On economic growth

August 23, 2013

“Economic growth” is a term frequently used in today’s media landscape, not as much as revenue or profit, but definitely more than ‘personal satisfaction’ or ‘happiness’. It seems like everyone needs or has economic growth: The US hopes for large economic growth to overcome its huge public debt, China expects economic growth to be 7% in 2013 and southern European States such as Greece and Spain need economic growth to deal with the problems of youth unemployment and increasing public debts. Zimbabwe is trying to recover from a small drop in economic growth due to inherent political and economic uncertainties, Myanmar is attempting to trigger economic growth through the opening of its former rather isolated markets, and even my small hometown hopes for more money through the miracle going by the name of economic growth.

 

If so many things can be solved by economic growth, what is it, where does it come from, how can you influence it and, most importantly, can you sustain it?

While the first question is fairly easy to answer namely that economic growth is an increase in the amount of goods and services produced by an economy, the following questions have consumed years of scientific research and still do. Even early thinkers such as David Hume, Adam Smith and David Ricardo tackled these questions intensively, but the first time economics became the center of public attention was during the Great Depression in the 1930s. Early economic pioneers such as Keynes, Hayek, Friedman and also Marx all proposed their very own ideas of how to solve the Great Depression and bring the world economy back on the track of sustainable growth.

The first mathematical representation of a growth model, now commonly accepted , was published by Robert Solow and Trevor Swan in 1956. Each country had a long-run equilibrium (called steady-state) that depended on the intersection of its population growth rate, its capital depreciation and its saving rate, which implicitly determined the capital that was available to each worker in the economy. Economies with less capital per worker (than their long-run level) tended to grow faster while economies with too much capital per worker shrank; thereby all of them were converging to their own steady- state. The main critique on the Solow-Swan model and its early successors, such as the Ramsey- Cass- Koopmanns intergenerational model, was that growth eventually ceased which was not what people observed in reality or they had just not reached that point yet.

The simple solution to overcome this problem seemed to include technological progress and improvements in human capital (mainly education), which had clearly been missing in former specifications. Early models therefore enabled economies to grow to infinity depending on elements that were determined outside of the models. In other words, technological progress and human capital guaranteed progress but there was no justification for their existence or for their growth.

The next quantum leap was the incorporation of R&D theories and imperfect competition into the growth framework most notably by Romer (1990) and Grossmann and Helpmann (1991); these models are called endogenous growth models. Technological advance from target-oriented R&D was now rewarded by some form of ex-post monopoly power, along the lines of Schumpeter (1934). According to this theory and its followers, economic growth can be positive in the long-run as long as there is no tendency for humanity to run out of new ideas.

The “Club of Rome”, based on Dennis Meadows famous books “The limits to growth” (1972), argues that industrialization, population growth, famine and especially the exploitation of limited natural resources will ultimately end this never-ending growth. Although their argumentation includes no explanation why people’s creativity in finding new ideas to innovate should stop with natural resources – modern economists argue that we are “standing on the shoulders of giants” meaning that people around the globe profit from ideas their ancestors had, enabling them to continuously innovate. As millions of people are actively working to use the resources of our common nature more efficiently, the dark predictions of the “Club of Rome” seemingly become more irrelevant.

Back to the development of growth theory: Economists observed in reality a conditional convergence of countries which was not featured by endogenous growth models any more, more recent publications therefore include a new effect, namely the diffusion of technology. As soon as a new idea is out, it slowly spreads across the world providing the basis for future research relying on the idea that imitation is cheaper than innovation itself.

In sum most theories are built on the factors of capital per worker, population growth, depreciation of capital, technological progress and human capital as drivers of economic growth, which can all be potentially influenced to improve economic growth.

 

What does this mean in today’s world?

Barro (2013) studied 100 countries between 1960-1995 and concludes that higher secondary education of males leads to higher economic growth (measured in GDP), while the same factor is insignificant for females indicating that female high-skilled labor is still used insignificantly in the world and should be used more to further improve growth. Primary education of women already reduces fertility, which positively affects growth. Especially high scores in science test have the strongest effects on the country’s economic situation followed by math scores.

 

Poor countries gain from opening up their trade barriers and thereby changing their terms-of-trade. Berthold and Gründler (2012) after their study of 188 countries between 1980–2010 present their most important finding: “Entrepreneurship matters.” How strong this effect is depends on the risk-averseness of the entrepreneurs, but in general it influences the accumulation of horizontal and vertical innovation and exerts positive influences on growth.

These policy implications based on the findings of modern economic theory built the framework for what numerous diplomats, non-profit associations, foundations and individuals work on daily. Political stability and property laws being the prerequisites for growth, the entrepreneurial environment that matters – the easier somebody can start his business, the easier he can generate income for employees and family and consequently the higher the growth rate of the country; finally education, especially in science, which is more than a very important for factor for growth, but an access to maturity and self- determination.

David Hoffmann
David Hoffmann

David Hoffmann is member of the “empowering people. Award” team at the Siemens Stiftung (foundation). He holds degrees in Economics and Geography and has worked on development issues in the European Parliament and the German Embassy in Moldova. He also worked as project coordinator for humanitarian disaster aid missions.

 

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