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11.5 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)

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.

Table 11.3 The cumulative impact of differential growth rates

Period A B C D E

in years g = 1% g = 2% g = 3% g = 4% g = 5%

0 $1 000 $1 000 $1 000 $1 000 $1 000

10 1 100 1 220 1 340 1 480 1 630

20 1 220 1 490 1 800 2 190 2 650

30 1 350 1 810 2 430 3 240 4 320

40 1 490 2 210 3 260 4 800 7 040

50 1 640 2 690 4 380 7 110 11 470

The data show how, over a period of 50 years, variations in growth rates

(g%) between countries A–E, cause a substantial divergence of relative living

standards.

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

Figure 11.1 The impact on per capita income of differential growth rates

Source: Galor and Mountford (2003).

Figure 11.2 The great divergence

$ 12 000

10 000

8 000

6 000

4 000

2 000

0

1% 2% 3% 4% 5%

Year

0 5 10 15 20 25 30 35 40 45 50

GDP per capita (1990 US$)

25 000

20 000

15 000

10 000

5 000

0

Year

1820 1870 1913 1950 1990

Africa

Asia

Western Europe

USA

Latin America

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).