Theories Of Economic Growth

Chapter 3 of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.

Keywords: Growth & Innovation;

As in most human endeavours, a historical perspective is invaluable, especially since economic thinking on growth has evolved over the last forty odd years. Historically, economists concerned with economic growth focussed on the accumulation of capital. But in the 1950s there were two major developments in economic thinking about growth. The first, which had a microeconomics focus, was concerned with the allocation of inputs into production and the outputs that were produced. The second was concerned with the more aggregate (macroeconomic) concerns of technical progress. Each has an important role for capital accumulation, but it had a less important role in economic growth than in earlier theories.

The Neo-classical Theory of Markets

Practically one can see the transition from capital to allocation in the quarrel over the ‘Think Big’ energy intensive installations of the late 1970s and early 1980s. The chief advocate, Robert Muldoon, came from the old school with its focus on capital investment. The vision he represented was that the major projects were a marvellous opportunity to contribute to economic growth in New Zealand by increasing capital intensity.

The populace tends to support this major investment approach, but Muldoon was so unpopular the other side of the argument obtained some political leverage, even if their analysis was more subtle – sometimes to the point of obscurity. Essentially their (allocationist) ‘neo-classical paradigm of market behaviour’ amounted to questioning whether the Major Projects were the best way to commit the nation’s resources. (In fact the failure of ‘Think Big’ proved to be more about the manner in which the risks were allocated between the public and private sector when world energy prices fell. It was a classic case of the privatisation of profits and the socialisation of losses.)

The debate over Think Big resulted in a new generation of allocationists swept aside the old economics in 1984.. (The extremist allocationists are generally known as ‘economic rationalists’ but in New Zealand they tend to be called ‘rogernomes’. Of course not all advocates of ‘more market’ are extremists.) In the previous three decades economist had developed an elaborate theory which said that under certain circumstances – the realities of which can be disputed – a market economy in which there was a minimum of government interventions would result in the best allocation of resources, and therefore the highest material output (GDP). At the superficial level the thesis was that the market system provided incentives for each player to maximise his (or her – the theory is not noticeably sensitive to women’s concerns) own wealth. In doing this individual improves the overall efficiency of the economy.

Providing it is not pushed to an extreme, there is much to be said for this approach. A properly working market system is a signalling device, in which the resource content of potential transactions are embedded in the price. It is a self-enforcing system, because a purchase involves exchanging money which represents a power to acquire resources for a product which has these resources. Thus there is an incentive for purchasers to go ahead only if they value the product more than the money they are outlaying. Such transactions involve an improvement in material welfare of each of the transactors – and in a sense for the economy as a whole.

But there are all sorts of problems with this analysis. Many will become apparent as the book progresses, but important ones are prices may not embody all the resources of social value (such as environment, culture or life itself). Moreover is the system need not be fair. On the other hand the alternatives to the complete elimination of the market system are not that attractive either. In the end we combine a market system for many areas of the economy with the more bureaucratic management for others. Many of the market liberalisations which occurred in the 1980s made good sense from this perspective although some were unnecessary, to be justified by ideological extremism.

What is astonishing is the poor growth record following the market liberalisation of the 1980s. In fact the New Zealand GDP per capita relativity to the rest of the OECD dropped 15 percent. The reason why is crucial in any debate on the economy, especially where further market liberalisation is being advocated. If the extremists got in wrong before, how can we be sure they wont get it wrong again?

While some of the more extreme market liberalisations may have damaged the economy, a moderate supporter of market reform might defend the reforms by accepting its allocative gains were small, probably in the order of one percent at most. (Some extremists talked of them giving a twenty percent boost to GDP.) The real justification for the reforms were more:
– they increased market choice (for those who maintained their income) including better quality of products, which are not easily measured in GDP;
– they reduced the range of government involvement in the economy, enabling the government to concentrate on what it did well (and, many would argue, with gains in political liberty);
– the economy became less rigid, and more able to deal with technological and external shocks. (The 1990s might illustrate the point for the economy seems to have operated more smoothly that in earlier years – although the big test is likely to be in the next decade.)
– they simplified the disinflation (the rate of inflation falling from around 15 percent p.a. to 2 percent p.a.) making it even less painful than it proved to be.

These are useful gains, which however have to be offset by many people appearing to be worse off as a result of the changes. For many of the changes also affected the distribution of income (and jobs). It seems that the market liberalisations generally had an enormous but erratic impact on the distribution of income, but the tax and benefit changes systematically favoured the rich over the poor. Moreover some jobs are less secure than they were before 1984 (especially in the public service) but other (typically private sector) jobs may be more secure, because they were not so vulnerable to being taxed out of existence to protect public sector jobs. (Central to the political economy of the growth process is that those who suffer from a change are almost always much more vociferous than those who benefit. When clothing tariffs were reduced, many garmentmakers found themselves redundant and publically bemoaned their distress. The public at large did not publically celebrate their cheaper clothes.)

These benefits and caveats, do not explain the economic stagnation. As this book (and elsewhere) argues, insufficient attention was paid to the external sector which is the engine of growth in a small open economy. More fundamentally, the neo-classical market paradigm is not particularly concerned with growth. All it was offering was a one-off boost from improved efficiency (which proved to be very small). Because policy focussed exclusively on market liberalisation and ignored the other prerequisites for growth policy (especially a viable exchange rate), the economy behaved exactly as the theory predicted. It stagnated.

The Neo-classical Theory of Economic Growth

About the same time as the neoclassical theory of markets evolved, a parallel but separate neo-classical theory of economic growth also developed. The growth theory assumed the conditions of the market theory, but it was not as static. As well as the theory’s elaborate mathematical analytics is an empirical finding due to Bob Solow published in a seminal paper published in 1957.

Solow’s central finding, replicated for many other data sets, for other periods and for other countries – including by Bryan Philpott for New Zealand – can be summarised as follows. Suppose the amount of capital and labour increase in an economy by 10 percent over a period. Then we might expect the economic output to increase by 10 percent too. In fact it increases by more than that 10 percent – significantly more. So there must be something else which is increasing output over time on top of the additional labour and capital and so on.

The paper described the other source of output, and hence the main source of economic growth, as ‘technical change’, a term which is often misused in such expressions as ‘80 percent of economic growth can be attributed to technology’. Solow defined his concept:

‘I am using the phrase ‘technical change’ as a shorthand expression for any kind of shift in the production function. Thus slowdowns, speedups, improvements in the education of the labour force, and all sorts of things will appear as ‘technical change’. (Solow’s italics)

In fact the technical progress – today it is measured as ‘total factor productivity’ (TFP) – is anything that cannot be explained by increases in labour and capital. A couple of British economists, Tommy Balogh and Paul Streeten went as far as saying that the residual was a ‘coefficient of ignorance’. You could say that those who think that we can increase economic growth by higher technical change are saying we should increase our coefficient of ignorance.

Economists have, of course, tried to reduce this ‘coefficient of ignorance’ by directly estimating the other factors contributing to economic growth. The results are not particularly satisfactory for various reasons, and even so often there remains a significant residual.

Ultimately the problem is that the Solow approach is so aggregate it obscures the really interesting issues. For instance the method, and much of the discussion based on it, assumes that capital is a well defined and readily measured notion, but how does one aggregate together a one horse shay with a Boeing 747 into a single index? How can one compare one hour of my working time with that of my grandfather’s work?

Similarly the approach assumes that the output of the economy can be represented by a single measure (such as GDP). At the heart of the next chapter is the theme that economic growth is about different sectors and products growing at different rates so the paradigm is not going to capture one of the most important features of the problem it claims to be studying. Solow was aware of the problem of aggregation, neatly sidestepping:
‘I would not try to justify what follows [that is the measurement of technical change and the aggregate production function] by calling on fancy theorems on aggregation and index numbers. Either this kind of aggregate economics appeals or it doesn’t. Personally I belong to both schools. If it does, I think we can draw some crude but useful conclusions from the results.’

‘Crude but useful’. Exactly. That is the best that we may hope for from such analyses. And Solow’s marvellous paper is just that. It points out the issue of economic growth is not just additional capital per worker. There appears to be some other important phenomenon which contributes to economic growth, and without which there would be little improvements in productivity. But we are far from clear what is this ‘technical change’.

Exogenous Technical Change

There is an empirical feature of the research which has led to the notion of ‘exogenous’ technical change. Over time, after allowing for fluctuations caused by the business cycle, the growth of this mysterious residual (sometimes called ‘total factor productivity’) seems to be relatively constant – apparently constant enough to treat the change as exogenous and over which policy had no influence. There are data series which, perhaps tenuously, suggest the underlying growth may be constant over decades and even as long as a century. Of course there are caveats, some of which will appear as the argument develops, but it was almost as if the situation could be described in the following ways.

Think of ‘technology’ as a series of blue prints – plans which tell how to combine labour and capital to get an output (a metaphor owed to Joan Robinson). The amount of output for any given amount of capital and labour will vary. (Although the blueprints makes one think of the sciences based on physics, chemistry, biology and so on, the technologies they illustrate may also included social possibilities including such important social technologies as money, the market mechanism and property rights.) We then rely on the market mechanism (as analysed in the neo-classical theory of the market) to chose the blueprints – the technologies – which gives the highest output. They do so, because they give the highest return on the inputs.

However, at any point in time not all the relevant the blueprints can be known. The ‘exogenous’ technical change model might be thought of as someone at a counter regularly handing over blueprints for new technologies from a warehouse. Not all the blueprints handed over are used (since they may be less efficient than others), but in this story businesses snap them up, and the process of market competition means the most productive ones get implemented reasonably quickly. It would appear that the rate of release of blueprints are such that the residual increases at a fairly constant rate over long periods, although implementation processes and costs probably smooths any short term fluctuations. It may have been that in earlier eras – say before the industrial revolution – the flow of new blueprints was much slower. Possibly the industrial revolution depended upon the unlocking the counter which provides the blueprints.

This is a very simplified account of the implicit process of technological change which underpins the original neo-classical growth model, I doubt that any economist – certainly not Solow – actually believed it. But in practice the account seemed to give a reasonable description of what happened at an aggregate level. And it seems to have the implication that policy can not influence the rate of technical change – that it was practically exogenous.

Endogenous Economic Growth

However at the micro-economic level – at the level of a business – it is clear that nobody acts on the basis that they have no control over the blueprints available. Indeed businesses spend much effort trying to generate new ‘blueprints’ (including implementing old ones better) through research and development, while governments invest in science in the hope that it will generate better blueprints.

This insight has resulted in a model of ‘endogenous’ technical change and growth, in which the rate of technical progress can be altered. In the blueprint fable, assume there is no manned counter at the warehouse, which is instead an enormous labyrinth, with the unexplored parts badly lit, and piles of blueprints of technology which prevent access to more advanced blueprints. The process of technological progress involves individuals and firms going into the unexplored part, identifying potentially interesting blueprints, understanding them and implementing (commercialising) them.

The picture presented here is of a much more active process in the seeking of technology, an activity that can be encouraged or discouraged by policy. For instance the government could subsidise people to look for the blueprints; it could assist the seekers and implementers to acquire skills that will enhance their chances of finding and implementing good blueprints, it could introduce intellectual property rights (such as patents) so businesses would have an incentive to seek blueprints; and so on. On the other hand the government could put regulatory barriers which reduced the opportunities to exploit blue prints, discourage people from acquiring skills, or set its property rights regime that the control of one blueprint prevents anyone else accessing the blueprints behind it.

It is even possible that different societies have different attitudes to seeking and implementing the blueprints, attitudes which are sometimes summarised under the rubric of ‘creativity’ but the mind set probably involves the attitude of the community to science, to the social sciences, to the arts and to entrepreneurship. Economist Richard Florida thinks a crucial element may the degree of tolerance in a society to the different and to the new. He instances those US metropolises which are more tolerant have a better economic performance.

Knowledge as a Pure Public Good.

Sitting behind this account of technology is the implication that because of the very nature of knowledge, it is not possible to regulate it entirely by the market mechanism. Not all knowledge can be given useful commercial property rights. (The rogernomes seemed to be antagonistic to intellectuals – something they shared with Lenin who said that after the revolution ‘first kill the intellectuals’ – because most of an intellectual’s output cannot be commercialised.)

It may even be a good thing that knowledge cannot be commercialised. Much (almost all?) is what is known as a ‘pure public good’, in that one person having it does not prevent another person from having it, and one person using it does not exclude another person from using it. (The term ‘good’ is being used here in its standard economic meaning as something which bestows some utility or benefit to its possessor. Thus a ‘good’ in this sense need not be tangible – it could be a service or idea. Nor need it be ethically ‘commendable’. Heroin is a ‘good’ in this sense.)

Consider a poem I much enjoy. But you can enjoy the poem too, without in any way infringing on my enjoyment. (Contrast a can of juice: if I drink it, you cant.) Once the poem is published I cannot exclude anyone else from enjoying it. (I can exclude others from drinking the juice by charging for it.) It is important for these purposes to distinguish the artefact which represents a poem – say a page of a book – from the idea of a poem. The idea is different from the artefact, which is not a public good.. For instance the idea can be represented by another artefact, or can be carried in one’s mind, or voiced in the air – as was the tradition of the minstrel. (As a – possibly pregnant – aside, knowledge is the primary constituent of philosopher Karl Popper’s ‘third world’ of ideas, whereas the artefacts are in his ‘first (objective) world’ . His second world is the world inside the mind. It may be that the third world is (entirely?) made up of pure public goods. There are pure and impure public goods in the first world, as well as private goods.)

Insofar as knowledge is a pure public good the market will under-supply it compared to private goods (such as cans of juice). What market incentive is there for a poet to provide new poems? Copyright payments via the artefacts which publish the poems provide some rewards, but in practice most countries have a variety of non-market rewards such as grants, subsidies, and prizes (which may be provided from public or private sources) to enhance the supply. Thus we need not be surprised that for knowledge creation there can be considerable non-market interventions to increase its production.

That this is not trivial is illustrated by what is currently happening to popular music. The world wide web and the CD means that the traditional means of pop stars funding themselves via royalties on recordings is collapsing, for their fans can digitally copy their works without payment. How the industry will develop is not at all obvious – but one suspects that measured by the monetary value of sales it will be a diminished one and the royalties for recording less. It may be that ultimately the fans will be worse off – unless some non-market interventions are instituted.

Much of economic growth policy is about the practicalities of interventions to provide and implement the knowledge – the technology, the blue prints – to enhance economic growth. There are particularities in New Zealand circumstances.

The Implications for New Zealand

Most of the economic growth debate has occurred from the perspective of the US economy. which is treated as the whole world. (In some respects it is, for it is so large and there are strong feedbacks between it and the rest of the world.) Thus the technology warehouse/labyrinth story refers to all the world and not just to a small country like New Zealand.

So how does the theory of endogenous growth and the difficulty of commercialising ideas apply to New Zealand? There are a lot of countries wandering around the technology warehouse. Much of what they find cannot be charged for. That can be true even when the ideas are embodied in artefacts. For instance, New Zealand has been a beneficiary of the computer hardware revolution – in particular the import and utilisation of increasingly powerful but nevertheless cheaper computers – even though it has not contributed much to its development.

The favourable terms which gave New Zealand these benefits are primarily the result of competition driving down the price. Producers cannot keep all the benefits of their innovations to themselves, even in the medium run. As a general rule technological innovation tends to benefit consumers in the long run, although in the short run the beneficiaries are often – but not always – the innovators, the producers, and the owners of relevant assets and human capital.

This has a very important consequence for growth rates of different countries. There is a tendency for lower per capita GDP countries, in the OECD anyway, to grow faster than the top income countries. The best explanation for this ‘convergence’ of production levels between the rich and poor (OECD) countries is that the poorer ones take on the technologies of the richer ones at less than cost. because it is more expensive to find them in the ‘warehouse’ than it is to copy the finders. So countries lower in the technological pecking order have an advantage. in terms of the cost of access to technology, which enables them to catch up if their other conditions are right. Not surprisingly, the United States has been the most vigorous nation in the pursuit of the imposition of rigorous intellectual property rights in the international economy. Even were it fully successful it would slow down rather than stop the convergence process.

But as we saw, possession of the blueprints is not in itself sufficient. There is the task of implementing them, and that requires various other conditions such as the right labour force, and also intellectual property rights to protect the local innovator, issues to be considered in later chapters.

Nevertheless one might expect New Zealand research and development to be more concerned with technology transfer and less with technology creation than the US. In some sectors where there are particularities to New Zealand circumstance – pastoral farming, specific horticultural products, pinus radiata, deep sea fishing … – technology creation, that is the identifying of blueprints in the warehouse, needs to be as pursued vigorously simply because nowhere else will they be doing so for the particularities of local resources. Thus the technologies cannot be imported. Indeed those industries where New Zealand leads the rest of the world have to have the most advanced technologies in the world.

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