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Chapter 7 147
Economic Growth: Theory and Policy



Ironically, the villain of the piece is actually the economy™s strong productivity
growth. If manufacturing and telecommunications workers had not become more pro-
ductive over time, their real wages would not have risen. In that case, the real wages of
teachers and doctors would not have had to keep pace, so their services would not have
grown ever more expensive. Paradoxically, the enormous productivity gains that have
blessed our economy and raised our standard of living also account for the problem of
rising tuition costs. In the most literal sense, we are the victims of our own success.




GROWTH IN THE DEVELOPING COUNTRIES6
Ernest Hemingway once answered a query of F. Scott Fitzgerald™s by agreeing that, yes,
the rich are different”they have more money! Similarly, whereas the main determinants
of economic growth”increases in capital, improving technology, and rising workforce
skills”are the same in both rich and poor countries, they look quite different in what is
often called the Third World. This chapter has focused on growth in the industrialized
countries so far. So let us now review the three pillars of productivity growth from the
standpoint of the developing nations, using China as the most outstanding recent exam-
ple of success.


The Three Pillars Revisited
Capital We noted earlier that many poor countries are poorly endowed with capital.
Given their low incomes, they simply have been unable to accumulate the volumes of
business capital (factories, equipment, and the like) and public capital (roads, bridges, air-
ports, and so on) that we take for granted in the industrialized world. In a super-rich
country like the United States, $150,000 or more worth of capital stands behind a typical
worker, while in a poor African country the corresponding figure may be less than $500.
No wonder the American worker is vastly more productive than his African counterpart.
Development assistance
But accumulating more capital can be exceptionally difficult in the developing world.
(“foreign aid”) refers to out-
We noted earlier that rich countries have a choice about how much of their resources to right grants and low-interest
devote to current consumption versus investment for the future. But building capital for loans to poor countries
the future is a far more difficult task in poor countries, where much of the population from both rich countries
may be living on the edge of survival and have little if anything to save for the future. and multinational institu-
tions like the World Bank.
For this reason, it has long been believed that development assistance, sometimes called
The purpose is to spur
foreign aid, is a crucial ingredient for growth in the developing world. Indeed, the World
economic development.
Bank was established in 1944 precisely to make low-interest development loans to poor
countries. Foreign direct
Development assistance has always been controversial. Critics of foreign aid argue that investment is the purchase
or construction of real
the money is often not well spent. Without honest and well-functioning governments,
business assets”such as
well-defined property rights, and so on, they argue, the developing countries cannot and
factories, offices, and
will not make good use of the assistance they receive. Supporters of foreign aid counter
machinery”in a foreign
that the donor countries have been far too stingy. The United States, for example, donates country.
only about 0.1 percent of its GDP each year. Can grants that amount to $60 per person”
Multinational
which is a fairly typical figure for the recipient countries”really be expected to make
corporations are corpora-
much difference?
tions, generally large ones,
While foreign aid can be critical in certain instances, it has certainly not been the secret to
that do business in many
China™s success. Instead, the Chinese have shown a remarkable willingness and ability to countries. Most, but not all,
save and invest”nearly half of GDP in recent years”despite their relatively low incomes. of these corporations have
In addition, China has welcomed foreign direct investment, often by multinational their headquarters in
corporations, which it has received in great volume. developed countries.




This section can be skipped in shorter courses.
6




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148 The Macroeconomy: Aggregate Supply and Demand



Technology You need only visit a poor country to see that the level of technology is
generally far below what we in the West are accustomed to. In principle, this handicap
should be easy to overcome. As noted in our discussion of the convergence hypothesis,
people in poor countries don™t have to invent anything; they can just adopt technologies
that have already been invented in the rich countries. And indeed, a number of formerly
poor countries have followed this strategy with great success. South Korea, which was
destitute in the mid-1950s, is a prime example. China is doing this today. Indeed, much of
the foreign direct investment flowing into China brings Western technology along with it.
But as we observed earlier, many of the developing nations, especially the poorest ones,
seem unable to join this “convergence club.” They may lack the necessary scientific and en-
gineering know-how. They may be short on educated workers. They may be woefully un-
dersupplied with the necessary infrastructure, such as transportation and communications
systems. Or they may simply be plagued by incompetent or corrupt governments. What-
ever the reasons, they have been unable emulate the technological advances of the West.
There are no easy solutions to this problem. One common suggestion is to encourage
foreign direct investment by multinational corporations. Industrial giants like Toyota
(Japan), IBM (United States), Siemens (Germany), and others bring their advanced tech-
nologies with them when they open a factory or office in a developing nation. They can
train local workers and improve local transportation and communications networks. But,
of course, these companies are foreign, and they come to make a profit”both of which may
cause resentment in the local population.
For this and other reasons, many developing countries have not always welcomed for-
eign investment. China, as mentioned above, is a big exception: It has welcomed foreign
investment with enthusiasm, especially for the technology it brings, and it has learned
avidly and openly from the West. However, multinational companies are rarely tempted
to open factories in the poorest developing countries, such as those in sub-Saharan Africa,
where skilled labor is in short supply, transportation systems may be inadequate, and
governments are often unstable and unreliable.

Education and Training Huge discrepancies exist between the average lev-
TA BL E 4
els of educational attainment in the rich and poor countries. Table 4 shows some
Average Educational Attainment
data on average years of schooling in selected countries, both developed and de-
in Selected Countries, 2000*
veloping. The differences are dramatic”ranging from a high of 12.3 years in the
United States 12.3
United States to less than 5 years in India and less than 2 years in the Sudan. In
Canada 11.4
South Korea 10.5 most industrialized countries, universal primary education and high rates of high
Japan 9.7 school completion are already realities. But in many poor countries, even com-
United Kingdom 9.4
pleting grade school may be the exception, leaving rudimentary skills such as
Italy 7.0
reading, writing, and basic arithmetic in short supply. In such cases, expanding
Mexico 6.7
and improving primary education”including keeping children in school until
India 4.8
Brazil 4.6 they reach the age of 12”may be among the most cost-effective growth policies
Sudan 1.9 available. The problem is particularly acute in many traditional societies, where
women are second-class citizens”or worse. In such countries, the education of
* For people older than 25 years of age
girls may be considered unimportant or even inappropriate.
SOURCE: Web site accompanying R. Barro and
J.-W. Lee, “International Data on Educational
China, again, offers a stunning contrast. It is raising the educational attainment
Attainment: Updates and Implications,” CID
of its population rapidly. It is sending legions of students abroad to study science,
Working paper No. 42, Harvard University,
2000, http://www.cid.harvard.edu/ciddata/
engineering, business, and economics (among other things). And it is seeking to
ciddata.html.

develop world-class universities of its own.

Some Special Problems of the Developing Countries
Accumulating capital, improving technology, and enhancing workforce skills are common
ingredients of growth in rich and poor countries alike. But many Third World countries also
must contend with some special handicaps to growth that are mostly absent in the West.

Geography Americans often forget how blessed we are geographically. We live in a
temperate climate zone, on a land mass that has literally millions of acres of flat, fertile



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Chapter 7 149
Economic Growth: Theory and Policy



land that is ideal for agriculture. The fact that our nation literally stretches “from sea to
shining sea” also means we have many fine seaports. Contrast this splendid set of geo-
graphical conditions with the situation of the world™s poorest region: sub-Saharan Africa.
Many African nations are landlocked, have extremely hot climates, and/or are terribly
short on arable land.

Health People in the rich countries rarely think about such debilitating tropical dis-
eases as malaria. But they are rampant in many developing nations, especially in Africa.
The AIDS epidemic, of course, is ravaging the continent. Although improvements in pub-
lic health are important in all countries, they are literally matters of life and death in the
poorest nations. And there is a truly vicious cycle here: Poor health is a serious impedi-
ment to economic growth, and poverty makes it hard to improve health standards.

Governance Complaining about low-quality or dishonest government is a popular
pastime in many Western democracies. Americans do it every day. But most governments
in industrialized nations are paragons of virtue and efficiency compared to the govern-
ments of some (though certainly not all) developing nations. As we have noted in this
chapter, political stability, the rule of law, and respect for property rights are all crucial re-
quirements for economic growth. By the same token, corruption and overregulation of
business are obvious deterrents to investment. Lawlessness, tyrannical rule, and war are
even more serious impediments. Unfortunately, too many poor nations have been victim-
ized by a succession of corrupt dictators and tragic wars. It need hardly be said that those
conditions are not exactly conducive to economic growth.




FROM THE LONG RUN TO THE SHORT RUN
Most of this chapter has been devoted to explaining and evaluating the factors underpin-
ning the growth rate of potential GDP. Over long periods of time, the growth rates of ac-
tual and potential GDP match up pretty well. But, just like people, economies do not
always live up to their potential. As we observed in the previous chapter, GDP in the
United States often diverges from potential GDP as a result of macroeconomic fluctua-
tions. Sometimes it is higher; sometimes it is lower. Indeed, whereas this chapter has stud-
ied the factors that determine the rate at which the GDP of a particular country can grow
from one year to the next, we know that GDP occasionally shrinks”during periods we call
recessions. To study these fluctuations, we must supplement the long-run theory of aggre-
gate supply, which we have just described, with a short-run theory of aggregate demand”
a task that begins in the next chapter.



| SUMMARY |
1. More capital, improved workforce quality (which is nor- change, rapid growth of demand, and a climate of polit-
mally measured by the amount of education and train- ical stability that respects property rights. Each of these
ing), and better technology all raise labor productivity factors is at least influenced by policy.
and therefore shift the production function upward. 4. Policies that increase education and training”the second
They constitute the three main pillars of growth. pillar of growth”can be expected to make a country™s
2. The growth rate of labor productivity depends on the workforce more productive. They range from universal
rate of capital formation, the rate of improvement of primary education to postgraduate fellowships in sci-
workforce quality, and the rate of technical progress. So ence and engineering.
growth policy concentrates on speeding up these 5. Technological advances can be encouraged by more edu-
processes. cation, by higher rates of investment, and also by direct
3. Capital formation can be encouraged by low real inter- expenditures”both public and private”on research
est rates, favorable tax treatment, rapid technical and development (R&D).



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Licensed to:
Part 2
150 The Macroeconomy: Aggregate Supply and Demand



6. The convergence hypothesis holds that countries with handicraft activities that are not amenable to labor-sav-
lower productivity levels tend to have higher productiv- ing innovations, they suffer from a cost disease that
ity growth rates, so that poor countries gradually close makes them grow ever more expensive over time.
the gap on rich ones. 11. The same three pillars of economic growth”capital,
7. One major reason to expect convergence is that techno- technology, and education”apply in the developing
logical know-how can be transferred quickly from the countries. But on all three fronts, conditions are much
leading nations to the laggards. Unfortunately, not all more difficult there”and improvements are harder to
countries seem able to benefit from this information obtain.
transfer. 12. The rich countries try to help with all three pillars by
8. Productivity growth slowed precipitously in the providing development assistance, and multinational
United States around 1973, and economists are still not corporations sometimes provide capital and better tech-
sure why. nology via foreign direct investment. But both of these
mechanisms are surrounded by controversy.
9. Productivity growth in the United States has speeded up
again since 1995, largely as a result of the information 13. Growth in many of the poor countries is also held back
technology (IT) revolution. by adverse geographical conditions and/or corrupt
governments.
10. Because many personal services”such as education,
medical care, and police protection”are essentially



| KEY TERMS |
Human capital 136 On-the-job training 141 Development assistance 147
Convergence hypothesis 137 Invention 142 Foreign direct investment 147
Capital 138 Innovation 142 Multinational corporations 147
Investment 138 Research and development
(R&D) 142
Capital formation 138
Cost disease of the personal

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