The mystery of economic growth

Well-known economist in 1994: “There are many economic puzzles, but there are only two really great mysteries. One of these mysteries is why economic growth takes place at different rates over time and across countries. Nobody really knows why….”

Same economist in 2013: “The reasons some countries grow more successfully than others remain fairly mysterious….”

I agree. When it comes to rich nations, we have very little clue about what yields faster economic growth over the medium to long run.

From the mid-1940s through the early 1970s, the American economy enjoyed healthy growth. But then the economy sputtered for a decade — a deep downturn in 1973-75, followed by high unemployment and inflation, followed in turn by a double-dip recession in 1980 and 1981-82. Academics and policy makers were befuddled.

The changed context spurred a slew of recommendations for how to rejuvenate the economy. The right blamed government overreach. Taxes, regulations, Keynesian demand management, and welfare state generosity had gone too far, in this view.

The left offered up myriad solutions of its own, including industrial policy, managed trade, a stakeholder-centered financial system, flexible specialization, lean production, corporatist partnerships between business, labor, and government, and collaboration between and within firms. In the mid-to-late 1990s, a Clinton-Reich-Rubin-Sperling approach embraced some of these ideas but emphasized education and skill development, free trade, and a commitment to balance the government budget during economic upswings. Like the “Third Way” orientation championed by Anthony Giddens and Tony Blair in the United Kingdom, adherents aimed to reconcile traditional left concerns for justice and fairness with an emphasis on economic growth.

As it turned out, America’s economic growth from 1979 to 2007 (peak to peak) was pretty healthy. It was slower than during the post-World War II “golden age.” But that isn’t surprising; growth was especially rapid in those years because it had been so slow in the 1930s and because so much of the industrial capacity in western Europe and Japan was destroyed during the war. U.S. GDP per capita grew at a rate of 1.9% per year between 1979 and 2007. That’s right on the long-run trend; the American economy’s average growth rate from 1890 to 2007 was 1.9%. The U.S. also did well in 1979-2007 compared to 19 other rich longstanding democracies. Adjusting for catch-up (nations that begin poorer grow more rapidly because they can borrow technology from the leaders), America’s growth rate was third best.

Unfortunately, we know very little about why. Was it due to the U.S. economy’s traditional strengths, such as its large domestic market and its array of large firms with established brands? To its strong universities and R&D, which keyed a successful transition to a high-tech service economy? To deregulation, tax cuts, and wage stagnation? To the adoption of some of the strategies proposed by the pro-growth progressives? To stimulative monetary policy (after the early 1980s)? To stock market and housing bubbles? To something else? We don’t know.

Nor do social scientists have a compelling explanation for why some rich nations have grown more rapidly than others in recent decades. We know that catch-up matters. Limited product and labor market regulations and participation by business and labor in policy making seem to help, but they account for only a small portion of the country differences in economic growth between 1979 and 2007. Even education seems to have played little role. Growth hinges on technological progress, which should be boosted by education, particularly in the modern knowledge-driven economy. Yet across the rich countries, those with higher average years of schooling, larger shares of university graduates, or faster increase in educational attainment have not grown more rapidly than others since the 1970s. (I’m not yet sure what I make of this.)

An interesting and perplexing piece of the growth puzzle is the tendency of countries to do well for a while and then falter. In the past half century, any number of national models have gone in and out of fashion, first surging and then falling back.

Economic growth is important. Yet for affluent countries, our knowledge about what causes faster or slower growth is very thin. It’s pretty remarkable, not to mention unfortunate.

7 thoughts on “The mystery of economic growth

  1. much of modern growth theory ranging from aghion to prescott is about why some rich nations have grown more rapidly than others in recent decades

    aghion attributes the slow down in growth in the EU after 1990 to a failure to make a transformation from imitation-based to innovation-based policy regimes and institutions.

    prescott blames taxes. Aghion rarely mentions taxes.

    prescott also mentioned barriers to the adoption of new technologies. he also mentions that difference that the timing of joining the EU made to relative growth rates across europe

  2. We might consider the role of cheap oil. The first well in 1859 struck oil at 69 feet. Now we have to drill miles under the ocean. There is less energy return on investment.

  3. I’d really love to see wealth (in)equality added to the list of independent variables in your Oxford Handbook article. I took a little freshman-level look at it here:

    Finding that wealth equality seems to have a strong correlation with long-term growth (the longer the lags, the larger the correlation).

    But I’d really love to see the kind of truly competent look at it (i.e., including convergence correction just for a start) that we find in your Oxford piece.

    I’d also really love to see median after-tax, after-transfer income used as the dependent variable, since it’s a pretty good measure of general national well-being…

    Any research out there that does a good job of this analysis?

  4. Steve: Good questions. I don’t think we have enough reliable cross-country wealth data to do a useful analysis. On median household income as the outcome: my inclination is to examine the determinants of GDP per capita growth and then the determinants of growth’s impact on median household income.

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