Guest Opinion: State economy rests on diverse portfolio

Published 8:06 am Wednesday, August 30, 2023

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By John Hood

The late Harry Markowitz, who won the 1990 Nobel prize in economics for his work on portfolio theory, reportedly said “diversification is the only free lunch” in investing. By distributing your savings across a broad base of stocks, bonds, and other asset classes, you maximize long-term gains and minimize risk — assuming that the performance of the assets in question isn’t strongly correlated.

Does the same wisdom apply at large scales? What about cities, regions, and states? When economies rest on a few industries, or a handful of large employers, residents tend to experience a bumpier ride. When those key industries or companies prosper, so do the communities in which they’re embedded. When sectors or firms falter — because of managerial errors or larger events such as adverse weather and technological disruption — dependent communities can sink into deep economic recessions even as the rest of the country powers on.

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To say a ride is bumpier, however, is not necessarily to say it’s not worth taking. Perhaps the good times are so good that the bad times are a reasonable price to pay for it. In the economic-development literature, you can find support for both models.

When companies producing similar or related goods and services are located near each other, for example, that makes it easier for people and ideas to flow more easily among them, driving gains in innovation and efficiency. Economists call this an agglomeration effect. Whether it be high tech in Silicon Valley and the Research Triangle, high finance in New York and Charlotte, or logistics and distribution hubs in Chicago and the Triad, industry concentrations are nothing new.

Still, I find myself persuaded by advocates of diversification, especially at the scale of metropolitan areas and states. North Carolina is better off for having all three of the industry concentrations I mentioned above, plus several more, rather than having all our eggs in a single basket, however capacious it may be.

Even at the local level, there’s compelling evidence that economic diversity is valuable. In 2013, the Journal of Economic Development published a study examining the economic diversity and performance of U.S. counties from 1990 to 2007. It concluded that “economic diversity has a positive impact on economic growth.” An earlier paper in the journal Land Economics also found that diversity was associated with both higher growth rates and lower levels of economic instability.

Putting the point another way, the World Bank observed in 2019 that “a lack of economic diversification is often associated with increased vulnerability to external shocks that can undermine prospects for longer-term economic growth.” If so, North Carolinians have good reason to celebrate. According to a recent study, our state has one of the most diversified economies in the country.

Decades ago, a University of Utah economist named Frank Hachman devised a way of measuring the economic diversification of communities and states. The latest version of the Hachman Index, published in March, ranked North Carolina sixth in the country. Only Missouri, Georgia, Arizona, Illinois, and Utah have more diversified economies.

Which economies are the least diversified? No surprises here. North and South Dakota, Alaska, Wyoming, and West Virginia constitute the bottom five states, dependent as they are on drilling and mining.

Now, to say it’s better for an economy to be diversified is not to say policymakers ought to go to great lengths to try to engineer such an outcome. It would be silly for governors and legislative leaders in Alaska or the Dakotas to throw up obstacles to oil and gas drilling on the grounds that their residents really ought to find work elsewhere. (Also, the politicians in question wouldn’t be governors or legislative leaders for long.) Nor should they use subsidies or regulations in an attempt to create artificial concentrations in politically favored places.

What isn’t silly, though, is for policymakers to remove barriers to entrepreneurship and to welcome new industries. That’s just good sense. And it’s been good for North Carolina.

John Hood is a John Locke Foundation board member.