Economic growth

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World and total OECD countries GDP growth rates.

Economic growth is the increase in the amount of the goods and services produced by an economy over time.^[1] It is conventionally measured as the percent rate of increase in real gross domestic product, or real 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 an area of study, economic growth is generally distinguished from development economics. The former is primarily the study of how countries can advance their economies. The latter is the study of the economic aspects of the development process in low-income countries.

As economic growth is measured as the annual percent change of gross domestic product (GDP), it has all the advantages and drawbacks of that measure. GDP per capita is not the same thing as earnings per worker. GDP includes all final goods and services in country in a year.

[edit] Short-term stabilization and long-term growth

Economists draw a distinction between short-term economic stabilization and long-term economic growth. The topic of economic growth is primarily concerned with the long run.

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 1990s and this has been attributed, in part, to changes in macroeconomic management...

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%.

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.

[edit] Theory

[edit] Origins of the concept

In 1377, the Arabian economic thinker Ibn Khaldun provided one of the earliest descriptions of economic growth in his famous Muqaddimah (known as Prolegomena in the Western world):

"When civilization [population] increases, the available labor again increases. In turn, luxury again increases in correspondence with the increasing profit, and the customs and needs of luxury increase. Crafts are created to obtain luxury products. The value realized from them increases, and, as a result, profits are again multiplied in the town. Production there is thriving even more than before. And so it goes with the second and third increase. All the additional labor serves luxury and wealth, in contrast to the original labor that served the necessity of life."^[2]

In the early modern period, some people in Western European nations developed 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. As there are difficulties in modeling complex self-organizing systems, various efforts to model the long term evolution of economies have produced mixed 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". 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, one policy attempted to foster growth 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.

[edit] Classical growth theory

Example: Growth of a market limited by saturation
Growth can occur with and without bounds. Logistic growth is an example for a bounded growth which is limited by saturation: In the picture the blue curve could depict the development of the size of an imaginary market with logistic growth. The red curve then would describe the growth of that market as the 1st derivative of the market volume. The yellow curve is the growth weighted by the size of the market. As for logistic growth, the yellow curve shows, that even a large market size cannot strengthen growth when approaching saturation. Logistic growth never is negative, but in the saturation area, the growth is as small as before the market took off. (In the example all curves are scaled to cover the range between 0 and 1.)

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 argued 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 aggregate 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 faster than population growth, industrialized economies substantially increased their incomes per capita in the next centuries.

[edit] Creative destruction and economic growth

Many economists view entrepreneurship as having a major influence on a society's rate of technological progress and thus economic growth.^[3] Joseph Schumpeter was a key figure in understanding the influence of entrepreneurs on technological progress.^[3] In Schumpeter's Capitalism, Socialism and Democracy, published in 1942, an entrepreneur is a person who is willing and able to convert a new idea or invention into a successful innovation. Entrepreneurship forces "creative destruction" across markets and industries, simultaneously creating new products and business models. In this way, creative destruction is largely responsible for the dynamism of industries and long-run economic growth. Former Federal Reserve chairman Alan Greenspan has described the influence of creative destruction on economic growth as follows: "Capitalism expands wealth primarily through creative destruction—the process by which the cash flow from obsolescent, low-return capital is invested in high-return, cutting-edge technologies."[4]

[edit] The neo-classical growth model

The 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^[4] and Trevor Swan^[5] 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 output growth 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.^[6]

[edit] Development economics

The latter half of the 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. This led to the field of development economics, including the work of Nobel laureates Amartya Sen and Joseph Stiglitz.However this model of economic development does not meet the demands of subaltern populations and has been severely criticized by later theorists.

[edit] New growth theory

Growth theory advanced again with the theories of economist Paul Romer in the late 1980s and early 1990s. Other important new growth theorists include Robert E. Lucas and Robert J. Barro.

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.^[7][8] 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).^[6] Recent empirical analyses suggest that differences in cognitive skills, related to schooling and other factors, can largely explain variations in growth rates across countries.^[9]

[edit] 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. ^[10]

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 ruin, 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.

[edit] Effects of growth

Economic growth has undeniable effects on the living conditions of the peoples of the earth. However, whether these effects are on balance positive or negative is currently open to debate.

[edit] Positive effects

Economist Xavier Sala-i-Martin argues that global income inequality is diminishing,^[11] and the World Bank argues that the rapid reduction in global poverty is in large part due to economic growth ^[12] The decline in poverty has been the slowest where growth performance has been the worst (ie. in Africa).^[13]

Happiness increases with a higher GDP/capita, at least up to a level of $15,000 per person.^[14]

Many earlier predictions of resource depletion, such as Thomas Malthus (1798) predictions about approaching famines in Europe, [5] The Population Bomb (1968), [6] [7] [8] Limits to Growth (1972), [9] [10] [11] and the Simon-Ehrlich wager (1980) [12] have proven false, one reason being that advancements in technology and science have continually allowed previously unavailable resources to be utilized more economically. [13] The book The Improving State of the World argues that the state of humanity is rapidly improving.

Those more optimistic about the environmental impacts of growth believe that, although localized environmental effects may occur, large scale ecological effects are minor. The argument as stated by economists such as Julian Simon states that if these global-scale ecological effects exist, human ingenuity will find ways of adapting to them.^{[citation needed]}

Economists theorize that economies are driven by new technology and ongoing improvements in efficiency — for instance, we have faster computers today than a year ago, but not necessarily computers requiring more natural resources to build. Also, physical limits may be very large if considering all the minerals in the planet Earth or all possible resources 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. However, depletion and declining production from old resources can sometimes occur before new resources are ready to replace them. This is, in part, the logical basis of the Peak Oil theory. Although individual oil wells and mines for other nonrenewable resources are often depleted, the availability of these resources has generally risen and their prices have dropped over the long-run.

[edit] Negative effects

Four major critical arguments raised against economic growth include:^[15]

1. Growth has negative effects on the quality of life: Many things that affect the quality of life, such as the environment, are not traded or measured in the market.
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."^[15]
3. Resources: The 2007 United Nations GEO-4 report warns that we are living far beyond our means. The human population is now larger and that the amount of resources it consumes takes up a lot of those resources available. Humanity’s environmental demand is purported to be 21.9 hectares per person while the Earth’s biological capacity is purported to be 15.7 ha/person.^[16] This report supports the basic arguments and observations made by Thomas Malthus in the early 1800s, that is, economic growth depletes non-renewable resources rapidly.^[17]
4. Distribution of income: The gap between the poorest and richest countries in the world has been growing.^[18]. Although mean and median wealth has increased globally, it adds to the inequality of wealth.

Some critics argue that a narrow view of economic growth, combined with globalization, is creating a scenario where we could see a systemic collapse of our planet's natural resources.^{[citation needed][19]} Other critics draw on archaeology to cite examples of cultures they claim have disappeared because they grew beyond the ability of their ecosystems to support them. 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.

The Austrian School argues 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 prefer having more leisure time to acquiring more goods and services, but this fufillment of desires would have a negative effect on GDP increase. 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, which best satisfies the wants of consumers. As such, Austrian economists believe that the individual should determine how much "growth" s/he desires.^[20]

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.^{[citation needed]} Some think this argument can be applied even to more developed economies.^{[citation needed]}

[edit] Growth 'to a point'

The two theories can be reconciled if it is recognised that growth improves the quality of life to a point, after which it doesn't improve the quality of life, but rather obstructs sustainable living.^[21] Historically, sustained growth has reached its limits (and turned to catastrophic decline) when perturbations to the environmental system last long enough to destabilise the bases of a culture.^[21]

[edit] Implications of climate change

see Economics of global warming

The predicted rate of economic growth has important implications for climate change policy. There is a trade-off between carbon based economic growth and the expected adverse impact of climate change caused partly by carbon based growth.^{[citation needed]}

The Stern Review, published by the United Kingdom Government in 2006, concluded that an investment of 1% of GDP per annum would be sufficient to avoid the worst effects of climate change, and that failure to do so could risk global GDP being 20% lower than it otherwise might be.

On the other hand, Nigel Lawson claimed that people in a hundred years time would be "seven times as well off as we are today", therefore it is not reasonable to impose sacrifices on the "much poorer present generation".^[22]

[edit] Prominent growth economists

[edit] See also

[edit] References

[edit] 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
• Weil, David N. 2008. Economic Growth. 2nd ed. Addison Wesley.

[edit] External links

[edit] Articles and lectures

• Economic Growth by Paul Romer, The Concise Encyclopedia of Economics.
• "Economic growth." Encyclopædia Britannica. 2007. Encyclopædia Britannica Online. 17 November 2007.
• Beyond Classical and Keynesian Macroeconomic Policy. Paul Romer's plain-English explanation of Endogenous Growth Theory.
• Size of Government and Economic Growth, Joint Economic Committee
• Does Economic Growth increase Living Standards?
• Who's afraid of economic growth? Essay by Daniel Ben-Ami on the contemporary anxiety about economic growth.
• CEPR Economics Seminar Series Two seminars on the importance of growth with economists Dean Baker and Mark Weisbrot
• On global economic history by Jan Luiten van Zanden. Explores the idea of the inevitability of the Industrial Revolution.
• The Economist Has No Clothes – essay by Robert Nadeau in Scientific American on the basic assumptions behind current economic theory

[edit] Data

• Historical data - since 1954 - comparing the US GDP growth rate versus the US Fed Funds Rate
• Angus Maddison's Historical Dataseries -Series for almost all countries on GDP, Population and GDP per capita from the year 0 up to 2003
• OECD Economic growth statistics