The Renaissance of Economic Growth Research
There is no doubt that one very important consequence arising from the work
of Keynes was that it led to a shift of emphasis from the classical long-run
issue of economic growth to the shorter-run issue of aggregate instability. As
Tobin (1997) emphasizes, Keynesian economics does not pretend to apply to
the long-run issues of growth and development. This is in sharp contrast to
the work of Adam Smith, David Ricardo and the other classical economists
who sought to understand the nature and causes of the ‘Wealth of Nations’
rather than focus on the issue of short-run instability. This should hardly
surprise us given the rapid self-equilibrating properties of the classical macroeconomic
model (see Chapter 2).
Even small differences in growth rates of per capita income, if sustained
over long periods of time, lead to significant differences in relative living
standards between nations. The importance of economic growth as a basis for
improvements in human welfare cannot be overstated because the impact of
even small differentials in growth rates, when compounded over time, are
striking (see Chapter 11). Barro and Sala-i-Martin (1995) provide a simple
but illuminating example of the long-term consequences of growth differentials.
They note that the US economy grew by an annual average of 1.75 per
cent over the period 1870–1990 thereby raising real GDP per capita from
$2244 in 1870 to $18 258 in 1990 (measured in 1985 dollars). If growth over
the same period had been 0.75 per cent, real GDP per capita in 1990 would
have been $5519 rather than $18 258. If, on the other hand, growth had been
2.75 per cent, then real GDP per capita in the USA by 1990 would have been
$60 841. Note how this amazing difference in outcomes arises from relatively
small variations in the growth rate. David Romer (1996) has also expressed
the same point succinctly as follows: ‘the welfare implications of long-run
growth swamp any possible effects of the short-run fluctuations that macroeconomics
traditionally focuses on’. In reviewing the differential growth
performances of countries such as India, Egypt, the ‘Asian Tigers’, Japan and
the USA, and the consequences of these differentials for living standards,
Lucas (1988) comments that ‘the consequences for human welfare involved
in questions like these are simply staggering. Once one starts to think about
them, it is hard to think about anything else.’ For some economists, such as
Prescott (1996), the renewed interest in growth over the last 20 years stems
from their belief that business cycle fluctuations ‘are not costly to society’
and that it is more important for economists to worry about ‘increasing the
rate of increase in economy-wide productivity and not smoothing business
fluctuations’. This position had been publicly expressed earlier by Lucas in
May 1985 when delivering his Yrjo Jahnsson lectures. There he argued that
post-1945 economic stability had been a relatively ‘minor problem’ especially
in comparison ‘to the costs of modestly reduced rates of growth’
(Lucas, 1987). More recently, Lucas (2003) has repeated this message using
US performance over the last 50 years as a benchmark. Lucas argues that ‘the
potential for welfare gains from better long-run, supply-side policies exceeds
by far the potential from further improvements in short-run demand management’.
Given the significant adverse impact that poor growth performance has on
economic welfare and the resultant importance attached to growth by economists,
it is perhaps surprising that the research effort in this field has been
cyclical. Although growth issues were a major concern of the classical economists,
during the period 1870–1945 economists’ research was heavily
influenced by the ‘marginalist revolution’ and was therefore predominantly
micro-oriented, being directed towards issues relating to the efficient allocation
of given resources (Blaug, 1997). For a quarter of a century after 1929–33,
issues relating to the Great Depression and Keynes’s response to that event
dominated discussion in macroeconomics.
As we shall discuss in Chapter 11, in the post-1945 period there have been
three waves of interest in growth theory (Solow, 1994). The first wave focused
on the neo-Keynesian work of Harrod (1939, 1948) and Domar (1947).
In the mid-1950s the development of the neoclassical growth model by
Solow (1956) and Swan (1956) stimulated a second more lasting and substantial
wave of interest, which, after a period of relative neglect between
1970 and 1986, has been reignited (Mankiw et al., 1992). Between 1970 and
1985 macroeconomic research was dominated by theoretical issues relating
to the degeneration of the orthodox Keynesian model, new equilibrium theories
of the business cycle, supply shocks, stagflation, and the impact of
rational expectations on macroeconomic modelling and policy formulation.
Although empirical growth-accounting research continued (for example
Denison, 1974), research on the theoretical front in this field ‘effectively
died’ in the 1970–85 period because economists had run out of ideas.
The third wave, initiated by the research of Paul Romer and Robert Lucas,
led to the development of endogenous growth theory, which emerged in
response to theoretical and empirical deficiencies in the neoclassical model.
During the 1980s several factors led to a reawakening of theoretical research
into the growth process and new directions in empirical work also began to
develop. On the theoretical front Paul Romer (1986) began to publish material
relating to his 1983 University of Chicago PhD thesis. In the same year,
1986, Baumol and Abramovitz each published highly influential papers relating
to the issue of ‘catch-up and convergence’. These contributions were
soon followed by the publication of Lucas’s 1985 Marshall lectures given at
the University of Cambridge (Lucas, 1987). This work inspired the development
of a ‘new’ breed of endogenous growth models and generated renewed
interest in empirical and theoretical questions relating to long-run development
(P.M. Romer, 1994a; Barro, 1997; Aghion and Howitt, 1998; Jones,
2001a). Another important influence was the growing awareness that the data
suggested that there had been a slowdown in productivity growth in the post-
1973 period in the major OECD economies (P.M. Romer, 1987a).
In the eighteenth and nineteenth centuries growth had been largely confined
to a small number of countries (Pritchett, 1997; Maddison, 2001). The
dramatic improvement in living standards that has taken place in the advanced
industrial economies since the Industrial Revolution is now spreading
to other parts of the world. However, this diffusion has been highly uneven
and in some cases negligible. The result of this long period of uneven growth
is a pattern of income per capita differentials between the richest and poorest
countries of the world that almost defies comprehension. Much of the motivation
behind recent research into economic growth derives from concern about
the origin and persistence of these enormous cross-country inequalities in
income per capita. The origin of this ‘Great Divergence’ in living standards
has always been a major source of controversy among economic historians
(Pomeranz, 2000). Recently, this issue has also captured the imagination of
economists interested in providing a unified theory of growth. Such a theory
should account for both the ‘Malthusian growth regime’ witnessed throughout
history before the eighteenth century, and the ‘modern growth regime’
that subsequently prevailed in those countries that have experienced an ‘Industrial
Revolution’ (see Galor and Weil, 2000). To sum up, the analysis of
economic growth has once more become an active and vibrant research area,
central to contemporary macroeconomics (Klenow and Rodriguez-Clare,
1997a) and will be discussed more fully in Chapter 11.
In the following chapters we will return to these issues, which over the
years have been an important source of controversy. But first we will begin
our tour of twentieth-century developments in macroeconomics with a review
of the essential features of the stylized ‘old’ classical model which Keynes
attacked in his General Theory.
There is no doubt that one very important consequence arising from the work
of Keynes was that it led to a shift of emphasis from the classical long-run
issue of economic growth to the shorter-run issue of aggregate instability. As
Tobin (1997) emphasizes, Keynesian economics does not pretend to apply to
the long-run issues of growth and development. This is in sharp contrast to
the work of Adam Smith, David Ricardo and the other classical economists
who sought to understand the nature and causes of the ‘Wealth of Nations’
rather than focus on the issue of short-run instability. This should hardly
surprise us given the rapid self-equilibrating properties of the classical macroeconomic
model (see Chapter 2).
Even small differences in growth rates of per capita income, if sustained
over long periods of time, lead to significant differences in relative living
standards between nations. The importance of economic growth as a basis for
improvements in human welfare cannot be overstated because the impact of
even small differentials in growth rates, when compounded over time, are
striking (see Chapter 11). Barro and Sala-i-Martin (1995) provide a simple
but illuminating example of the long-term consequences of growth differentials.
They note that the US economy grew by an annual average of 1.75 per
cent over the period 1870–1990 thereby raising real GDP per capita from
$2244 in 1870 to $18 258 in 1990 (measured in 1985 dollars). If growth over
the same period had been 0.75 per cent, real GDP per capita in 1990 would
have been $5519 rather than $18 258. If, on the other hand, growth had been
2.75 per cent, then real GDP per capita in the USA by 1990 would have been
$60 841. Note how this amazing difference in outcomes arises from relatively
small variations in the growth rate. David Romer (1996) has also expressed
the same point succinctly as follows: ‘the welfare implications of long-run
growth swamp any possible effects of the short-run fluctuations that macroeconomics
traditionally focuses on’. In reviewing the differential growth
performances of countries such as India, Egypt, the ‘Asian Tigers’, Japan and
the USA, and the consequences of these differentials for living standards,
Lucas (1988) comments that ‘the consequences for human welfare involved
in questions like these are simply staggering. Once one starts to think about
them, it is hard to think about anything else.’ For some economists, such as
Prescott (1996), the renewed interest in growth over the last 20 years stems
from their belief that business cycle fluctuations ‘are not costly to society’
and that it is more important for economists to worry about ‘increasing the
rate of increase in economy-wide productivity and not smoothing business
fluctuations’. This position had been publicly expressed earlier by Lucas in
May 1985 when delivering his Yrjo Jahnsson lectures. There he argued that
post-1945 economic stability had been a relatively ‘minor problem’ especially
in comparison ‘to the costs of modestly reduced rates of growth’
(Lucas, 1987). More recently, Lucas (2003) has repeated this message using
US performance over the last 50 years as a benchmark. Lucas argues that ‘the
potential for welfare gains from better long-run, supply-side policies exceeds
by far the potential from further improvements in short-run demand management’.
Given the significant adverse impact that poor growth performance has on
economic welfare and the resultant importance attached to growth by economists,
it is perhaps surprising that the research effort in this field has been
cyclical. Although growth issues were a major concern of the classical economists,
during the period 1870–1945 economists’ research was heavily
influenced by the ‘marginalist revolution’ and was therefore predominantly
micro-oriented, being directed towards issues relating to the efficient allocation
of given resources (Blaug, 1997). For a quarter of a century after 1929–33,
issues relating to the Great Depression and Keynes’s response to that event
dominated discussion in macroeconomics.
As we shall discuss in Chapter 11, in the post-1945 period there have been
three waves of interest in growth theory (Solow, 1994). The first wave focused
on the neo-Keynesian work of Harrod (1939, 1948) and Domar (1947).
In the mid-1950s the development of the neoclassical growth model by
Solow (1956) and Swan (1956) stimulated a second more lasting and substantial
wave of interest, which, after a period of relative neglect between
1970 and 1986, has been reignited (Mankiw et al., 1992). Between 1970 and
1985 macroeconomic research was dominated by theoretical issues relating
to the degeneration of the orthodox Keynesian model, new equilibrium theories
of the business cycle, supply shocks, stagflation, and the impact of
rational expectations on macroeconomic modelling and policy formulation.
Although empirical growth-accounting research continued (for example
Denison, 1974), research on the theoretical front in this field ‘effectively
died’ in the 1970–85 period because economists had run out of ideas.
The third wave, initiated by the research of Paul Romer and Robert Lucas,
led to the development of endogenous growth theory, which emerged in
response to theoretical and empirical deficiencies in the neoclassical model.
During the 1980s several factors led to a reawakening of theoretical research
into the growth process and new directions in empirical work also began to
develop. On the theoretical front Paul Romer (1986) began to publish material
relating to his 1983 University of Chicago PhD thesis. In the same year,
1986, Baumol and Abramovitz each published highly influential papers relating
to the issue of ‘catch-up and convergence’. These contributions were
soon followed by the publication of Lucas’s 1985 Marshall lectures given at
the University of Cambridge (Lucas, 1987). This work inspired the development
of a ‘new’ breed of endogenous growth models and generated renewed
interest in empirical and theoretical questions relating to long-run development
(P.M. Romer, 1994a; Barro, 1997; Aghion and Howitt, 1998; Jones,
2001a). Another important influence was the growing awareness that the data
suggested that there had been a slowdown in productivity growth in the post-
1973 period in the major OECD economies (P.M. Romer, 1987a).
In the eighteenth and nineteenth centuries growth had been largely confined
to a small number of countries (Pritchett, 1997; Maddison, 2001). The
dramatic improvement in living standards that has taken place in the advanced
industrial economies since the Industrial Revolution is now spreading
to other parts of the world. However, this diffusion has been highly uneven
and in some cases negligible. The result of this long period of uneven growth
is a pattern of income per capita differentials between the richest and poorest
countries of the world that almost defies comprehension. Much of the motivation
behind recent research into economic growth derives from concern about
the origin and persistence of these enormous cross-country inequalities in
income per capita. The origin of this ‘Great Divergence’ in living standards
has always been a major source of controversy among economic historians
(Pomeranz, 2000). Recently, this issue has also captured the imagination of
economists interested in providing a unified theory of growth. Such a theory
should account for both the ‘Malthusian growth regime’ witnessed throughout
history before the eighteenth century, and the ‘modern growth regime’
that subsequently prevailed in those countries that have experienced an ‘Industrial
Revolution’ (see Galor and Weil, 2000). To sum up, the analysis of
economic growth has once more become an active and vibrant research area,
central to contemporary macroeconomics (Klenow and Rodriguez-Clare,
1997a) and will be discussed more fully in Chapter 11.
In the following chapters we will return to these issues, which over the
years have been an important source of controversy. But first we will begin
our tour of twentieth-century developments in macroeconomics with a review
of the essential features of the stylized ‘old’ classical model which Keynes
attacked in his General Theory.
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