THE THEORY OF ECONOMIC GROWTH

Why have some nations grown so fast and others not at all? How do some nations push out their production-possibilities curves so much faster than others? What, in short, is the theory of ceonomic growth? Only through answering this ques tion can we really understand why some nations are rich and some are poor. Alas, there is no one simple theory that seems to explain everything. But there is growing consensus on some central factors in the growth process and it is on these that we shall concentrate.

Supply and Demand Factors in Economic Growth

As we shall see, the classical economists had a simple answer to questions about economic growth. The basic productive factors were land, labor, and capital. Growth in total output depended on the combined expansion of these productive factors, reflecting especially enterprise, hard work, and thrift. And the growth in output per capita depended largely on the growth in population relative to the growth in land and capital available for production. They stressed the supply factors—the ones that move out the nation’s production-possibilities curve.

Nearly two centuries later the classical economists still look basically right. It is the “real” (supply) factors that matter most in economic growth—the accumulation of productive capital goods, the growth in the size and efficiency of the labor force, the natural resources (“land”) which a nation has; and how we add on research, education, and technical advance which permit us to produce more with any given amount of capital, labor, and natural resources.

Beyond land, labor, capital and technology, many historians and economists point to other, more tenuous factors—the energy and “drive” of a nation’s people, the social and economic mobility of its classes, the economic institutions it devises, its governmental and political structure and traditions. Although we set most of these forces aside for the moment, it is important not to forget them.

These “supply” factors matter most, but in a private-enterprise economy money demand matters too. Unless aggregate demand is adequate to take goods off the market, they will not long be produced. And unless prospective money demand promises reasonabje returns, the new capital goods and research necessary for economic growth will not be forthcoming.

Summary: On the supply side, the problem of economic growth is to increase the productive capacity of the economy—basically through diverting resources from current consumption to investment in capital goods, research, education, and other activities that increase future productive capacity; through increasing the size and quality of the labor force; and through improving the economic and social-political organization of the society. On the demand side, the first problem is to be sure that there is always adequate total demand to induce high-level utilization of the productive capacity that exists; otherwise, potentially available output is wasted and the inducement to new investment is reduced. (This has been the focus of Chapters 11 to 14.) The second problem on the demand side is to channel spending from consumption into saving and investment, so that society’s stock of capital goods and human resources will be built up to increase future output. Thus, on the demand side, both the level of aggregate demand (C + I + CE) and the proportion going into investment (private and governmental) help to control the growth rate.

Almost all economists would agree with the preceding paragraphs. But just how these forces interact, and which are more important under what circumstances, are more difficult questions. A brief look at the historical development of the theory of economic growth is a good way to start to answer them.

Adam Smith—Progress through
Enterprise and Thrift

Men have long been concerned with progress, with a better life. This is not surprising, since man, for most of his history, has been hungry, often unprotected from the elements, bitterly poor by the standards we now know. How is it that in the last 200 years, mainly only in a few nowindustrialized nations of the Western world, has man managed to rise rapidly from poverty to our present comfortable ways of living?

Adam Smith, in his famous Wealth of Nations in 1776, first saw the central rationale of an individual-self-interest, market-directed economy. Let each individual seek his own self-interest—the highest profit he can make, a job at the best wage he can command. But let there be competition in the market so that no seller dares put his price above what others charge, and no buyer can drive down the price of labor he hires because workers will go elsewhere. Then, Smith wrote, self-interest, the most powerful motivating force of all, will be harnessed by the forces of competition to produce those goods men want to buy at the lowest prices that cover their cost of production. Better than any planner or dictator could, self-interest, harnessed by competition, will produce the greatest good for all—as if directed by an invisible hand. This was the case for a self-interest, private-enterprise, market-directed economy—in dramatic contrast to the “command” economies of the lords, the kings, and the pharaohs who had ruled the world’s economies through many centuries before.

But Smith was interested equally in the progress of society. Would these forces lead man to an ever-better life? His answer was “yes”—because self-interest could produce not only hard work and enterprise, but also thrift and accumijla  tion. As man saved part of what he produced, the savings of many individuals could mean new factories, new machines, better houses. Thus, thrift and accumulation, savings from the fruits of hard labor, were the foundations of economic growth, of progress toward a better life.

To be sure, more machinery and more capital would mean a larger demand for workmen, and this in turn would lead to higher wages, until profits—the special source of, and stimulus to, accumulation_-were eaten away. But Smith saw no crisis in this process. He observed that higher wages and more food would lead to more people, and thus to more workers. This in turn would tend to push wages back down, lowering the costs of businessmen as it lowered the real wages of the worker. And so profits and accumulation would again become possible, with further progress.

While Smith was crystal clear on the role of the market in organizing a self-regulating economy, he was less explicit on just where this interacting process of accumulation and population growth would take society and on how fast it would raise real wages (output per worker). And little wonder. Economists still, 200 years later, debate the answer. But Smith’s was an optimistic world, of self-interest and of order. It was a world ~— of progress for those who worked hard and saved, and for societies made up of such men. And Smith’s analysis still has fundamental lessons to teach us in the world of today.