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The Secret Sauce of Economic Growth

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Over the last few decades, the field of economics has made important strides in understanding economic growth. The secret sauce in the new growth theory is something called increasing returns. They are not not supposed to occur in classical economics and don't occur in classic models of the broad economy. However, they do occur in the real world. Cities, for example, would not exist without them. Expressed simply, increasing returns are the improvements in economic output that arise from mixing the right recipe of ingredients together, ingredients that enhance the value of one another. They show up in cities, regional clusters and firms as economies of scale.

While we may associate economies of scale with large companies--Henry Ford's giant River Rouge plant, for example, where steel came in one end and cars out the other--in fact, you don't need a large company to get scale economies. (Large firms exist because they simplify interaction; people within a firm don't need to negotiate a contract every time they work together.) Economies of scale also occur among lots of small companies and players in close vicinity to one another which is what takes place in a city. While increasing returns don't have to create large firms, what they do create is all good: growth, new jobs and growing regions that include large and small companies alike. The secret sauce that makes it all work are what economists call externalities--the benefits participants confer on one another. Paul Romer has used the word recipe to describe this mix. In other words, just as tomatos, garlic and cheese enhance the value of one another in a dish, complementary skills among people working together or the spillovers in the air in places like Silicon Valley create increasing returns: the secret sauce of economic growth.

America has seen many great agglomerative clusters in its history that have helped fuel the American dream. One such cluster arose in Detroit. Alfred Sloan, legendary GM CEO in his classic book, My Years at General Motors (that Bill Gates used as his roadmap to building Microsoft) describes the early years when he worked at a ball bearing company and the industry grew on a platform of complementary skills and knowledge in the air about making brakes, ball bearings, tires, engines and all the other ingredients of a car.

Detroit fell on hard times, as the Super Bowl Chrysler commercial featuring Eminem recently underscored, but is now vying to retrieve its greatness. But the story of Chicago's slaughter houses, New York's hat makers and financial companies, Boston's Route 128, California's Silicon Valley, Charlotte's banks and a host of other clusters are virtually synonymous with the story of American economic greatness.

However, research has also shown that clusters do not have to be geographic. Standards, it turns out, allow the secret sauce of increasing returns to work across wider distances by allowing providers of complementary products to find one another. A classic example is the introduction of common standards in the garment business led to its expansion outside of New York's garment district. More recently, the Internet led to an entire wave of economic growth.

Thus the second great growth story in American economic history is national growth that took place based on standards across our unsurpassed national networks, first our rail and Interstate Highway systems, but more recently, our communications network. Networks with open standards allow actors not only across America but across the world, to interact with one another and increase the value of one another's output and knowledge.

The key to networks creating the secret sauce of increasing returns is open standards that let a smart phone and person in New York talk to a server in California. The Internet has obviously fueled grown in the last decade. Which brings me to clean energy.

Energy is an industry with storied clusters of its own. The oil patch in Texas and Louisiana--that grew up around American oil--in time became far bigger than our oil alone supported. Long after Spindletop pumped its last barrel, leaving a salt dome that is now used for storage behind, US oil companies helped develop oil in Arabia, Nigeria, Venezuela, Mexico and, indeed, all over the world. Recently, US engineers unlocked the mystery of shale gas which promises to be a game changer in energy for years to come.

However, while US companies are still leaders in extracting oil, imported oil has grown fantastically expensive for a simple reason: the formation of OPEC. Our oil import bill last year was $337 billion, about $3,000 per household. The way GDP is calculated this comes right off the top, lowering our GDP by 2.23%. Oil is still a good business for the US (though it comes with geopolitical and environmental costs), but our need to import two thirds of it has created a massive drain on wealth. To see just how large it is, imagine how good Americans would feel if every household received a $3,000 per year raise in perpetuity?

The question is how do we transition to cleaner forms of energy that do not lie abroad?

History suggests if we are serious about doing clean energy we need to generate some increasing returns. Right now the biggest clusters of clean energy activity are not in the United States. They are in Germany, Japan and China. But it is not too late for us to get a healthy share of the pie. Silicon Valley has obviously been active in clean technology. Clearly, there is an emerging clean tech cluster in California. The beginnings of an electric vehicle cluster are evident as well, with Tesla assembling the Tesla sports car in Menlo Park and, in partnership with Toyota, preparing to build a family car at the repurposed NUMMi plant in Fremont. Because electric cars are very similar to gasoline ones, automakers are building them at or near where they make existing cars. GM is building the Volt in Detroit and Nissan the Leaf in Smyrna Tennessee. A123 is building batteries in Michigan. GE builds turbines in Michigan as well. Hard hit Michigan could be a center for clean manufacturing. To get these clusters into gear, however, we need to generate more local American demand.

The second way to apply the secret sauce of economic growth to clean energy is across our networks. NIST in conjunction with DOE, FERC and others is sensibly working on open standards for the Smart Grid that can facilitate network effects and externalities across the communications portion of the grid. It is vital that these standards stay open. However, perhaps the greatest network of them all, with respect to clean energy, the electricity network, itself, is still far too balkanized, proprietary and byzantine. Clean energy is being held back in the United States by a blizzard of complex regulations that block hookup to the network as well as open use of the network to connect complementary players and even producers and consumers. The Green Lane proposal I unveiled last week--a proposal to create an open access lane across the electricity with plug and play connectivity to provide easy on and off ramps--is one way to unleash the network effects (or secret sauce) that the electricity network ought to be providing.

The best part of opening up the electricity network is that it will lead to the formation of geographic clusters in Michigan and elsewhere building turbines, solar panels, as demand ramps up for clean power and related products.

The American economy is in recovery. But it is recovering slowly. To unleash real growth and wealth creation, it is time to apply some secret sauce in the form of network effects and increasing returns to refuel the American Dream.

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