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1.10 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. The important ‘Keynes versus the classics’

debate sets the scene for subsequent chapters of this book.