Why is Economic Growth So Important?

Why is Economic Growth So Important?
Since the middle of the eighteenth century human history has been dominated
by the phenomenon of modern economic growth. In the eighteenth and
nineteenth centuries economic growth had been largely confined to a small
number of countries (Bairoch, 1993; Easterlin, 1996; Maddison, 2001). Gradually,
‘modern’ economic growth spread from its origins in Great Britain to
Western Europe and initially to overseas areas settled by European migrants
(Landes, 1969, 1998). 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 (see Tables 11.1 and 11.2). The importance of economic
growth as a basis for improvements in human welfare cannot be overstated
and is confirmed by numerous empirical studies (see, for example, Dollar and
Kraay, 2002a, 2002b). Even small inter-country 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. There is no better
demonstration of this fact than the impact on living standards of the growth
experiences of the ‘miracle’ East Asian economies compared with those of
the majority of sub-Saharan African economies since 1960 by which time the
decolonization process was well under way.
It is worth remembering throughout this discussion that the doubling time
for any variable growing exponentially at an annual rate of 1 per cent is
approximately 70 years. The so-called ‘rule of seventy’ says that if any
variable grows at g per cent per annum, then it will take approximately 70/g
years for that variable to double in value. More formally, this can be demonstrated
as follows (Jones, 2001a). If yt is per capita income at time t, and y0
some initial value of per capita income, then the value of yt is given by
equation (11.1):
yt y e
= gt 0 (11.1)
Equation (11.1) says that if y0 grows continuously and exponentially at a rate
g, its value at time t will be yt. Let the length of time that it will take for per
capita income to double (that is, for yt = 2y0) be t*. Therefore t* will be the
solution to equations (11.2) and (11.3) below:
2y0 = y0egt∗ (11.2)
590 Modern macroeconomics
t∗ = log2/g (11.3)
Since log 2 ≈ 0.7, then for a growth rate of 1 per cent, t* ≈ 0.7/0.01 ≈ 70 years.
We can generalize this relationship and say, for example, that any country
which has per capita income growth of g = 5 per cent will see its living
standards double in 70/g = 14 years. Thus the impact of even small differentials
in growth rates, when compounded over time, are striking. David Romer (1996)
has expressed this 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’. Barro and Sala-i-Martin (2003) also
argue that ‘economic growth … is the part of macroeconomics that really
matters’, a view in large part endorsed by Mankiw (1995), who writes that
‘long-run growth is as important – perhaps more important – than short-run
fluctuations’.
Table 11.3 illustrates the compounding effect of sustained growth on the
absolute living standards of five hypothetical countries, labelled A–E, each of
which starts out with an income per capita of $1000.
The hypothetical data in Table 11.3 are replicated in Figure 11.1, which
clearly highlights how diverging living standards can emerge over what is a
relatively short historical time period of 50 years. Following Galor and
Mountford (2003) in Figure 11.2 we also reproduce the actual growth experience
of different regions of the world using Maddison’s (2001) data.
Figures 11.1 and 11.2 illustrate how economic growth is the single most
powerful mechanism for generating long-term increases in income per capita
as well as divergence in living standards if growth rates differ across the
regions and countries of the world. Over very short time horizons the gains
from moderate economic growth are often imperceptible to the beneficiaries.
However, over generations the gains are unmistakable. As Rosenberg and
Birdzell (1986) argue:
Over the year, or even over the decade, the economic gains (of the late eighteenth
and nineteenth centuries), after allowing for the rise in population, were so little
noticeable that it was widely believed that the gains were experienced only by the
rich, and not by the poor. Only as the West’s compounded growth continued
through the twentieth century did its breadth become clear. It became obvious that
Western working classes were prospering and growing as a proportion of the
whole population. Not that poverty disappeared. The West’s achievement was not
the abolition of poverty but the reduction of its incidence from 90 per cent of the
population to 30 per cent, 20 per cent, or less, depending on the country and one’s
definition of poverty.
These views, emphasizing the importance of long-run economic growth, have
also featured prominently in policy statements in recent years. For example,
in the concluding section of the introduction to the Council of Economic
Advisers’ (CEA) Economic Report of the President (2004, p. 27) we find the
following statement:
As the Founding Fathers signed the Declaration of Independence the great economist
Adam Smith wrote: ‘Little else is requisite to carry a state to the highest
degree of opulence from the lowest barbarism but peace, easy taxes, and tolerable
administration of justice: all the rest being brought about by the natural course of
things’. The economic analysis presented in this Report builds on the ideas of
Adam Smith and his intellectual descendants by discussing the role of government
in creating an environment that promotes and sustains economic growth.
The importance of sustainable growth was also emphasized in providing
justification for the change in monetary policy arrangements made in the UK
in May 1997. Within days of winning the election, the ‘New Labour’ government
announced that the Bank of England was to operate within a new
institutional framework giving it operational independence with respect to
the setting of short-term interest rates. The economic case for this new
arrangement was provided on 6 May 1997 by the Chancellor of the Exchequer,
Gordon Brown, when, in an open letter to the Governor of the Bank of
England, he stated that ‘price stability is a precondition for high and stable
levels of growth and employment, which in turn will help to create the
conditions for price stability on a sustainable basis. To that end, the monetary
policy objective of the Bank of England will be to deliver price stability (as
defined by the Government’s inflation target) and, without prejudice to this
objective, to support the Government’s economic policy, including its objectives
for growth and employment’ (Brown, 1997; see also Brown, 2001).
The power of economic growth to raise living standards is perhaps best
illustrated by the history of the twentieth century. Despite two devastating
world wars, the Great Depression and collapse of international integration
during the interwar period, and the rise and fall of the socialist experiment,
the majority of the world’s population are better off than their parents and
grandparents in terms of income per capita (PPP$). If life expectancy is taken
into account there has been a remarkable improvement in welfare (see Crafts,
2003).