Economic Growth
I. Asking the Right Questions
In a world of unbelievable wealth, widespread poverty exists. As Americans raised in one of the wealthiest societies in human history, we may fail to understand the nature of our situation. We see the television reports of extreme poverty in Bangladesh or sub-Saharan Africa – or even in Appalachia or Mississippi or Cairo, Illinois – and we ask "What causes such poverty?" Why are some countries, or some areas within our own country, so poor, when so many of us are so wealthy?
Younger Americans, especially, may not fully appreciate how wealthy they are. Even middle-aged Americans, such as your professor, have lived long enough to experience massive improvements in the material standard of living. Even I, a solidly middle-class American, was raised in a house that lacked running water and plumbing until I was six years old. Most Americans my age didn’t experience the pleasure of using an outhouse – most houses had indoor plumbing in the 1950s – but I was far from alone. A sizable minority of rural houses lacked plumbing even in 1960.
Now we see stories, such as one in the October 8th edition of the Champaign-Urbana News Gazette, in which we are expected to feel sorry for a young preschool special-education teacher whose apartment rent consumes so much of her income that she can no longer afford to subscribe to all the specialty channels on cable TV. In all seriousness, the journalist who wrote the article presents this as a problem to be addressed by government.
Just how wealthy have we become? Here are a few statistics that might begin to answer that question. The following table shows the percentage of U.S. households that owned particular appliances in 1992.
Table 1
|
Product |
Percent of Households |
|
Clothes washer |
90 |
|
Dishwasher |
53 |
|
Microwave |
86 |
|
Radio |
99 |
|
Television |
98 |
|
Clothes Dryer |
82 |
|
Vacuum Cleaner |
99 |
|
VCR |
83 |
|
Personal Computer |
40 |
Furthermore, in 1996 there were 63 telephones for every 100 Americans; 128.4 cell phones per 1000 people (that’s surely gone up a great deal since then!); 776 TVs per 1000 people; and 57 automobiles per 100 people. (These data come from Myths of Rich and Poor by W. Michael Cox and Richard Alm, pp. 97-98. They provide the same data for a number of other countries as well.)
Do such statistics make it safe to say that most Americans are, in a material sense, quite well off? In an absolute sense, the answer is surely Yes. But how does we measure up in a relative sense? To answer that question, we need to compare our current standard of living with the current standard of living in other countries and with the standard of living of our forebears.
Comparing standards of living across countries is difficult, partly because different countries use different moneys (dollars vs. yen vs. pesos, and so on) and partly because different climates have different requirements for living comfortably. Nevertheless, we can derive a reasonable rough measure of the standard of living across countries by looking at per capita GDP figures. Table 2 presents estimated per capita real GDP in U.S. dollars of 1990 buying power for a number of countries for the year 1992. Note the wide range of values across countries.
Table 2
|
Country |
Per Capita GDP in 1990 U.S. Dollars |
|
USA |
21,558 |
|
Switzerland |
21,036 |
|
Germany |
19,351 |
|
Canada |
18,350 |
|
France |
17,959 |
|
South Korea |
10,010 |
|
Argentina |
7,616 |
|
Mexico |
5,112 |
|
Poland |
4,726 |
|
Turkey |
4,422 |
|
China |
3,098 |
|
India |
1,348 |
|
Bangladesh |
720 |
|
Zaire |
353 |
|
Ethiopia |
300 |
Source: Angus Maddison, Monitoring the World Economy 1820-1992 (OECD, 1995)
Although one would probably find little difference between the standard of living of an "average" American and an "average" German, one would find an almost unimaginable difference between the American or the German and an "average" Ethiopian or Bangladeshi. In fact, most people in the world live on an income much closer to the average Ethiopian income than to the average American income. In short, most of the people in the world are poor.
Before asking, "Why are they poor?", you should realize that, until relatively recent times, nearly everyone in the world was poor. Such evidence as economic historians have been able to gather indicates that what is remarkable is not that the world houses so many poor people today but that it is home to so many wealthy people. Never before in the history of mankind has such a large percentage of the world’s population not been poor. Thus, from an historical perspective, the question we should be asking is, "Why are so many people wealthy today?" Or, if you prefer, "Why did some economies produce so much wealth over the last three or four centuries, when never in previous history had such an increase in wealth occurred?"
II. Historical Perspective
Sustained economic growth is a relatively recent phenomenon. Around the time of Christ, people throughout the world lived precariously. A drought (or an unusually severe flood) that reduced harvests frequently led to starvation for some of the poorest people. A two- or three-year drought meant widespread starvation for people in particular locations. Even in the Mediterranean world, where Rome reigned supreme, and where ships plied the Mediterranean Sea carrying grain from the fertile fields of North Africa (I’m not joking) to other parts of the Empire, famine was a very real possibility. In less-developed parts of the world, such as Europe north of the Alps or Africa south of the Sahara, life was a day-to-day, year-to-year struggle.
A thousand years later, conditions hadn’t changed much in most places. By AD 1000 the Chinese had learned to harness the great rivers of China for use in growing rice. For the most part, the Han people (who we today call Chinese) were reasonably well fed and clothed, although their rice culture was susceptible to disruption by floods. But they were the exception. Throughout Asia, Africa, Europe, and, we suppose, North and South America, famine was a specter haunting the land.
Over the next few centuries, the rate of technological innovation increased both in Europe and in China. The medieval European economy, bound as it was to feudalism and battered by political conflicts, did not seem a likely place for the growth of technology. However, innovations in agriculture, mining, metallurgy, and textile manufacture slowly but surely raised the standard of living. The Chinese progressed much faster. The Chinese educational system was superior, and the resources of a large imperial government were available to pursue ideas of merit. On the whole, the Chinese were well ahead of the Europeans technologically in the period 1000-1500.
Examples of Chinese Technology
Despite all these advantages, China failed to progress economically in subsequent centuries. In fact, by the 18th and 19th centuries, the Chinese had forgotten much of what they had known about technological processes a few centuries earlier.
Why did the Chinese economy stagnate? The primary reason seems to be that, to an unusually large extent, the development of Chinese technology depended on the support and encouragement of the Chinese government. Because of China’s peculiar "hydraulic economy," the economy had for centuries been centrally directed. That the system worked so well as it did is surprising. But when the emperors of the Ming and Manchu dynasties lost interest in technology, the government withdrew its support. The loss of interest may have resulted from a desire to maintain social stability. Economic growth, especially growth driven by technological change, is always a disturbing force. Perhaps the Chinese ruling class simply did not wish to incur the social costs of continued growth. Certainly, the xenophobic attitude displayed by the Chinese in the 18th and 19th centuries indicates their preference for social stability.
The Rise of Europe
As China began a slow decline into economic stagnation, the pace of economic growth quickened in Europe. Unlike the majestic Chinese Empire, Europe was a hodge-podge of relatively small political units, created and frequently re-created from the feudal realms that arose during the Middle Ages. Frequently hostilities broke out among states, and for several centuries, wars may have been more common in Europe than anywhere else in the world.
Ironically, the competition among kingdoms produced one beneficial effect: Competition enhances economic efficiency. States that wished to be European powers had to promote economic growth. Thus, with frequent, temporary setbacks, European governments instituted policies that favored their productive citizens. Laws that had, for political and religious reasons, suppressed markets were replaced by laws that acknowledged property rights – the right to use personal property as the owner saw fit, within broad limits. Governments also developed commercial law and the court systems needed to enforce the laws. This promoted honesty in trading and encouraged more people to trade.
In the wake of the Renaissance and the Protestant Reformation, a new dedication to scientific discovery and a new ethic of personal responsibility arose. Both contributed to the increasing pace of technological innovation and business creation. Even warfare itself contributed to economic gain, as European military might was used to colonize large areas of the Americas and Asia. (African colonization came later.) European shipping was unparalleled, enabling the Dutch and British, in particular, to sell to world markets.
The inventions that drove European growth after 1500 were mostly what Joel Mokyr (author of The Lever of Riches) calls "microinventions" – improvements and adaptations of ideas discovered previously. New agricultural techniques increased food supplies. Small, but cumulatively important, innovations in shipbuilding gave rise to faster, safer, larger, more mobile ships. The winds and water were harnessed more effectively because of improvements in windmills and waterwheels. Slow but cumulative gains were made in textile production, mining, metallurgy, optics, and mechanics. Slowly but surely these technological improvements raised the European standard of living far above what it had been only a couple of centuries before. To modern people, used to continual improvements in the standard of living, this might not seem like much. To the Europeans living in the 16th, 17th, and 18th centuries, the improvements were wonderful to behold.
Why Europe? The simplest answer may be that more individual freedom existed there than anywhere else in the world. Individuals had real possibilities in Europe, thanks to the growing respect for human liberty. Freedom brought prosperity.
III. Thinking About Growth
Our framework will be summarized by a simple equation: Y/L = A . F (K/L, H/L).
In this equation, A represents "ideas," or technology in a very broad sense. Formally, economists call A total factor productivity. It is a measure of how much output per worker is forthcoming from the quantity of factor inputs being used. F(.) is a function. It says that Y/L depends on the factor inputs K/L and H/L.
K stands for physical capital, such as plant and equipment. The more physical capital per worker, the more the average worker should be able to produce. H stands for human capital, the skills and training that enable workers to solve problems and work effectively. More highly trained workers – workers with more human capital – should be able to produce more output than unskilled workers. K and H are "things" that affect production.
The growth equation separates the factors affecting growth into two categories: Ideas and Things. Economists who attempt to model the growth process have discovered that this is a fruitful way to consider the forces affecting economic growth.
Ideas can be used simultaneously by many people. An idea is like a recipe. Many different bakers can use the same recipe at the same time, even though they cannot all use the same material inputs or ovens. Ideas can be shared. Because of this, good ideas can produce large effects on output per worker. Huge numbers of workers can benefit from the same good idea.
Things can be put to only one use at any given time. An oven is extremely important to cake production, but adding a single oven will have a limited effect on the well-being of all bakers in the economy. Since things cannot be used by everyone at once, they have smaller effects on Y/L. (See Paul M. Romer, "Theory, History, and the Origins of Modern Economic Growth," AEA Papers and Proceedings, May 1996: 202-06.)
An Example
Suppose Y/L = A.(K/L).5(H/L).5, where raising a factor to the power of .5 is taking the square root of the factor. Also suppose that A = 2, K/L = 2, and H/L = 2. Then Y/L = 2 x 2.5 x 2.5 = 4 (since the square root of 2 times the square root of 2 is 2).
Now, let’s increase one of the "things." Suppose K/L rises to 3. Y/L = 2 x 3.5 x 2.5 = 2(1.73)(1.41) = 4.9. Increasing K/L by 50 percent increases Y/L by 22.5 percent. If we had instead raised H/L to 3, the same result would have occurred.
Now, instead of increasing a factor input (a "thing"), let’s increase total factor productivity, our measure of technology (our "ideas"). If A increases from 2 to 3, Y/L increases to 3(2.5)(2.5) = 3 x 2 = 6. What does this demonstrate? A fifty percent increase in technological knowledge produces a 50 percent increase in Y/L. Improvements in "ideas" have the potential to increase output per worker by more than increases in "things."
Why? Because ideas can be shared. Ideas are "non-rivalrous goods," in the jargon of economics. Because many people can use an idea at once, a really good idea can have immense effects on output per worker. This is why Joel Mokyr calls technological innovation "the lever of riches." Just as a lever increases the force a person can apply to an object, improved technology increases the effectiveness of factor inputs ("things") in producing outputs.
Three Growth Processes
Economic growth is not a simple process driven by a single cause. Economists who have studied economic growth have located a number of different sources of growth. We will concentrate on three processes. Even as we separate growth into three growth processes, you should realize that, in the real world, all three processes interact.
Growth that is driven by investment in physical capital or investment in human capital is called Solovian Growth. In the 1950s, MIT economist Robert Solow developed a mathematical model to describe such a growth process, hence the name. As we have seen, increases in K/L or H/L provide workers with more physical or mental capital with which to work, thereby increasing output per worker.
Capital investment is necessary for any type of growth to occur. Even if the growth process is being driven by technological innovations, those innovations typically make their way into the production process in the form of better machines (or at least different machines). New ideas usually lead to investment in capital.
High rates of investment can lead to strong growth for extended periods. For example, during the 1950s and 1960s, the West German economy invested heavily in physical capital, raising the K/L ratio dramatically. Output per worker grew apace. Similarly, the Soviet Union achieved some of the highest growth rates in the world from the 1950s into the 1970s by investing heavily in "heavy industry" – steel production, oil production, coal production, and various other industries that used lots of steel, oil, and coal. In 1961, Nikolai Khrushev, while speaking before the General Assembly of the United Nations, took off his shoe and pounded it on the podium, declaring "We will bury you." He meant that the Soviet Union would bury the West economically, since the USSR was growing so much faster than the western economies.
However, investment-driven growth has one serious drawback: diminishing marginal productivity. The principle of diminishing marginal productivity states that increasing one input while holding other inputs constant will eventually result in smaller and smaller output gains from additional units of investment. Thus, the Solow growth model predicts investment-driven growth will slow over time. Of course, that’s exactly what happened to the Soviet economy in the 1980s. Growth basically evaporated – at a time when the U.S. economy was beginning to grow faster than it had in years. This led to rather severe political problems for the Soviet leadership.
The Asian Miracle(?)
The fastest-growing area in the world from around 1960 to about 1995 was the Pacific Rim. Not only Japan, the most-productive economy in the East, but Taiwan, South Korea, Hong Kong, and Singapore grew at astounding rates. Per capita growth rates of 6-to-8 percent per year enable an economy to double its standard of living every nine-to-twelve years. In less than three decades, the "Asian Tigers" turned themselves from poor countries into relatively wealthy economies, knocking on the door of "first-world" status.
The spectacular growth of the Asian Tigers led to a spate of books on the "Asian miracle." Some writers argued that cultural factors underlay the Tigers’ success. Asian workers were believed to be more disciplined and harder working than western workers. Others argued that the Asian style of management was the source of their great success. Nearly everyone predicted that, within a couple more decades, the Asian economies would surpass the U.S. economy.
In 1993, while the Asian Tigers were still flying high, economist Alwyn Young published research on the sources of Asian growth. Using data on investment in physical and human capital, output, and population growth, Young demonstrated that nearly all of the Tigers’ gains in output per worker could be explained by increases in K/L and H/L. In other words, the Asian growth was investment driven, just like the earlier Soviet growth. Young argued that the Tigers had been able to grow so rapidly because they had increased all inputs simultaneously. They devoted nearly 40 percent of output to capital investment (forgoing consumption); they doubled their years of schooling; and they doubled their labor force participation rates, thus expanding the number of workers. But such doubling of inputs could not continue. Labor force growth was slowing already; so were the percentage increases in K and H. Thus, Young predicted, diminishing marginal productivity would set in, and the Asian Tigers’ incredible growth rates would fall.
Professor Young was, of course, correct. Growth rates of Pacific-Rim economies were falling even before the financial crisis of the mid-1990s threw the economies into a deep recession. After some initial indignation, the leaders of the Asian Tigers admitted that their growth had been input-driven. But they argued that much of their investment had laid the groundwork for increases in total factor productivity in the future. If that doesn’t occur – if A doesn’t grow – Asian growth will indeed be slow in the future.
The patron saint of economists is the Scottish moral philosopher Adam Smith (1723-1790). In his masterpiece on economics, An Inquiry into the Nature and Causes of the Wealth of Nations, Smith investigated the manner in which nations generate economic growth. Smith wrote before the first industrial revolution, and his theory focused on commercial expansion – economic growth driven by increasing trade in growing markets.
Smith’s theory is based on the concept of the division of labor. Smith understood that small workshops, which were the typical industrial enterprise in the 18th century, were not very efficient. Workers had to perform multiple tasks, and they were rather slow in performing them. If smaller workshops could be replaced by a single factory, labor productivity would increase. Each worker could specialize in one task, thereby becoming extremely proficient at that task. In combination with other workers, the quantity of output that could be produced would rise dramatically. Smith illustrated this in the first chapter of The Wealth of Nations with his example of the pin factory.
In modern parlance, Smith was focusing on economies of scale. He recognized that producing larger quantities could reduce the per-unit cost of production. In other words, the average total cost curve falls as output in a single factory is expanded. The catch was that the larger quantity of output had to be sold. It does no good to produce huge quantities of pins cheaply if only a small portion of the pins can be sold.
If a firm was to engage successfully in large-scale production, it had to have a market large enough to absorb the goods produced. Thus, Smith recognized that efficient was likely to take place in large cities or in locations with access to relatively cheap transportation, i.e., seaports.
In Smith’s terminology, the division of labor is limited by the extent of the market. If markets can be extended by increasing the demand for the product; through population growth; or through innovations in transportation that reduce the cost of shipping the product, then more-efficient production processes can be used. Greater efficiency leads to economic growth.
Example
The Dutch, in the 17th century, and the English, in the 18th, demonstrated the power of market expansion to stimulate economic growth. Both the Dutch and English were master sailors. They opened trade between Southern Asia (the "Spice Islands") and Europe by sailing around the Horn of Africa into the Indian Sea. There they acquired (by fair means or foul) the spices so desired by Europeans in an age lacking refrigeration. Both the Dutch and the English became wealthy by operating a re-export business: Shipping in huge quantities of spices and (later) tea, breaking them down into smaller units, and re-exporting them at a large profit. These profits were plowed back into the shipping trade and used to build up businesses in the Netherlands and England. The Scots built up Glasgow in the same manner, trading tobacco.
A somewhat more problematic example was the explosive growth of the British textile trade. The First Industrial Revolution occurred in England in the opening decades of the 19th century, and cotton textile manufacturing was the industry that revolutionized production.
English spinners and weavers had been working cotton in the West of England for decades. Mostly rural peasants, the spinners and weavers worked on farms during the planting and harvest seasons. But during the down times in agriculture, they spun yarn or wove yarn into cloth in their homes. Small-time capitalists would purchase the raw cotton to be spun and provide it to the spinners, paying them at a piece rate for their work. They would carry the spun yarn to the weavers, also paying them piece rate for their weaving.
The invention of water-powered looms enabled the capitalists to move the weaving operation into factories, where they could better control the quality of the cloth being produced. Water-powered looms were much larger than hand looms, so the scale of operation increased greatly. Now, this isn’t a clean example of Smithian growth, because a technological innovation started the process. But the greater efficiency of water-powered textile mills enabled the English textile industry to increase the production of cotton goods many times over. The English mills could produce far more cotton than the English market could absorb. But, of course, England occupies an island, and water transportation was (and still is) the most efficient transportation on earth. So the British marketed their cotton textiles around the world, generating a huge increase in the size of the market and speeding economic growth in Great Britain.
Smithian growth appears in the output equation as an increase in A. Factor inputs are used more efficiently, and output per worker increases.
In 1912, the Austrian economist Joseph Schumpeter wrote an influential book describing yet another growth process. Schumpeterian growth is growth driven by increases in knowledge. These increases in knowledge include technological innovations proper and changes in institutions that revolutionize the ways goods are produced or marketed.
Technological innovations come in two forms. Process innovations improve the efficiency of producing goods or services. That is, they lower the costs of production. The water-powered cotton looms discussed above are an example of a process innovation. Product innovations result in new or improved products that partially or completely replace existing products in the market. An example of a product innovation is the cassette tape and cassette player, which entirely displaced 8-track tapes and largely displaced reel-to-reel tape players.
Examples
The invention of the microchip created whole new industries. Not only do we have a flourishing computer industry, but our houses are filled with all sorts of electronic devices that use microchips as the "brains" to perform various tasks. The invention of the microchip completely destroyed the vacuum tube industry over the course of a few years. This was an example of what Schumpeter termed "creative destruction." The creation of a new product led to the elimination of another industry.
Today, fiber optics is revolutionizing telecommunications. Over time, ordinary phone cable will be replaced with fiber optic cables that carry far more information. This has already occurred to a significant extent. Fiber optics open up the possibility of information transmission on a scale never before contemplated, at prices much lower than thought possible. A large fiber optics industry already exists, and it is growing rapidly.
On an entirely different plane, the development of markets in Europe in the late Middle Ages revolutionized the way goods are produced and distributed. As markets grew in geographic penetration and efficiency of exchange, the self-sufficient feudal system gave way to an interdependent system based on trade. The consequences for Europe were immense. Markets opened up possibilities never contemplated by serfs on the great manors of Europe, unleashing creative powers that had lain dormant for centuries.
Schumpeterian innovations increase Y/L by increasing total factor productivity, A. Since innovations in knowledge are non-rival goods – ideas – they can be shared widely and can have huge effects on economic growth.