The poor and the rich

The poor and the rich - ECONOMIC GROWTH From The Economist,...

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Unformatted text preview: ECONOMIC GROWTH From The Economist, 5/25/96 Reprinted with permission. Distrib. by Special Features/Syndic. Sales © 1996 The poor and the rich In recent years, researchers have moved closer to answering the most impor- tant question in economics: why are some countries richer than others? NDERSTAN DING growth is surely the most urgent task in economics. Across the world, poverty remains the single great— est cause of misery; and the surest remedy for poverty is economic growth. It is true that growth can create problems of its own (congestion and pollution, for instance), which may preoccupy many people in rich countries. But such ills pale in comparison crucial for understanding growth—the no- tion of diminishing returns. He showed how additional inveSIment in land tended to yield an ever lower return, implying that growth would eventually come to a halt— though trade could stave this offfora while The foundations ofmodern growth the- ory were laid in the 1950s by Robert Solow and Trevor Swan. Their models describe an technological progress. Yet this is a force that the model itself makes no attempt to explain: in the jargon, technological pro- gress is, in the neoclassical theory, “exoge- nous" (ie, it arises outside the model). The second implication is that poorer countries should grow faster than rich ones. The rea— son is diminishing returns: since poor countries start with less capital, they should reap higher returns from each slice of new investment. Theory into practice Do these theoretical implications accord with the real World? The short answer is no. The left—hand chart on the next page shows average growth rates since 1870 of 16 rich countries for which good long—term data ex— ist. Growth has indeed slowed since 1970. Even so, modern growth rates are well above their earlier long—run average. with the harm caused by the eco- nomic backwardness of poor coun— tries—that is, of the larger part of the world. The cost of this backwa rdness, measured in wasted lives and need- less sulfering, is truly vast. To its shame, economics ne- glected the study of growth for many years. Theorists and empirical re— searchers alike chose to concentrate on other fields, notably on macro- economic policy. Until the 1980s, with a few exceptions, the best brains in economics preferred not to focus on the most vital issue ofall. But over the past ten years or so, this has changed. Stars such as Robert Lucas of the University of Chicago, who last year won the Nobel prize in eco- nomics, have started to concentrate on growth. As he says of the subject, “the consequences for human welfare . . . are simply staggering. Once one starts to think about them, it is hard to think ofanything else” Early economists certainly thought about them. Adam Smith’s classic 1776 book was, after all, called an “Inquiry into the Nature and Causes of the Wealth of Nations”. Many building-blocks for understanding growth derive from him. Smith reckoned that the engine ofgrowth was to be found in the di- vision of labour, in the accumulation of capital and in technological progress. He emphasised the importance of a stable le— gal framework, within which the invisible hand of the market could function, and he explained how an open trading system would allow poorer countries to catch up with richer ones. In the early 19th century, David Ricardo formalised another concept THE ECONOMIST MAY 25TH 1996 A pauper’s harvest economy of perfect competition, whose output grows in response to larger inputs of capital (ie, physical assets of all kinds) and labour. This economy obeys the law of diminishing returns: each new bit ofcapi— tal (given a fixed labour supply) yields a slightly lower return than the one before Together, these assumptions give the neoclassical growth model, as it is called, two crucial implications. First, as the stock of capital expands, growth slows, and even- tually halts: to keep growing, the economy must benefit from continual infusions of This appears to contradict the rst implication, that growth will slow over time It may be that an accelera- tion of technological progress ac counts for this, but this should hardly console a neoclassical theo- rist, because it would mean that the main driving force of growth lies be— yond the scope of growth theory. What about the second implica— tionfiare poor countries catching up? The right—hand chart overleaf plots, for 118 countries, growth rates between 1960 and 1985 against their initial 1960 level of GDP per person. If poor countries were catching up, the plots on the chart should follow a downward—sloping pattern: coun— tries that were poorer in 1960 should have higher growth rates. They do not. Indeed, if there is any discern— ible pattern in the mass ofdots, it is the opposite: poorer countries have tended to grow more slowly. Having arrived at neoclassical growth theory, however, economics by and large forgot about the subject. It had a model that was theoretically plausible, but did not seem to fit the facts. How best to proceed was unclear. Then, af— ter a pause of 30 years, along came “new growth theory”. This newschoolhas questioned,am0ng other things, the law of diminishing re— turns in the neoclassical model. If each ex— tra bit of capital does not, in fact, yield a lower return than its predecessor, growth can continue indefinitely, even without technological progress. A seminal paper was published in 1986 by Paul Romer (see references at the end). It showed that if you 23 ECONOMIC GROWTH ' Annual average growth 16 rich countries, '56 1950- 1870- 1390- l9l0- l930- 1970- The growth conundrum GDP per person 90' 1910? 30 SO 70 90 50mm: 'Emncmlr Growth" by Ruben Burro A Xavier Sam-Mum, (McGr-w-HIIL I995) Growth and 1960 income 118 countries 75 .V‘ o N m 4, GDP per person, 1960-85. annual average 96 change a 1.5 Log of real GDP per person, I960 “3 (ounlrtel 114 countries broaden the idea of capital to include hu- man capital (that is, the knowledge and skills embodied in the workforce), the law ofdiminishing returns may not apply. Sup- pose, for example, that a firm which invests in a new piece of equipment also learns how to use it more efficiently. Or suppose it becomes more innovative as a by—product of accumulating capital. In either case, there can be increasing, not decreasing, re- tums to investment. In this and other ways, new growth theorists can explain how growth might persist in the absence oftechnological pro- gress. But, they have gone on to ask, why as— sume away such progress? A second strand of new growth theory seeks to put techno- logical progress explicitly into the model (making it “endogenous”, in the jargon) This has obliged theorists to ask questions about innovation. Why, for instance, do companies invest in research and develop- ment? How do the innovations ofone com— pany affect the rest of the economy? A furtherdivergence from the neoclassi- cal view follows. As a general rule, a firm will not bother to innovate unless it thinks it can steal a march on the competition and, for a while at least, earn higher profits. But this account is inconsistent with the neoclassical model’s simplifying assump- tion of perfect competition, which rules out any “abnormal” profits. So the new growth theorists drop that assumption and sup- pose instead that competition is imperfect. Attention then shifts to the conditions un- der which firms will innovate most pro- ductively: how much protection Should intellectual-property law give to an innova— tor, for instance? In this way, and not be- fore time, technological progress has begun to occupy a central place in economists’ thinking about growth. In the latest resurgence of interest in growth theory, however, the original neo- classical approach has enjoyed something ofa revival. Some economists are question- ing whether the “new” theories really add much. For instance, the new theory em pha— sises human capital; arguably, this merely calls for a more subtle measure of labour than the ones used by early neoclassical theorists. More generally, it is argued that if factors of production (capital and labour) are properly measured and quality—ad— justed, the neoclassical approach yields ev— erything of value in the new theory, with— out its distracting bells and whistles. So it often proves in economics: the mainstream first takes affront at new ideas, then reluc— tantly draws on them, and eventually claims to have thought ofthem first. The missing link To non-economists, however, both ap- proaches seem curiously lacking in one cru— cial respect. Whereas in popular debate about grovvth, government policy is usually the main issue, in both neoclassical and new growth theory discussion of policy takes place largely off-stage. To the extent that government policy affects investment, for instance, either could trace out the ef— fects on growth—but the connection be- tween policy and growth is tenuous and in- direct. Each approach may take a strong view about the role ofdiminishing returns, but both remain frustratingly uncommit— ted about the role of government. An upsurge of empirical work on growth is helping to fill this hole—and, as a by-product, shedding further light on the relative merits ofthe new and neoclassical theories. The nuts and bolts ofthis work are huge statistical analyses. Vast sets of data now exist, containing information for more than 100 countries between 1960 and 1990 on growth rates, inflation rates, fertil— ity rates, school enrolment, government spending, estimates ofhow good the rule of law is, and so on. Great effort has been de» voted to analysing these numbers. One key finding is “conditional con— vergence", a term coined by Robert Ba rro, a pioneer of the new empirical growth stud» ies. His research has found that ifone holds constant such factors as a country’s fertility rate, its human capital (proxied by various 10 measures of educational attainment) and its government policies (proxied by the share of current government spending in GDP), poorer countries tend to grow faster than richer ones. So the basic insight ofthe neoclassical growth model is, in fact, cor— rect. But since, in reality, other factors are not constant (countries do not have the same level of human capital or the same government policies), absolute conver- gence does not hold. Whether this is a depressing result for poor countries depends on what deter- mines the “conditional” nature of the catch—up process. Are slow-growing coun- tries held back by government policies that can be changed easily and quickly? Or are more fundamental forces at work? Most empirical evidence points to the primacy of government choices. Countries that have pursued broadly free—market pol— icies—in particular, trade liberalisation and the maintenance of secure property rights—have raised their growth rates. In a recent paper, Jeffrey Sachs and Andrew Warner divided a sample of 111 countries into “open” and “closed”. The “open” economies showed strikingly faster growth and convergence than the “closed” ones. Smaller government also helps. Robert Barro, among others, has found that higher government spending tends to be associ- ated with slower growth. Human capital—education and skills— has also been found to matter. Various sta- tistical analyses have shown that countries with lots ofhuman capital relative to their physical capital are likely to grow faster than those with less. Many economists ar- gue that this was a factor in East Asia’s suc- cess: in the early 19605 the Asian tigers had relatively well—educated workforces and low levels of physical capital. A more difficult issue is the importance of savings and investment. One implica- tion ofthe neoclassical theory is that higher investment should mean faster growth (at least for a while). The empirical studies sug- gest that high investment is indeed associ— ated with fast growth. But they also show that investment is not enough by itself In fact the causality may run in the opposite direction: higher growth may, in a virtuous circle, encourage higher saving and invest- ment. This makes sense: communist coun— tries, for instance, had extraordinarily high investment but, burdened with bad poli— cies in other respects, they failed to turn this into high growth. The number—cm nching continues; new grovvth—influencing variables keep being added to the list. High inflation is bad for growth; political stability counts; the re— sults on democracy are mixed; and so on. The emerging conclusion is that the poor‘ est countries can indeed catch up, and that their chances ofdoing so are maximised by policies that give a greater role to compe- THF FCUNOMIST MAI 25TH1996 tition and incentives, at home and abroad. But surely, you might think, this hides a contradiction? The new growth theory sug- gests that correct government policies can permanently raise growth rates. Empirical crosscountry analysis, however, seems to show that less government is better—a con- clusion that appeals to many neoclassical theorists. This tension is especially pro nounced for the East Asian tigers. Advo cates of free markets point to East Asia’s trade liberalisation in the 1960s, and its his— tory of low government spending, as keys to theAsian miracle Interventionists point to subsidies and other policies designed to promote investment. Reflecting the present spirit of rap- prochement between the growth models, it is now widely argued that this contradiction is more apparent than real. Work by Alwyn Young, popularised by Paul Krugman, has shown that much oftheAsian tigers’ success can be explained by the neoclassical model. It re— sulted from a rapid accumula- tion of capital (through high in- vestment) and labour (through population growth and in— creased labour—force participa- tion) On this view, there is noth— ing particularly miraculous about Asian growth: it is an ex- ample of “catch-up”. Equally, however, the outlines of East Asian success fit the new growth model. Endogenous growth the- ory says that government policy to increase human capital or fos- ter the right kinds of investment in physical capital can perma— nently raise economic growth. The question is which aspect of East Asian policies was more important— which, up to a point, is the same as asking which growth model works best. Although debate continues, the evidence is less strong that micro—level encouragement of particular kinds of investment was crucial in Asia. Some economists dissent from that judgment, but they are a minority. Most agree that broader policies of encouraging education, opening the economy to foreign technologies, promoting trade and keeping taxes low mattered more One more heave There is no doubt that the neoclassical model of the 19505, subsequently en- hanced, together with the theories pit) neered by Mr Romer, have greatly ad— vanced economists’ understanding of growth. Yet the earlier doubt remains. Both models, in their purest versions, treat the role of government only indirectly. The new empirical work on conditional con— vergence has set out to put this right. The fact remains that in the earlier theoretical THE ECONOMIST MAV 25TH 1996 Thejoy walth debate between the neoclassical and the new schools, the question that matters mostiwhat should governments do to pro mote growth?~was often forgotten. A new paper by Mancur Olson makes this point in an intriguing way. The start- ing-point for today’s empirical work is a striking fact: the world’s fastest-growing economies are a small subgroup of excep— tional performers among the poor coun— tries. Viewed in the earlier theoretical per— spective, this is actually rather awkward. Mr Romer’s theories would lead you to ex- pect that the richest economies would be the fastest growers: they are not. The basic neoclassical theory suggests that the poor— est countries, on the whole, should do bet— ter than the richest: they do not. Neither ap proach, taken at face value, explains the most striking fact about growth in the world today. Mr Olson argues that the simplest ver- sions of both theories miss a crucial point. Both assume that, given the resources and technology at their disposal, countries are doing as well as they can. Despite their dif— ferences, both are theories about how changes in available resources afiect out— put—that is, both implicitly assume that, if resources do not change, output cannot ei— ther. But suppose that poor countries sim— ply waste lots of resources. Then the best way for them to achieve spectacular growth Main papers cited “increasing Returns and Long-Run Growth”. By Paul Romerjoumal of Political Economy, 1986. “Economic Reform and the Procas of Global Integra~ tion". Byjeffrey Sachs and Andrew Warner. Brookings Pa» pers on Economic Activity, 1995 “The Tyranny ofNumbers: Confronting the Statistical Re- alitics of the East Asian Experience". By Alwyn Young. NEER working paper 4680,1994. “Big Bills Left on the Sidewalk: Why Some Nations Arc Rich. and Others Poor“. By Mancur Olson.)oumal of Eco- nomic Perspectives, forthcoming. ll ECONOMIC GROWTH is not to set about accumulating more of the right kind of resources—but to waste less ofthose they already have Marshalling the evidence, Mr Olson shows that slow-growing poor countries are indeed hopelessly failing to make good use of their resources. Take labour, for in- stance If poor countries were using labour as well as they could, large emigrations of labour from poor to rich countries (from Haiti to the United States, for instance) ought to raise the productivity of workers left behind (because each worker now has more capital, land and other resources to work with). But emigration does not have this elTect. Data on what happens to migrants in their new homes are likewise inconsistent with the two growth theories. Im- migrants’ incomes rise by far more than access to more capital and other resources would imply. It follows that labour (including its human capital, entre— preneurial spirit, cultural traits and the rest) was being squan— dered in its country of origin. When workers move, their in— comes rise partly because there is more capital to work with—but also by a further large margin, which must represent the wast— age incurred before. Mr Olson ad- duces similar evidence to show that capital and knowledge are being massively squandered in many poor countries. This olTers a rationale for the pattern of growth around the world—a rationale that, consis- tent with the recent work on con— ditional convergence, places ECO- nomic policies and institutions at the very centre According to this view, it is putting it mildly to say that catch-up is possible: the economic opportunities for poor countries are, as the tigers have shown, phenomenal. The problem is not so much a lack of re— sources, but an inability to use existing re— sources well. It is surely uncontroversial to say that this is the right way tojudge the per— formance of communist countries (those exemplars of negative value—added) before 1989. Mr Olson’s contention is that most of today’s poor countries are making mistakes ofan essentially similar kind. The question still remains: what are the right policies? One must turn again to the empirical evidence That seems a frustrat- ing answer because, suggestive though re— centwork on conditional convergence may be, such findings will always be contested. Citizens of the world who sensibly keep an eye on what economists are up to can at least take pleasure in this: the profession has chosen for once to have one ofits most vigorous debates about the right subject. 25 ...
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The poor and the rich - ECONOMIC GROWTH From The Economist,...

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