Economic Growth in the Global Economy 19.1
19 c h a p t e r
SHORT RUN VERSUS LONG RUN
John Maynard Keynes, one of the most influential economic thinkers of all times, once said that “in the long run, we are all dead.” The reason Keynes said this is that he was primarily concerned with explaining and reducing short-term fluctuations in the level of business activity. He wanted to smooth out the business cycle, largely because of the implications that cyclical fluctuations had for buyers and sellers in terms of unemployment and price instability.
No one would deny that Keynes’s concerns were important and legitimate.
At the same time, however, Keynes’s flippant remark about the long run ignores the fact that human welfare is greatly influenced by long-term changes in a nation’s capacity to produce goods and services. Emphasis on short-run economic fluctuations ignores the longer-term dynamic changes that affect output, leisure, real income, and lifestyle.
What are the determinants of long-run economic change in our ability to produce goods and services? What are some of the consequences of rapid economic change? Why are some nations rich while others are poor? Does growth in output improve our economic welfare? These are a few questions we need to explore.
DEFINING ECONOMIC GROWTH
Economic growth is usually measured by the annual percentage change in real output of goods and services per capita (real GDP per capita), reflecting the expansion of the economy over time. In Chapter 3, we introduced the production possibilities curve. Along the production possibilities curve, the economy is producing at its potential output. How much the economy will produce at its potential output, sometimes called its natural rate of output, depends on the quantity and quality of an economy’s resources, including labor, capital (like factories, machinery, tools, and productive skills), and natural resources (land, coal, timber, oil, iron, and so on). In addition, technology can increase the economy’s production capabilities. As shown in Exhibit 1, improvements in and greater stocks of land, labor, capital, and entrepreneurial activity will shift the production possibilities curve outward. Another way of saying that economic growth has shifted the production possibilities curve outward is to say that it has increased potential output.
THE RULE OF 70
If Nation A and Nation B start off with the same population and the same level of real GDP, will a slight difference in their growth rates over a long period of time make much of a difference? Yes. In the first year or two, the difference will be small, but even over a decade, the difference will be large,
406 CHAPTER NINETEEN | Economic Growth in the Global Economy
Economic Growth
s e c t i o n
19.1
_ What is economic growth?
_ What is the Rule of 70?
Capital Goods Consumption Goods
0
Economic Growth and the Shifting Production Possibilities Curve
SECTION 19.1
EXHIBIT 1
Increases in capital, land, labor, and entrepreneurial activity can expand the production possibilities curve.
and after 50 to 100 years, it will be huge. The final effect will be a much higher standard of living in the nation with the greater economic growth, ceteris paribus.
A simple formula, called the Rule of 70, shows how long it will take a nation to double its output at various growth rates. If you take a nation’s growth rate and divide it into 70, you will have the approximate time it will take to double the income level.
For example, if a nation grows at 3.5 percent per year, then the economy will double every 20 years (70/3.5). However, if an economy only grows at 2 percent per year, the economy will double every 35 years (70/2); and at a 1 percent annual growth rate, it will take 70 years to double income (70/1). So even a small change in the growth rate of a nation will have a large impact over a lengthy period.
In Exhibit 2, we see the growth rates in real GDP per capita for selected industrial countries. Because of differences in growth rates, some countries will become richer than others over time. With relatively slower economic growth, today’s richest countries will not be the richest for very long. On the other hand, with even slight improvements in economic growth, today’s poorest countries will not remain poor for very long.
Because of past economic growth, the “richest” or “most developed” countries today have many times the market output of the “poorest” or “least developed” countries. Put differently, the most developed countries produce and market more output in a day than the least developed countries do in a year.
The international differences in income, output, and wealth are indeed striking and have caused a great deal of friction between developed and less developed countries. The United States and the nations of the European Union have had sizable increases in real output over the past two centuries, but even in 1800, most of these nations were better off in terms of market output than such contemporary impoverished countries as Ethiopia, India, and Nepal.
Productivity: The Key to a Higher Standard of Living
Will the standard of living in the United States rise, level off, or decline over time? The answer depends on productivity growth. Productivity is the amount of goods and services a worker can produce per hour. Productivity is especially important because it determines a country’s standard of living. For example, slow growth of capital investment can lead to lower labor productivity and, consequently, lower wages. On the other hand, increases in productivity and higher wages can occur as a result of carefully crafted economic policies, such as tax policies that stimulate investment or programs that encourage research and development.
The link between productivity and the standard of living can be understood most easily by recalling the circular flow model in Section 3 of the previous chapter. The circular flow model showed that aggregate expenditures are equal to aggregate income.
In other words, the aggregate values of all goods and services produced in the economy must equal the payments made to the factors of production— the wages and salaries paid to workers, the rental payment to capital, the profits, and so on. That is, the only way an economy can increase its rate of consumption in the long run is if it increases the amount it produces. But why are some countries so much better than others at producing goods and services? We will see the answer in the next section, as we examine the determinants of productivity— quantity and quality of labor resources, physical capital, and technological advances.
Economic Growth 407
Growth in Real GDP per Capita in Selected Industrial Countries
EXHIBIT 2
Ten-Year Averages 1982–1991 1992–2001
United States 2.3% 2.1% Japan 3.5 0.9 Germany 2.4 1.4 France 2.0 1.7 Italy 2.1 1.8 United Kingdom 2.4 2.5 Canada 1.1 2.1
SOURCE: International Monetary Fund, World Economic Outlook, September 2000. Printed by permission from International Monetary Fund.
www.imf.org
FACTORS THAT CONTRIBUTE TO ECONOMIC GROWTH
Many explanations of the process of economic growth have been proposed. Which is correct? No single definition can give a complete picture of economic growth. However, each explanation may be part of a more complicated reality. Economic growth is a complex process involving many important factors, no one of which completely dominates.
We can at least list four factors that nearly everyone would agree have contributed to economic growth in some or all countries:
1. The quantity and quality of labor resources (labor and human capital)
2. Increase in the use of inputs provided by the land (natural resources)
3. Physical capital inputs (machines, tools, buildings, inventories)
4. Technological knowledge (new ways of combining given quantities of labor, natural resources, and capital inputs), allowing greater output than previously possible
Labor
We know that labor is needed in all forms of productive activity. But other things being equal, an increase in the quantity of labor inputs does not necessarily increase output per capita. For example, if the increase in the quantity of labor input is due to an increase in population, per capita growth might not occur because the increase in output could be offset by the increase in population. However, if a greater proportion of the population works (that is, the labor force participation rate rises) or if workers put in longer hours, output per capita will increase—assuming that the additional work activity adds something to output.
When workers acquire qualitative improvements (learning new skills, for example), output can increase. Indeed, it has become popular to view labor skills as human capital that can be augmented
408 CHAPTER NINETEEN | Economic Growth in the Global Economy
1. Economic growth is usually measured by the annual percent change in real output of goods and services per capita.
Improvements in and greater stocks of land, labor, capital, and entrepreneurial activity will lead to greater economic growth and shift the production possibilities curve outward.
2. According to the Rule of 70, if you take a nation's growth rate and divide it into 70, you have the approximate time it will take to double the income level.
1. Why does the production possibilities curve shift out with economic growth?
2. Even if “in the long run we are all dead,” are you glad earlier generations of Americans worked and invested for economic growth?
3. If long-run consequences were not important, would many students go to college or participate in internship programs without pay?
4. When the Dutch “created” new land with their system of dikes, what did it do to their production possibilities curve?
Why?
s e c t i o n c h e c k
Determinants of Economic Growth
19.2
_ What factors contribute to economic growth?
_ What is human capital?
or improved by education and on-the-job training.
Like physical capital, human capital has to be produced, usually through the use of teachers, schoolrooms, libraries, computer labs, and time devoted to studying.
Natural Resources
An abundance of natural resources, like fertile soil, and other raw materials, like timber and oil, can enhance output. Many scholars have cited the abundance of natural resources in the United States as one reason for its historical success. Canada and Australia are endowed with a large natural resource base and high per capita incomes. Resources are, however, not the whole story; for example, Japan and Hong Kong have had tremendous economic success despite having relatively few natural resources.
One the other hand, Brazil has a large and varied natural resource base, yet its income per capita is relatively low compared with many developed countries. It appears that a natural resource base can affect the initial development process, but sustained growth is influenced by other factors.
However, most economists would agree that a limited resource base does pose an important obstacle to economic growth.
Physical Capital
Even in primitive economies, workers usually have some rudimentary tools to further their productive activity. Consider the farmer who needs to dig a ditch to improve drainage in his fields. If he used just his bare hands, it might take a lifetime to complete the job. If he used a shovel, he could dig the ditch in hours or days. But with a big earth-moving machine, he could do it in minutes. There is nearly universal agreement that capital formation has played a significant role in the economic development of nations.
Technological Advances
Technological advances stem from human ingenuity and creativity in developing new ways of combining the factors of production to enhance the amount of output from a given quantity of resources.
The process of technological advance involves invention and innovation. Innovation is the adoption of the product or process. For example, in the United States, the invention and innovation of the cotton gin, the Bessemer steel-making process, and the railroad were important stimuli to economic growth. New technology, however, must be introduced into productive use by managers or entrepreneurs who must weigh the perceived estimates of benefits of the new technology against estimates of costs. Thus, the entrepreneur is an important economic factor in the growth process.
Technological advances permit us to economize on one or more inputs used in the production process. They can permit savings of labor, such as when a new machine does the work of many workers.
When this happens, technology is said to be embodied in capital and to be labor saving. Technology, however, can also be land (natural resource) saving or even capital saving. For example, nuclear fission has permitted us to build power plants that economize on the use of coal, a natural resource.
The reduction in transportation time that accompanied the invention and innovation of the railroad allowed businesses to reduce the capital they needed in the form of inventories. Because goods could be obtained more quickly, businesses could reduce the stock kept on their shelves.
Determinants of Economic Growth 409 Countries that do not keep up with technology will generally be unable to keep up their economic growth and standard of living. If a country is technologically backward, it will lose global competitiveness and often rely on a narrow range of exports that will eventually eliminate their profitability in the global economy. For example, a country that relied on exporting copper may lose its market as other countries around the world convert their phone and cable lines to fiber optics.
© Lawrence Lowery/PhotoDisc/Getty One Images
THE IMPACT OF ECONOMIC GROWTH
Economic growth means more than an increase in the real income (output) of the population. A number of other important changes accompany changes in output. Some have even claimed that economic growth stimulates political freedom or democracy, but that correlation is far from conclusive. While there are rich democratic societies and poor authoritarian ones, the opposite also holds. That is, some features of democracy, such as majority voting and special interest groups, may actually be growth retarding.
For example, if the majority decides to vote for large land reforms and wealth transfers, the consequences will be higher taxes and market distortions that will reduce incentives for work, investment, and ultimately economic growth. However, a nation can pursue a number of policies that will increase economic growth.
SAVING RATES, INVESTMENT, CAPITAL STOCK, AND ECONOMIC GROWTH
One of the most important determinants of economic growth is the saving rate. To consume more in the future, we must save more now. Generally, higher levels of saving will lead to higher rates of investment and capital formation and, therefore, greater economic growth. Individuals can either consume or save their income. If individuals choose to consume all their income, there will be nothing left for saving, which businesses could use for investment purposes to build new plants or replace worn-out or obsolete equipment. With little investment in capital stock, there will be little economic growth. Capital can also increase as a result of injections of capital from abroad (foreign direct investments), but the role of national saving rates in economic growth is of particular importance.
410 CHAPTER NINETEEN | Economic Growth in the Global Economy
1. The factors that contribute to economic growth are increased quantity and quality of labor, natural resources, physical capital, and technological advances.
2. Labor can be improved through investment in human capital—that is, education, on-the-job training, and experience can improve the quality of labor.
1. Why is no single factor capable of completely explaining economic growth patterns?
2. Why might countries with relatively scarce labor be leaders in labor-saving innovations? In what area would countries with relatively scarce land likely be innovative leaders?
3. Why could an increase in the price of oil increase real GDP growth in oil exporting countries like Saudi Arabia and Mexico, while decreasing growth in oil importing countries like the U.S. and Japan?
4. How is Hong Kong a dramatic example of why abundant natural resources are not necessary to rapid economic growth?
Raising the Level of Economic Growth
19.3
_ Why is the saving rate so important to increasing economic growth?
_ Why is research and development so important to economic growth?
_ Why are property rights so important to increasing economic growth?
_ What impact will free trade have on economic growth?
_ Why is education so important to economic growth?
Exhibit 1 clearly shows that sustained rapid economic growth is associated with high rates of saving and investment around the world. However, investment alone does not guarantee economic growth. Economic growth hinges on the quality and type of investment as well as on investments in human capital and improvements in technology.
RESEARCH AND DEVELOPMENT
Some scholars believe that the importance of research and development (R&D) is understated. Research and development consists of the activities undertaken to create new products and processes that will lead to technological progress. The concept of R&D is broad indeed—it can include new products, management improvements, production innovations, or simply learning by doing. However, it is clear that investing in R&D and rewarding innovators with patents have paid big dividends in the past 50 to 60 years. Some would argue that even larger rewards for research and development would spur even more rapid economic growth. In addition, an important link exists between R&D and capital investment. As already noted, when capital depreciates over time, it is replaced with new equipment that embodies the latest technology.
Consequently, R&D may work hand-in-hand with investment to improve growth and productivity.
THE PROTECTION OF PROPERTY RIGHTS IMPACTS ECONOMIC GROWTH
Economic growth rates tend to be higher in countries where the government enforces property rights. Property rights give owners the legal right to
Raising the Level of Economic Growth 411
10 9 8 7 6 0 40 15 20 25 30 35 0
GDP Growth (percent per year) Gross National Saving (percent of GDP)
Vietnam 1991–94 Greece 1961–73 Mauritius 1985–94 Chile 1987–94 Portugal 1965–73 Indonesia 1968–94 Botswana 1979–94 Thailand 1987–94 Malaysia 1987–94 Hong Kong 1961–94 Singapore 1961–94 Rep. of Korea 1983–94 Japan 1961–73 China 1978–94 Fed. Rep. of Germany 1951–55 Côte d'Ivoire 1968–78
Saving Rates and GDP Growth during High-Growth Periods in Selected Economies
SECTION 19.3
Free trade and a stable monetary environment are important to economic growth, but governance is important, too. The government has to protect private property and individual rights and enforce contracts; otherwise, globalization can lead to corruption and violence. Russians have high levels of education, but a legal system that does not reliably protect people’s rights has led to lower output levels.
© AP Photo/Mikhail Metzel
NOTE: Data are annual averages for the periods indicated.
SOURCE: World Bank, World Development Report, 1996, Oxford University Press, 1996.
keep or sell their properties—land, labor, or capital.
Without property rights, life would be a huge “freefor- all,” where people could take whatever they wanted.
In most developed countries, property rights are effectively protected by the government. However, in developing countries, this is not usually the case. If the government does not enforce property rights, the private sector must respond in costly ways that stifle economic growth. For example, an unreliable judiciary system means that entrepreneurs are often forced to rely on informal agreements that are difficult to enforce. As a result, they may have to pay bribes to get things done, and even then, they may not get the promised services. Individuals will have to buy private security or pay “organized crime” for protection against crime and corruption. In addition, landowners and business owners might be fearful of coups or takeovers from a new government, which might confiscate their property altogether. In short, if government is not adequately protecting property rights, the incentive to invest will be hindered, and political instability, corruption, and lower rates of economic growth will be likely.
FREE TRADE AND ECONOMIC GROWTH
Allowing free trade can also lead to greater output because of the principle of comparative advantage.
Essentially, the principle of comparative advantage suggests that if two nations or individuals with different resource endowments and production capabilities specialize in producing a smaller number of goods and services and engage in trade, both parties will benefit. Total output will rise. This will be discussed in greater detail in the Chapter on International Trade.
EDUCATION
Education, investment in human capital, may be just as important as improvements in physical capital.
At any given time, an individual has a choice between current work and investment activities like education that can increase future earning power.
An individual will usually accept reduction in current income to devote current effort to education and training. In turn, a certain return on the investment is expected because in later years, the individual will earn a higher wage rate (the amount of the
412 CHAPTER NINETEEN | Economic Growth in the Global Economy
Ten years ago, Nobel laureate Milton Friedman had just three words of advice for countries crawling out from under communism: privatize, privatize, privatize. But now he says he was wrong—that establishing the rule of law is probably more basic than privatization. In fact, in some countries, privatization without the rule of law is just stealing.
Friedman isn’t alone in changing his mind to champion the rule of law in societies.
• Robert Lawson, author of “Economic Freedom of the World,” has elevated the rule of law over the role of taxes as the key building block of successful economies.
• In the report, the two top countries in economic freedom are Hong Kong and Singapore, and while neither is very democratic or politically liberal, both once belonged to Britain and drew on British common law—as did 8 of the top 10, including the U.S., which came out at number 3.
Lawson reports a general worldwide trend toward an expansion of the rule of law, holding the line on taxes, and promoting sounder monetary policies and freer trade.
SOURCE: Brian Mitchell, “Economic Freedom Depends on Rule of Law, Survey Says,” Investor’s Business Daily, July 9, 2002. For more on legal systems, go to http://www.ncpa.org/iss/int.
RULE OF LAW IS PARAMOUNT, FRIEDMAN NOW SAYS
In The NEWS
increase depending on the nature of the education and training as well as natural ability). For example, in the United States, a person with a college education can be expected to earn almost twice as much per year as a high school graduate.
One argument for government subsidizing education is that the investment can increase the skill level of the population and raise the standard of living.
However, even if the individual does not benefit financially from increased education, society may benefit culturally and in other respects from having its members highly educated. For example, more education can lead to lower crime rates, new ideas that may benefit society, and more informed voters.
With economic growth, illiteracy rates fall and formal education grows. The correlation between per capita output and the proportion of the population that is able to read or write is striking. Improvements in literacy stimulate economic growth by reducing barriers to the flow of information; when information costs are high, out of ignorance, many resources flow to or remain in uses that are unproductive. Moreover, education imparts skills that are directly useful in raising labor productivity, whether it is mathematics taught to a sales clerk, engineering techniques taught to a college graduate, or just good ideas that facilitate production and design.
Raising the Level of Economic Growth 413 Improving education is a relatively inexpensive way to enrich the lives of people living in poorer countries.
Education allows these countries to produce more advanced goods and services and enjoy the wealth created from trading in the global economy. Taiwan, India, and Korea are now part of the high-tech global economy, but most of Africa, with the lowest levels of education, has been left behind.
© Robert Caputo/Aurora/PictureQuest
The message of the Asian experience is clear: Good universal basic education makes most people more productive and satisfied with their own lives, more adaptable to changing circumstances, and better qualified to contribute to their own and national development, according to William Ratliff.
Reforming Asian countries have already taken long strides toward participating effectively in the modern world, he says, while most Latin American countries are hopping in that direction when they are not stumbling and falling back. Latin America’s growth has been intermittent at best, in large part because most of that region’s leaders have not promoted serious and systematic reforms that would allow the people to break out of the prison of traditional ways.
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