Hopefully, you enjoyed the last article on growth and consumerism and were waiting for this article. If not, please do skim through the article “Consumerism driving growth?” since this is where we started our conversation about growth.
This article will provide you with a framework for a better understanding of growth and its components. It is based on an article published by INSEAD, which you can consult in the sources if you would like a detailed version of what’s summarized here.
The essence of economic growth for all economic entities over the world are innovation, initial conditions, investments, and institutions, which you might want to memorize as the 4 I’s of growth.
Innovation, also known as the technological frontier, is our capacity to invent new technologies, new products as well as new management forms and new types of organisations (such as open offices for example). The most advanced stages of these innovations define the world technological frontier.
Initial conditions: countries on this frontier enjoy the highest production per worker. History shows that countries reaching the technological frontier tend to converge to a similar growth rate of about 1,85% over the last century, while countries further from the technological frontier tend to grow faster. Notice that convergence can only happen in an environment where technology and goods can flow freely between countries (Isn’t it, Donald?). One might ask if this is going to last forever in a world of finite resources… We will try to give a lead to explore this issue in the next article. For now, let’s keep it to the framework.
Growth, as we know, should come from increases in productivity or increases in inputs. Bigger factories or new technologies all come from investment. Thus, a country that grows fast enjoys, among others, high investment rates. It has been shown that countries with low levels of capital and productivity grow faster when more capital is added. Intuitively, you can grasp the idea that a country with a lot of workers without the proper equipment will grow much faster (aka increases its productivity) once the workers benefit of the equipment, paid by the additional capital. Interestingly, only a small percentage of the capital invested in those “developing countries” comes from abroad. Usually, it is the country itself that provides the capital. Foreigners are responsible for the transfer of knowledge.
Until now, making your economy grow seems to be quite straight forward since it is just a matter of investment and innovation. But, as stated in the INSEAD paper, there are at least 3 reasons why reality isn’t that rosy. The first reason was stated in my last article and can be summarized as follows: consuming more leads to investing less, and if the agent is too close to the level of subsistence, investing is not appealing at all, since it may threaten today’s survival. Secondly, the government might divert the flow of capital to the wrong recipients for the wrong reasons, such as pride or closed-mindedness. Governmenst should not interfere too much with the markets; they should rather watch over the health of the economic ecosystem. The third reason is linked to the second and concerns the environment for doing business. Ultimately, every investment decision is a balance between risk and return, and these are highly linked to the institutional framework (legal, political, and economic institutions as well as social norms and culture). For example, a country with weak legal institutions and blurry property rights raises the risk of the investment tremendously. Check out the World Bank database to look at which countries are good to do business with.
In summary, for any given country, initial conditions are predetermined, but the institutional framework can be improved by government efforts, which will in turn encourage investment and incentivize innovations.