Long-Run Economic Growth

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1 Long-Run Economic Growth

2 Economic Growth Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things. ~Adam Smith

3 Economic Growth: Background Economic growth increases in real GDP per capita For most of human history, no sustained increases in output per capita occurred, and the lives of most people were poor, nasty, brutish, and short-lived (Thomas Hobbs).

4 Economic Growth: Background Sustained economic growth first began with the Industrial Revolution in England in the late 18 th century. Due to sustained economic growth, you live in a world that is very different than the world of your grandparents when they were young. The difference between you and a person in a poor country is that you live in a country that has sustained economic growth

5 Economic Growth from 1,000,000 B.C. to 1300 A.D. In 1,000,000 B.C., Bradford DeLong estimated that the GDP per capita was about $140 year the minimum amount necessary to sustain to life. In 1300 A.D., DeLong estimated that worldwide GDP per capita was still $140. For most of human history, the typical person had only the bare minimum of food, clothing, and shelter necessary to sustain life and few people survived beyond the age of 40.

6 Industrial Revolution Significant growth didn t occur until the 19 th century as a result of the Industrial Revolution which started in England around Industrial Revolution application of mechanical power to the production of goods. Before this, the production process relied upon human or animal power. Spinning jenny, water frame, steam engine.

7 Why England? The Industrial Revolution is a turning point in human history, but why did it begin in England and not elsewhere? There is no consensus, but Douglas North argues that institutions in England differed significantly from those in other countries which promoted economic growth. Glorious Revolution of 1688 limited monarchial powers and established a Bill of Rights. The monarch could no longer suspend laws, levy taxes, make royal appointments, or maintain a standing army during peacetime without Parliament's permission. It put Britain on the path towards constitutional monarchy and parliamentary democracy.

8 Why England? By upholding private property rights, protecting wealth, and eliminating arbitrary tax increases, these institutional changes gave entrepreneurs the incentive to make the investments necessary to implement technological developments, particularly the spinning jenny and water frame. Without these institutional changes, entrepreneurs would have been reluctant to risk their property or wealth by starting a new business.

9 Why England? Although not all economists agree with North s specific argument about the Ind. Rev., most economists agree that economic growth is unlikely to occur without the institutional framework described by North.

10 Three Industrial Revolutions IR #1 (steam, railroads) from 1750 to IR #2 (electricity, internal combustion engine, running water, indoor toilets, communications, entertainment, chemicals, petroleum) from 1870 to IR #3 (computers, the web, mobile phones) from 1960 to present. IR #2 was more important than the others and was largely responsible for 80 years of relatively rapid productivity growth between 1890 and In contrast, IR #3 created only a short-lived growth revival between 1996 and Source:

11 Economic Growth from 1,000,000 B.C. to the Present Growth rates for the entire world Time Span 1 million B.C. to 1300 A.D. 0% 1300 to % 1800 to % 1900 t % Rates of long-run growth in real gdp per capita

12 Small Differences in Growth Rates Matter The difference between 1.3% and 2.3% may seem trivial, but over long periods of time, small differences in growth rates have significant impacts. FV = PV(1 + i) t Lets assume that you invest $100 at either 1.3% or 2.3% (or that an economy initially has a GDP of 100 and grows at either 1.3% or 2.3%)

13 Small Differences in Growth Rates Matter Interest (or growth) rate Number of time periods (in years) Future value Interest (or growth) rate Number of time periods (in years) Future value

14 Small Differences in Growth Rates Matter An economy that took off at 1900 and grew 2.3% compared to an economy that stagnated in 1900 and only grew at 1.3%, would have an economy 2.67 times larger. That would be roughly comparing the US whom has a GDP per capita of $48,147 to Croatia whom has a GDP per capita of $18,338.

15 Argentina vs. Italy In 1950, Argentina had a real GDP per capita of $5,474 (measured in 2005 dollars) that was larger than Italy s of $5,361. Over the next 60 years, Argentina grew on average of 1.4% while Italy averaged 2.8%. In 2010, Argentina had a GDP per capita of only $12,931 while Italy had risen to $27,930.

16 Is Income All That Matters? No, many sub-saharan countries who have a GDP per capita under $1,000 have made significant improvements over the years in health, education, democracy, and political stability. Some increases in standard of living do not require increases in income and rely on technology and knowledge, such as mosquito nets and inexpensive vaccines. However, increases in standard of living are limited without rising incomes.

17 What Makes Workers More Productive? Labor productivity depends upon Quantity of capital per hour worked Level of technology Human capital Labor Productivity = Real GDP Aggregate hours

18 Three Main Sources of Technological Change 1. Better Machinery and Equipment from the steam engine to improvement in computers. 2. Increases in Human Capital through education, experience, and training 3. Better Means of Organizing and Managing Production

19 The Per-Worker Production Function We can illustrate economic growth with the perworker production function The relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant. ***STOP: Per-worker production function***

20 New Growth Theory The neoclassical growth model fails to explain how or why technological change occurs, which led to the rise of the endogenous growth model in the 1980 s. Model of long-run economic growth that emphasizes that technological change (human capital, innovation, and knowledge) is influenced by economic incentives.

21 New Growth Theory Firms have an incentive to implement technological change in a market economy. However, knowledge capital is nonrival and nonexcludable, which may lead to the free rider problem. Since knowledge is nonrival and nonexcludable, it is a public good and a type of market failure.

22 New Growth Model Gov t policy can help increase the accumulation of knowledge capital Protecting intellectual property with patents and copyrights Subsidizing research and development Subsidizing education

23 New Growth Theory and Schumpeter's Creative Destruction Entrepreneurs unleash a gale of creative destruction that drives old products and often the firms who produced them out of the market. The profit motive is the incentive.

24 Growth Rates in the US Years Growth % % % % %

25 Economic Growth in the US From 1950 to 1972, technological change allowed the US economy to avoid the diminishing returns to capital that stifled growth in the Soviet economy. Then for two decades, beginning in 1973, labor productivity slowed and didn t pick back up to the mid 1990 s. Mid 1990 s experienced technological change in electronics, computing, and telecommunications.

26 What caused the slowdown? Several explanations, but none are satisfactory Labor productivity only appears to have slowed down. Problems measuring the economic transition from a manufacturing economy to a service-oriented economy. Measurement problems in improvement in health and safety. During this time, new laws required firms to spend billions of dollars in reducing pollution, improving workplace safety, and redesigning products to make them more safe. This may have increased overall well-being, but reduced output.

27 What caused the slowdown? The oil shocks of 1973 and 1979, which increased the cost of production. Energy-reliant industries, such as pipelines, oil and gas extraction, automobile repair services experienced the largest slowdowns in productivity. The baby boomers entered the workforce and had marginal managerial skills of lower quality. As managers aged and become more experience, labor productivity increased.

28 US Labor Productivity: Broken Down Output per hour Contribution of Capital Contribution of Labor (Human Capital) Contribution of Technology

29 Why isn t the Whole World Rich? The neoclassical growth model shows that poor countries will grow faster than rich countries since: (i) they have the greatest returns to increased capital and (ii) can piggy-back off of technology developed by rich countries. Has this catch-up or convergence occurred? Catch-up hypothesis the prediction that the level of GDP per capita in poor countries will grow faster than rich countries.

30 Have the World s Economies Converged or Diverged? From , the global economy has seen a divergence, not a convergence. In 1870, rich countries had 9 times the GDP per capita than poor countries. By 1990, that ratio increased to 45 to 1. Ratio of per capita GDP: Richest and Poorest Countries Year Rich Countries Poor Countries

31 What Happened? Many countries were stuck at the starting gate and never took off. These countries were stuck with an economy of persistent subsistence. However, countries that did grow; there was catch up growth.

32 What Happened? However, from 1990 to early 2000 s, less developed started to catch up and during this time, the economic gap closed. High Income Countries 2.5% Middle Income Countries 3.2% Low Income Countries 4.3% Average GDP growth rates from 1990 to early 2000 s

33 Starting Points Matter Even though low income countries caught up during this time, starting points matter. For example: Country A starts off with $500 GDP per capita, grows for 8%, at the end of 40 years GDP per capita ~$11,000 Country B starts off with $30,000 GDP per capita, grows for 2%, at the end of 40 years GDP per capita ~$66,000. Even though a 60:1 ratio went to a 6:1 multiple, there are still huge differences.

34 What Prevents Low-Income Countries from Rapid Growth? There is no single answer, but some common factors are: Failure to enforce the rule of law Wars and revolutions Poor public health and education Low rates of savings and investment

35 What Prevents Low-Income Countries from Rapid Growth? Failure to Enforce the Rule of Law Well-defined and enforceable property rights and contracts make entrepreneurs feel safe in taking risks with their property to start businesses. Many poor countries lack a functioning legal system. In some countries, the legal system is filled with bribery and political favoritism. Many poor countries have experienced capital flight to developed countries due to corruption and economic difficultiese. There are less returns to capital in developed countries, but it is a safer investment.

36 Corruption and Parking Tickets Two economists, Fisman and Miguel, looked at parking violations received by UN delegates in NYC. Under international law, UN delegates cannot be prosecuted for violating US laws, including parking violations. Fisman and Miguel found that delegates from the most corrupt nations had 15 time more parking violations than the delegates from the least corrupt nations. (The most corrupt nations were significantly poorer).

37 What Prevents Low-Income Countries from Rapid Growth? Wars and Revolution Many poor countries have experienced extended periods of war and civil unrest, such as Afghanistan, Angola, Ethiopia, Central African Republic, Congo, and Mozambique.

38 What Prevents Low-Income Countries from Rapid Growth? Human capital is one of the main determinants of labor productivity Many poor countries have poor educational systems and many workers struggle to read and write. Many low-income countries suffer from diseases that are non-existent in developed countries. Only a few people in developed countries suffer from malaria while over more than 1 million Africans die from it each year.

39 What Prevents Low-Income Countries from Rapid Growth Low Rates of Savings and Investment Poor financial systems in the low-income countries which makes it hard for banks to match up savers with borrowers. Plus, it is difficult to save when you are living in abject poverty where the average GDP per capita can be under $1,000 a year. How does one save off that?

Chapter 10: Long-run Economic Growth: Sources and Policies

Chapter 10: Long-run Economic Growth: Sources and Policies Yulei Luo SEF of HKU February 13, 2012 Learning Objectives 1. Define economic growth, calculate economic growth rates, and describe trends in