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Mysteries of Growth

1.

The standard measure of a national economy’s overall performance is its real gross domestic product (GDP). This is just the sum of all the goods and services produced during the year (except those used up in further production), valued at going market prices and then corrected for price inflation. The graph on this page shows yearly real GDP per person in the population of the United States from 1948 to 2000.

Two characteristics stand out clearly from the graph. The first is a rising trend, the statistical image of economic growth. If you were to pencil in a smooth curve it would rise from about $11,000 in 1948 to about $34,000 in 2000, or at 2.19 percent a year on average. But the rate of growth is not constant; there are intervals of faster and slower growth (for instance from 1990 to 2000 and from 1973 to 1983). The second characteristic is that real GDP per person fluctuates within this larger trend in what are often called business cycles, though the fluctuations are not very regular. The existence of business cycles suggests that it would be more accurate to plot the trend through the cyclical peaks than through the midpoints. That would reflect the commonly accepted notion that real GDP is more often below the economy’s normal capacity to produce than above it. This second sort of trend, from peak to peak, is usually called the economy’s “potential” output: not an absolute limit, but a level of production that cannot be exceeded for long without strain and likely inflation.

The distinction between trend and fluctuations is not merely descriptive. They represent different mechanisms. The conventional wisdom—which I believe to be correct—takes the general upward trend to be driven mainly by factors on the supply side: by improvements in the education, training, and skills of workers; by technological innovation; and by increases in the stock of machinery and equipment per worker as well as the replacement of obsolete equipment with new versions adapted to the latest and most productive technology.1 Of course education, capital investment, and innovation are not elemental forces. They result from choices and respond to pecuniary and other incentives.

The short-term fluctuations, on the other hand, are driven primarily by demand-side forces: by changes in the willingness and ability of families and firms (and foreigners) to buy goods and services. When real GDP falls below potential, it is not because some factor has diminished the economy’s capacity to produce, but because producers and sellers cannot find enough willing buyers at the prices they are charging. (Do not leap to the conclusion that a round of price reductions would cure this problem. Lower prices would mean lower incomes generally, and perhaps the expectation of further price reductions. Both are likely to lead to a further weakening of demand. The result might be little or no improvement in economic conditions.)

This way of looking at the trend in economic growth and the fluctuations within it has implications for public policy. If the goal is to steepen the growth trend, then policy should be directed at improving skills (often described as investment in human capital), encouragement of research and development, and promotion of capital investment. If the goal is to end a recession, a short-term slowdown of economic growth, and move the economy closer to its potential output, then policy should aim to increase private and public spending on goods and services for private consumption, public purposes, and, once again, business investment, housing, and other durable goods.

That business investment can stimulate both short- and long-term growth is a reminder that demand-side and supply-side forces are not wholly independent of each other. Some kinds of demand add to potential output; others do not. For example, spending to build a new factory increases potential output but spending to build a recreation room does not; nor does dining in a restaurant. Some supply-side changes will stimulate demand, as when new technology induces firms to spend on up-to-date computers and induces families to increase their total spending, especially on new goods. Economics is full of such two-way chains of causation.

2.

The title of Jeff Madrick’s new book is Why Economies Grow, which suggests that it is mainly about the causes of the trend in growth: why it may be high or low, rising steeply or almost flat. But the subtitle is “The Forces That Shape Prosperity and How To Get Them Working Again,” and that sounds more like a tract on avoiding or limiting recessions. As I have already pointed out, there are connections between the two. The most important is that a chronically depressed economy may eventually put a damper on the search for new production technology and on the investment in new equipment that often goes along with it.

In fact, Madrick sometimes fails to be precise about the distinction between trend and fluctuations. This is hardly surprising: when you read in a newspaper that the economy “grew” last quarter at an annual rate of 4 percent, no one bothers to explain that some part of that increment represents a permanent rise in trend, while the rest marks a temporary upward movement in the business cycle. When Madrick, or anyone else, passes from one to the other without noticing, the result is occasional confusion, especially about the appropriate policies. But sometimes he hits a target that needs to be hit. This mixture of two themes causes trouble; but it allows the author to score some points.

The good moments occur, as you might expect, when Madrick validly insists that there are interactions between business cycle and growth trend, between the demand side and the supply side: for instance that businesses respond to demand by searching for new products, and that people try to equip themselves for jobs that are actually available. Some modern economists—the school is centered at the Universities of Chicago and Minnesota, but they are widely represented and respected—tend to (over)emphasize the self-balancing properties of the market economy, and like to play down the occurrence of persistent gaps between potential output and actual output. This allows them to claim that, on the whole, the economy follows the best path it can in the light of (a) the preferences of the inhabitants (with respect to work and leisure, and with respect to their present and future satisfactions) and (b) known technological possibilities.

For this school of thought, temporary aberrations in economic growth are the result either of unpredictable variations in tastes and technology or of misguided interventions by governments into the workings of the system in attempts to smooth fluctuations that cannot and should not be smoothed. Madrick is on strong ground when he urges that the development of the supply-side forces of human capital, physical capital, and technological progress are at least partially governed by necessarily political choices about public investment in infrastructure, education, and health care, and by the pressure of demand in expanding markets. I will come back to this.

The bad moments occur sometimes in attempts to find general principles about economic growth, and sometimes in inadequate or unproved analysis of more concrete aspects of the interplay between supply and demand. Several general questions are suggested by the title of the book: if we knew in any detail “why economies grow,” we would be close to holding the key to the economic universe.

Madrick seems to think, as a matter of principle, that there must be a single answer to the question. He writes as if there is necessarily a chain of causes and effects that can be written down from left to right; the task is to find the left-most item in this chain, what he sometimes calls the First Mover. This is altogether reminiscent of theological disquisitions. Causal chains in economics have a habit of doubling back on themselves. If there is a causal mechanism leading from A to B, there is very likely to be another one leading from B to A. (Malthus, for example, thought that high wages induced rising population, and also that a large population depressed wages.) Any attempt to work backward from right to left may very well end in such a web of mutual causation.

It is only fair to say that Madrick recognizes this in principle. There are sentences like: “In fact, many factors cause and enhance economic growth, and in turn affect each other.” Or again: “Most of these [a long list] are necessary conditions for growth…. All are both cause and consequence.”

But then one reads much sharper statements: “This book argues that the growth of markets…was the predominant factor in Western economic development.” Further: “…Market size and the dissemination of information are furthest left and are closest to first movers or true leaders. In addition, the first of these is the size and expansion of markets for goods and services.”

I am in the awkward position of thinking that the weak message is too weak and the strong message too strong. One important school in modern economics—the one I have already mentioned—seriously underplays the role of the demand side in economic growth. I take Madrick’s opposing message to be the strong one, but I think he does not get the balance right. The focus on market size is excessive.

With this starting point, Madrick interprets the standard theory of economic growth as a case of technological determinism. It has been found, as an empirical matter, that technological progress is the largest contributor to the upward trend of real GDP per person in modern industrial economies. Since many economists stop there, Madrick argues that they must regard technology as the First Mover. I think this overstates the case.

Particularly useful here is the economist’s concept of an “exogenous” variable, a factor whose effects are provisionally taken as given in order to limit the scope of an analysis. This device can work, provided that any causal chains leading from the things that are being analyzed—the “endogenous” variables—back to the exogenous variables are relatively weak. If I am studying the demand for restaurant meals, I will notice that it surely depends on—among other things—the degree of prosperity of the national economy. People eat out when they are flush. I know, of course, that the restaurant industry itself is one small contributor to that degree of prosperity; but the contribution is small enough for the error involved in neglecting it to be minor. For this reason, I can agree to take the degree of prosperity as exogenous, and therefore crucial for understanding the ups and downs of the restaurant industry as long as I am thinking about the market for restaurant meals. But that does not make it a First Mover. On the other hand, an analysis of the labor market, or even the automobile market, would have to be structured quite differently because what happens to jobs and wages, or what happens to car sales, has economy-wide effects that are too big to be neglected. In such cases we can’t take general prosperity as given.

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    I hasten to add that this use of the phrase has nothing to do with the pop notion of “supply-side economics.”

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