Lecture 7: The Basics of Economic Growth

Now let us return once more to our basic graph, Figure 5-5 repeated here as Figure 7-1. If you looked at per capita GDP in different countries, you would notice substantial differences in per capita income. If you looked at many nations, you would also find substantial differences over time in the level of per capita income.

Figure 7-1
Our Basic Model

This figure summarizes the basic macroeconomic model. Starting with the upper left-hand panel and moving counterclockwise, the demand and supply of labor determines the number of people working. In turn, the number of people working determines the total level of GDP. The demand and supply of loans determines the real interest rate, and hence the division of output between consumption and saving. Finally, the equation of exchange determines the price level.

The explanation lies in the lower left-hand corner, in the production function. Different nations have different levels of productivity. That is the subject of this lecture.

We have already discussed the Malthusian Model. Writing in the late 18^th century, Thomas Malthus argued that the world was doomed to a standard of living where people were barely able to survive. His reasoning was that population tended to grow at a much faster rate than the resources needed to sustain that population, especially food. Therefore, at some point, population growth would need to be checked, by famine or some other means, until the population was small enough to be supported by the available food supply.

Was Malthus right? Most of the data in Figure 7-2 supports the argument. The top panel shows the population of England during the Middle Ages. Population takes a steep decline during the years of the Black Death before growing once again. The second panel shows the average real wage during the same years - a good way of estimating the standard of living of the average worker. Notice that the real wage declines when the population is increasing and increases during the years of the Black Death. In other words, as people died off, more resources were available for those who survived. The Black Death was an economic boon to those who lived through it. Perhaps Malthus was correct.

You know from your own experience that Malthus was ultimately wrong. The world’s population has skyrocketed this century, but we have more than enough food to feed everyone, with some left over. Those who go hungry usually cannot get to the food, as in Somalia, where local warlords kept it from the people. Meanwhile, the rest of world struggles to get rid of excess crops. Look again at Figure 7-2. Notice that during the 17^th century (the 1600s), both population and real wages were increasing. In other words, the average worker was becoming better off even though there were more people. In fact, the very end of the graph shows real wages in England going off the chart! Malthus spoke too soon.

Figure 7-2
Population and Real Wages in the Middle Ages

This figure shows data on population and wage rates in England during the middle ages. At the time of the black death, the population declined by 1/3 and wage rates soared. The boost in incomes was temporary. Population grew and wages fell.

Note, however that, at the end of this graph, wages begin to soar. That is the story of this lecture.

So what happened? If you remember your history, you know that the Industrial Revolution occurred first in England around 1800. This is about the time when real wages started to increase dramatically, as shown in Figure 7-2. However, the real wage was able to increase, even though population was increasing, beginning in the 1600s. This was a period of significant change in England. Several kings had sought to increase the Crown’s revenue by seizing goods for “public purposes” (in other words, because the King wanted them), paying judges so they would rule in the King’s favor, adding new members to Parliament so that new taxes could be passed, and forcing rich merchants to make loans to the Crown that were never repaid, among other things.

The excesses of the Kings led to a civil war in England. Eventually, in 1688, Parliament brought in a new King and Queen, William and Mary of Orange (The Netherlands) in what has been called “The Glorious Revolution.” It was glorious because William and Mary agreed that only Parliament had the right to impose taxes without interference, that the right of the King to seize property and force loans would be subject to common law, and that the King should in all other ways abide by the laws governing the realm. In other words, the king was under the same law as other citizens. Getting to this point had been a long process in England. The first significant milestone in this process was the signing of the famous Magna Carta in 1215, where an English king first consented to the idea that all came under the law, even the king. In 1688 the process was complete and the law was supreme. From that time forward, England was also economically different.

It was no accident that the industrial revolution happened in England first. Since then, many nations have seen huge increases in their standards of living. But can we really expect per capita GDP to continue to grow? Or will Malthus ultimately be right once again? Persistent economic growth is a relatively new phenomena compared to the many centuries of human misery and poverty. Furthermore, although we have seen dramatic increases in the standard of living for many countries over the last three centuries, many more countries have seen little or no economic growth. Our main task in this lecture is to understand the source of economic growth and understand something of our future prospects.

The Pattern of Economic Growth In History

If the term “economic growth” has crossed your path at all, it was most likely through a news report that said something like the following: “The U.S. economy grew 4.1 percent in the preceding quarter.” Although such reports are important, we are interested in a longer period in this discussion. To get our standard of living to double or triple requires more than a couple of years of economic expansion. The persistent growth of per capita GDP over the last 300 years is best described as unprecedented and gradual.

The Long View

Throughout most of recorded history (and presumably before then), most people have lived in poverty. There have been civilizations that were able to increase the standard of living for a portion of their populations, but not to the degree we have seen in modern times and not for the vast majority of their citizens. For example, two thousand years ago, Rome was a very advanced city, with many wealthy citizens that enjoyed a life of luxury. However, they were able to enjoy that lifestyle on the backs of the many slaves that supported their extravagance and lived in poverty. Eventually, the city and the empire fell into ruins.

Today’s economically advanced countries have mostly middle-class populations. That is, most of the population enjoys a lifestyle where they have some amount of affluence that continues to increase over time. This is very different, or unprecedented.

This tremendous and persistent rise in the standard of living has been gradual. Table 7-1 shows the increases in per capita GDP for the United States and the United Kingdom since the 18^th century. Our standard of living in 1998 was almost 22 times higher that it had been in 1776. But just like the tortoise who beat the hare by slow, steady progress, this tremendous economic growth was achieved slowly over time. The average growth in per capita GDP was only 1.8% annually. Over time, small changes add up to large results.

Table 7-1 Real Per Capita GDP in 1998 Dollars
Year	United States	United Kingdom
1776	$1,450	$1,350
1860	$2,550	$3,000
1900	$5,450	$5,300
1950	$12,500	$8,150
1998	$31,500	$22,000

Recent History

At the end of World War II, per capita GDP in Europe was well below that of the United States. The difference has essentially disappeared as these countries have caught up with the United States. For the past twenty years, other countries such as South Korea and Taiwan have exhibited growth rates well above that of the United States. While their per capita GDP has not yet caught up with the United States, most economists agree that it is only a matter of time before that happens.

By way of illustration, Figure 7-3 shows per capita GDP for the United States (or at least the log of per capita GDP) and for a country closing the gap, catching up with the United States. During the catch-up period, GDP growth is high, but slows as the country approaches the leader. The catch-up Theorem holds that countries with low per capita GDP will eventually catch up with the “leader”, the country with the highest level of per capita GDP. During the period of catching up, the laggard will have a higher growth rate than the leader (how else do you catch up). As it catches up, the growth rate will slow and eventually converge to that of the leader.

Figure 7-3
Economic Growth Since World War II for some industrialized countries

This graph compares 1960-1990 growth rates for countries as a function of the per capita GDP in 1960. As you can see, it provides strong support for the catch-up phenomena.

Other countries may well be on their way to closing the gap. Following the end of the Cold War, many former members of the Soviet Empire have begun to make significant economic progress. Most economists fully expect countries like Poland, Hungary, and the Czech Republic to close the gap, perhaps not immediately, but certainly in the next 40 years. Following Mao’s death, China began to turn to a market economy. In doing so, China has achieved substantial economic growth. There is reason to believe that China may well be on its way to catching up with the United States. In the past few years, some – but not all – economists have begun to think that India may be on the way to growing faster than the US.

Figure 7-4
Growth Rates for non-Industrialized Countries

When we plot the same data for countries outside the industrialized world, we get a different pattern. Here catch up seems to be working for some countries and not for others.

As Figure 7-4 shows, other countries have not done as well. For example, at the end of World War II, Argentina had a per capita GDP somewhere between Canada and the United States. Since then, Argentina has slipped, and now has a relatively low GDP. The United Nations classifies Argentina as a “Developing Country”, though until quite recently it would have been more proper to classify Argentina as an “Undeveloping Country”. Other countries such as Bangladesh, Afghanistan, Madagascar and Ethiopia have seen little growth in per capita GDP or negative growth in GDP.

How did it happen?

We should be very interested in understanding how we achieved these gains in our standard of living. If we can identify where this growth comes from, we might be able to understand if it is possible to continue this process.

What accounts for economic growth? We have a simple economic equation to explain the economics of growth. We know that a good equation for describing the level of a country’s GDP at time t is:

Real GDP = AK^1/3L^2/3,

where

A = level of technology

K = amount of capital

L = labor force

The term “level of technology” is simply a way of stating how much output can be obtained with a given level of capital and labor. In other words, if we do not change the amount of labor or capital, it is still possible to produce more goods and services if we have a better or faster or more efficient way of production - what we call technological progress. This term is important and we will discuss it in more detail later.

This equation is good because it identifies three inputs that cause real GDP to increase. However, we are interested in changes in the standard of living or per capita GDP. To get that we need to divide real GDP by the population. For simplicity, let’s assume that the population we’re interested in is the working population. This isn’t exactly true, but it allows us to divide both sides of this equation by L to get per worker GDP, which is very similar to per capita GDP.

Real GDP per worker = (AK^1/3L^2/3)/L,

which can be rewritten as

Real GDP per worker = A * K^1/3 * L^2/3 * L^-1,

If you remember your algebra, L^2/3 multiplied by L^-1 equals the sum of their exponents or L^-1/3. Making this substitution gives us

Real GDP per worker = A(K/L)^1/3,

This equation tells us that our standard of living depends on two things:

· Technological progress

· An increase in the amount of capital per worker

Technological progress means that we are finding better and smarter ways of producing goods and services. An increase in the amount of capital per worker means that we are giving each worker, on average, more tools with which to produce goods and services. Each of these is a source of economic growth, so we will want to discuss each in turn, starting with capital per worker.

Capital Growth as a Source of Economic Progress

In most countries, both population and the labor force are growing. If there is no capital growth, then the amount of capital per worker will shrink. Some capital accumulation is required to keep the amount of capital per worker constant. And indeed some capital accumulation is called for to accommodate technological change.

While capital accumulation is both important and desirable, generations of politicians and other deep thinkers have carried the point too far and suggested that the way to solve all of our economic problems is to increase our saving rate so that we have more rapid capital accumulation. If we do so, or so the argument goes, the capital stock will grow at a faster rate than the labor force and we will have additional growth in per capita GDP. It certainly explains why Germany caught up with us after World War II and why Korea is catching up with us now.

The difficulty is that those rates are unsustainable. To illustrate the point, suppose that our GDP is $8 trillion and that our capital stock is $20 trillion. Both numbers are slightly off, but it helps to work with round numbers. Suppose for sake of argument, that we were to start investing 50% of our GDP, adding it to the capital stock. (To make life easy, we assume no growth in total factor productivity and no growth in either the population or the labor force). Now our economic data would look something like the Table 7-3:

Table 7-3 Data on Capital and Growth
(1) Year	(2) GDP (Billions)	(3) Investment (Set at 50% of GDP)	(4) Capital Stock (Billions)	(5) Capital Stock Next Year = (3) + (4)	(6) Percent Growth in Capital Stock =[(5)–(4)]/ (5)	(7) Rate of GDP Growth = (1/3)(6)
1	8000	4000	20000	24000	20.0%	6.7%

That is, we would have achieved a significant boost in per capita GDP, now growing at 6.7% a year.

The difficulty comes if we try to sustain this rate of growth. The next table shows what happens to the economy over the next few years. This table shows that the growth rate drops. In the ten years shown here, the rate has dropped from 6.7 percent to 3.3 percent. Why? The 20% growth in the capital stock leads to only a 6.7 percent growth in GDP. To continue to grow at 6.7% a year, the capital stock would need to continue to grow at 20% a year, and that would mean that investment would need to continue to grow at 20% a year. If investment is to grow at 20%, it must become an increasing percentage of GDP. Ultimately, it will have to exceed 100% of GDP, which obviously cannot be.

In short, boosts in the saving rate can cause temporary boosts in the growth rate, but it is not a source of permanent change in the growth of GDP. Table 7-4 shows what happens if the process continues

Table 7-4 A Continuation of the Growth Process
(1) Year	(2) GDP (Billions)	(3) Investment (Set at 50% of GDP)	(4) Capital Stock (Billions)	(5) Capital Stock Next Year = (3) + (4)	(6) Percent Growth in Capital Stock = [(5)–(4)]/(5)	(7) Rate of GDP Growth = (1/3)(6)
1	8000	4000	20000	24000	20.0%	6.7%
2	8533	4267	24000	28267	17.8%	5.9%
3	9039	4520	28267	32786	16.0%	5.3%
4	9521	4760	32786	37547	14.5%	4.8%
5	9982	4991	37547	42537	13.3%	4.4%
6	10424	5212	42537	47749	12.3%	4.1%
7	10850	5425	47749	53174	11.4%	3.8%
8	11260	5630	53174	58804	10.6%	3.5%
9	11658	5829	58804	64633	9.9%	3.3%

Technological Progress as a Source of Economic Growth

If the economic gains from increasing the capital stock are limited, then economic growth over time must be due mostly to technological change, sometimes referred to as technological progress or increases in factor productivity. Whatever we call it, it refers to anything that allows us to produce more goods and services with the same amount of capital and labor. That sort of progress can come in a number of different forms, so it is worth spending some time to talk about each.

New inventions and discoveries

Put quite simply, we know more than our ancestors did. New machines and new processes are invented every day. In many cases, these inventions seem to occur exogenously, through fortuitous discoveries. In other cases, the discoveries occur because people or businesses or governments invest in research and development.

A warning: do not look for dramatic breakthroughs. Technology appears to be a trend-like process or a series of small improvements on existing technologies. Consider, for instance

· The steam engine

· The tractor

· The electric light bulb

· The computer (personal or otherwise)

The initial form of many new technologies is crude and relatively inefficient, requiring following improvements to make the technology viable. Once in while, a dramatic breakthrough will occur, with immediate and widespread implications for an economy. The moveable type printing press would be a rare example of this type of invention, as it enabled a rapid diffusion of knowledge and ideas throughout Europe.

Diffusion of the knowledge

New inventions and new knowledge is not enough. People have to know about it and decide that they can benefit from the adoption of the new technology before they can put it to use. For example, there were no fewer than 17 patents filed for a mechanical sewing machine. Only one of these machines ever became widely adopted, thanks to the genius of the inventor and the marketing prowess of Mr. Singer, the founder of the sewing machine company that bears his name. The other 16, although perhaps good ideas, never became widely adopted. Just having a new gadget does not ensure that total factor productivity will increase.

New types of Industrial Organization

New types of businesses are important in promoting economic efficiency. Three traditional examples come to mind.

· Several hundred years ago, the British pioneered the notion of a limited liability corporation, the predecessor of our modern industrial corporation. ATT, for example, has current capital of about $60 billion. That represents the investment of millions of persons. The telecommunications giant would not be feasible without millions of investors and in turn they would not be willing to invest without the assurance of limited liability.

· Also, consider the invention of the modern financial intermediary. The modern banking industry makes possible a lot of business dealings that would not have been possible even 50 years ago.

· John D. Rockefeller made a lot of his fortune by pioneering the first "national" corporation that could do business thorughout the country.

Increased Specialization

When the Constitution was adopted, transportation was very limited. George Washington’s trip from Mount Vernon to New York, where he took the oath of office, took several weeks. A letter mailed from Mount Vernon to New York also took weeks. Today, the drive takes about four to five hours, and requires less than an hour by airplane. We now expect cell phones with built-in Internet access, assuring rapid communication. The improvement in transportation and communication makes increases specialization possible, since one or two firms meet the demands of the entire country or in some cases the entire planet.

Americans have become somewhat jaded to this process, but it is nonetheless remarkable. We think nothing of logging onto the Internet and ordering a book from a company like Amazon. If you stop and think about all the processes involved in making this happen, you will see that it takes:

· Interconnected computers constituting the Internet.

· A bank willing to issue you a credit card, which pays Amazon essentially immediately and expects you to pay them in time. (Some banks actually prefer that you not pay on time so they earn more interest.)

· Highly sophisticated computer software to keep Amazon going.

· The ubiquitous United Parcel Service, which actually delivers the book.

· A legal system ensuring these parties can work together.

They all tie the United States into the largest single market in the world.

Human Capital

The modern American Labor Force is better educated today than in the past, and all economists stress the importance of investment in education. We refer to this as an investment in human capital, and we increasingly believe that it may be as important as the investments we make in physical capital and in research and development. This is not an endorsement of higher education, though that does make a difference. Education does not have to take place in the classroom (we learn a lot about our jobs by just doing them). Indeed, not all classroom education is oriented to human capital creation (a course in French Literature may be very worthy, but is unlikely to make you more productive).

What Causes Technological Progress?

If technological change is so important for economic growth, we need to understand what causes technological change.

Economic Freedom, Incentives, and Growth

So far, we have secured a link between technological change and economic growth. The deeper question is “What causes technological change?” in all its forms. That is not an easy question, but it undoubtedly has something to do with economic freedom. Economic freedom can be defined as the absence of constraint or coercion upon those seeking to undertake an economic pursuit. Economic activity may face constraining or coercive behavior either because of direct government action or because a government permits such behavior. In other words, producers, distributors and consumers have economic freedom if they face no obstacles to their economic decisions.

For example, consider Miller’s Pizzeria. Suppose the manager has found out that there is a way to improve the performance of the pizzeria’s oven, so that it can bake 10 percent faster while still producing the same quality pizza. This change will undoubtedly improve the production capability and profitability of the pizzeria. However, the adjustments to the oven require a technical team to come at great cost. If the manager is convinced that the adjustment, by itself is worthwhile, what sorts of constraints might prevent the pizzeria from making the change?

Here are some possibilities:

· The government taxes very profitable firms at a high rate.

· The technicians are foreign and the government prevents such trade in services.

· Government regulations impose a big “red tape” burden.

· The government allows high officials to simply claim ownership of profitable firms for their own benefit.

· Miller’s Pizzeria needs a loan to pay for the change, but the banks will only lend money to businesses approved by the government.

· The local police force is corrupt and will insist on expensive bribes to allow the work to proceed.

This is just a partial list - you may be able to think of some others. The point is, if something limits the economic freedom of Miller’s Pizzeria, they will be much less likely to make the sorts of changes that we would identify as technological change because the incentive to make the changes has been reduced in some way.<