Economic growth

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World GDP/capita changed very little for most of human history before the industrial revolution. (Note the empty areas mean no data, not very low levels. There are data for the years 1, 1000, 1500, 1600, 1700, 1820, 1900, and 2003.)

Economic growth is the increase in value of the goods and services produced by an economy. It is conventionally measured as the percent rate of increase in real gross domestic product, or GDP. Growth is usually calculated in real terms, i.e. inflation-adjusted terms, in order to net out the effect of inflation on the price of the goods and services produced. In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment," which is caused by growth in aggregate demand or observed output.

As economic growth is measured as the annual percent change of gross domestic product, it has all the advantages and drawbacks of that measure.

Measuring growth

GDP increase since 1990 for the IMF "advanced economies".

The real GDP per capita of an economy is often used as an indicator of the average standard of living of individuals in that country, and economic growth is therefore often seen as indicating an increase in the average standard of living.

However, there are some problems in using growth in GDP per capita to measure general well being.

  • GDP per capita growth varies depending on the basket of goods used to deflate the nominal value or on the base year of measure.
  • GDP per capita does not provide any information relevant to the distribution of income in a country.
  • GDP per capita does not take into account negative externalities from environmental damage consequent to economic growth. Thus, the amount of growth may be overstated once we take environmental damage into account.
  • GDP per capita does not take into account positive externalities that may result from services such as education and health.
  • GDP per capita excludes the value of all the activities that take place outside of the market place (such as cost-free leisure activities like hiking).
  • GDP per capita does not include activities of the informal sector of the economy in precise form. Only as approximate estimates.

Economists are well aware of these deficiencies in GDP, thus, it should always be viewed merely as an indicator and not an absolute scale. Economists have developed mathematical tools to measure inequality, such as the Gini Coefficient. There are also alternate ways of measurement that consider the negative externalities that may result from pollution and resource depletion (see Green Gross Domestic Product.)

The flaws of GDP may be important when studying public policy, however, for the purposes of economic growth in the "short" long run it tends to be a very good indicator (in the very long run it is greatly distorted by the large changes in relative prices and sectors in the economy). There is no other indicator in economics which is as universal or as widely accepted as the GDP.

Other measures of national income, such as the Index of Sustainable Economic Welfare or the Genuine Progress Indicator, have been developed in an attempt to give a more complete picture of the level of well-being, but there is no consensus as to which, if any, is a better measure than GDP. GDP still remains by far the most often-used measure, especially since, all else equal, a rise in real GDP is correlated with an increase in the availability of jobs, which are necessary to most individuals' survival.

Origins of the Concept and Theories of Economic Growth

In the early modern period, some people in Western European nations began conceiving of the idea that economies could "grow", that is, produce a greater economic surplus which could be expended on something other than mere subsistence. This surplus could then be used for consumption, warfare, or civic and religious projects. The previous view was that only increasing either population or tax rates could generate more surplus money for the Crown or country.

Now it is generally recognized that economic growth also corresponds to a process of continual rapid replacement and reorganization of human activities facilitated by investment motivated to maximize returns. This exponential evolution of our self-organized life-support and cultural systems is remarkably creative and flexible, but highly unpredictable in many ways. Since science still has no good way of modeling complex self-organizing systems, various efforts to model the long term evolution of economies have produced few useful results.

During much of the "Mercantilist" period, growth was seen as involving an increase in the total amount of specie, that is circulating medium such as silver and gold, under the control of the state. This "Bullionist" theory led to policies to force trade through a particular state, the acquisition of colonies to supply cheaper raw materials which could then be manufactured and sold.

Later, such trade policies were justified instead simply in terms of promoting domestic trade and industry. The post-Bullionist insight that it was the increasing capability of manufacturing which led to policies in the 1700s to encourage manufacturing in itself, and the formula of importing raw materials and exporting finished goods. Under this system high tariffs were erected to allow manufacturers to establish "factories". (The word comes from "factor", the term for someone who carried goods from one stage of production to the next.) Local markets would then pay the fixed costs of capital growth, and then allow them to export abroad, undercutting the prices of manufactured goods elsewhere. Once competition from abroad was removed, prices could then be increased to recoup the costs of establishing the business.

Under this theory of growth, the road to increased national wealth was to grant monopolies, which would give an incentive for an individual to exploit a market or resource, confident that he would make all of the profits when all other extra-national competitors were driven out of business. The "Dutch East India company" and the "British East India company" were examples of such state-granted trade monopolies.

In this period the view was that growth was gained through "advantageous" trade in which specie would flow in to the country, but to trade with other nations on equal terms was disadvantageous. It should be stressed that Mercantilism was not simply a matter of restricting trade. Within a country, it often meant breaking down trade barriers, building new roads, and abolishing local toll booths, all of which expanded markets. This corresponded to the centralization of power in the hands of the Crown (or "Absolutism"). This process helped produce the modern nation-state in Western Europe.

Internationally, Mercantilism led to a contradiction: growth was gained through trade, but to trade with other nations on equal terms was disadvantageous. This – along with the rise of nation-states – encouraged several major wars.

The modern conception of economic growth began with the critique of Mercantilism, especially by the physiocrats and with the Scottish Enlightenment thinkers such as David Hume and Adam Smith, and the foundation of the discipline of modern political economy. The theory of the physiocrats was that productive capacity, itself, allowed for growth, and the improving and increasing capital to allow that capacity was "the wealth of nations". Whereas they stressed the importance of agriculture and saw urban industry as "sterile", Smith extended the notion that manufacturing was central to the entire economy.

David Ricardo would then argue that trade was a benefit to a country, because if one could buy a good more cheaply from abroad, it meant that there was more profitable work to be done here. This theory of "comparative advantage" would be the central basis for arguments in favor of free trade as an essential component of growth.

Income per capita was essentially flat until the industrial revolution. This period of time is called the Malthusian period, since it was governed by the principles explained by Thomas Malthus in his "Essay on the Principle of Population." In essence, Malthus said that any growth in the economy would translate into a growth in population. Thus, although aggreagate income could increase, income per capita was bound to stay roughly constant. The mainstream theory of economic growth states that with the industrial revolution and advancements in medicine, life expectation increased, infant mortality decreased, and the payoff to receiving an education was higher. Thus, parents began to place more value on the quality of their children and not on the quantity. This led to a drop in the fertility rates of most industrialized nations. This is known as the breakdown of the Malthusian regime. With income increasing drastically and population dropping, industrialised economies drastically increased their incomes per capita in the next centuries.

This notion of growth as increased stocks of capital goods (means of production) was codified as the Solow-Swan Growth Model, which involved a series of equations which showed the relationship between labor-time, capital goods, output, and investment. In this modern view, the role of technological change became crucial, even more important than the accumulation of capital. This model, developed by Robert Solow and Paul Samuelson in the 1950s, was the first attempt to model long-run growth analytically. This model assumes that countries use their resources efficiently and that there are diminishing returns to capital and labor increases. From these two premises, the neo-classical model makes three important predictions. First, increasing capital relative to labor creates economic growth, since people can be more productive given more capital. Second, poor countries with less capital per person will grow faster because each investment in capital will produce a higher return than rich countries with ample capital. Third, because of diminishing returns to capital, economies will eventually reach a point at which no new increase in capital will create economic growth. This point is called a "steady state."

The model also notes that countries can overcome this steady state and continue growing by inventing new technology. In the long run output per capita depends on the rate of saving but the rate of growth of output should be equal for any saving rate! In this model the process by which countries continue growing despite the diminishing returns is "exogenous" and represents the creation of new technology that allows production with fewer resources. Technology improves, the steady state level of capital increases and the country invests and grows. The data does not support some of this model's predictions, in particular, that all countries grow at the same rate in the long run, or that poorer countries should grow faster until they reach their steady state. Also, the data suggests the world has slowly increased its rate of growth. [1]

In the early 20th century, it became the policy of most nations to encourage growth of this kind. To do this required enacting policies, and being able to measure the results of those policies. This gave rise to the importance of econometrics, or the field of creating measurements for underlying conditions. Terms such as "unemployment rate", "Gross Domestic Product" and "rate of inflation" are part of the measuring of the changes in an economy.

In mainstream economics, the purpose of government policy is to encourage economic activity without encouraging the rise in the general level of prices (in other words, increase GDP without creating inflation). This combination is seen as, at the macro-scale (see macroeconomics) to be indicative of an increasing stock of capital. The argument runs that if more money is changing hands, but the prices of individual goods are relatively stable, then it is proof that there is more productive capacity, and therefore more capital, because it is capital that is allowing more to be made at a lower cost per unit. See Economies of scale, Inflation, Hyperinflation, Price, Supply and demand.

Unsatisfied with Solow's explanation, economists worked to "endogenize" technology in the 1980s. They developed the endogenous growth theory that includes a mathematical explanation of technological advancement.[2][3] This model also incorporated a new concept of human capital, the skills and knowledge that make workers productive. Unlike physical capital, human capital has increasing rates of return. Therefore, overall there are constant returns to capital, and economies never reach a steady state. Growth does not slow as capital accumulates, but the rate of growth depends on the types of capital a country invests in. Research done in this area has focused on what increases human capital (e.g. education) or technological change (e.g. innovation).[4]

Robert Lucas, Jr., on growth theory:

"The consequences for human welfare are simply staggering. Once one starts thinking about them, it is hard to think of anything else."

The late 20th century, with its global economy of a few very wealthy nations, and many very poor nations, led to the study of how the transition from subsistence and resource-based economies, to production and consumption based-economies occurred, leading to the field of Development economics, including the work of Amartya Sen and Joseph Stiglitz.

The long-run path of economic growth is one of the central questions of economics; in spite of the problems of measurement, an increase in GDP of a country is generally taken as an increase in the standard of living of its inhabitants. Over long periods of time, even small rates of annual growth can have large effects through compounding (see exponential growth). A growth rate of 2.5% per annum will lead to a doubling of GDP within 28 years, whilst a growth rate of 8% per annum (experienced by some Four Asian Tigers) will lead to a doubling of GDP within 9 years. This exponential characteristic can exacerbate differences across nations. For example, the difference in the annual growth from country A to country B will multiply up over the years. A growth rate of 5% seems similar to 3%, but over two decades, the first economy would have grown by 165%, the second only by 80%.

The short-run variation of economic growth is termed the business cycle, and almost all economies experience periodical recessions. The cycle can be a misnomer as the fluctuations are not always regular. Explaining these fluctuations is one of the main focuses of macroeconomics. There are different schools of thought as to the causes of recessions but some consensus- see Keynesianism, Monetarism, New classical economics and New Keynesian economics. Oil shocks, war and harvest failure are obvious causes of recession. Short-run variation in growth has generally dampened in higher income countries since the early 90s and this has been attributed, in part, to better macroeconomic management.

Other Theories

Theories of economic growth, the mechanisms that let it take place and its main determinants abound. One popular theory in the 70's for example was that of the "Big Push" which suggested that countries needed to jump from one stage of development to another through a virtuous cycle in which large investments in infrastructure and education coupled to private investment would move the economy to a more productive stage, breaking free from economic paradigms appropriate to a lower productivity stage. [5]

Analysis of recent economies success shows a close correlation between growth and climate. It is possible that there is absolutely no actual mechanism between the two, and the relation may be spurious. In early human history, economic as well as cultural development was concentrated in warmer parts of the world, like Egypt.

According to Acemoglu, Johnson and Robinson, the positive correlation between high income and cold climate is a by-product of history. Former colonies have inherited corrupt governments and geo-political boundaries (set by the colonizers) that are not properly placed regarding the geographical locations of different ethnic groups; this creates internal disputes and conflicts. Also, these authors contend that the egalitarian societies that emerged in colonies without solid native populations, and which could be exploited by individual farmers led to better property rights and incentives for long term investment than those where native population was large, and together with the tropical climate, colonizers were led to plunder and run, and to create exploitative institutions, a situation which did not foster growth or private property rights. Colonies in temperate climate zones as Australia and USA did not inherit exploitative governments since Europeans were able to inhabit these territories and set up governments that mirrored those in Europe. It is important to note that Sachs among others do not believe this to be the case.

Criticism

The real GDP per capita of an economy is often used as an indicator of the average standard of living of individuals in that country, and economic growth is therefore often seen as indicating an increase in the average standard of living.

Four major critical arguments are generally raised against economic growth: [6]

  1. Growth has negative effects on the quality of life: Many things that affect the quality of life are not traded in the market and measured and the market, and they generally lose value when growth occurs, such as the environment.
  2. Growth encourages the creation of artificial needs: Industry cause consumers to develop new tastes, and preferences for growth to occur. Consequently, "wants are created, and consumers have become the servants, instead of the masters, of the economy."[citation needed]
  3. Resources: similar to the arguments made by Thomas Malthus, economic growth depletes non-renewable resources rapidly. [7]
  4. Distribution of income: growth may reinforce and propagate unequal distribution of income.

Supporters argue that global income inequality is in fact diminishing,[8] and that the rapid reduction in global poverty is in large part due to economic growth, according to World Bank.[9] However, decline in poverty has been the slowest where growth performance has been the worst (in Africa). [10] Happiness increases with a higher GDP/capita, at least below around $15,000 per person.[11] Although it is important to notice that the gap between the richest in the world and the poorest is growing.[12] Predictions of rapid depletion, such as Thomas Malthus (1798), The Population Bomb (1968), Limits to growth (1972), and the Simon-Ehrlich wager (1980) have been proved false, one reason being that advancements in technology and science have continually allowed new resources to be utilized economically. The book The Improving State of the World argues that the state of humanity is rapidly improving.

The concept of economic growth (as well as econometrics[13]) is also challenged by adherents to the Austrian school of economics. Austrian economists stress the role that entrepreneurs play in economic development. Entrepreneurs create innovative new products and technologies, reorganize production to reduce costs, invest in new capital, and are alert to new profit opportunities. Austrian economists see the economy as evolving and developing, rather than growing. Mainstream economists pay too much attention to capital accumulation, and treat capital as homogenous. The Austrian economist Ludwig von Mises did discuss capital accumulation, but was more focused on investment in new types of capital, and the organization of the structure of production. Austrians focus on real world issues, while mainstream economists develop mathmatical models that explain nothing real.

Austrians also note that the concept of "growth" or the creation and acquisition of more goods and services is dependent upon the relative desires of the individual. Someone may favour spending more leisure time preferable over acquiring more goods and services. Also, they claim that the notion of growth implies the need for a "central planner" within an economy. To Austrian economists, such an ideal is antithetical to the concept of a free market economy, without the presence of governmental intervention. As such, Austrian economists believe that the individual should determine how much "growth" s/he desires.[14]

Growth in economic activity necessitates some growth in consumption of resources - for instance, it is impossible to produce goods without resource and energy inputs, and it is impossible to have the economy running without the further input of energy to transport people and goods. Steady growth is, by its nature, an exponential function. A quantity that grows according to an exponential function exhibits a doubling in size at a regular time interval (called the doubling time). If the rate of consumption of a non-renewable resource is growing steadily (for instance, 5% per year), then that rate will double regularly. At 5% growth per year, in approximately 14 years the consumption rate will have doubled. After another 14 years the rate will have quadrupled. After a century of 5% annual growth, the resource will be consumed at a rate 130 times the original rate. Professor Albert Bartlett describes this in detail in his famous lecture, "Arithmetic, Population and Energy", which he first gave publicly in 1969 and has since delivered over 1600 times.

The 1972 Limits to Growth report to the Club of Rome also demonstrated mathematically that perpetual growth in consumption of non-renewable resources is impossible. The report demonstrated that, even if all known reserves of minerals and energy resources were multiplied by five (due to new discoveries and new technology), the exponential nature of economic growth would lead to the exhaustion of most major resources within, at most, about 100 years at the then average rates of annual growth in consumption. Clearly these predictions are subject to changes, such as a reduction in the rate of consumption growth. However, the total quantity of extractable resources (especially energy resources) is finite, and therefore the mathematical fact remains that exponential growth in the rate of their consumption cannot continue forever.

There are also concerns with the environmental and ecological effects of economic growth, especially relating to growth in mining, forestry, agricultural and industrial activities. Many researchers feel these sustained environmental effects can have an effect on the whole ecosystem. They claim the accumulated effects on the ecosystem put a theoretical limit on growth. Some draw on archaeology to cite examples of cultures they claim have disappeared because they grew beyond the ability of their ecosystems to support them. The claim is that the limits to growth will eventually make growth in resource consumption impossible.

Others are more optimistic and believe that, although localized environmental effects may occur, large scale ecological effects are minor. The optimists claim that if these global-scale ecological effects exist, human ingenuity will find ways of adapting to them.

The rate or type of economic growth may have important consequences for the environment (the climate and natural capital of ecologies). Concerns about possible negative effects of growth on the environment and society led some to advocate lower levels of growth, from which comes the idea of uneconomic growth, and Green parties which argue that economies are part of a global society and a global ecology and cannot outstrip their natural growth without damaging them.

Canadian scientist David Suzuki stated in the 1990s that ecologies can only sustain typically about 1.5-3% new growth per year, and thus any requirement for greater returns from agriculture or forestry will necessarily cannibalize the natural capital of soil or forest. Some think this argument can be applied even to more developed economies.

Mainstream economists would argue that economies are driven by new technology — for instance, we have faster computers today than a year ago, but not necessarily computers requiring more natural resources to build. We may have been able to break free from physical limitations by relying on more knowledge rather than more physical production. Also, physical limits may be very large if using resources gained from space colonization, such as solar power satellites, asteroid mining, or a Dyson sphere. The book Mining the Sky: Untold Riches from the Asteroids, Comets, and Planets is one example of such arguments.

Further reading

  • Barro, Robert J. 1997. Determinants of Economic Growth: A Cross-Country Empirical Study. MIT Press: Cambridge, MA.
  • Erber, Georg, and Harald Hagemann, Growth, Structural Change, and Employment, in: Frontiers of Economics, Ed. Klaus F. Zimmermann, Springer-Verlag, Berlin – Heidelberg – New York, 2002, 269-310.
  • Foley, Duncan K. 1999. Growth and Distribution. Harvard University Press: Cambridge, MA.
  • Garrison, Roger. 1998 Time and Money
  • Hamilton, Clive 2002. Growth Fetish.
  • Jones, Charles I. 2002. Introduction to Economic Growth. 2nd ed. W. W. Norton & Company: New York, N.Y.
  • Kirzner, Israel. 1973 Competition and Entrepreneurship
  • Lucas, Robert E., Jr., "The Industrial Revolution: Past and Future," Federal Reserve Bank of Minneapolis, Annual Report (2003) online edition
  • Mises, Ludwig E. 1949 Human Action 1998 reprint by the Mises Institute
  • Schumpeter, Jospeph A. 1912 The Theory of Economic Development 1982 reprint, Transaction Publishers
  • Schumpeter, Jospeph A. 1942 Capitalism, Socialism, and Democracy Harper Perennial

See also

References

  1. ^ Elhanah Helpman, The Mystery of Economic Growth, Havard University Press, 2004.
  2. ^ Romer, 1986
  3. ^ Lucas, 1988
  4. ^ Elhanah Helpman, The Mystery of Economic Growth, Havard University Press, 2004.
  5. ^ Rosenstein-Rodan
  6. ^ Case, K.E., and Fair, R.C. 2006. Principles of Macroeconomics. Prentice Hall. ISBN-10: 0132226456, ISBN-13: 978-0132226455.
  7. ^ Meadows, D.L., Meadows, D.L., and Randers, J. (1973) The Limits to Growth Washington, DC: Potomac Associates.
  8. ^ Global Inequality Fades as the Global Economy Grows Xavier Sala-i-Martin. 2007 Index of Economic Freedom.
  9. ^ Poverty, Growth, and Inequality World Bank
  10. ^ Fischer, Stanley. "Globalization and Its Challenges." American Economic Review May 2003, p.13.
  11. ^ In Pursuit of Happiness Research. Is It Reliable? What Does It Imply for Policy? The Cato institute. April 11, 2007
  12. ^ Pritchett, Lant. "Divergence, Big Time." Journal of Economic Perspectives Summer 1997 [1]
  13. ^ http://www.gmu.edu/departments/economics/bcaplan/whyaust.htm
  14. ^ Man, Economy and State [2], Austrian economist Murray Rothbard

External links

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