What is economic growth? (And why we won’t have any)

Originally blogged from A view from the Trenches which goes onto explain why our economic system works how it does, with abit of light economic theory, historically and haphazardly…..

As we are in the final stage of the global bubble, I realize that we often fail to ask the most obvious questions. In this case, as every central banker tells us that his policies are directed to obtain growth, the obvious question is…how do we define economic growth? What is economic growth? Yes, yes, I know that what they do is simply monetize deficits and enable the transfer of wealth between sectors and generations, but there is also an intellectual battlefield, which we should be aware of.

In the next sections, I will (extremely) briefly walk through the history of the idea of economic growth to this day. Obviously, I cannot be exhaustive and I encourage you to do further research on the works mentioned below. At the end, I examine what view policy makers have on economic growth, if any…

When did this all begin?

When did the idea of economic growth first appear? Up to the 18th century, economic thinking was predominantly concerned with comparative statics, intellectual exercises designed to establish causes and consequences of policy making.

I dare to suggest that the concern on economic growth grew before the French Revolution, when the distribution of income was first examined. My suggestion contradicts Nicholas Kaldor, who finds David Ricardo pioneering the theory of distribution. Although David Ricardo explicitly says in the preface to his “Principles of Political Economy and Taxation” that: “…To determine the laws which regulate this distribution, is the principal problem in Political Economy…”, my view is that this perspective had already been adopted by Francois Quesnay, in 1759, and was the foundation of the Physiocracy. If agriculture was the basis of economic growth, a distribution of income favouring this sector was thought to be advisable. I copied below the very same Tableau Economique, probably the first economic model (designed by Quesnay):


The idea that there was an “optimal” distribution of income triggered the investigation of what determines the same. Simultaneously and brewed by Malthus, there was another idea: Full employment requires a growing income. Perhaps this idea, which we are reminded of every two months by the minutes of the Federal Open Market Committee meeting at 2:15pm, goes all the way back to Karl Marx.

It was on these two pillars (i.e. distribution of income and the relation between employment and output) that the modern theory of economic growth was born, with the additional analysis of how capital is created.

Roy F. Harrod

The first “modern” discussion on economic growth is probably that of R. F. Harrod, titled “An Essay in Dynamic Theory”, published in 1939.

Harrod’ work has historical relevance although it is not original and merely seeks to give Keynes’ thought a dynamic dimension. His main assumptions are that the supply of savings is determined by income (i.e. interest rates play no role, which would have probably made him a good FOMC member). For Harrod, investment responds to income growth and there is always equilibrium in the savings market.

Just like in the rest of the modern discussions on economic growth, monetary aspects are completely ignored. There is a constant concern –sometimes turned into an obsession- to address equilibrium conditions. These analytic frameworks are Walrasian in structure (I also discussed Walras here) and ignore the impact of aggregate leverage in a credit-based monetary system. I think there is no excuse for such omission, for it is clear that already in the 1930s the Austrian school was very much aware of such impact.

Harrod worked within a single commodity and production factor model, and held that a departure from equilibrium would activate a self-fulfilling, spiraling instability.

He anticipates Ben Bernanke and followers, when he asserts that to address such instability, policy is required: “…The ideal policy would be to manipulate the proper warranted rate, so that it should be equal to the natural rate…” Sounds familiar?

Evsey D. Domar

After World War II, Evsey Domar presented his work “Capital expansion, rate of growth and employment”, in January 1946.

Domar incorporated prices into his model, but assumed no fluctuations. Unlike Harrod, he was not obsessed with equilibrium in the savings market, but discussed the generation of capital in an economic system. He brought attention to the issue of full employment: “…Our first task is to discover…the rate of growth at which the economy must expand in order to remain in a continuous state of full employment…”

He was not just referring to the employment of labour, but of capital too. In this regard, he precedes John B. Taylor’s famous “rule”, because he examines the dynamics of the gap between potential and actual output (he actually focused on the relation between change in output and investment, which he called potential social average investment productivity).

James Tobin

Almost a decade later, economists were still working with the assumptions that the factors of production were fixed and that the monetary context had no impact on economic growth. James Tobin was to challenge the status quo in a paper titled “A Dynamic Aggregative Model” published in April of 1955, by the Journal of Political Economy.

For Tobin, economies have constant returns to scale (“…if labor and capital expand over time in proportion, then output will expand in the same proportion…”). His innovation is the introduction of “asset preferences”, as one more variable affecting economic growth.

Tobin assumes that we either hold currency (zero interest) or real assets. There are no financial assets (i.e. paper that pays a rent). Inflation or deflation is therefore the product of shifts in our aggregate allocation, between currency and real assets, driven by preferences. For instance, if we decide to hold less currency (i.e. we bid for real assets), there will be inflationary pressures.

Interestingly, he realized that technological progress is deflationary, and recommended monetary expansion to offset deflation. His merit was in understanding the implication of said expansion. Tobin tells us that the same “…cannot be accomplished by monetary policy in the conventional sense but must be the result of deficit financing… (…)…clearly, such a discussion requires the introduction of additional types of assets, including bank deposits and private debts…” In other words, he anticipated our current “problem”: Lack of collateral, in a credit-based system with shadow banking. For a good discussion of this system, read here, from Zerohedge.com. Tobin concludes that under such expansion”…the normal result is that consumption will be a larger and investment a smaller share of a given level of real income…”

Robert Solow

Mr. Solow is “the” name in the theory of economic growth. His work on this field eventually earned him the Nobel Prize in Economics, in 1987. His ground-breaking work appeared one year later than Tobin’s, in February 1956, published at the Quarterly Journal of Economics and titled “A contribution to the Theory of Economic Growth”.

Solow takes Harrod’s and Domar’s research but abandons the assumption that production takes place under conditions of fixed proportions (between labour and capital), allows for a rate of technological change, and incorporates an interest rate-sensitive savings function.

Solow’s conclusions are powerful and based on the axiom that in the long-run, our economic system has constant returns to scale. The main conclusion is that full employment (or perhaps I should say, an optimal ratio between labor and capital) is not (as suggested by his predecessors and Ben Bernanke) obtained from a key level of output/income, but from a key marginal productivity of capital, which in turn determines the real wage rate. How do we get to that key marginal productivity of capital? Thanks to perfect price flexibility, within a stable monetary system (implied; for those interested, refer equations 10-12 of his model). Lastly, Solow incorporates technological progress as an exogenous (i.e. arbitrary, not determined by his model) and neutral variable.

It’s a pity –in my opinion- that Solow did not explore the monetary aspects implied in his work. His idea of economic growth makes sense under commodity-based money (i.e. no central banking), because one can reasonably agree with him on the elasticity of supply of factors (capital and labour, he excludes land) to their respective prices (interest rate and wages). But I guess that if he had done that, he would have been an Austrian by now, and possibly less popular… Robert Solow is currently Institute Professor of Economics emeritus at MIT and recently wrote (here) on the ongoing financial crisis.

The Austrian School

I do not think that one can point to a unique author within the Austrian school, on the theory of economic growth. In fact, the Austrian school rightly denies a special spot to economic growth and focuses instead on what Jesús Huerta de Soto calls “dynamic efficiency”. If humans act purposefully and the price system works freely, all it takes to improve our standard of living is to allow markets to allocate resources where consumers want them to be. The market is a cooperation and coordination process.

With regards to income distribution, Von Mises made the case that it is a flawed concept. We do not produce something and then distribute the income generated by it. The distribution of that income is already decided, agreed and precedes production. And that product gets made precisely because of and not in spite of, that agreed income distribution.

With regards to the full employment of resources, under a transparent market, with prices signalling where resources are needed and were they are not, unemployment is simply at a natural and low rate, the result of constant change/creative destruction.

Equilibrium is a ridiculous concept, because under it, no change would occur. It is exactly that constant reallocation of resources, carried out by the entrepreneur (an absent figure under all other economic schools) the factor that increases our efficiency, our productivity. Hence there is no need for an optimal savings rate or an optimal stock of capital.

Money and financial assets are relevant, because as medium of indirect exchange and store of value, respectively, they enable the necessary coordination among humans to satisfy their needs. This coordination leads to specialization and improvement of production methods. When money dies under inflation, specialization dies with it too. Risk-taking is acknowledged and not exogenous. It is the blood of entrepreneurship.

If I still have to name economists within the school that focused on the idea of growth, I come up with three: Roger Garrison (Auburn University and adjunct scholar of the Mises Institute), Israel M. Kirzner and Frederick Von Hayek.

What policy makers are doing today

Having very succinctly mentioned the topics, axioms and conclusions around economic growth, we can legitimately ask ourselves what position policy makers of the 21st century have on the same.

Let’s start by acknowledging who the policy makers are: The global cartel of central banking. Fiscal policy is non-existent or even subdued, repressed, as members of the European Monetary Union are witnessing. All members of this cartel are highly educated and many of them even have an academic background, I would expect from them to have a view on each of the topics mentioned above. Let’s see…

Income Distribution

Apart from the explicit wealth transfer from taxpayers to the banking and government sectors, and the implicit ones (a) from wage earners to stock holders and (b) from future generations to the present one, I am afraid that there is no clear, laid-out view with respect to an optimal distribution between labour and capital. Not that I endorse one, as I agree with the Austrian perspective, but I would assume central bankers have an opinion on this point.

Proportion of production factors

The current zero-interest rate policy has completely inverted the risk-return relationship in the capital structure of the centrally planned economies. For instance, banks act like private equity firms. It is now the new normal to see a bank extend a loan at below market prices to win a debt or equity mandate. Once that loan has given the financial support to proceed with public capital raising, it is also normal to see the same companies implementing share buybacks or dividend payment increases, either with bank debt or public capital. There is also no concern about the distortions generated in the labour market by the ultra-low interest rates or the labour legislation itself.

Output growth

Growth in output is the target of economic policy in any mainstream discussion. The approaches differ not in how to get there (all opinions agree in that the stock of capital has to grow) but in how the stock of capital can best increase.

What is the view of the central banking cartel on how to grow output? Surprisingly, not via an increase in the marginal productivity of capital, but via the so called wealth effect: As interest rates fall, asset prices increase (it doesn’t matter which assets see their prices rise) and the assets can be used as collateral to leverage a higher than previously possible consumption level. This consumption level will drive output growth, and this increase in output –they believe- will bring about full employment.

The wealth effect is mistakenly attributed to Keynes, who actually argued against it:

“…For whilst an increase in the quantity of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money; and whilst a decline in the rate of interest may be expected, cet. par., to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of interest; and whilst an increase in the volume of investment may be expected, cet. par., to increase employment, this may not happen if the propensity to consume is falling off.…”Chapter 13, , The General Theory of Employment, Interest and Money

Thus, the central banking cartel has its own interpretation of economic growth and it does not fit any of the perspectives presented above.

Final words

This was a very, very brief discussion on economic growth. I understand it may have been too abstract and I tried to make it as easy to understand as possible, because I firmly believe that there is value in a historical perspective on economic thought, vis-à-vis current policy.

I discussed only those works I was more familiar with and omitted other important economists, in no particular order, like Hicks, Swan, Robinson, Phelps, Malinvaud, Arrow, Kahn, Kaldor and Sidrauski .


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