As we saw in Economic Growth: Background, growth is not automatic. For more than a millennium, China was the most technologically progressive nation on earth. Then, sometime after 1400, the Chinese economy began to lose its creativity. By 1600 it was becoming technologically stagnant. By 1800, China was technologically backward compared to Europe. Of course, the pattern in Europe was just the opposite. Technological creativity had risen in the 12th and 13th centuries, subsided in the 14th century (devastated by the plague), and resumed in the 15th century, becoming more rapid over time.
Joel Mokyr lists three conditions for technological creativity.
We will consider these conditions in turn.
1. Cultural Factors
Mokyr’s first condition might be termed "cultural factors," since it gets at the manner in which individuals in the society view their condition in life. Cultural traits that are conducive to technological creativity include the following:
2. Institutional Factors
The institutions of society – the laws, habits, and behavioral patterns that frame the way we interact with one another – are vitally important to the success of an economy. Institutions can either promote personal initiative, creativity, and interaction or thwart them. Two particularly important economic institutions are the following:
The Importance of Markets
Markets provide incentives for people to use resources efficiently. Acquiring productive resources is costly. Just how costly depends upon the prices at which different resources sell. The price system induces producers to utilize those resources that are relatively most abundant – that have the lowest relative prices – while leaving the relatively scarcer resources – those with higher relative prices – to their most valuable uses. Efficient production enables the economy to produce a greater value of goods and services than inefficient production.
Economists have understood the resource-allocation benefits of the price system since the time of Adam Smith. But it wasn’t until the 1930s and 1940s that an Austrian economist named Friedrich Hayek pointed out another major positive aspect of markets.
Hayek argued that markets enable traders to make use of huge amounts of dispersed knowledge. Each of the producers and consumers in a market know particular things that no one else knows, but no one knows very much about the particular conditions prevailing in the entire market.
Every person working in a firm understands certain elements of the production process in a way that no one else does. Much of this personal knowledge is tacit; the person with the knowledge cannot articulate it and so cannot explain it fully to others. However, the person is capable of making use of the knowledge. The genius of the market is that it brings together the knowledge of millions of market participants in the form of prices and quantities.
Without markets, most of the knowledge in the economic world would go unused. In effect, the knowledge wouldn’t exist. Thus, it is fair to say that markets transmit and create knowledge. The market is a discovery process.
3. Diversity and Tolerance
Technological innovation is a disruptive process. It alters the status quo, overturning the power of the social elite and establishing a new elite. Many societies are unwilling to tolerate such constant social upheaval. Consequently, the ruling classes in such societies attempt to suppress technological innovation. Thus, technological advance occurs primarily in societies that are willing to tolerate change and the strange sorts of people who promote change.
The leader in this area in early-modern Europe was the Netherlands. The Dutch were, at that time, largely a homogeneous people. Devout Calvinists, the saw everything they did through the lens of the Bible. They were called to do their best for the glory of God. But devout as the Dutch were, they were extremely tolerant of both social mobility and of foreigners who wanted to share in the political and economic freedom that the Netherlands afforded. Thus, the Dutch Republic was largely controlled by merchants and manufacturers, who promoted the institutions on which economic growth thrives. Furthermore, the Netherlands acted as a magnet for those in other European nations who found themselves persecuted either for their success or for their beliefs. French protestants (Huguenots), Jews and others streamed into Amsterdam and other Dutch cities and contributed greatly to the inventiveness that made the Netherlands the world’s premier economy in the 17th century.
The importance of tolerance should not be underestimated, as a quotation from George Gilder’s Wealth and Poverty (p. 109) makes clear:
One of the little probed mysteries of social history is society’s hostility to its greatest benefactors, the producers of wealth. On every continent and in every epoch the peoples who have excelled in creating wealth have been the victims of some of society’s greatest brutalities. Recent history has seen, in Germany, the holocaust of Jews; in Russia, the pogroms of Kulaks and Jews; in northern Nigeria, the eviction and slaughter of Ibo tribesmen, in Indonesia, the killing of near a million overseas Chinese; in China itself, the Red Guard rampages against the productive; in Uganda, the massacre of whites and Indians; in Tanzania, their expropriation and expulsion; in Bangladesh, the murder and confinement of the Biharis. And as the seventies drew to a close, much of the human wealth and capital of both Cuba and Southeast Asia was relegated to the open seas.
The foregoing suggests a three-point summary of what we have learned about the conditions necessary for economic growth.
1. Necessary institutional framework. This includes at least the following:
a. Political stability. Economies cannot function if society is riven constantly by political strife, revolution, or civil war.
b. Meaningful property rights. People will take risks and engage in productive activity only if they enjoy most of the fruits of their activities.
c. Tolerance of innovative behavior. Innovation requires change from the status quo. A society that represses change won’t be innovative and won’t grow.
2. Proper incentive structure. Of especial importance is
a. Reward for risk taking
3. Efficient way to develop and utilize knowledge. In a practical sense, this boils means
a. Market determination of prices. Without market prices, resources will be misallocated, and entrepreneurs will lack the information needed to respond to the wants of consumers.
Perhaps no American industry better illustrates the growth process than the automobile industry. American mechanics began producing automobiles before the turn of the century. The Duryea brother of Springfield, MA, who were bicycle mechanics, built a carriage driven by a one-cylinder engine in 1893. By 1899, many individuals and some thirty companies had build around 2,500 automobiles. Important producers included Ransom Olds (father of the Oldsmobile); the Dodge brothers, Horace and John, who made transmissions for Olds and later became partners with Henry Ford; the five Mack Brothers of New York, who produced their first truck in 1900; the Studebaker Brothers of South Bend, IN; Walter Chrysler, who worked for General Motors until 1919 and later started his own company; and, of course, Henry Ford himself.
(1) During the first phase of automobile production, the market was highly fragmented. In 1909, at the peak of the fragmentation, some 274 companies were manufacturing cars in the United States, mostly with low volumes, high margins, and high prices. Production took place in factories that essentially were collections of workshops. Auto production was still a craft, and the targeted consumer base was small but wealthy. Cars were becoming more than toys, but nothing resembling a mass market existed.
The second phase began when Henry Ford revolutionized the production process. Ford’s revolution began with a vision for what the automobile market could be and what the automobile itself should be. He believed that the car could be a mass-consumer product, that the average working person could be put behind the wheel of an automobile. But he also knew that, to accomplish such a market transformation, he would have to standardize automobile design and construction and develop a new production process.
(2) Ford’s solution to the product problem was the Model T – "the ultimate standardized machine." Extremely simple – small, light, and strong – it contained the barest minimum of moving parts. Production of the Model T was carried out on an assembly line. Ford demanded that all parts be manufactured precisely, so that perfect interchangeability enabled workers to assemble cars rapidly. The results were remarkable. In October 1913, it had taken 12 hours, 28 minutes to assemble a chassis. In the spring of 1914, with the assembly line, it took 1 hour, 33 minutes.
(2) Ford’s giant Highland Park, MI, plant employed more than 15,000 in 1915. The plant’s work force eventually grew to more than 65,000 workers. To reduce labor turnover, Ford instituted the "five-dollar day," paying more than twice the going rate for mechanical labor. He also shortened the day from nine to eight hours, and eventually cut back the workweek from six to five days. In exchange for all these benefits, Ford expected "strength-sapping, mind-numbing" work, which, before the "generous" wage increase and reduction of the work day, had led to an annual turnover rate of 300-400 percent.
(2) Ford’s production process catapulted Ford Motor Co. into a class of its own. Ford’s costs were so much lower than its competitors’ costs that Ford could sell its cars at prices dramatically lower than its competitors’ prices. [Draw ATC curves and explain.] Henry Ford believed that the only thing that kept working families from buying a car was a high price. So he lowered the price. In 1908, a Model T sold for $850. By 1912 the price had dropped to $600, by 1920 to $440, and by 1924 to only $290. Ford ruled the auto industry.
Ford’s development of the assembly-line process is an instance of Schumpeterian creative destruction. With its drastically lower costs, Ford drove most competing auto manufacturers out of business. To build his huge assembly lines, Ford invested large sums in a conveyer system to move the growing auto along the assembly line and in machinery to manufacture many of the standardized parts that went into the Model T. Thus, a Solovian growth process was also underway. Finally, by greatly increasing specialization and thereby reducing costs, and by paying a wage high enough to enable workers to purchase a Model T, thereby extending the market for cars, Ford generated Smithian growth.
(3) General Motors, under the direction of Alfred P. Sloan, began its assault on Ford’s market position first by emulating Ford’s production techniques. GM established assembly-line operations and standardized all parts production. GM costs then came into line with Ford’s. This illustrates an important fact about the real-world process of economic growth: Not all companies use the same technologies. At any given time, one or two companies will have cutting-edge technologies, while all the rest of their competitors will be using technologies that are far inferior. Until the competitors catch up, the leaders will enjoy a large cost advantage and will earn the profits that go with such a cost advantage.
(4) Having matched (or nearly so) Ford in production efficiency, Sloan’s GM went Ford one better. Sloan developed the technique of market segmentation and used it to sell differentiated, flashier GM cars to people who had previously owned Fords. All Model T’s were black; black paint dried faster than any other. But had du Pont Chemical Co. invented colored lacquer that dried quickly. GM began offering its cars in different colors. Furthermore, GM offered several model lines, beginning with Chevrolet at the bottom, and proceeding upward through Pontiac, Oldsmobile, and Buick to Cadillac. These cars shared many of the same parts, which held down production costs, but they gave customers a choice.
(4) Car buyers liked choice. In 1917, Ford had a 42.4% of the U.S. market, while GM had an 11.2% share. By 1937, Ford’s share was down to 21.4%, while GM’s was up to 41.8%.
(4) GM’s development of a segmented market is another example of a Smithian growth process. The total market for GM products was extended, and GM achieved economies of scale in several product lines at once. GM’s contribution to Schumpeterian growth was Sloan’s development of the multi-division organizational structure. No such corporation existed before. Sloan’s genius, in creating a single corporation with multiple divisions, was to give individual division chiefs a lot of responsibility and then hold them accountable for the profitability of their divisions. Thus, Schumpeterian innovation can be institutional, as well as technological.
(5) The growth of the American auto manufacturing industry provides an excellent example of how our three growth processes intertwine. Since it was an industry that was large relative to the size of the U.S. economy, growth of the auto industry was important to the growth of the U.S. economy as a whole.
As our bedtime story indicates, economic growth is a disruptive, messy process. As Schumpeter said, it is a process of creative destruction.
The economy doesn’t simply get bigger, adding more and more of what already exists. Rather, it changes qualitatively as it expands quantitatively. New industries arise and displace old industries, thereby displacing the workers who earned their living from the old industries, while at the same time creating new jobs and new opportunities for those looking for employment.
Source for Bedtime Story: Thomas K. McGraw, ed., Creating Modern Capitalism: How Entrepreneurs, Companies, and Countries Triumphed in Three Industrial Revolutions (Harvard U. Press, 1997), Chapter 8: "Henry Ford, Alfred Sloan, and the Three Phases of Marketing," by Thomas K. McGraw and Richard S. Tedlow.
Policies to Promote Growth
In 1870, U.S. real GDP per capita (in 1985 dollars) was $2,244. This gave Americans one of the highest standards of living in the world. Not the highest, mind you – the British enjoyed a per capita real GDP of $2,693 in 1870 – but still enough to attract immigrants from all over the world. Over the next 120 years, U.S. per capita real GDP grew at an annual rate of 1.76%. By 1990, U.S. per capita real GDP had reached $18,258. In the UK, real GDP per capita had grown a bit slower, at 1.36% per year. The result was a 1990 income of $13,589.
Obviously, 0.4% difference in the growth rate makes a huge difference, given enough time. Compounding builds incomes much faster if the growth rate is even a little larger. Thus, we can infer that policies to increase the growth rate even a little bit are important.
Any wealthy economy must have many of the basic institutions needed for growth; otherwise, it would not have become wealthy in the first place. The most important institutions are those that accompany true economic and political freedom: property rights and markets.
A government that wishes to encourage growth should encourage risk taking. Both process and, especially, product innovation are risky endeavors. Most attempted innovations fail. Those economies that grow tend to have many innovators, so that some innovations succeed, even as most fail. Governments can encourage innovation in a variety of ways. One of the most important is by establishing and protecting patents and copyrights that enable successful innovators to reap the rewards from their innovations for a period of time. Monopoly profits are a strong incentive to product innovation. Another way innovations may be encouraged is by reducing the taxes of firms that engage in research activities.
Governments should also promote competition. Frequently this means that the government itself should not create monopoly situations by preventing firms from competing in particular markets. Antitrust actions against firms that attempt to "buy up the competition" may also increase competition. However, innovation is driven by profits, so a government shouldn’t be too eager to hamper innovative firms simply because they are earning large profits. If these firms are in dynamic markets, their monopoly profits won’t last long, even if the government does nothing to reduce them.
Many governments of wealthy nations themselves invest heavily in research and development. Basic research – "science" – often can be better carried out by government funded projects that link numerous private organizations together than by any single firm. Universities play an important role in the growth process in the United States. After basic innovations have been made – "macroinventions" – the development phase of R&D typically is best left to the firms that can find ways to make use of the new knowledge.
Since economic growth of any type requires investment, another way a government can encourage growth is to encourage saving. If all income is consumed, nothing is left to invest in productive capital. This applies to human capital as well as physical capital. The acquisition of skills and training must be financed, just as the acquisition of machines and buildings must be.
Finally, governments can contribute to growth by maintaining low inflation rates. Studies have shown that high inflation retards economic growth. What is high? No specific cut-off between "low" and "high" inflation exists, although it’s clear that even a 10 percent inflation rate doesn’t seem to have significant negative effects on growth. However, inflation of 20% or more is another matter. Inflation reduces the efficiency of the price system. Firms don’t understand what price changes mean. Has demand for a particular product increased (increasing relative price), or has spending in general increased, forcing all prices upward? In the first case, the firm should respond by producing more; in the second case, it probably should not produce more. The confusion created by such price movements leads firms to make more mistakes, reducing efficiency and economic growth.
Poor economies generally have many problems that wealthy economies overcame decades, if not a century or more, ago. A major problem throughout Africa, parts of Asia, and much of Latin America has been political instability. An economy cannot thrive if a nation is torn by political strife. Thus, the first priority in promoting economic growth is to establish political stability. (By the way, that doesn’t mean democracy in the form to which Americans are accustomed. Economic freedom is important, but governments that are a good deal more autocratic than the United States’ government have permitted enough economic freedom to promote tremendous growth. Three examples are Singapore, South Korea, and Chile.)
The second step, after establishing political stability, is to allow markets to work. Governments must set the rules by which market participants play, but the economy is more likely to prosper the less the government is directly involved as a market participant. In particular, central planning stunts growth, the experience of the Soviet Union during the 1950s-1970s notwithstanding. The Soviet economy produced a lot of stuff, but, as we eventually learned, it wasn’t stuff that the Soviet citizens wanted. That hardly qualifies as economic growth.
Since most poor countries have autocratic governments, an important step toward wealth creation is reducing bureaucratic control over the economy. India, for example, has the potential to develop into a medium-income country, perhaps even into a high-income country. They have more than enough labor, and a significant portion of the labor force is well educated. Indians who have emigrated to the United States and other developed countries have proven to be extremely productive workers and, frequently, extremely effective inventors and entrepreneurs. The simple truth is that the Indian bureaucracy stifles creativity in their own country.
Economic research has demonstrated that economies that are open to international trade grow faster than those that are closed. International trade appears to enhance growth by increasing the rate at which better technologies are acquired and utilized. Trade brings contact with foreigners who are familiar with the superior technologies, making technology transfers easier and more likely. Trade also increases competition within economies, thus encouraging domestic firms to produce more efficiently.
Since investment in physical and human capital must be financed, and many poor countries find it difficult to accumulate savings, it is important that the government not squander the economy’s savings through deficit spending on "consumption goods." Government’s may borrow justifiably to invest in public capital goods, such as roads, water and sewage systems, and harbors. But government spending on goods that do not contribute to future production amounts to a waste of savings.
Finally, economic research has also shown that a sound financial system contributes to economic growth. Poor economies have no need for an ultra-sophisticated financial sector such as that found in the United States. However, a sound banking system is very important. Banks encourage ordinary people to save by providing safe, liquid assets for savers to hold. The funds collected by issuing savings and checking deposits can be used to finance investment. Well-regulated banks operating on a profit-making basis tend to increase saving while channeling credit to borrowers who propose to engage in profitable ventures. In this way, banks not only increase investment, they help to allocate funds to the most-profitable projects, thereby increasing the overall efficiency of the economy.