What Drives Economic Growth?

Third draft of Chapter 3 of Transforming New Zealand. Comments welcome. (Second Draft).

Keywords: Growth & Innovation;

Once upon a time – not so many years ago actually – economic growth was thought to be the result of increasing combinations of labour and capital. Because of ‘diminishing returns’ – that is that each additional dollop of labour and capital was less productive, it was generally assumed that at some time – perhaps in the time of today’s children – economic growth would come to an end and there would be economic stagnation. This was before the days about the worry of exhausting the available resources, and issue returned to briefly later. The stagnation was seen as solely due to diminishing returns in capital and labour.

However by the late 1950s economic growth had been to persistent for too longs to be entirely comfortable with this thesis. Moreover, economists observed that additional labour and capital could not explain all the economic growth. There had to be another source.

The central finding, replicated over many other data sets, including for different periods and for different countries (Bryan Philpott was New Zealand’s researcher par excellence in this regard) can be summarised as follows. Suppose the amount of capital and labour increase in an economy by 10 percent over a period. Under the old theory we would expect that economic output would increase by 10 percent (or a little less, given diminishing returns). However the practical experience is that output would increase by more than that 10 percent – significantly more. something else which is increasing output over time on top of the additional labour and capital and so on.

The seminal paper by Bob Solow in 1957 described this other source of output, and hence the main source of economic growth, as ‘technical change’. Source labelled this source by:
‘the phrase ‘technical change’ .. 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)

So technical progress – today it is sometimes called ‘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 usually 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.’

‘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’, although there is a tendency for everybody with an axe to grind to attribute the residual to their particular axe.

What then can this ‘technical change be? The best explanation Think of ‘technology’ as a series of blue prints – plans which tell how to combine labour and capital to get an output (a metaphor we owe to Joan Robinson). The amount of output for any given amount of capital and labour will vary. (Although the expression ‘blueprints’ makes one think of the natural sciences such as physics, chemistry, biology, they also included social possibilities including such important social technologies as money, the market mechanism, managerial approaches, and property rights.) Businesses (and households) then chose from all the known blueprints – the technologies. Typically they chose the one that gives them the highest output for the resources available.

The idea of choosing these blueprints should not be too complicated. Suppose you want to go to the beech for a swim. Your blueprints might include using the car, or a bike, or walking, or taking a bus or … What economists conclude is that ‘frequently’ – a word used by Adam Smith in this context – the choice of blueprint will result in the minimum use of labour, capital and other resources. And that will lead to – frequently – the highest output in a certain sense.

Suppose a new blueprint turns up – the neighbours want to go too so you can share a car. Perhaps it uses less resources, so not only do you chose it, but that releases resources which can be used to increase output even further. So the supply of new blueprints may be contributing to the increasing output of the economy.

For a long time we tended to treat the supply of new blueprints as if it was ‘exogenous’, that is the rate they came along could not be changed. It was if there was someone at the counter of the Great Blueprint Warehouse regularly handing over blueprints for new technologies at a rate determined by the counter staff. Not all the blueprints handed over are used (since they may be less efficient than others) or are immediately useful, but in this story businesses snap them up, and the process of market competition means the most productive ones get implemented reasonably quickly. It may have been that in earlier eras – say before the industrial revolution – the flow of new blueprints was much slower so the rate of growth was slower. Possibly the industrial revolution depended upon the unlocking the door to the counter which provides the blueprints.

This is a very simplified account of the implicit process of technological change which underpins what was for many years the standard 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.

However 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. In that sense we have to think of the technical change as endogenous.

What this means in the blueprints fable, is that there is no manned counter at the warehouse. Instead, behind the counter is an enormous labyrinth, with unexplored badly lit passages and caverns, stacked high with blueprints of technology, the ones in front preventing access to more advanced ones. The process of technological progress involves individuals and firms going into the unexplored part and guessing from all that is readily available those which are potentially interesting.

The resulting picture 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 because they own them and can charge others for their use; 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’ although also important are attitudes 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 argues that those US cities which are more tolerant also have a better economic performance.

Sitting behind this account of technology is the implication that it is not possible to regulate knowledge entirely by the market mechanism, because it not all of it can be readily commercialised. (It has seemed to me that the Rogernomics antagonism to intellectuals – shared with Lenin who said that after the revolution ‘first kill the intellectuals’ – may be in part because much of an intellectual’s output cannot be bought.)

Much knowledge is what is known as a ‘pure public good’, for 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. Consider a poem I much enjoy. But you can enjoy the poem too, without in any way infringing on my enjoyment. (In contrast if I drink a can of juice 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 drinking it.)

Insofar as knowledge is a public good the commercial 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? The requirement of copyright payments to publish the poems provide some – albeit frequently inadequate – reward. In practice most countries have a variety of non-market rewards such as grants, subsidies, and prizes to enhance the supply. We need not be surprised that for knowledge creation there can be considerable non-market interventions to increase its production, for the market does not always deliver well.

Consider the supply of pharmaceuticals for treating HIV-AIDs. The cost of making the drugs is small, but drug companies charge many times over to pay for the enormous costs of development, so they say. (‘Fossicking around in the warehouse’ obtaining pharmaceutical blueprints can incur a billion dollars – and the result is not always a successful drug.) But these are past costs. ‘Why should’, you might say, ‘people in desperate need of the drugs pay for them?’ The big Pharma explain that they only went ahead with the development that its expenses would be paid, not to mention all the development they did on drugs that did not make it to the market. If those costs are not, the Pharma will go bankrupt, because they have incurred a lot of debt to fund the development. And even if they dont, they will have no incentive to develop new and better drugs. To which the infected say, ‘that is all very well, but I am going to die unless I get the drug.’ Let me stop at this stage, simply saying that when I was doing some work on the economics of pharmaceuticals, I thought the current way of funding the extension of knowledge about them was terrible – but all the alternatives were worse. The point of this paragraph is that there are often not easy solutions – market or otherwise – to funding the acquisition of important knowledge.

That not all knowledge can be made fully commercial has an important implication for New Zealand. The fable of the technology warehouse refers to the entire world and not just to a small country. Most useful technology is generated offshore. There are a lot of countries wandering around the technology warehouse. Much of what they find cannot be charged for.

So New Zealand has been a beneficiary of the computer hardware revolution, by importing and utilising increasingly powerful but nevertheless cheaper computers – even though it has not contributed much to its development. The favourable terms are the result of competition driving down price while enhancing technology. Producers cannot keep all the benefits of their innovations to themselves. As a general rule new technologies tend to benefit consumers in the long run as above normal profits get driven to zero, although producers get the supernormal profits in the short run.

There is a tendency for lower per capita GDP countries with good economic infrastructure to grow faster than the top income countries, and eventually catchup with them on a GDP per capita measure. 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 it cost to produce them. While there will need to be special adjustments in the new location and thus some technological sophistication is still required, the advantage. in terms of the cost of access to technology enables countries lower in the technological pecking order to catch up although once they have their growth slow down to the others’ growth rate. The free lunch from access to top technology is over.

(However while New Zealand research and development needs to be concerned with technology transfer, in some sectors where there are New Zealand – 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, so the technologies cannot be imported, where New Zealand industries or production processes lead the world.)

The blue print fable ignores that there are many other actors – scientists, workers, entrepreneurs, managers, financiers, … – involved in the implementing technology. Possession of the blueprints is not enough. Each claims to have the crucial role in the process. One is reminded of another fable in which the various parts of the body claim to be the most important. The argument is settled by one of the parts going on strike and the reminder suffering. I cannot recall which was the critical body part, I read the story as a child, but with hindsight one observes that if any part of the body goes in strike, the remainder are likely to suffer. Arguing one is crucial relative to the rest is for children. The same point applies to the application of technology.

Where do resources fit into this story? They were implicit in the opening paragraph in the reference to diminishing returns, because resource depletion is one of the sources of that effect. As a general rule, however, there has to been a tendency for technology to enhance existing resources and find new ones, so although there are regions which have been run down because of resource depletion – the West Coast for example – ths far the world economy has not. That does not mean it never will. One day all the hydrocarbon reserves may be consumed, and the room in the blueprint warehouse devoted to liquid fuels may have been emptied. At which point diminish returns will kick in with a vengeance and economic growth may slow down or even contract.

Another issue which this economic growth exposition needs to touch upon is that of efficiency. Production efficiency is the notion that the production process gets the maximum output foir the resources available to it. This is the concerns of engineers and managers and – if the management is wise – the production workers. Additionally, economists are concerned with allocative efficiency – that all resources and factors of production are deployed where they make the greatest contribution to total output or whatever is the economic objective. Thus an economist is not simply concerned with whether each car is efficient, but they are also concerned that the petrol and cars are being used for the best social purpose.

Over the years economist have 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. 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.

One of the earliest formulations of this thesis was Adam Smith’s famous ‘invisible hand’, which meant that while the butcher and baker pursued their own self interest, in doing so they ‘frequently’ (Smith’s caveat) resulted in a socially beneficial outcome. Alas two hundred and more years later, economists still have to say ‘frequently’. They know it is not ‘always’ and not ‘mostly’ (and noyt ‘occasionally’ either) but they do know a bit more about when there is an effective alternative to the invisible hand.

It was such considerations which led to the market liberalisation we associate with the rogernomics of the 1980s. Sadly many of the reforms were extremist as the reformers seemed to forget the Smithian ‘frequently’. Their promised gains of ‘twenty percent ‘of GDP never occurred. The extremists did not notice that the underlying theory was essentially about a static economy. The irony never struck them that when they applied their theory the economy stagnated.

(Nevertheless their were useful gains to the economy from the market reforms including:
– 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.
– they made the disinflation (the rate of inflation falling from around 15 to 2 percent p.a.) less painful.
But of course there were costs too.)

Thus the market is an important part of the growth process, but it is not as important as finding and implementing technology. Its most important roll may be to help find and implement the best technology.

How Fast Can New Zealand Go?

There is a long history of promising to accelerate the New Zealand economy’s growth rate – and not delivering. In the early 1970s, the National Development Conference projected a growth rate of 4.5 percent p.a. for the economy. Impractical in the circumstances, the economy averaged nearer half the target over the next few years. A 1991 study concluded that it would take almost twenty years to return to the top half of the OECD (The 1991 slogan was ‘10 in 2010′). The stretch growth rate was about 4 percent p.a. In the 1990s the New Zealand economy grew about as fast as the OECD (3 percent p.a.) so there was no significant movement up the OECD relativities.

Both of these projections followed an enormous effort collecting and analysing data. Today’s calls for an economic growth rate of 6 percent p.a. are probably even more irresponsible, and the demand that New Zealand should return to the top half of the OECD in GDP per capita terms by 2011 is totally unrealistic. The target seems to have been set by a group of Auckland business people, without any economic advice. As one Auckland businessman, remarked to me, all it involves is doubling New Zealand’s productivity growth rate. That is arithmetically true, but that does not make it feasible. In fact that businessman was one of the best in the country, but he was unable to double productivity growth in his enterprise. Reality is more than arithmetic.

A salutary image from the America Cups was the sleek black yacht limping back to port. Twice they tried to sail it faster than conditions allowed, the boat shipped (literally) tonnes of water, bits broke, and they gave up the race. Business people know the equivalent thing can happen if they try to drive their businesses too fast. Economies can also be like that. We are unlikely to be able to turn the ship around much faster than in 1991. Certainly the sorts of demands being made by the strident but uninformed look quite unrealistic. They need to remember that trying to sail a boat – or an economy – too fast, can break a boom into a bust.

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