The Sources of Economic Growth

As we have learned, there are two ways to model economic growth: (1) as an outward shift in an economy’s production possibilities curve, and (2) as a shift to the right in its long-run aggregate supply curve. In drawing either one at a point in time, we assume that the economy’s factors of production and its technology are unchanged. Changing these will shift both curves. Therefore, anything that increases the quantity or quality of factors of production or that improves the technology available to the economy contributes to economic growth.

The sources of growth for the U.S. economy in the 20th century were presented in the chapter on sources of production. There we learned that the main sources of growth for the United States from 1948 to 2002 were divided between increases in the quantities of labor and of physical capital (about 60%) and in improvements in the qualities of the factors of production and technology (about 40%). Since 1995, however, improvements in factor quality and technology have been the main drivers of economic growth in the United States.

In order to devote resources to increasing physical and human capital and to improving technology—activities that will enhance future production—society must forgo using them now to produce consumer goods. Even though the people in the economy would enjoy a higher standard of living today without this sacrifice, they are willing to reduce present consumption in order to have more goods and services available for the future.

As a college student, you personally made such a choice. You decided to devote time to study that you could have spent earning income. With the higher income, you could enjoy greater consumption today. You made this choice because you expect to earn higher income in the future and thus to enjoy greater consumption in the future. Because many other people in the society also choose to acquire more education, society allocates resources to produce education. The education produced today will enhance the society’s human capital and thus its economic growth.

All other things equal, higher saving allows more resources to be devoted to increases in physical and human capital and technological improvement. In other words, saving, which is income not spent on consumption, promotes economic growth by making available resources that can be channeled into growth-enhancing uses.

Explaining Recent Disparities in Growth Rates

Toward the end of the 20th century, it appeared that some of the world’s more affluent countries were growing robustly while others were growing more slowly or even stagnating. This observation was confirmed in a major study by the Organization for Economic Co-operation and Development (OECD),The material in this section is based on Organization for Economic Co-operation and Development, The Sources of Economic Growth in OECD Countries, 2003. whose members are listed in Table 8.1 "Growing Disparities in Rates of Economic Growth". The table shows that for the OECD countries as a whole, economic growth per capita fell from an average of 2.2% per year in the 1980s to an average of 1.9% per year in the 1990s. The higher standard deviation in the latter period confirms an increased disparity of growth rates in the more recent period. Moreover, the data on individual countries show that per capita growth in some countries (specifically, the United States, Canada, Ireland, Netherlands, Norway, and Spain) picked up, especially in the latter half of the 1990s, while it decelerated in most of the countries of continental Europe and Japan.

The study goes on to try to explain the reasons for the divergent growth trends. The main findings were:

• In general, countries with accelerating per capita growth rates also experienced significant increases in employment, while those with stagnant or declining employment generally experienced reductions in per capita growth rates.
• Enhancements in human capital contributed to labor productivity and economic growth, but in slower growing countries such improvements were not enough to offset the impact of reduced or stagnant labor utilization.
• Information and communication technology has contributed to economic growth both through rapid technological progress within the information and communication technology industry itself as well as, more recently, through the use of information and communication technology equipment in other industries. This has made an important contribution to growth in several of the faster growing countries.
• Other factors associated with more growth include: investments in physical and human capital, sound macroeconomic policies (especially low inflation), private sector research and development, trade exposure, and better developed financial markets. Results concerning the impact of the size of the government and of public sector research and development on growth were more difficult to interpret.
• With qualifications, the study found that strict regulation of product markets (for example, regulations that reduce competition) and strict employment protection legislation (for example, laws that make hiring and firing of workers more difficult) had negative effects on growth.
• All countries show a large number of firms entering and exiting markets. But, a key difference between the United States and Europe is that new firms in the United States start out smaller and less productive than those of Europe but grow faster when they are successful. The report hypothesizes that lower start-up costs and less strict labor market regulations may encourage U.S. entrepreneurs to enter a market and then to expand, if warranted. European entrepreneurs may be less willing to experiment in a market in the first place.

The general concern in the second half of the 1970s and the 1980s was that economic growth was slowing down and that it might not be possible to reverse this pattern. The 1990s and early 2000s, in which growth picked up in some countries but not in others, suggested that the problem was not universal and led to a search for the reasons for the disparities in growth rates that emerged. The OECD study described above gives some possible explanations. The findings of that study practically beg countries to examine closely their economic policies at a variety of levels and to consider changes that may add flexibility to their economies.

In closing, it is worth reiterating that economic freedom and higher incomes tend to go together. Countries could not have attained high levels of income if they had not maintained the economic freedom that contributed to high incomes in the first place. Thus, it is also likely that rates of economic growth in the future will be related to the amount of economic freedom countries choose. We shall see in later chapters that monetary and fiscal policies that are used to stabilize the economy in the short run can also have an impact on long-run economic growth.

Case in Point: Economic Growth in Poor Countries … or Lack Thereof

Figure 8.12

Economist William Easterly in his aptly named book The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics admits that after 50 years of searching for the magic formula for turning poor countries into rich ones, the quest remains elusive.

Poor countries just need more physical capital, you say? Easterly points out that between 1960 and 1985, the capital stock per work in both Gambia and Japan rose by over 500%. The result? In Gambia, output per worker over the 25-year period rose 2%; in Japan, output per worker rose 260%.

So, it must be that poor countries need more human capital? Again, he finds startling comparisons. For example, human capital expanded faster in Zambia than in Korea, but Zambia’s annual growth rate is 7 percentage points below Korea’s.

Too much population growth? Too little? More foreign aid? Too much? As Easterly proceeds, writing a prescription for growth seems ever more difficult: “None has delivered as promised,” he concludes (p. xi).

While Easterly does not offer his own new panacea for how to move countries to a higher level of per capita GDP, where the model presented in this chapter does seem to provide some explanations of why a country’s growth rate may vary over time or differ from another country’s, he does argue that creating incentives for growth in poor countries is crucial. Acknowledging a role for plain luck, Easterly argues that good government policies—ones that keep low such negatives as inflation, corruption, and red tape—and quality institutions and laws—ones that, for example, honor contracts and reward merit—will help.

How to actually improve such incentives might constitute the next great quest:

“We have learned once and for all that there are no magical elixirs to bring a happy ending to our quest for growth. Prosperity happens when all the players in the development game have the right incentives. It happens when government incentives induce technological adaptation, high-quality investment in machines, and high-quality schooling. It happens when donors face incentives that induce them to give aid to countries with good policies where aid will have high payoffs, not to countries with poor policies where aid is wasted. It happens when the poor get good opportunities and incentives, which requires government welfare programs that reward rather than penalize earning income. It happens when politics is not polarized between antagonistic interest groups. . . . The solutions are a lot more difficult to describe than the problems. The way forward must be to create incentives for growth for the trinity of governments, donors, and individuals.” (p. 289–90)

Source: William Easterly, The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics (Cambridge: MIT Press, 2002).