (e.g., chemicals, including drugs) are substantially more spatially concentrated than are R&D labs as a whole.

Tests using local K-functions reveal several concentrations of R&D labs (Boston, New York-Northern New Jersey, Philadelphia-Wilmington, and Washington, DC) that appear to represent research clusters. We verify this conjecture using significance-maximizing techniques (e.g., SATSCAN) that also address econometric issues related to “multiple testing” and spatial autocorrelation.

We develop a new procedure for identifying clusters – the multiscale core-cluster approach — to identify labs that appear to be clustered at a variety of spatial scales. We document that while locations in these clusters are often related to basic infrastructure, such as access to major roads, there is significant variation in the composition of labs across these clusters. Finally, we show that R&D labs located in clusters defined by this approach are, all else equal, substantially more productive in terms of the patents or citation-weighted patents they receive.

I was very pleased to join Russ Roberts for his Econtalk podcast, in which we discussed the new book. Check it out here.

This, meet this.

I’ve been meaning to respond to a few points made by Aaron Renn in a recent review of The Gated City, and I’ve finally found a few spare minutes to do so. So!

First, Renn asks about the distinction between employment density and residential density. At a very local level, this is obviously important, as he points out. The economy of the employment-dense downtown Washington neighborhood is very different from that of the population-dense Adams Morgan neighborhood. These distinctions are interesting and important, but not that critical for the argument I’m making. Most of the studies I cite focus on employment density at fairly large scales — counties or metropolitan areas, for instance. At those scales employment and population densities closely track each other, as one would expect, and the population numbers are easier to get at higher frequencies for more places and at smaller scales (which is useful in computing weighted-average densities).

Next, Renn writes:

Another is that the book heavily focuses on the supply side of the equation (i.e., the ability to build) as opposed to the demand side. But arguably demand had a bigger role to play in driving up housing costs in places like NYC…

No amount of new supply would have been able to keep up with the significant deregulation of finance that occurred in the last two decades (repealing Glass-Steagall, raising the ceilings on the share of national deposits held by a single institution, etc) and Helicopter Ben’s printing presses.

Also, assume we were able to moderate the price of housing in these places somewhat. What would that do for us? Well, NYC and SF would still remain among the most expensive places in America to live. This means that they are going to continue to draw principally those who are able to tap into the particular wealth generating functions of those regions, along with those who particularly value the amenity set of those cities or who are following network path migration. However, the industry groups that are now predominant in those cities are ones that employ almost exclusively high end labor. So what this would mean in my view is that instead of say the top 1% being able to live and work in these places, we extend that down to the top 2% or 3%.

I would disagree that I focus on the supply side. A critical part of my argument is that technology has increased the productive role of big, dense cities, leading to a significant increase in demand to live in such places. Without rising demand, tight supply has no effect on prices. I focus on supply as the solution, because the only way to reduce prices on the demand side is to make the cities less attractive, which seems like an unpleasant option to me.

Deregulation increased the return to some portions of the finance trade, but it seems to me that the impact of technology has been more significant (Bernanke has essentially nothing to do with it; note that these trends are now several decades old). New technologies allow top financiers to control vast sums of money in investments around the world with the greatest of ease. Hedge funds aren’t a new innovation; they’ve been around half a century. But hedge-fund activity exploded in recent decades thanks mostly to the direct impact of technology (and the indirect impact of technology on top incomes, which created more demand for high-end money management).

There is absolutely a level of supply growth that could have dealt with soaring demand and prevented skyrocketing housing costs. There’s no technical infeasibility to such growth. The obstacles are political and cultural. During the industrial revolution, America’s large cities grew by 500% or more. There is no tolerance for growth at anywhere near that level now. That doesn’t mean it’s impossible, just outside our comfort zone.

At any rate, marginal improvements are the best we can hope for. I’m not suggesting that freer building in big cities will eliminate inequality at a stroke. I’m merely suggesting that a more liberal approach to building is one important way to help maintain the dynamism and broad-based opportunity of the American economy.

Two other points. First, Renn echoes some other writers in wondering how much of the higher productivity in cities is due to compositional effects, that is, from exclusion of low-ability workers. The answer, as I acknowledge in the book, is some. But there is a significant effect over and above this. Controlling for individual characteristics, there is a benefit to being in a smart city. That is, if you take individuals with similar skill levels and put them in different cities, the one in the city with more skilled workers will be more productive. Gated cities don’t thrive because of exclusion; they actively make the workers there more productive.

Finally, Renn makes a good point when he writes:

So to really boost employment, we’d need more than just cheaper land making labor more available at a reasonable cost. That might provide some boost. But we would also need business model innovation.

I agree! And one of the points I aimed to make in the book is that during periods of dramatic technological change cities become more important, because they are laboratories of experimentation. Early last century, within America’s large industrial cities, there was a constant conversation taking place across competitors. Firms worked constantly to improve new technologies, but also to find ways to build successful businesses around them.

Just recently, a Google employee named Steve Yegge wrote a memo to his coworkers which was accidentally posted publicly. It’s a fascinating look at the process of innovation in Silicon Valley. Not simply product innovation; Yegge specifically discusses the way that cultural differences at Google rivals give them an edge in exploiting the business potential of the platform. Yegge previously worked at Amazon, and he writes in a fashion which suggests that his audience will also be intimately familiar with the strategies and goings on at companies like Facebook and Apple. It is as if these ideas are in the air, to use Alfred Marshall’s phrase. It is in places like Silicon Valley that people are grappling with how best to deploy the wondrous new technological tools at our disposal, and how best to build businesses around them.

This is why dense, productive, innovative cities are so important. It’s why it’s important to make sure that workers can afford to live in such places. The jobs these innovators create will be good ones. And they will create more of them if the local labor market isn’t incredibly tight thanks to high housing costs.

Renn suggests that my solutions may merely mean that we squeeze a few more horsepower out of the American economic engine. I’m happy to agree with that. That, after all, is how all of humanity’s modern progress has occurred. All of the stunning technological innovations of the industrial revolution didn’t lead to rocketing economic growth; since the early 19th century, potential growth has held remarkably steady at around 2% a year. It’s just that across decades, the effect of pushing growth up just that little bit has an enormous impact. If America had growth half a percentage point faster each year for the past two decades, we’d all be much, much richer.

Aaron Renn

And here’s an interview on the book at Reason.

I didn’t respond to Randal O’Toole’s first take on The Gated City because, quite frankly, it didn’t appear that he’d read it. Now he insists that he has, and yet…well let’s just go through his points. First, on whether density facilitates productivity growth:

Avent cites research showing that denser American cities have higher labor productivity. For example, a 1996 study uses 1988 data to show a correlation between the urban densities and the wages and salaries earned in the various states such doubling job density raises incomes by 6 percent.

Six percent isn’t very much, and in order to reach even this conclusion, the authors of the study left out states that had lots of mining industries, which depend more on mineral density than population density. If they hadn’t left those states out, Alaska would have been the most-productive state. Even if some industries do benefit from density, not all do.

Avent cites several other studies, but does not mention this one, which compares density with technological innovation, a field that–unlike mining–strongly depends on the personal contacts that supposedly are gained from density. The study did find a correlation between density and innovation, but it also found an optimal density and an optimal city size. In other words, at some point, more density is no longer better. In particular, the optimal urban area size is about 750,000 people and the optimal density is about 2,000 jobs per square mile–roughly Baltimore or Philadelphia. Baltimore and Philadelphia are far from the nation’s densest urban areas, and in fact Houston is right between them.

O’Toole seems to accept the relationship; indeed, he directs us to a paper in which the authors conclude:

These findings confirm the widely held view that the nation’s densest locations play an important role in creating the flow of ideas that generate innovation and growth.

His principal criticism seems to be that in the paper in question, the authors estimate an optimal density which is not, in his view, that dense. That’s not much of a complaint, in my view. I’ve been careful not to specify an optimal density; in fact, I suspect that such a density is likely to vary significantly across industries, institutions, and with transportation and communication technologies. The empirical evidence supporting a positive relationship between density and productivity is strong. There is comparatively little work on optimal densities. At any rate, the policy implications don’t seem to tilt in O’Toole’s supposed ideological direction. I can’t imagine why a libertarian would want to go around telling willing city residents that they’re living at too high a density. And if productivity falls above certain densities, the market should quickly adjust; we’d see little wage growth in cities near the threshold, and consequently little growth in housing costs. Of course that’s not what we observe.

O’Toole goes on:

Another problem with Avent’s first claim is that most of the studies he cites compare the relationship between density and productivity at a single point in time. But the whole point of The Death of Distance is that this relationship is getting weaker all the time. This study, for example, found that the correlation between density and productivity declined from 41 percent in 1940 to 7 percent in 1980. It seems likely that, by the time any city can do anything about its density, the benefit of being denser will be negligible.

Now, this is really remarkable. I argue — I think quite clearly — that the relationship between density and productivity appears to be growing stronger, precisely because of technological developments. I cite research indicating that since the 1980s R&D spillovers appear to have become more important, that in recent decades the return to talent has increased in dense cities, and that in recent decades density explains a surprisingly large share of real wage growth. I point to Ed Glaeser’s work, which indicates that the “Death of Distance” phenomenon that gutted urban industry appears to have strengthened knowledge agglomerations and increased the return to ideas. Cato’s chief urban scholar seems to have no knowledge of these strands of the literature, nor does he appear to have spent all that much time with my book.

O’Toole then argues that I’m incorrect to blame NIMBYs for high housing costs. Instead, local zoning rules are to blame. Again, he seems strangely ignorant of the arguments I actually made. I write that residents of dense cities oppose new development and use a variety of mechanisms — tight zoning rules, historical preservation, and political pressure among them — to achieve their ends. I’m not sure how O’Toole thinks most city rules get on the books; presumably, local interests have had something to do with it.

Finally, there’s this:

Perhaps the greatest flaw is in the third step of Avent’s reasoning. “I don’t wish to tell anyone where to live, and I certainly don’t want the government having its way in the matter,” says Avent. But if the NIMBYs and their urban-growth boundaries and large-lot zoning disappeared, these regions would all become less dense, not more dense. Housing costs would become more reasonable, and the areas might actually become more productive, but not because of density.

The trouble is that, although Avent doesn’t support coercive government policies, many other density advocates do. And Avent specifically cites transit-oriented developments as a way of increasing density without realizing the huge amount of coercion that is required for many of those developments, including prescriptive zoning, tax subsidies, and artificial restraints on low-density development so that some people will have little choice but to live in the higher densities.

Frankly, I have no idea what kind of economic model he’s using here or what evidence he has in mind. I’m not sure what would happen if zoning rules were relaxed across the board. Home price data suggest that there would be a lot of new construction in dense, high-cost cities. Given the high cost of land, it seems likely that densities would rise. Based on the research I’ve examined, and that which O’Toole himself cites, it seems likely that this growth would result in more people living in dense areas and earning higher wages, thanks to rising labor productivity. Now, maybe O’Toole is arguing that cities would like to grow outward but are prevented in doing so by NIMBY rules, such that relaxed zoning would lead to sharply reduced densities. Again, there is scant evidence for this assertion, but I’m happy to admit that it’s a possibility. Either way, I can’t see why O’Toole wouldn’t be in favor of making it easier to build new housing — of whatever sort the market wants — in cities, especially those where home prices and productivity levels are high.

I discuss several different ways to make it easier for cities to satisfy demand for housing, and transit-oriented development is one of them. It seems clear that government intervention would be required to support such a policy, and O’Toole seems very unhappy about this. Whether he’s just as unhappy about the taxes, infrastructure spending, and zoning rules that typically accompany suburban growth isn’t clear. But in general, I’m interested in changes that increase, on net, a landowner’s ability to build as he wishes. It seems clear to me that TOD is a useful way to get local governments to accept upzoning, and landowners seem more than happy to build as much as the government will let them. Libertarians might not approve, but it seems to be a more liberal approach than the status quo.

I do appreciate O’Toole’s engagement with the book, such as it is. I sincerely hope that libertarians will consider the arguments I make and warm to the theme.

Rob Pitingolo’s response to The Gated City has now been posted at Greater Greater Washington under the headline, “Housing is more than supply and demand”. I actually think this headline is a little unfair to Rob, who is not in fact arguing that housing is more than supply and demand. Rather, he’s arguing that housing is not a commodity. That is, homes aren’t all perfect substitutes for each other:

There are many unique types and styles of housing, some of which are more desirable than others. When demand for housing rises in a neighborhood, rents will rise, regardless of the type or quality of the housing. A neighborhood might have century-old rowhouses, 1970s apartments, and brand new luxury buildings. If demand is rising in that neighborhood, rents for all types of these units will rise.

But what if a neighborhood doesn’t have any vacant land sitting around waiting to be developed? How do you increase the supply of housing when there’s no place to build new housing? Basically, you have to knock something down and replace it with higher density housing.

Let’s imagine that a developer is proposing to level some not-so-great ’60s-style townhouses in an urban neighborhood. In their place, the developer is going to build a multi-level apartment complex with a gym, pool on the roof, and ground-floor retail. Perhaps the developer is going to knock down 10 low-quality units and replace them with 50 high-quality units, for a net-gain of 40 housing units.

Even though the number of housing units in the neighborhood goes up, it’s virtually guaranteed that the market rents for those new units are going to be higher than the rents for the old units. So the folks who might have been able to afford one of the ’60s-style townhouses no longer can afford a luxury-apartment in the neighborhood.

This is a good point. Supply matters, but not all housing types are perfect substitutes. If you tear down cheap, low-quality housing to build lots of high-quality housing, then the cost of housing across the metro area as a whole may fall (or grow more slowly) along with the cost of high-quality housing. But you’ve reduced the supply of low-quality housing. Residents displaced from cheap housing who can’t afford the lower cost of high-quality housing may find themselves in a pickle. The solution, however, is not to restrict development (and to be clear, Rob isn’t necessarily suggesting that it is).

There are two key things to remember. The first is that the more development a metro area approves, the less development pressure there will be on any given piece of land. If most of the city is zoned to accommodate tall buildings, then a lot of new demand for the city will flow to those new buildings, placing less cost pressure on the land atop which sit low-quality units. Consider Brookland, in Washington. The land around the Metro station is mostly empty, and local residents are fighting “dense” developments on that land, by which we mean buildings up to 6 stories tall. But residence in the District on metro-accessible land is in very high demand. The less of that demand is accommodated by new, high-quality buildings on empty land, the more will be shifted toward the older homes in the neighborhoods around the station.

The second thing to remember is that when I say I want looser housing regulations, I mean it. I’m bothered by rules that prevent owners from subdividing existing houses — an important means through which affordable housing can be provided. I wish it were easier to convert outbuildings, basements, and similar structures into housing. I wish people weren’t anxious to keep urban industrial land zoned for industrial uses in the misguided view that industry will be coming back to central cities. I’m not just interested in making the supply of high-quality housing more flexible. I want that flexibility to extend across housing types.

Rob is right; lower-income residents might well oppose new development out of a fear that it will mean replacing old, affordable homes with new, unaffordable ones. Those residents are mostly the victim of efforts to make it hard to build everywhere. And if those concerned about the poor succeed in blocking redevelopment of older homes, they’re not stopping displacement — oh, no. They’re simply shifting it elsewhere, to places where the poor aren’t quite as good at finding advocates for their interests.

Noah Smith writes a post that touches on some themes in The Gated City, particularly those relating to the export advantages of healthy cities. I comment on his post here, but I wanted to add to the argument with a passage from the book. At Free Exchange, I write:

In other sectors, the gains to firm concentration remain. We observe concentration in these sectors where there are…concentrations of economic activity, as you might expect. If we look at the tradable sectors in American cities, we see things like finance, management, technical consulting, high-tech research and manufacturing, information, systems design, and so on—that is, human-capital intensive industries on the innovative frontier. Collections of smart people are good at taking new ideas, turning them into workable business models, and marketing those businesses around the world.

I elaborate on the point in Chapter 3:

Within this space, where the ideas are “in the air”, there is a greater level of “technological congruence”. Think of it like this: if you’ve been following and participating in a conversation between friends, then you’re likely to find a particularly witty crack funny — you were there for the build-up. If you later report the punchline to another buddy, he probably won’t get it. He had to be there.

Innovation is like that. You often can’t drop a new technology into a random situation and expect local firms and workers to exploit the technology to its fullest. They haven’t been participating in the conversation that led up to innovation, that often spelled out the principles on which it relies and the problems it’s meant to solve. Even if they can get it to work, they’ll frequently be at a loss if it breaks down, and there’s almost no chance that they can continue to refine and improve the innovation.

Cities aren’t simply a collection of raw human talent. Instead, they’re the processing power embodied in the conversation that talent conducts. Innovations and technologies that perform well in one processor might not be compatible with others. And large cities act as potent idea processors.

This processing role that cities play — supporting a conversation that drives innovation — applies almost exclusively to fledgling technologies. In the early years of a new technology, the conversation is of critical importance. Firms are attempting to understand its capabilities, to make it work better, and to reorganize modes of production and business models to optimize the new, big idea. At this stage, awareness of the context of the technological discussion is crucial. Among the firms and individuals within the innovative city circulates a large body of knowledge of what has worked and failed so far, and what is likely to bear fruit in the future. Transplant that technology to a tabula rasa at this stage, and it will be nearly useless.

As the technology matures, the importance of the technological community wanes. Much of the tacit knowledge is written down, codified, and taught in schools or training programs. Processes become standardized and easier to explain to newcomers. Consequently, it becomes easier to shift use of the technology abroad. This is a key way in which the city fuels growth across the economy, by domesticating new technologies and making them accessible enough for deployment outside the initial all-important technological community. But it’s also a process that diminishes the importance of the city, at least insofar as a particular technology is concerned.

Eventually, new ideas are tapped out. Every permutation is explored and every efficiency realized. The technology can be used anywhere; it’s simply a matter of plugging in the machines and passing out the manuals. At this point, a technology is entirely offshorable. There is no longer any need to pay the premium to be close to the center of discovery and development. This moment can be a destabilizing and painful transition point for the innovative city. But so long as it hasn’t lost its innovative capacity during the process of wringing ever greater efficiencies out of the initial technology, it should go on to tinker with and develop new and different ideas.

The difficulty of achieving technological congruence in places apart from innovating cities is one of the great challenges of developmental economics. Most of the technology the world has is fairly simple to use and reproduce (if not for you and I then for trained engineers), and yet there are massive wealth disparities across the world. Some of the gap is due to institutional differences and variation in education. But history is also littered with examples of economies that tried and failed to import and develop around existing technologies. Local populations unfamiliar with the deep (and often tacit) knowledge underlying the original process of innovation struggle to successfully deploy even basic technologies…

Economic growth is not a zero-sum game. That is not to say that Americans never face costs related to growth abroad; they certainly do. It is to say that growth abroad is clearly good for the welfare of the world as a whole and is generally good for the welfare of Americans, particularly when American government policy is set appropriately.

To the extent that Americans are interested in exporting goods or services or ideas rather than jobs, it’s worth reflecting on the role of the productive city. This processing machine, including the human capital of its residents and the tacit knowledge of the ongoing innovative discussion they share, is not easily replicable abroad. Believe me, firms would love to be able to do just that; moving away from the high land and labor costs of big American cities is very good for profits. But they often cannot afford to. The value of the urban agglomeration is simply too great.

China can’t easily reproduce our innovative cities. Right now, unfortunately, America seems more interested in chasing smokestacks than in strengthening its existing advantages.

Here’s Tim Lee

Rob Pitingolo

Jim Gleeson

And a second look from Lloyd Alter, who seems to have warmed to the book.