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How do economies grow?

At the macro level, economics is essentially the study of the two lines on the chart below.

The wavy line shows actual GDP. It rises quickly sometimes, at others it rises less quickly or falls. Why it gyrates like this is the subject of macroeconomics. The other line is the trend line of growth. This is the average of the wavy line over some period. Simply put, it is the same line but with the waves averaged out.

This line might be flat, in which case GDP isn’t rising at all. It might be sloping downwards, in which case GDP is declining. Or, we hope, it is pointing upwards indicating GDP growth. Economic growth theory investigates the causes behind these longer term trends. Over the years, there have been basically three theories.

Make more shovels! (Constant returns to scale)

The earliest is the Harrod-Domar model.

The basic assumption here is that more capital makes a worker more productive and generates higher GDP. Using your hands to dig a ditch won’t get you very far, but add a capital input such as a shovel to your labor, and you will dig more ditches for each bit of labor expended. Harrod-Domar assumed that there was a linear relationship between increases in the capital stock (shovels) and increases in output (ditches). So, if it required 1 shovel to 10 ditches, 2 shovels will produce 20 ditches, 3 shovels will produce 30 ditches… In the jargon, this was known as ‘constant returns to scale’.

In the post-war world this model was influential in early development economics. It suggested that dumping capital inputs, such as factories, in labor rich but capital poor parts of the world would increase GDP. All too often, the capital inputs ended up being pretty useless.

Invent JCBs…somehow! (Diminishing returns to scale)

The next model of growth, the Solow model, started from the obvious flaws in the Harrod-Domar model.

Consider our ditch digger. With his bare hands he dug one ditch a day. With the shovel he digs 10 a day. The increment of adding the one shovel is a pretty hefty 9 ditches. But what happens if you give him a second shovel? Won’t you get another increment of 10 ditches for a total of 20 ditches? Of course not. He can only use one shovel at a time. We can add shovel after shovel and they will just pile up unused while he carries on producing 10 ditches a day. Indeed, by the time he has a stockpile of 5 shovels only one of which he using, the number of ditches dug per shovel has fallen from 10 to 2. We now have what are known as ‘diminishing returns to scale’.

The Solow model said that growth came from technological improvement. A company like Caterpillar might invent a machine that enables the worker to dig 100 ditches a day. But this technological progress took place outside the model. The source of growth was said to be ‘exogenous’. Technological progress fell “like manna from heaven”, the textbooks said. Some economists quipped that the Solow model of economic growth didn’t actually explain economic growth.

Have ideas! (Increasing returns to scale)

In reaction to this, the current model of economic growth is known as ‘endogenous growth theory’ (EGT – its author was too modest to name it the Romer model).

As well as its failure to explain economic growth, the Solow model also failed to match observed reality, at least much beyond the short run. The world does have an ever expanding capital stock and returns to it are not diminishing. Neither are they constant. In fact, they are increasing. How to explain that?

There are two answers. First, capital comes from investment. The first two models talk about investment in capital, such as machinery or infrastructure. EGT talks about investment in human capital. Government and private sector institutions can nurture innovation by providing incentives for individuals and businesses to be inventive. By bringing the source of innovation into the model, EGT made the exogenous endogenous, hence the name.

Second, EGT recognizes the importance of ‘productivity’. Simply put, this means the more efficient combination of productive inputs such as labor and capital.

Taken together, technological innovation and productivity make up what the jargon calls Total Factor Productivity. Theory and evidence show this to be the main driving force behind sustained economic growth.

The economy can keep growing 

Endogenous growth theory is a powerful thing. It essentially removes barriers to economic growth. People who look at the sluggish growth and poor productivity in developed economies in recent years often deduce that this is some new normal. We are said to have run into some sort of limit, possibly of ideas. But they said this in the 1930s as well. So far, human beings have not been short of ideas. There doesn’t seem to be any reason to assume we have emptied the well.

John Phelan is an economist at Center of the American Experiment. 

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