In some capacity or the other, we have thought about why living standards vary across different countries. Why are some countries rich and some extremely poor? It is essentially a question that has prodded many economists, policymakers, institutionalists, and political scientists across academia for a long time. Interestingly enough, we as laymen often seem to preoccupy ourselves with growth, claiming that our economy is not growing at a fast pace and there are major hindrances to the drivers of economic growth. Then, others talk about the regress of development and cite reasons for the failure of development policies. All this is pretty much acknowledged and multiple views are stemming from new research about why countries continue to remain poor. It is often cited growth and development go hand in hand as the social, political, cultural, and economic traits of an economy are interconnected. In this chapter, I will categorically refrain from addressing these issues, at least in a major portion of it. These are battles that have remained inconclusive and in some positive probability are likely to continue.
Instead, I will reflect upon some major advances in growth theory, that at different points in time tried to capture how economies grew. If growth is a major prerequisite to the developmental process, which inarguably is the case, it may make some sense to start by reviewing certain models of economic growth. As one can very well understand it is not only a tough and rigorous ambition it is also fraught with inconsistencies and contradictions. Also, there are other references one can refer to in the process which one definitely should. My objective here will be to decipher a little bit about different growth models. The interested reader may dwell a lot deeper into the intrinsic details, which would serve the purpose of writing this piece. The reader is forewarned in advance that we shall be discussing certain issues strictly keeping in mind the neo-classical framework.
To lay the foundations for the same, one has to go back to Adam Smith’s book ‘An Inquiry into the Nature and Causes of the Wealth of Nations where he argues about how transactions take place in the economy among agents and their behavior towards it. Putting precisely Smith’s theory of growth was an analysis from a microeconomic perspective. Smith advocated an increase in labor productivity utilizing division of labor and an increase in productive labor utilizing capital accumulation which became the basis of classical economics. Smith was followed by David Ricardo who emphasized the importance of
comparative advantage and gains from trade which would essentially lead an economy to grow. However, the starting point of neo-classical growth theory was laid by the Harrod- Domar model which was typically a Keynesian model of economic growth. The main argument was that there is no reason for an economy to have balanced growth. However, the model received a fair share of criticism like there was no reason for growth to be sufficient to maintain a full-employment equilibrium. Also, savings were assumed to be constant in the model which is a gross oversimplification as proposed by economic theory. Savings rate can very well differ among households which is an endogenous (choice) variable for them and depends upon household preferences. Neither the assumption that return to capital remains constant can’t be accepted without ignorance. The capital flight that has always occurred in the course of economic history has several reasons for it. The primary reason is that capital has always been advanced to those sectors or economies which are capital deficient, the simple reason being returns to capital turns up to be higher in such sectors because it is more valued there. Another important reason can be the political climate prevailing in the economy. In a worse political climate where investment returns are uncertain, the investor lacks confidence and is unsure about his return. Another reason can be that the macroeconomic fundamentals in an economy are not very strong (e.g., if there is a continuous depreciation or devaluation of the exchange rate, bank runs, etc) which distills the confidence of the investor. Moreover, the model has been criticized for assuming that the productive capacity is proportional to capital stock. If capital is mobile, which financial capital often is, it is difficult to sustain such an assumption.
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Towards Neo-Classical Growth Models
The inefficiencies arising from the Harrod-Domar model paved way for Robert Solow and Trevor Swan to establish ‘Growth’ in the 1956 model which tried to do away with these restrictive assumptions. The Solow model tried to address long-run economic growth by taking up issues related to capital accumulation, labor, and population growth. We are aware of the basic Solow and the propositions the model tries to establish, so I must not hinge on it. However, a few remarks will be in place. As suggested in the model poor countries will catch up with their richer counterparts in terms of income per capita if both have similar savings rates. This argument has not yielded much empirical evidence over the years (except in the case of Japan, which raised its’ savings rate in the 1950s and ’60s and experience a higher growth rate and a slowing rate of output per worker, since it stabilized its’ savings rate in 1970s). The main message of the Solow model is that long-run growth is achievable only through technological progress. William Baumol tried to empirically test the Solow model and found a strong correlation between countries’ output growth over a long period (1870-1979) and their’ initial wealth only to be contested by Bradford De Long’s findings who claimed that the non-randomness of the sampled countries and measurements errors in GDP biased Baumol’s findings. However, an important aspect here is that absolute convergence only holds when countries or regions have similar characteristics such as the same quality of institutions persisting over time, free markets, similar human capital accumulation policies among others. However, in certain aspects and particularly due to its rich mathematical treatment Solow model has a great deal of appeal till day.
There are many important and meaningful extensions of the Solow model. For instance, David Cass and Tjalling Koopmans 1965 integrated the analysis of Frank Ramsey’s consumer optimization which effectively came to be known as the Cass- Koopmans model. Another important extension to the Solow model was the human capital augmented version by Mankiw- Romer- Weil where they go on to discuss fundamentally Total Factor Productivity (TFP), which is much lower than found in the basic Solow model. This model is much more powerful in explaining income differences across countries mostly because they didn’t take human capital as a factor of production. However, we now make space for discussing the overlapping generations model.
Growth with Overlapping Generations
In the previously discussed models, we assume that there is a representative household that makes decisions regarding variables like savings rate, which is a choice variable for them. However, the assumptions of the representative household are not appropriate in many cases as households do not have an infinite time horizon and new households arrive over time. New economic interactions take place i.e., decisions made by older generations affect prices faced by younger generations. Overlapping generation models aid the case and provide a tractable alternative to the infinite horizon representative agent models. However, the equilibrium in such models may be ‘dynamically inefficient’. By this, we essentially mean that the competitive equilibrium may not be Pareto efficient. An intuition for the same is that an individual who lives at a particular period faces a price determined by the capital stock with which they are working and actions of the previous generations arising due to monetary externalities affect the welfare of the current generation. Dynamic inefficiency in this case typically arises from overaccumulation. The process is somewhat initiated by the requirement of the current generation to save for old age. However, the more they save, the lower is the rate of return on savings, which further encourages them to save more. In this way, the effect on the future rate of return to capital is a pecuniary externality on the next generation. A way of ameliorating overaccumulation is by introducing alternative ways of providing consumption. However, with no dynamic inefficiency, any transfer of resources would make some future generations worse off. This somewhat forms the crux of the overlapping generations model minus the algebraic messy mathematics one encounters when reading in detail. However, it is worthy to stress that these theoretical results hold under certain restrictive assumptions such as Constant Relative Risk Aversion (CRRA) utility functions and Cobb Douglas technology.
Stochastic Growth Models
In the baseline neo-classical growth models, we assume the presence of complete markets, which implies that individuals can fully insure against idiosyncratic risks. Also, households and firms can trade using any Arrow- Debreu commodity. A model was developed by Brock and Mirman in 1972, where the source of uncertainty was aggregate shocks. This model was the generalization of neo-classical growth and the starting point of real business cycle models. The main focus of the model is on the optimal growth problem, where they go on to solve for social planner’s maximization problem in a dynamic neo-classical environment with uncertainty. Since the first and second welfare theorems still hold with competitive and complete markets, the equilibrium growth path is identical to the optimal growth path, although the analysis of equilibrium growth is more involved and introduces us to several new concepts. As mentioned earlier this model forms the foundation of real business cycle (RBC) models, the exposition of which is useful for mainly two purposes Firstly, the Brock- Mirman model is one of the most important applications of neo-classical growth under uncertainty. Secondly, new insights originate from the introduction of labor supply choices into the neo-classical growth model under uncertainty. We now will briefly discuss growth under incomplete markets under which we discuss the Bewley model. We will not go into the intricate details of the model but as a mark of observation, we note that the interest rate is relatively depressed compared to the neoclassical growth model certainty because each household has an additional self-insurance incentive to save. These additional savings increase the capital-labor ratio and reduce the equilibrium interest rate. However, two potential shortcomings are in place. The first inefficiency from overaccumulation of capital is unlikely to be important for explaining income per capita differences across countries. Second, the assumption of incomplete markets in this model may be extreme in this case.
There are many other models of economic growth, for example, there are first-generation models of endogenous growth, open economy growth models like the Lamfalussy model and the Beckerman model, which essentially are long-run models of economic growth in an open economy. Also, one must be aware of the unified growth theory advanced by Oded Galor which was developed in light of the failure of endogenous growth theory to capture empirical regularities of the growth process and to highlight the rise of extreme inequality. All this calls for discussion, analysis, and reflection but in the interest of space, we will leave this aside. The interested reader is encouraged to go through these theories.
Growth theory was one of the main themes of research in the 1990s made popular by the publication of a series of papers by economists like Robert Barro, Paul Romer, Xavier Sala –i- Martin, Phillipe Aghion, Peter Howitt amongst many others. All of them have various important contributions to this field which I would have liked to discuss. However, economic growth lost most of its’ flavor mostly after the turn of this century, when countries especially the South Asian countries achieved good rates of growth. Today’s research is more focused on inequality and the drivers behind it.
A notable feature of the long-run experience of many societies is that the early stages of economic development were characterized by slow or no growth in income per capita and by frequent economic crises. The process of take-off led to faster growth and a more steady (less variable) growth process. An investigation of these issues requires a model of stochastic growth trade-off between investment in risky activities and safer activities with lower returns. At the early stages of development, societies do not have enough resources to invest in sufficient many activities to achieve diversification and are thus forced to bear considerable risk. As a way of reducing this risk, they also invest in low-return safe activities, such as storage or safe technology and low-yield agricultural products. The result is an equilibrium process that features a lengthy period of slow or no growth associated with high levels of variability in economic performance. The growth is truly stochastic and an economy can escape this stage of development and take off into sustained growth only when its risky investments are successful for several periods. When this happens, the economy achieves better diversification and also better risk management through more developed financial markets. Better diversification reduces risk and also enables the economy to channel its investments in higher return activities, increasing its productivity and growth rate.
As a final shot, let us not forget that growth may be necessary for fostering development but it is not in any way sufficient. Economies have to take much care that they have proper institutions, coordination in markets, and effective implementation policies to make growth work. Then, there are political economy questions that are quite complex to analyze. For economic growth to benefit the majority of people i.e., for it be to shared and inclusive, the policymaker must focus on a host of other things such as education and health. India, as I see it is trying to become a superpower based on a largely uneducated and unhealthy labor force where in history no country has done that. As early as 1867, during the Meiji Restoration, Japan went for a state of complete education and healthcare. These are really important issues to be kept in mind when any policymaker thinks about economic growth. An elusive quest for growth may be an objective for policymakers and there can be nationalistic issues regarding growth fetishism but there is always a reason for them to be cautious about rising inequality and multidimensional deprivation, at least in the context of India.
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