The process of economic growth is defined as the sustained increase in the output of a country or region. It is usually measured as the increase in real gross domestic product (GDP) over a period of time, which could be a few years or even decades.
In 1980, China’s average annual per capita income was close to US $310, while a Bolivian national had an average annual income of US $2,090 and someone from Venezuela had an income of US $7,838 (all figures expressed in purchasing power parity, or PPP, dollars, as explained in chapter 1). That is, the average income of a Chinese citizen was one-seventh that of a Bolivian and one-twenty-fifth that of a Venezuelan.
By 2017, China’s per capita income was about twenty-one times the 1980 figure, while Bolivia’s average income had grown slowly and Venezuela’s income had decreased over the same period. Thus today an average Chinese citizen has more than twice the income of a Bolivian, and also more than the average income of a Venezuelan. What is surprising is that such dramatic changes in the relative living standards of these countries occurred within a relatively short period—only three decades.
Cases of rapid economic growth for some countries and economic stagnation or decline for others are far from isolated. While Chile and Ecuador had similar incomes in 1980, today an average Chilean lives with more than twice the income of the average Ecuadorean. Similarly, in 1980 South Korea had a per capita income one quarter that of Spain, whereas today a Korean has a slightly higher income than a Spaniard. What are the causes of such differences? Why do some countries grow so much more than others? What should a country do to grow more?
Growth rates and real GDP levels differ substantially from one economy to another, resulting in huge differences in per capita income between countries—the per capita income in Luxembourg is more than three hundred times that of Burundi. And even though the difference is much lower when measured in PPP terms, Luxembourg’s average income is still more than one hundred times Burundi’s.
Note that slight differences in annual growth rates have a strong impact on the level of per capita income over a long period. With per capita growth of 1 percent a year, it takes about seventy years to double the average income per person; however, if growth is 3 percent per annum, a country will have to wait only twenty-three years to double its per capita income; and if the rate reaches 7 percent annually, per capita income doubles in just a decade.
In what follows, we highlight the changes experienced by an economy over several decades (in the long term), and therefore the short-term fluctuations known as business cycles will not be considered. This does not mean that business cycles do not affect economic growth. In this respect, recent studies indicate that in the long run, countries with the most volatile economies, or the highest frequency of economic fluctuations, experience less economic growth than countries that are more stable.
To understand the changes in the material wealth of the world, we must begin by examining development over the centuries. Table 3 shows the evolution of world population and per capita output in the last two thousand years. Note that the real leap forward occurred in the last phase, when the per capita output growth rate increased to almost 1.3 percent per year and the population grew at more than double its growth rate in the previous stage. This jump coincides with the Industrial Revolution, when modern economic growth began.
Table 3 Population and per capita GDP growth in the last twenty centuries (annual average)
| Economic phase | Period | Rate of population increase | GDP per capita (%) |
|---|---|---|---|
|
Agricultural economy |
0–1500 |
0.04 |
0.01 |
|
Advanced agricultural economy |
1500–1700 |
0.16 |
0.04 |
|
Merchant capitalism |
1700–1820 |
0.46 |
0.07 |
|
Capitalism |
1820–2017 |
1.06 |
1.26 |
Source: For years 0–2010, Maddison, Phases of Capitalist Development; for years 2010–2016, International Monetary Fund, World Economic Outlook 2018.
As an economy enters the last stage of growth, it undergoes important changes in its economic structure. As a result, we observe some common patterns in different countries and regions. The characteristics of this common process are the following:
At the end of the eighteenth century, following years in which the economy grew very slowly, important analysts doubted that economic growth would ever be enough to support the rapidly increasing population. Thomas Malthus, a famous British thinker, viewed the population increase occurring in Britain with great pessimism. In addition, he was convinced that per capita GDP would fall under the weight of a demographic explosion. According to his point of view, if the population exceeded the economic capacity, then the number of inhabitants would be adjusted, if not by wars, by disasters such as famines or epidemics. In his own words:
The power of population is so superior to the power in the earth to produce subsistence for man that premature death must in some shape or other visit the human race. The vices of mankind are active and able ministers of depopulation. They are the precursors in the great army of destruction, and often finish the dreadful work themselves. But should they fail in this war of extermination, sickly seasons, epidemics, pestilence and plague advance in terrific array, and sweep off their thousands and tens of thousands. Should success still be incomplete, gigantic inevitable famine stalks in the rear, and with one mighty blow levels the population with the food of the world. (Malthus, “First Essay on Population 1798”)
Fortunately, Malthus committed one of the most important prediction errors in world economic history. Although some regions have advanced much more than others, the global economy has generally experienced sustained and unprecedented economic growth over the last two centuries. One notable case is that of the so-called Asian tigers—South Korea, Hong Kong, Taiwan, and Singapore. These countries were essentially poor economies dependent on foreign aid in the early 1960s; however, between 1960 and 2000, their GDP per capita increased, on average, at a rate of 6 percent per year. These figures are even more impressive compared to the 1.6 percent per annum observed in Latin America and the 2.7 percent per annum experienced by industrialized nations that are members of the Organisation for Economic Co-operation and Development (OECD) for that same period. In South Korea, for example, per capita GDP grew at an average annual rate of 5.9 percent during those four decades. In other words, in just over a generation the average Korean became ten times richer!
Although the subject has been much discussed, there is some consensus on the factors that promoted this “miracle” in Asian nations. A well-known World Bank study from 1993, The East Asian Miracle, found that domestic private investment and the rapid growth of human capital (the investment in education and training programs, which increases the productive capacity of the labor force), sustained by high saving rates, served as the growth engine. To this one must add the presence of stable macroeconomic policies, trade liberalization, and a well-qualified labor force.
The world’s population grew rapidly in the last hundred years, from about 1.6 billion people in 1900 to almost 8.3 billion in 2016. According to a United Nations projection, there will be 9.1 billion people by 2050. As a result, there will be increasing pressure on terrestrial ecology and essential natural resources such as drinking water and biological diversity in the tropics. This, however, is not enough to support Malthus’s claim.
In the previous chapter, we indicated that the production function is the relationship between output, production inputs, and technology. In this relationship, output growth is often linked to the degree of technological innovation and to the growth of capital and labor in the economy.
Labor and capital shares are measured in the national accounts. In most Latin American countries, the share of income from labor (i.e., the sum of a country’s citizens’ work income) as a percentage of total GDP is low compared to that of developed countries mainly because labor is relatively abundant and wages are low. Additionally, the share or labor income as a percentage of total GDP may also be low owing to the existence of self-employment and small businesses, which, if not correctly accounted for, hides from the statistician what percentage of income corresponds to wages and how much corresponds to the profits from personal activities.
Let us clarify this point with an example. Assume that the share of labor production of GDP is 40 percent, while the share of capital is 60 percent. Now, suppose that the labor force increases by 1.8 percent annually, technology grows by 1.6 percent, and the capital stock grows by 4.2 percent. In this case, we would predict an annual increase in GDP of 4.8 percent (1.6% + (0.4 × 1.8%) + (0.6 × 4.2%)).
An interesting case is that of Chile, where the labor share in GDP is estimated at around 52 percent. Between 1986 and 2015, employment increased by 2.5 percent annually, the capital stock grew at an average rate of 4.9 percent, and total factor productivity (TFP) grew at around 1.3 percent. TFP is the component of economic growth that is not explained by an increase in the productive factors (capital and labor); thus TFP is interpreted as the fraction of economic growth attributable to technological progress. We would formulate annual GDP growth as 1.3% + (0.52 × 2.5%) + (0.48 × 4.9%) = 5.0 percent per year. However, this average of two decades hides very diverse behaviors: between 1986 and 1996 GDP grew at an annual average of 7.3 percent and productivity grew at 3.4 percent; in the following decade (1997–2007), GDP increased at 4.2 percent and productivity at 0.77 percent; while in the last years (2008–2015), GDP grew by 3.4 percent and productivity decreased by 0.36 percent (all figures are annual averages). The previous analysis reveals that in recent years, not only did TFP not contribute, on average, to economic growth, it decreased it. This observation highlights the importance of technological progress as a fundamental driver of growth in a country. Technological progress is understood as improvement in the tools needed for the production process, from computational software and programs to specific abilities and knowledge.
Robert Solow, winner of the Nobel Prize in Economics for his contributions to growth theory and its measurement, first used his analysis to measure the sources of US growth between 1909 and 1949. His results were surprising: he estimated that technological progress was responsible for 88 percent of economic growth.
On the other hand, a study of the sources of economic growth in the seven largest Latin American economies since the 1940s concluded that capital accumulation accounted for a much larger fraction of per capita GDP growth than did technological progress.
There is an interesting debate as to the sources of accelerated growth experienced by some developing countries, particularly the Asian tigers discussed earlier in this chapter. From the early 1960s to 2010, the per capita output of many Asian countries grew at rates above 5 percent per year, the highest in history for such a prolonged period.
One of the most controversial issues is whether Asia grew as a result of greater accumulation of productive factors or whether the growth was due to technological modernization. The evidence indicates that both aspects played important roles, although the accumulation of productive factors (labor and capital) has predominated in some countries.
Recent studies of economic growth suggest that capital, including human capital (i.e., the value brought by well-educated, well-trained workers), may play a more important role than is suggested by current economic models. The basic notion of these new studies is that capital investment, whether in machinery or in people, improves not only the productive capacity of the company or the worker but also the productive capacity of other companies and other related workers. In economic jargon, this benefit for others is known as a positive externality. This could happen if, for example, there are spillovers of knowledge between companies and workers who are using the new technologies. In this sense, if a company acquires new knowledge, other nearby companies could also benefit from it. Such knowledge spillovers help explain why high-tech companies tend to cluster in specific areas, such as Silicon Valley near San Francisco and Route 128 around Boston in the United States.
Savings and investment decisions, as well as the efficiency of such investments, depend to a large extent on economic policies, institutions, and even the physical geography of a country or region.
There is now enough evidence to identify the key empirical factors that best explain the growth of different countries over the past forty years.
The evidence suggests that the growth of an economy depends more on the institutions and policies that are implemented than on the cultural characteristics of the population.
The case of North and South Korea is a good example of this thesis. In 1945, at the end of World War II, the Korean Peninsula was artificially divided in two, north and south. The former was initially occupied by the Soviet Union and the latter was dominated by the United States. Before that, the peninsula had been a unified territory for centuries; hence, inhabitants on both sides shared the same cultural codes, customs, traditions, and even festivities. However, while South Korea began to implement pro-market institutions that promoted competition and allowed the free flow of goods, capital, and people, North Korea instead established a centralized system that imposed severe restrictions on the economy.
The diverging paths of development that the two parts of the peninsula followed speaks for itself. In 1990, forty-five years after the division, the per capita GDP of South Korea was already six times that of North Korea. By 2016, the per capita GDP of South Korea was more than twenty times that of North Korea. East and West Germany represented a similar case right up to the fall of the Berlin Wall in 1991. In 1990 the pro-market Federal Republic of Germany, or West Germany, had a per capita GDP almost four times that of the German Democratic Republic (East Germany). These examples clearly illustrate that the growth of an economy depends more on its institutions than on cultural factors.
These examples clearly illustrate that the growth of an economy depends more on its institutions than on cultural factors.
Studies on the matter during the last decade have provided this theory with robust empirical evidence. The distinguished MIT economist Daron Acemoglu and his British colleague, James Robinson, are outstanding contributors to this topic. They used historical data and sophisticated empirical methods to conclude that the main determinant of differences in prosperity across countries is differences in institutions. According to their findings, achieving greater economic growth and prosperity requires reforming institutions, something that depends heavily on political processes.
Following the thesis supported by Acemoglu and Robinson, China gives reason for debate. Between 1980 and 2010, the Chinese economy grew at an impressive average rate of 10 percent, and at a no less impressive rate of 7.5 percent between 2011 and 2017. On the other hand, one must consider the significant influence the Chinese government still maintains over some areas of production. When this control is considered along with the facts that capital does not flow freely and that political institutions are far from transparent, one might have reason to doubt that institutions are really the greatest determinant of countries’ development. However, although China does not have “optimal” economic or political institutions, the country has enacted substantial reforms in recent decades in the direction of a more open and decentralized economy. These reforms were critical for greater productivity growth, a key driver of China’s economic performance. Thus the case of China reaffirms the importance of institutions to achieving economic prosperity.
Whether natural resources are a factor that contributes to economic growth has long been debated in economics. Intuitively, a country endowed with large reserves of natural resources should be able to obtain large revenues by exploiting them, thus becoming richer than other countries. However, several studies have shown that economies with abundant natural resources tend to grow less than resource-scarce economies, a phenomenon known as the resource curse. Researchers who have explored this phenomenon include Sachs and Warner; Boschini, Pettersson, and Roine; and Van der Ploeg.
Several theories attempt to explain why resource revenues may have an adverse effect on economic growth. Some authors have pointed out that the intrinsic volatility associated with the price of natural resources increases overall volatility in the country, thus affecting investment decisions. Natural resource revenues may also generate incentives for rent-seeking, which occurs when entrepreneurs find it more profitable to lobby in order to obtain a portion of the resource rents instead of engaging in productive activities. Other studies have highlighted the political effects of an abundance of natural resources, since large resource revenues may lead to corruption or may be used to gain political support instead of improving local living standards.
There is probably no unique explanation for the resource curse; however, most authors agree that a resource-abundant country is not condemned to poor economic performance. There are many resource-abundant countries with low economic development, such as Sierra Leone, Bolivia, and the Democratic Republic of Congo, though other resource-abundant countries have successfully promoted economic growth, such as Norway, Australia, and Botswana. Countries that have exploited their abundant natural resource endowments and simultaneously accomplished economic development were most likely able to do so because of the quality of their economic and political institutions.
Once again, institutions are a key determinant of differences in prosperity across countries. Solid macroeconomic institutions will help reduce the volatility associated with the international price of natural resources, well-stablished property rights will avoid rent-seeking incentives, and government accountability and transparency will reduce corruption.