Conversation with Arnold Kling, economist, founder of EconLog

Kedrosky: I’m here with Arnold Kling. He’s the creator of the EconLog weblog, one of the most popular economics blogs on the interwebs. Formerly with – got an eclectic background. Was formerly with the Federal Reserve Board of Governors and as you put it, I think what was it, your career n minus 1 was known, internet entrepreneur, career n minus 2 was with Freddie Mac, and career n minus 3 was an economist with the feds. Does that sound about right?

Kling: Yeah.

Kedrosky: So let’s go back to career, a little bit maybe, and talk a little bit about career n minus 1 just because I know so little about it. But why don’t you tell me a little bit about your sort of background and career as an entrepreneur given that we’re doing this for the Kauffman Foundation.

Kling: Okay. Well, it’s way back in 1994 and I’m not having fun as an intrapreneur at Freddie Mac, discovering the usual problems with the intrapreneur that they love your ideas only after you’ve done the hard work of selling them to senior management. At that point, they decide that they need somebody else to implement them. And it’s also a time when the internet is about to be freed for commerce. And I was so unhappy at Freddie Mac and I see this vehicle for commerce that’s going to allow people without a whole lot of capital to jump in and try new businesses. So I launched something that was intended to shake up the markets for real estate and home mortgages. I mean, here I am in 1994, the entire internet territory was wide open to be settled. So I launched something called homefair.com and 1994 was way too early. At that time, there were no home buyers. It was a college audience, but I didn’t know that since I had no business background. I didn’t do any market research to realize it, that it was all a college student market. But I sort of hung on for a year and then eventually found partners who knew a lot more about business but not so much about the Internet and it was a good combination. We eventually developed I think probably one of the more profitable web sites in the year that people began to care less and less about profits. And so when the bubble picked up steam, we decided we’d rather be selling into it than participating. And so one of the companies that was going public in 1999 ultimately bought our company. So I tell young people nowadays that if you get a chance to sell an internet business in 1999, I recommend doing it.

Kedrosky: Great ex-post advice.

Kling: Yes.

Kedrosky: So that was … was it, you guys sold it to, was it homestore? I’ve forgotten now.

Kling: Yes, homestore.com which was, which probably would have gone bust like a lot of the internet bubble stocks of that era, but it was backed by the National Association of Realtors and so they made sure it kept going. And as far as I know, it still exists, however I don’t ever visit the site.

Kedrosky: So as you sort of, you know, that was what? You had about a five year run as an entrepreneur, is that about right if I have the dates right here?

Kling: Yeah.

Kedrosky: So as you sort of think back on that, I mean, what, how is it – I guess put it differently. How has it kind of informed you, the way that you think about, you know, as an economist think about entrepreneurship? In what ways has it kind of surprised you in terms of informing it or maybe not informing it when you think about the world as an economist?

Kling: I think my experience both at Freddie Mac and as an entrepreneur really altered my view as an economist. First of all, you become quite aware that there’s no such thing as a profit function sitting out there. You just don’t have that kind of information to solve business as a calculus problem. Secondly, one of my lines is you would not be nearly as impressed with or frightened by large organizations if you’d ever worked for one. The difficulty that large organizations have with internal politics and bureaucracy I think is intrinsic and very severe. So the contrast between the speed and with which we could try things with my small internet business and the painful process of trying to persuade senior management to do any sort of experiment at Freddie Mac just could not have been stronger. I mean, you know, in some sense I’ve launched five businesses in the time it would take to persuade senior management to try one project. That may be even understating it. You can maybe launch ten businesses in the time it would take to persuade senior management to launch one project or a hundred. And it’s just – so it’s a very different scale. So you really appreciate the advantages that entrepreneurs have in terms of speed and ability to deal with trial and error and just the different roles that different types of businesses play in the business ecosystem. Obviously, you know, entrepreneurs don’t dominate everything. There are certainly some advantages to large firms. You know, once they, once you figure out how to operate a business and can kind of replicate it over and over again, then you stop being quite as experimental and you install a bureaucracy because you don’t want your employees just running away, pulling the company in too many different directions at once. So I understand the role of the large organization ecosystem, but at the same time, for me personally, the smaller startup environment was a lot more rewarding and I think I also appreciate that that has a definite role in the business ecosystem.

Kedrosky: That which does? I’m sorry, say again?

Kling: That the small entrepreneurial startup has a definite role and it’s going to have a lot of advantages, particularly in settings where the best approach is not at all clear. What Amar Bhide calls environments with a lot of ambiguity.

Kedrosky: Right. Sure. As you said, sort of ability to, you know, this sort of adaptive progress. And then you talk about this a little bit in the new book so we’ll maybe come back to that. What sort of model did you have in your head of, you know, coming out of a sort of a more orthodox, I’ll say for want of better word, economics background? Was it sort of a more traditional view, a more sort of Schumpeterian view in terms of this sort of destructive role that entrepreneurs play? What sort of model did you have in your own head prior to your sort of own entrepreneurial experience?

Kling: Well, I don’t think I even thought about it or was, at that time, was trying to make any connection between what I was doing and what I’d learned in economics.

Kedrosky: Right.

Kling: So, you know, if you’d asked me to talk about entrepreneurs as an economist, I probably would have given the sort of standard, well, these are the people who mix together the labor and capital and …

Kedrosky: Right.

Kling: … take a little bit of risk. But I really hadn’t thought that much about what entrepreneurial is. I mean, I don’t think I, I think it’s not just the entrepreneur, but the whole system of entrepreneurship is what that accomplishes.

Kedrosky: As you sort of, and you know, you’ve written about this a number of times and on the blog and elsewhere. But I mean, as you sort of go forward, I mean, some have argued that Freddie Mac, Fannie Mae, that Freddie and Fannie in some ways, you know, sort of belatedly and unfortunately became much more entrepreneurial in the dying days of the mortgage bubble. Do you see any sort of metaphor in there in terms of their willingness to take on risks and become more fluid in terms of how they approach the market that they operated in?

Kling: I guess, I don’t necessarily see it as becoming more entrepreneurial. I think they’re, they did manage to lose something that is one of the real assets of large corporations and that’s sort of organizational know-how and organizational culture. Now, I think that is just because there was some transitions that happened to take place at the CEO level that were almost idiosyncratic. I sometimes think that the whole mortgage crisis afforded it an option for some idiosyncratic changes at the top of those companies. And that may or may not be a reasonable way of looking at it.

Kedrosky: Yeah, I mean, as you say, maybe – this is sort of a more of a sort of cultural and management drift than anything else which is, you know, endemic obviously and one of the reasons why as you alluded at the outset that people shouldn’t be nearly as terrified of large companies as they sometimes are.

Kling: Yeah. Well, this was – I think this was a very odd way for them to get into trouble because, you know, both companies had had lots of negative experiences with experiments with low doc loans and regional house price declines and I know there are literally dozens of those people at Freddie Mac who knew better than to do what they did and it was only the mindset of a CEO coming in and saying, “You guys are all wrong. I’m going to change this place.” And that’s actually pretty rare in business organizations. Typically, you don’t get that kind of change.

Kedrosky: As a bit of a digression, but I’m just curious what you think. There is a lovely book out, years old now, from a sociologist and I think she’s at Boston U, but Diane Vaughn about the Challenger disaster and some of the precursors leading to it and sort of the sociological and almost an anthropological investigation of the Challenger disaster and the space shuttle. And one of the claims she makes in the book, based on sort of her analysis of an engineering intensive culture, and I’ll try and bring this back to Freddie and Fannie in a second, is that in an engineering intensive culture, there is this kind of slow drift that happens that she sort of renames as this kind of normalization of deviance that as you, over time, you have a heuristics in terms of what works and what doesn’t and what you should and shouldn’t do in your culture sort of dictates that. But as you sort of over time kind of to, for want of a better word, get away with things. Meaning that, you know, we launched in the case of Challenger at lower and lower launch temperatures and really weren’t paying attention to some of the consequences of that in terms of, you know, damage done to O-rings and other things that you declare the abnormal normal and say, I guess, we were wrong in terms of the heuristics from which we were operating, that we actually can do these things that we used to think were extremely dangerous. And I’ve often wondered, as the mortgage industry, you know, has become much more quantitative, at least in terms of the construction of some of the synthetic packages out there, that you know, it’s kind of – that sort of, you know, mutated into a much more engineering intensive culture that maybe is more prone to this kind of normalization of deviance, that in some ways that kind of led to this drift that you’re talking about. I’m curious what you think about that?

Kling: I think that’s a very interesting way of looking at it. You know, the example that comes to mind is actually … the thing that drove me away from Freddie Mac is I tried to push them to use credit scoring as a lending technique and that, you know, that – it does have some tremendous advantages over what came before it, of sort of human judgment in looking at credit reports. But one of the things that I think happened is that people began to overestimate what they could accomplish with credit scoring, that they became, they viewed it as kind of super tool and they didn’t take into account the fact that the major adoption of credit scoring occurred in an era of ever rising house prices and it hadn’t been tested in an era of falling house prices. So I think that is an interesting example. I am also, since we’re talking at the time of the BP oil spill, I’m wondering if your sociological story describes that because I listened to one YouTube of a 60 Minutes broadcast and it sounds like the people began just, that there were so many things that were malfunctioning and yet the drill was still working that people began to think of all that malfunctioning as normal. It could survive anything.

Kedrosky: Right. And exactly, I mean, the applicability had occurred to me as well, that across many of these, what people miss, I suppose, you know, we get in the case of BP that it’s an engineering intensive culture. And to the extent you buy the sociological explanation, the Vaughn sort of normalization of deviance argument, that we get that at BP. And I think maybe, what maybe many people missed in the context of this, you know, increasing quantification of the financial services industry, that this industry too had begun to have some of the characteristics of an engineering intensive culture and that you need to arrest this kind of, this internal momentum towards normalizing deviance in the face of outcomes that seem to suggest that we’re being too cautious.

Kling: Yeah. One thing about the sociology of both Challenger and this is what I have labeled the suits versus geeks divide. That is that I think the [inaudible] were aware of the middle one certainly, of the limitations and the risks of their models. But the leaders, the types of people who could actually become executives of firms wanted to see things in more, you know, in less settled terms and in more in terms of, you know, look at what we can accomplish with this stuff.

Kedrosky: Right.

Kling: As opposed to what are the, you know, what are the limitations.

Kedrosky: Right, right, exactly. And as I said, more than anything else, it just sort of struck me as an unremarked kind of parallel across these phenomena. So let’s, I mean, just maybe before entirely abandoning discussions of it because it’s so entertaining of what happened in the period leading up to 2008 and it kind of leads into the discussion of where we go from here. Where do you feel like we’re at in the context of, you know, regulatory reform, the healing if you will of the economy and sort of our path forward from here? What would be your read of the temperature in terms of both sort of the, from a policy standpoint I suppose, from a regulatory perspective, and then from a broader economic perspective?

Kling: My view of the financial reform is that it’s a symbolic gesture that has no real meaning. You know, they have to tell the public that we’re doing something. In fact, they, the people in Washington and the people in Wall Street, can’t really imagine anything better than the status quo a few years ago. And so the regulations are really not, not designed to make any fundamental changes. And those who are from outside Washington tend to be quite critical. We tend to view that they’re just setting us up for the next crisis ten or twenty years down the road, or maybe not that far. So it’s been a much ado about nothing is kind of my view of the regulatory story.

Kedrosky: Well …

Kling: Um …

Kedrosky: Go on.

Kling: So the economy as a whole, I take the view that for whatever reason, sometimes the economy seems to – we’re kind of always in this dynamic, Schumpeterian state of, you know, creative destruction. But occasionally, we get periods of really lots of, lots of destruction being bunched at once and maybe not enough, not much creation relative to that. And I think this is one of those periods. I mean, I think it’s going to be a long time getting out of it just as it was a long time getting out of it in the 1930s and I’m not convinced that there’s much that government can do about it because I think a lot of it is structural. A lot of it is sort of an overhang of changes that were kind of delayed and covered up while the various bubbles were going on. But there’s just a lot of structural change that’s kind of hanging over the economy, you know, continued decline in manufacturing production work, you know, the overall manufacturing production can continue to rise even though the people employed are falling. And I think the changes that the internet is going to bring into the structure of the economy haven’t really been absorbed yet, just as I think the changes caused by the internal combustion engine had not really been absorbed as of 1930, but by 1950 at the end, the shape of the economy began to seem a lot clearer.

Kedrosky: That’s, you know, and we can press more on that. But I think maybe it’s a better way to approach it is, that makes a nice transition over into maybe talking about some of the ideas in your new book with, newish book, I guess, with Nick Schulz, its From Poverty to Prosperity, which kind of I think tries to wrap and I’ll give my version of it and then you can feel free to redirect. But I mean, which kind of I think tries to wrap a framework around the way that sort of economics is being transformed in many ways you argue in the face of some of these phenomena that you’re describing in terms of this scarcity versus abundance in sort of economics too, if you will. And I want to just maybe open up by just reading a quick excerpt here from really early on and maybe get you to talk a little bit more about this and see if we can push on it a bit. You talk about this idea, metaphor really I guess, of “from the meadow to the food court.” And I’ll just read what you talk about.

You talk about how the economies evolve from one of scarcity to one of abundance. The meadow in which people are imagined like a grazing herd is a metaphor for a Malthusian subsistence. The food court, in which a plethora of recipes allows for the substitution among ingredients is a metaphor for the abundance generated by knowledge which is this intangible asset. And let’s maybe start right there. I think it’s an interesting way of kind of getting into what I think one of the main themes of the book is, is this transition in economic terms in economies terms and in sort of terms of our thinking about the consequences of thinking in sort of Malthusian terms and scarcity and maybe a static model to a more dynamic model predicated upon abundance. Not just in form of sort of the internet, but just more broadly. So does that – let’s maybe start there. Is that sort of the cornerstone of your thinking in the book?

Kling: I think so. I mean, it’s – In general, emphasis is on intangible factors that matter. And the source of abundance that’s intangible is the fact that ideas don’t involve scarcity. You know, I can reuse your idea without detracting from the idea in any way. The other intangible factor is a liability and that’s institutions and, you know, predatory governments, people, cultural resistance to learning, things that impede people from taking advantage of ideas and taking advantage of economic improvement. So the story of abundance and the fact that ideas to not provide scarcity and in fact have increasing returns, there’s a great story to explain, you know, how we can be so much better off now than 100 years ago. That’s a lousy story to try to explain how Haiti is poor and the US is rich because, you know, Haiti should have access to the ideas we have and if our claim is that the ideas are what’s important and physical capital and physical resources are not so important, then it becomes especially puzzling to try to figure out how some countries are rich and some countries are poor and that’s where you have to go to the other intangible, the liability side of the intangible thing which in the case of Haiti would be history of very bad government and perhaps some cultural impediments to learning.

Kedrosky: So I’m curious how you respond to this because, you know, it’s an appealing model and in many ways it’s an elaboration on things that, you know, many folks in sort of the increasing return side of things, you know, Brian Arthur, I mean, Paul Romer said this and he’s in the book as well. It’s a nice collection of interviews with many people who have got sort of provocative perspectives on these very ideas. But nevertheless, let’s talk a little bit more about this sort of idea of scarcity and these sort of ingredients versus the Malthusian subsistence. A critic might say, and there’s lots of folks right now and BP is in the headlines, so a critic with sort of an energy mentality might say it’s an illusion that we have an abundance of ingredients from which to choose because it’s really masking that underneath all of them is this kind of implicit societal subsidy we’ve had over the last 100 years coming from this cheap high density supply of energy called oil, that in the absence of that, most of these so-called ingredients in the context of the building blocks of finding other solutions to problems we face are fairly illusory, that it’s really just masking it underneath all of this, it’s really all about energy. I mean, I suppose that’s a restatement in many way of sort of the peak oil view of things, but just as a more broader perspective, you know, I’m curious what you’d think about the idea that the abundance we see in terms of all of these profusion of ways of potentially dealing with problems we face in an area like energy, given sort of BP’s position in the headlines is really all about sort of this underlying oil. And the point was made I thought in an amusing way just last night on The Daily Show. Jon Stewart had a clip where he put up what the last eight presidents all promising to, you know, end our dependence on foreign oil and, of course, they all say it in more or less the same rote terms and nothing has changed. And the cynic would say, “Well, that’s just because, you know, politicians are, you know, craven and silly.” And a more pragmatic answer might be, well, maybe it’s just because it’s hard. It’s hard to really – we’re discovering the substrate of our sort of economic growth and that substrate is oil and energy?

Kling: I would say that of all the things the physical resources where scarcity is difficult to overcome, energy seems to be the leader. I remember in 1978, the American Economic Association put out a special issue of its journal and there was a fascinating article called, The Age of Infinite Substitutability, which said basically that anything could be substituted for. The one factor that we had not figured out yet how to produce, you know, sort of in almost infinite quantities was energy. But if we were to solve that problem, that basically you could then alleviate any shortage of any other thing. So water, we could take care of, land, food, anything. So it was this very optimistic thing but with this caveat, well, energy is the tougher one. So energy is a tough one and, you know, I think the, you know, if solar power truly follows a Moore’s Law type path, then which is what somebody like Ray Kurzweil thinks, then in 20 years or so, the cost of solar power will fall below the cost of oil and it will go the way of, you know, charcoal, as you know, no longer being any kind of a significant form of fuel. If that doesn’t happen, then we’re in for some long difficult problems.

Kedrosky: You know, and may which be an understatement I suppose. But I mean, I think it’s just a, the thing that worries me. I mean, there was another Kurzweilian thing in the weekend New York Times making a similar sort of point, and it often seems to go unstated. That underneath a lot of the current, you know, fondness for the singularity and the abundance and the transformation of life and society because of this wonderful thing called the internet, as you say, seems to miss the difficulties in substituting probably the single most important component in all of this which is energy. And the absence of it being as cleanly substitutable as so many of the other components that might, you know, I think a legitimate concern is maybe the entire argument becomes considerably shakier.

Kling: Yeah, I guess in the background, I think that – I suspect that we can solve the energy problem, but you know, it’s hard to predict when or how. You know, that’s the nature of innovation. If we’re easily predictable, …

Kedrosky: Everybody would be doing it, yes.

Kling: Yeah.

Kedrosky: No, no, exactly right. One more quick thing before we wrap up because we’re getting to the end of our time and it’s another thing that kind of touches back on I think something you closed the book talking about. And it’s probably, I’m hoping, going to be in the headlines shortly which is the, which is patents specifically and maybe intellectual property more broadly and its role in this discussion of abundance and you have kind of a pragmatic view of this. But I don’t know if want to try and ground it in this. But I mean, me, I suppose myself like many others have been sort of waiting with a cross of entertainment and baited breath as the Supreme Court apparently, you know, beats itself up internally about this Bilski decision which has been, I think, now the most delayed or overdue decision in the modern history of the Supreme Court and obviously this one has to do with business process related patents. But there’s lots of discussion about a broader Bilski decision and the implications for the patent system at large and software in particular which is a highly controversial area. But just quickly describe sort of – you have a fairly pragmatic view of the role of intellectual property protections and patents in particular.

Kling: Yeah, my view and I’m not an absolute bigot in either direction. I don’t view it, intellectual property, well, that’s property and, you know, it’s man mixing his labor with something, therefore you own it. You know, that’s one type of bigot. And the other bigot says, no, ideas are, that it takes force, the use of force to stop people from using ideas as opposed. So let, you know, the – you know, it’s a violation of freedom to have any kind of intellectual property laws. I think that, you know, my extreme examples are, you know, when a drug company spends hundreds of millions of dollars doing research and testing and then, you know, somebody else could just take the formula and replicate, you know, and make the pills for pennies, I think that the drug companies should get something. My guess is that something should not be in the form of a patent. So I can see getting rid of all patents and maybe all copyrights, but in exchange for some kind of prize system where, you know, people who work hard and develop things get prizes. And one advantage of that is, you know, you could, as you’re setting up prizes, you would understand how, you know, the amount of work it might take to do something. So you might give a billion dollar prize for some, you know, very difficult development in solar power because it’s, you know, very important and very difficult to do. A much smaller prize for writing a hit song or a jingle for an ad. So I could see changing from an intellectual property perspective to a prize perspective perhaps as a way of balancing out the various issues there.

Kedrosky: And given, I mean, to be somewhat of a cynic, given the vested interest involved, what’s the prospect for something like that happening? Which makes a great deal of sense.

Kling: Yeah, I think it’s very difficult to move off of existing system. And yeah, I don’t – you know, I wouldn’t even begin to propose a way to get from here to there in terms of the intellectual property.

Kedrosky: Are you optimistic at all about, you know, about the Bilski decision to the extent you followed it, that maybe the delays mean we’re actually going to see some sort of wholesale rethinking at least with respect to some of the more problematic areas of current IP?

Kling: Somehow I don’t think we’re going to get … the Supreme Court is going to come down and come up with something is magical either from a substantive perspective or from a, you know, political process perspective.

Kedrosky: Yeah, it’s, you know, it would certainly require a leap given recent history. But it would be nice to see. We’re just about, we’re just at the end of our time here, so I want to thanks, Arnold, very much for doing this. It’s been a great discussion. I’m glad you could sit in for the half hour.

Kling: I enjoyed it a lot.

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