Economic growth and development

Robert Lucas, a Nobel Prize winning economist, once said that once you start thinking about economic growth, it is hard to think about anything else. Indeed, rapid economic growth year after year can lift the living standard for large masses of people and can bring more economic security, better health care and education, and much more. Yet, incomes remain stubbornly low in much of the world. There are economic miracle cases of countries where incomes have doubled every 10 years or so and there are disaster cases where incomes have stagnated for decades. Why?

1. What is economic growth and development?

Economic growth is defined as the rate of increase of the Gross Domestic Product (GDP) of a country. An increase in GDP means that the country produces more goods and services this year than it did last year.

However, an increase in the GDP does not mean that the income of the average person is also increasing. It could be that the population is increasing even faster than the GDP. Then, the GDP per person would be declining. Therefore, if we are interested in economic development, i.e. whether incomes are growing, we look at GDP per person. If we are interested in the size of the economy, we look at GDP.

Why do we equate production and income? All the goods and services produced in a country are sold to households, firms, government entities, and foreigners. The revenue from these sales end up in the pockets of people who are either employees (getting salaries) or capital owners (getting dividends and rents). In other words, all of the income comes from the sale of goods and services. More production means more income, less production means less income. The country cannot consume more than it produces. Respectively, GDP measures income.

Of course, an increase in GDP per capita does not mean that everyone is getting richer. Most of the additional income may go to relatively few capital owners and less goes to employees. For that, we need to look at income inequality. Also, even if everyone’s income is growing, that does not mean they live better. There could be crime, environmental pollution and other problems. The Human Development Index published by the United Nations broadens the notion of development by incorporating health and education outcomes along with income. Still, GDP per capita is the most widely used measure of economic development and we focus on it.

2. The importance of long-run economic growth

Over time, the expansion of the economy is due to rapid annual growth and "compounding." Compounding means that each year the increase in GDP comes on top of the increase during the preceding year. In other words, the increases are cumulative.

For example, China's GDP in 2008 was about 22 trillion yuan (the Chinese currency). Then in 2009 it grew by about 10 percent to 24 trillion yuan. In 2010, it grew again by about 10 percent to 27 trillion yuan. The economic growth in both years was similar. However, while in 2009 the economic growth added 2 trillion yuan to the economy, in 2010 it added 3 trillion yuan. That is because the 10 percent growth in 2010 came on top of the growth in 2009.

The question then is not only how to achieve rapid economic growth but how to sustain it over time. In other words, we should care about long-term economic growth. When we look across many countries and many years, economic growth is on average 2.5 to 3 percent per year. If an economy grows by 7-8 percent per year for several years, as the Chinese economy, that is extraordinary. With 8 percent economic growth, GDP doubles in size every nine years.

3. How do economies grow?

Broadly speaking, there are three ingredients to economic growth:

Physical capital. These are the machines, equipment, buildings, land, and other tangible inputs into the production process. When companies invest in more equipment, this allows them to expand production over time and to contribute to economic growth.

Labor. These are all the people employed in the economy. The economy can expand by simply increasing the number of people who work. This could be the result of population growth or greater labor force participation rate. For example, the entry of female workers into the labor force has been a great boost to economic development in many countries. For example, in 1980, 41 percent of German women who could work were either employed or were looking for a job. By 2010, that number increased to 53 percent. Those additional workers produced goods and services and helped expand the economy.

Productivity. Productivity is the amount of output produced with given labor and physical capital. The question here is not how many people are working and what machines they use but how well the labor and machines are put to use. Is the work organized well? Are resources wasted on inefficient company practices or in dealings with a corrupt public administration?

To sum, the economy can expand if there are more people working, if they use more machines and equipment, and if the people and machines are put to better use. Historically, most of the advancements in economic growth have been associated with increased productivity. That, however, is not true for all counties at all times. Less developed countries grow primarily through investment in capital and incorporating more people into their labor force. The rapid rates of industrialization in Asia can be largely attributed to investment in new equipment and expanding the work force. As countries develop, their pattern of economic growth begins to shift. Innovation, rather than imitation, becomes more important. Hence, economic growth requires new technology and improvements in productivity.

Whether or not a country is able to make the transition to high productivity growth depends on many factors. Innovation requires a well educated population, strong protection of patents and copyrights, institutions that support the growth of new ideas, and well functioning financial markets that can finance these ideas. Without those factors, development reaches a ceiling and further improvements are tough to generate.
4. Is the world income inequality getting smaller?

If poor countries grow faster than rich countries, over time they will catch up in terms of their level of income. This process is called income convergence. Alternatively, incomes would diverge if the rich countries grow more rapidly than poor countries. If economic growth is the same everywhere, then the differences in income across countries would remain the same.

There are two main reasons for why incomes across countries might converge over time.

Technology spillover. One reason is that innovations and technologies that are developed in the rich countries soon become available in the poor countries. That happens, for example, through foreign direct investment as companies from the rich countries bring new technologies to the poor countries. When the same technology is available everywhere, then incomes would also tend to become equal over time because technology is an important ingredient of economic development.

Based on that argument, incomes would converge faster if a poor country is ready to use the advanced technology. If it has an educated work force and stable political and economic conditions, the technological spillover is more likely to occur. Conversely, if its education system and institutions are not well developed, the new technology cannot be adopted. The income of the country will lag behind the income of countries with better education and institutions.

Diminishing returns. The second reason is that investments in the rich countries are less profitable than investments in the poor countries. Think of it as follows. If an accounting firm (in a rich country) has 10 computers, one more computer will make little difference. If an accounting firm (in a poor country) has no computers at all, then buying one computer would make a big difference. The investment in that first computer would pay off handsomely. Therefore, international investment would flow primarily from the rich countries to the poor countries where profits are greater. This inflow of investment will make poor countries richer.

However, returns could also be increasing, instead of diminishing. In the example above, if the firm has many computers and much experience using them, an additional computer will be put to good use. If it has only one computer, then it may not know what to do with it. In that version of the story, adding investments to already rich firms or countries is more profitable. Then, investment flows to them and makes them even richer. Incomes around the world diverge instead of converging.

What is the evidence? There is income convergence across countries that are already fairly affluent. For example, incomes have converged significantly in the European Union and other rich countries in North America and elsewhere. Looking more broadly, there is no evidence that the incomes of poor countries in Africa, Latin America and elsewhere have gained relative to the rich countries. In fact, when it comes to the poorest countries, there has even been some income divergence.

5. What factors determine if an economy grows rapidly?

A vast number of economic analyses have identified the following factors for economic development: rule of law, education, international trade, and financial development.

Rule of law

In countries with strong rule of law:

- Property rights over land, equipment, and personal items are clear.
- The property rights are protected by law.
- Contracts between people, businesses, and the government can be enforced legally.
- Business regulations are clear and enforced in a transparent manner.

In such environments people make long-term investments and build large organizations. In contrast, if the property rights and contracts are not enforced and the business regulations are not clear, most of the economy consists of small family owned firms with little modern equipment. A high-tech, prosperous economy would not develop.
Recognizing the importance of the rule of law does not mean that we know how to improve it. Countries with weak legal systems and inefficient administration seem to be like that for decades, if not centuries. Although improvements are possible, they are painfully slow.

Education

Education contributes to economic development in many ways. An educated labor force can use new technologies raising the productivity and competitiveness of firms. Education is also essential for the creation of new technologies. A better educated labor force is more flexible and mobile. Economic studies across many countries and periods show that the greatest benefit for development comes from primary education. At that level, students become literate and develop basic math skills that allow them to participate in the economy. This raises their incomes and lowers income inequality. Increased access to higher levels of education is also important but the benefits are smaller. The benefits from strong higher education become important as countries approach the technological frontier and their development depends on producing new technologies. Better education also improves health outcomes and girl’s education in particular strengthens reproductive health. More broadly, better education helps strengthen the democratic processes and improve governance.

Various measures for education, such as the percent of teenagers who are enrolled in secondary schooling, are routinely included in statistical models that explain economic growth across countries and over time. The education variable is almost always “statistically significant”, i.e. there is substantial empirical evidence that education contributes to economic growth.

International trade

You can read our guide on international trade for a more comprehensive account of the issues surrounding it. Here we mention only the benefits from trade that are pertinent to our discussion on development.

- It allows firms to expand their markets and to increase sales. The greater scale of production lowers their cost and makes them more competitive.

- International trade exposes firms to international competition and forces them to adopt new technologies and practices to stay competitive.

- Foreign investment increases as foreign companies can open production facilities in one country and sell their products in other countries.

- The economy can concentrate on the types of products it is good at and import the rest. In that way its resources are used optimally.

- Firms can take advantage of cheaper imported goods for their production processes that make them more cost-effective.

Financial development

The "financial system" includes banks, stock markets, insurance companies, and other financial institutions. "Financial development" means that the financial system is fairly large and performs the important functions described below:

- It provides financing for large firms so they can expand their scale and implement complex technologies. That is possible as the financial system pools together the savings of various individuals and small firms and can finance large projects.
- It evaluates the prospects of different investments and allocates financing to the most promising ones. In that way, the available funds in the economy are put to good use.
- It monitors whether the funds are used prudently and as intended.
- It helps savers diversify risk. Banks and stock markets pool together the savings of thousands of individuals and invest them in many projects. That lowers the risk to individuals because the funds are spread out across many different investments.

Of course, the financial system may or may not perform well the functions described above. Sometimes, it channels too much money to poor investments and the result is a banking crisis. Similar to international trade, you can read our guide to the financial system for more information about these issues.

6. Virtuous and vicious cycles

The factors that drive economic development depend to a large extent on the level of economic development of a country. Richer countries can invest resources in strong legal, educational, and financial institutions that further promote economic development. In contrast, poor countries lack the resources to develop such institutions. We call these “virtuous” and “vicious” cycles of economic development.

Based on that logic, countries could be “jump-started” by an external entity, such as the World Bank or the European Union that provides funds to build institutions and improve education. One notable success story is the Marshall Plan that provided development assistance from the U.S. to Germany after World War II. It helped Germany rebuild its economy and get on a high economic growth track. Unfortunately, it is hard to come up with other equally successful cases. In most cased, external assistance has no effect on long-term economic growth as the money is not used effectively or its volume is not sufficient to make a radical change. Therefore, countries have to come up with internal ways to promote economic development and switch from a vicious to a virtuous cycle.

Additional resources

Human Development Index, an alternative and broader measure of welfare. Available from: http://hdr.undp.org/en/statistics/hdi/

World Development Report from the World Bank with information about every country and the world economy as a whole. Available from: econ.worldbank.org/

The World Bank website with abundant documents and data on economic development and poverty. Available from: www.worldbank.org

The United Nations Development Program with analyses and data on poverty and economic development issues. Available from: http://www.undp.org

Recommended academic readings (classics, advanced, with quite a bit of math)

Baumol, William. “Productivity Growth, Convergence, and Welfare.” American Economic Review, December 1986.

Sala-i-Martin, Xavier. “I Just Ran Four Million Regressions” National Bureau of Economic Research, Working paper 6252, 1997.

Romer, Paul. ”Increasing Returns and Long-Run Growth.“Journal of Political Economy, 1002-37, 1986.

Solow, Robert M. “Contribution to the Theory of Economic Growth. Quarterly Journal of Economics. 65-94, 1956.


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