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Theories of Economic Growth

Over the years, economists from different schools of thought have had plenty to say on what really drives economic growth for an economy. In this chapter we review some of these ideas. In particular we consider the importance of supply-side factors in determining the trend rate of growth for countries competing in the global economy.

Trend growth
Economic growth is best defined as a long-term expansion of the productive potential of the economy.

Trend economic growth refers to the smooth path of long run national output. Measuring the trend rate of growth requires a long-run series of macroeconomic data (perhaps of 20 years or more) in order to identify the different stages of the economic cycle and then calculate average growth rates from peak to peak or trough to trough.  Another way of thinking about the trend growth rate is to view it as an underlying speed limit for the economy. In other words, it is an estimate of how fast the economy can reasonably be expected to grow over a number of years without creating an unsustainable increase in inflationary pressure.

A question of potential – the productive capacity of the UK economy grows each year

The chart above shows the estimated level of potential national income for the UK over the last thirty years. There are two main points to notice from the chart. Firstly, we expect that our real national income will rise each year. This is because of improvements in productivity; an expanding labour supply; the effects of capital investment spending and also the effects of technological change and innovation. Secondly, what matters is the long run average growth of potential national income. For the UK, we have a trend growth rate of around 2.5% per year. This can fluctuate depending on the overall strength of the economy and the health (or otherwise) of the supply-side of the economy. The OECD estimates that during the 1990s and early years of the current decade, our trend growth rate has been a little higher than 2.5%. But raising it to 3% per year seems to have been a bridge too far!
For our trend rate of growth to be higher the UK economy needs to do a number of things:

1. Raise capital investment spending as a share of national income.
2. Achieve higher productivity from both capital inputs and from our labour supply.
3. Expand the size of the labour supply, perhaps through an increase in the migration of high productivity workers.
4. Increase the level of research and development and increase the pace and application of innovation across the economy.

Many factors explain our productivity gap – among them low capital investment and a skills shortage

It is quite interesting to see how the estimated trend growth rates differ from country to country. The chart above is again drawn from the OECD figures. Notice how a country such as Ireland has a much faster growth of potential national income. During the mid 1990s when the Irish boom was at its peak, the trend growth rate was over 7% a year, enough for her GDP to double virtually every ten years. This trend rate has come down but remains more than double that of the average for the countries inside the Euro Zone. Spain is another country enjoying a relatively fast growth of potential GDP and this has been accompanied by a rise in her relative living standards over the last twenty years.

Hungary, one of the ten countries that joined the European Union in May 2004 when the EU enlarged, has a trend growth rate of 4% per year. This is typical of low to middle-income countries with fairly strong growth potential, as they experience high levels of inward investment and rising incomes.

The effects of an increase in long run aggregate supply are traced in the diagram below. An increase in LRAS allows the economy to operate at a higher level of aggregate demand – leading to sustained increases in real national output.

Government policies to improve the trend growth rate
Over the last twenty years, government of different political persuasions, have put in place policies which they expect will be successful in raising investment, encouraging entrepreneurship and improving incentives to work. Potential output in the long run depends on the following factors

(1) The growth of the labour force
If the government can increase the number of people willing and able to seek paid work, then the employment rate increases leading to a higher output of goods and services. The Government has relied on a number of job schemes designed to raise employment including New Deal and changes to the tax and benefit system. Changes in the age structure of the population also affect the total number of people seeking work. And we might also consider the effects that migration of workers into the UK from overseas, including the newly enlarged European Union, can have on the UK’s labour supply.

(2) The growth of the nation’s stock of capital
A rise in capital investment adds directly to GDP in the sense that capital goods have to be designed, produced, marketed and delivered. Higher investment also provides workers with more capital to work with. New capital also tends to embody technological improvements which providing workers have sufficient skills and training to make full and efficient use of their new capital inputs, should lead to a higher level of productivity after a time lag.

(3) The trend rate of growth of productivity of labour and capital.
For most countries it is the growth of productivity that drives the long-term growth. The root causes of improved efficiency come from making markets more competitive and achieving better productivity within individual plants and factories.  Increased investment in the human capital of the workforce is widely seen as essential if the UK is to improve its long run productivity performance – for example – increased spending on work-related training and improvement in the UK education system at all levels.

(4) Technological improvements
Changes in technology are important because they reduce the real costs of supplying goods and services which leads to an outward shift in a country’s production possibility frontier

Economic growth and causation – different schools of thought
For many years, economists have been discussing the causes of growth and development. There is little sign of a consensus emerging! Here are some of the main lines of thought.

Neo-Classical Growth
The “neo-classical” model of growth was first devised by Nobel Prize winning Economist Robert Solow over 40 years ago. The Solow model believes that a sustained increase in capital investment increases the growth rate only temporarily: because the ratio of capital to labour goes up (i.e. there is more capital available for each worker to use). However, the marginal product of additional units of capital is assumed to decline and thus an economy eventually moves back to a long-term growth path, with real GDP growing at the same rate as the growth of the workforce plus a factor to reflect improving productivity. 

A ‘steady-state growth path’ is eventually reached when output, capital and labour are all growing at the same rate, so output per worker and capital per worker are constant.
Neo-classical economists who subscribe to the Solow model believe that to raise an economy's long term trend rate of growth requires an increase in the labour supply and also a higher level of productivity of labour and capital.

Differences in the rate of technological change between countries are said to explain much of the variation in growth rates that we see. The neo-classical model treats productivity improvements as an ‘exogenous’ variable, meaning that productivity improvements are assumed to be independent of the amount of capital investment.

The significance of productivity as a source of supply-side performance and as a contributor to long-term growth is now widely accepted by many economists. A recent analysis of the long term prospects for Britain from the International Monetary Fund argued that the main challenge for the UK in the years ahead is to improve factor productivity since there remains a sizeable productivity gap between the UK and many of our major international competitors.

Endogenous Growth Theory

Endogenous growth economists believe that improvements in productivity can be linked directly to a faster pace of innovation and extra investment in human capital. They stress the need for government and private sector institutions which successfully nurture innovation, and provide the right incentives for individuals and businesses to be inventive. There is also a central role for the accumulation of knowledge as a determinant of growth. We know for example that the knowledge industries (typically they are in telecommunications, electronics, software or biotechnology) are becoming increasingly important in many developed countries.

Supporters of endogenous growth theory believe that there are positive externalities to be exploited from the development of a high valued-added knowledge economy which is able to develop and maintain a competitive advantage in fast-growth industries within the global economy.

The main points of the endogenous growth theory are as follows:

• The rate of technological progress should not be taken as a constant in a growth model – government policies can permanently raise a country’s growth rate if they lead to more intense competition in markets and help to stimulate product and process innovation.
• There are increasing returns to scale from new capital investment. The assumption of the law of diminishing returns which forms the basis of so much textbook economics is questionable. Endogenous growth theorists are strong believers in the potential for economies of scale (or increasing returns to scale) to be experienced in nearly every industry and market.
• Private sector investment in research & development is a key source of technical progress.
• The protection of private property rights and patents is essential in providing appropriate and effective incentives for businesses and entrepreneurs to engage in research and development
• Investment in human capital (including the quantity and quality of education and training made available to the workforce) is an essential ingredient of long-term growth. This is discussed next.
• Government policy should encourage entrepreneurship as a means of creating new businesses and ultimately as an important source of new jobs, investment and innovation.

The Importance of Human Capital
The basis of human capital lies in the theories of the Theodore Schultz, an economist at the University of Chicago who was awarded the Nobel Prize for Economics in 1979. Schultz, an agricultural economist, produced his ideas of human capital as a way of explaining the advantages of investing in education to improve agricultural output. Schultz demonstrated that the social rate of return on investment in human capital in the US economy was larger than that based on physical capital such as new plant and machinery.

Gary Becker, the 1992 Nobel Prize winner for economics, built on the ideas first put forward by Schultz, explaining that expenditure on education, training and medical care could all be considered as investment in human capital. He wrote that “people cannot be separated from their knowledge, skills, health or values in the way they can be separated from their financial and physical assets."

Innovation
Innovation is the creation of new intellectual assets. We can make a useful distinction between:

Process innovation: This relates to improvements in production processes, the more efficient use of scarce resources to produce a given quantity of output - leading to improvements in productive and technological efficiency

Product innovation: This is the emergence of new products which better satisfy our ever-increasing needs and wants - leading to improvements in the dynamic efficiency of markets in providing goods and services
Indeed, it is often the ‘drive to innovate’ which is the primary motive for capital investment in the first place, not least in international markets where a firm's competitive edge is determined by the success of strategies designed to find viable innovations that give it what is often called ‘first mover advantage in a market’. Innovation in the pharmaceutical industry; in telecommunications; in household goods and in biotechnology is good examples of sectors where successful innovation is the key to maintaining a competitive advantage.

In short - successful innovation is a stimulus to long-run growth because:

• It acts as a catalyst for higher rates of investment in fixed capital and increased investment in human capital which helps to shift out the production possibility frontier
• It can act as a spur to faster productivity growth (with time lags) because of its impact on technological progress
• Innovation also creates a demand for new products from consumers for example in industries where existing products are nearing the end of their product life-cycle

Social benefits from innovation
There are potentially huge positive externalities from technology spill-over effects arising from innovation for example in the pharmaceutical industry where new drugs improve the quality of life and increase life expectancy and also improvements in car manufacture and design that reduce the risk of serious injury from road accidents.

Inter-firm collaboration in the creation and use of innovations can also act as a key contributor to industry-wide growth leading to external economies of scale. Indeed this form of co-operative behaviour between businesses is judged to be legal by the European competition authorities whereas price fixing and other forms of anti-competitive behaviour is now the subject of frequent investigations and legal action.

The US economist William Baumol in his recent book “The Free-Market Innovation Machine” stresses that firms use innovation as a ‘prime competitive weapon’. However, firms do not wish to risk too much innovation, because it is costly, and can be made obsolete by rival innovation. So, firms have responded to this through the sale of technology licenses and participation in technology-sharing compacts with other firms that can pay huge dividends to the economy as a whole. According to Baumol, innovative activity becomes mandatory, in his words, ‘a life-and-death matter for the firm.’

Social capital and economic growth

We have seen that investment in physical capital and human capital are both regarded as important sources of long term growth for modern countries competing in the global economy. There is also increasing interest in a concept known as social capital – if you like, a third strand in the idea that capital promotes growth.

Social capital focuses on the value of social networks in improving productivity in an economy. According to the author Robert Putnam in a book entitled “Bowling Alone”, “it refers to the collective value of all social networks and the inclinations that arise from these networks to do things for each other"? So, social capital cites the interrelationships between individuals as a major driver of growth.

Putnam talks about “bonding” and “bridging” social capital, with the latter as the one which enhances productivity. This is the idea that social groups bridge from one to another through shared interests, such as ten-pin bowling. This creates an atmosphere of trust and friendliness between people, which has numerous benefits for society as whole, which some would term as positive externalities. For example, a sense of “togetherness” among the bowling fraternity will indeed increase the growth of the bowling sector of the economy, since more meetings will require more money to be spent on hiring bowling alleys and buying all the other ingredients for a great night’s bowling. However, the atmosphere of trust and friendliness created may also allow people to be more amiable to the idea of sharing lifts to and from meetings, thus lowering car pollution. A trivial example it may be, but it suffices to show how social capital can have an impact on the society as a whole.

“Bonded” social capital, on the other hand, creates exclusivity. Groups, such as gangs, are based on hierarchical patronage rather than meritocratic methods, potentially meaning that productivity falls. However, in both these examples social capital is being used for advantage. The problem with the latter is that this advantage is for a number of individuals rather than for collective society.

Social networks can be used to spread beneficial ideas, causing individuals and society to simultaneously progress. An example of this would be, in times of low savings (which could potentially cause a pensions crisis in the future), social networks spreading the “acceptability of saving, and thus benefiting the economy.

Sunrise in India – how quickly will the emerging market countries including India, China, Mexico, Indonesia, Brazil and Russia come to dominate the global economy? Can they maintain their fast growth rates?

• Key Points
  Economic growth is a long-run increase in the capacity of the economy to produce goods and services, and can be illustrated by an outward shift in the production possibility frontier.
• Trend growth is the long term non-inflationary increase in output (GDP) caused by an increase in productive capacity i.e. LRAS.
• Growth occurs because of an increase in the quantity and/or quality of factor resources.
  Human capital is the skill and knowledge level of the workforce, as well as their health. The higher the quality of human capital, the higher the productivity as workers adapt more effectively to new technologies and learns to perfect their respective specialised jobs. Actual skill levels, as opposed to educational qualifications, are now seen as powerful drivers of economic growth.
• Social capital represents the networks and shared values which lead to greater social co-operation and mutual trust
• Innovation is a major determinant of growth. It helps to lower costs and it also creates new markets, a source of demand, revenue and profits for businesses in the domestic and the international economy.