Cities and the Wealth of Nations

Jane Jacobs is best known for her classic and hugely respected critique of modern urban planning, The Death and Life of Great American Cities. But, after that work, she expanded her writing into macroeconomics and the analysis of economic growth, and believed that she'd found a better explanation than previously advanced for how economies grow and develop. Cities and the Wealth of Nations, along with The Economy of Cities and The Nature of Economies, is part of her presentation of that analysis.

This sort of book is tricky, both to read and to discuss. Jacobs was a brilliant woman, keenly observant, and with a broad-ranging understanding of the nature and mechanisms of cities. Her work on urban planning is justly famous; among other things, she presents the most cogent and comprehensive argument against strict zoning that I've ever seen. She generally argues for complexity over simplicity, always a difficult thing to do well but frequently the source of the best analyses. However, none of those properties make her a macroeconomist, and economics, particularly macro, is a notoriously difficult field.

Very smart people are capable of sounding persuasive and well-informed on just about any topic to which they turn their attention. That doesn't, however, make them right. It shows that they know how to construct an argument and avoid obvious logical errors, but it doesn't mean their assumptions and background knowledge are sufficient to the topic. It's therefore always worth approaching brilliant people writing outside of their field with some skepticism. The easy markers of inaccuracy will be missing, but deeper problems may be lurking and difficult to find on a simple reading.

That's one issue. The other is that Cities and the Wealth of Nations was first published in 1984 and therefore probably written in 1982 and 1983, right at the end of the stagflation crisis in the United States. Jacobs opens the book with a history of both demand-side and supply-side economics, concluding by using stagflation to show that both have failed to explain modern economics. In 1982, when Paul Volker and the Federal Reserve still were keeping the funds rate at high levels to fight stubborn inflation despite a national recession, that conclusion appeared inescapable. However, just two years later, inflation had collapsed and the Phillips curve now seems revalidated as a tool for macroeconomic analysis. Both demand-side and supply-side economics have developed explanations for stagflation that do not require overturning the rest of their theory, and Keynesian analysis in particular now appears redeemed by the results of Volker's persistent application of classic Keynesian remedies through the early 1980s.

The broader problem here is that macroeconomics is complicated, hard to discuss with any scientific rigor, and prone to significant hindsight reinterpretation. It's depressingly easy to come up with plausible-sounding theories, easy to discredit them in the light of the current crisis, and very difficult to determine whether the resolution of that crisis supports your new theory or renders it unnecessary.

That's the background for Cities and the Wealth of Nations: it's an iconoclastic look at macroeconomics that presents a city-centered theory of economic growth that doesn't fit into either classic demand-side or supply-side economics, written at the height of a crisis that seemed to discredit mainstream economics but, in retrospect, probably didn't. And it's written by a brilliant thinker and gifted author, but possibly outside her area of primary expertise. There are a lot of warning signs there, but also a lot to intrigue.

The theory itself is expanded from The Economy of Cities, which I've not (yet) read: economic growth happens primarily through cities, and specifically through a cycle of city import replacement. A city starts by making some set of products for export to other cities and using the profits from that export to import products of interest from other cities. As its wealth increases and a wide selection of imports builds up, city industry finds local ways to make things that were previously imported from elsewhere, possibly more efficiently or more creatively, by applying knowledge from other local city industries to the new market. That investment leads to building up a new city industry, which eventually becomes another export market for the city. The profits from that export are used to buy more imports, which eventually in turn become candidates for local replacement.

Import substitution has a very bad name in macroeconomics due to some spectacular failures of government policy, primarily in South America, so it's worth reinforcing here that by import substitution Jacobs does not mean hamhanded government attempts to assemble local industry like a Lego set while forcing consumers to purchase from it. She discusses at some length why the approach taken in some South American countries to encourage development of local industry was doomed to failure. Instead, import substitution here is a dynamic, unpredictable, and creative process of repurposing local talent and established support industry to find innovative ways to make or improve products previously made elsewhere, something that happens as part of a free-market process and with only an unpredictable subset of the goods that a city is importing. It's a process that relies heavily on cross-pollination between industries and creative repurposing of infrastructure for one industry for use in another industry.

Cities and the Wealth of Nations goes beyond that analysis of the economic lifecycle of a city to talk about the regions surrounding cities, how they feed into and are influenced by the city economy, and then to talk about non-city regions and the groupings they fall into. It is a reconstruction of macroeconomics around the city, rather than the country, as the fundamental unit. And, in the process, there is a lot of fascinating analysis, ranging from the economic effects and questionable morality of farming technology improvements in the absence of meaningful city work for displaced workers through the failure of transplant industries to the perils of extraction economies. Much of what Jacobs says here lines up well with things I've heard from other economists, such as the dangerous dead-end trap of resource extraction economies. Other parts, particularly the devastating analysis of the perils of agricultural improvement happening in isolation from change in the rest of the economy, I'd not seen elsewhere and found very thought-provoking.

One of the most interesting parts, and one that seems particularly timely given the current Euro crisis, is Jacobs's look at the effects of currency on her model of city economic growth. If a city has its own currency (true either for city-states or for countries small enough to only have one full city large enough and healthy enough to follow Jacobs's model), the exchange rates of that currency tend to have beneficial signaling properties for the city. As the city becomes more and more successful at export, its currency tends to rise in value because it's running a trade surplus, which both encourages imports (which become cheaper) and which eventually push the city into innovating or diversifying because the exports become more expensive and less competitive. When it is in a cycle of import replacement and development of new export industries, when exports have fallen and innovation is just starting to take root, its currency tends to drop in value, both encouraging people to buy locally (and support the new innovative industries) and providing a boost to new export business. The changes in exchange rates act as a brake on cities becoming too successful exporting a single product, since that leads to a stronger currency and therefore falling exports while simultaneously providing a rich variety of imports around which to innovate.

Jacobs argues that national currencies that span multiple cities destroy nearly all the benefits to this innovation cycle. At best, they tend to be neutral, not responding to the city economic cycle at all. This can lead to cities continuing specialization in a single product for far too long, since the currency never sends a signal that innovation is required by making exports more expensive. This makes the city both fragile and unstable over time, leading (in Jacobs's analysis) to unstoppable collapse when something finally undermines the too-specialized export industry. Detroit is her example of this. It also means there's no natural mechanism to encourage fledgling local industries via a weak currency, which acts as a natural import tariff. One can substitute real import tariffs, but since those are a political act they tend to be distorted by lobbying and to last far longer than they should, protecting industries beyond the point where that's useful for early innovation or protecting the wrong industries entirely.

Even worse, a national currency can send exactly the wrong message. If the national economy is doing well but some cities are doing poorly, the continued strong currency provides no assistance to fledgling import substitution and can make it difficult for local innovative industry to get established in those cities. If the country is running largely on a limited export business (or, worse, on resource extraction), there's a political incentive to keep the currency weak, but this prevents cities from importing a wide variety of goods that provide fodder to the next cycle of innovation.

Jacobs follows this reasoning to argue that, in an ideal world, we would have far more currencies than we do, and speculates that single national currencies have a tendency to undermine formation of healthy city regions and encourage creation of single mega-cities that dominate national economies to the exclusion of other cities. I'm not sure how much I buy this analysis, but it comes at currencies from an interesting angle while still supporting some of the analyses of the benefits of multiple currencies that I've read elsewhere.

As one can see from the length of the review, there's a lot packed into a relatively small book (and there are whole topics I've not touched on, such as the benefits of city trade with other cities at their same level of development rather than only with advanced cities). While there are good reasons to be skeptical of the validity of Jacobs's overarching theory (I would, at least, want to read scholarly reaction to it from other economists), it's full of specific observations and smaller analyses that I think are useful even if the overall theory has holes. Sustained economic growth is hard, and as with her work on urban planning, Jacobs embraces complexity and tries to build theories on specific observations instead of idealized conditions. That is a valuable contribution to the discussion.

I would recommend reading this book with some skepticism, but if you're interested in macroeconomics, I would recommend reading it. If nothing else, it's full of thought-provoking case studies. Jacobs's point that a country is an artificial economic unit and that national economic policy is therefore inherently misaligned with natural economic patterns seems self-evidently correct, and it's good to take some time and think about what the alternatives might look like. I'm going to be watching for more discussion of this view of macroeconomics.

Rating: 8 out of 10

Reviewed: 2011-12-10