- Causes of Economic Growth
The topic of economic growth, and how to drive economic growth, is an important one for policy makers and businessmen alike. Indeed, especially after the 2007-2008 financial crisis in which many previously healthy economies fell into recession, economic growth has emerged as one of the most concepts in the current policy climate.
Traditionally, the factors of economic growth are embodied in the GDP equation: AD=C+I+G+X-M (Mankiw, 2008). John Maynard Keynes, a famous economist, was really the first to develop this equation for factors that drive economic growth. In this conceptualization, aggregate demand is the product of five different factors: consumption, investment, government spending, exports and imports (Mankiw, 2006).
Consumption is the first factor or cause of economic growth. Consumption in this context is limited to personal consumption; that is, consumption among private individuals for purchases of goods and services. Consumption can also be divided into different types of goods such as durable goods, nondurable goods, and commodities (Mankiw, 2006). Durable goods are large-ticket items such as cars, computers, and the purchase of appliances. Nondurable goods are typically goods such as food and clothing that have a limited consumption time; non-durable goods also includes trip to restaurants and other establishments such as those typically found in the mall. Finally, commodities are also included under the category of consumption. Commodities include the purchase of metals such as gold and silver.
Overall, consumption plays a key role in driving economic growth for more developed economies. For example, consumption traditionally composes 60-70% of gross domestic product in the United States; consumption also plays a substantive role in the economic growth of Europe. The reason consumption plays a greater role in driving growth in developed economies is, for the most part, they have higher per-capita income levels that translate into greater disposable income. At the same time, these economies also tend to be free-market economies where the offering of credit to consumers is an important way to promote economic growth.
The second main element of economic growth is investment. Individuals or corporations can engage in investment. Businesses typically make investments in capital equipment such as computers, machinery, buildings, or other goods related to the production of goods and services. Investment, however, is not limited to large businesses. Small-to-medium sized businesses may also engage in investment in such items as cars, trucks, or equipment used for accounting and investing.
Regardless the size or stage of economic growth, investment tends to play a major role in economic growth. This is especially true in the case of China. Since 1979, the Chinese economy has registered double-digit growth levels. Investment has played a key role in driving this growth. Indeed, the level of investment in China has varied between 50-65% of the country’s total GDP. This was because firms did not have any where to put their money, and decided to (over) invest in capacity such as building new houses, new factories, or investing in factory equipment to increase production. Regardless of the size and stage of economy, investment plays a key role in driving economic growth. This is especially because corporate investment is linked to other variables in the growth equation such as hiring, consumption, and exports.
The third major factor of growth is government spending. Government spending includes government purchase of goods and services that are used for government or public purposes. For example, the government may spend money to construct roads for driving, may build schools and employ teachers from tax dollars, and may purchase missile protection systems to protect people from foreign attack. Keynes posited that government expenditure could be a particularly powerful source of economic growth, particularly during times when the private sector did not spend on investment, thus also denting possible consumption expenditures (Mankiw, 2008). This was purported to be the case in the United States and other countries after the 2007-2008 financial crisis. Numerous countries introduced “stimulus” packages that pledged government expenditures in key areas such as infrastructure, education, and health in order to promote economic growth after it cratered. Although there is mixed evidence regarding the efficacy of government expenditure to drive economic growth (known in the literature as the “multiple”), many governments used it to effect.
The fourth and fifth growth drivers are related: imports and exports. Imports are goods and services that are purchased from abroad. Imports are the only growth category that is subtracted in the GDP identity. That is, the total amount a nation imports from abroad is subtracted from growth because this represents expenditures on goods and services purchased from foreign economies. Exports are an important driver of economic growth. Exports represent goods and services that are purchased by foreign individuals abroad. Exports have a positive contribution to economic growth. Indeed, exports played a key role in the development of many Asian economies in the 1970s and 1980s. Known collectively as the Asian “Tigers”, countries such as Japan, South Korea, Singapore, Hong Kong, and China developed their economies through producing lower-priced goods and selling them abroad. The problem with using exports as a main growth strategy is two-fold: 1) as a country’s economy develops, wages and other production costs naturally rise meaning that exports become more and more expensive; 2) being competitive with exports usually mean having a cheaper currency that can lead to political problems.
2. Per-capita growth and living standards
Gross domestic product (GDP), whether in the aggregate or on a per-capita basis, is a statistic under rhetorical fire. Indeed, the measure is a good approximation of the value of goods and services produced in a country over a defined period of time. The measure, however, is an incomplete measure of how individuals fare in the economy whether that be as a function of living standards or their general satisfaction. In defense of GDP, it makes no claim to inform the latter issues; GDP is primarily used by governments across the world because it is easier to calculate than other more inclusive statistics (IMF, 2011). At the same time, however, it does tend to privilege economic growth as the most important economic metric. This essay will argue, based on the data provided for four countries, that per-capita GDP is not necessarily a good proxy to measure living standards in a country (Nielsen, 2011).
First, a quick methodological word on how per-capita GDP is calculated. Per-capita GDP is essentially a disaggregated measure of total GDP on an individual basis (World Bank, 2012). That is, in order to calculate the per-capita GDP for any country one takes the aggregate level of GDP output in goods and services and divides it by the total population size (IMF,2011). Thus, per-capita GDP does not fundamentally represent what each person in the economy “earns” but rather each person’s share in a country’s economic output (IMF,2011). This is an important distinction, particularly when trying to assess whether per-capita GDP is a good proxy for living standards in a country.
Looking at the data one can see how distortions in the calculation method may lead to a somewhat misleading impression of an individual’s standard of living in a country. Qatar is the country with the highest per-capital level of all four countries. There are two different measures for each country: The United Nations per-capita statistic, which essentially measures per-capita GDP in local currency meaning that countries with a weaker currency will register a lower per-capita GDP; the IMF measure which essentially measures per-capita from the same base currency meaning that it strips out differences in per-capita GDP due to currency fluctuations (Nielsen, 2011). The UN ranks Qatar fourth based on per-capita GDP; the IMF ranks Qatar first based on per-capita GDP- the difference between the two means that Qatar’s currency was likely weaker versus other currencies. Despite Qatar’s high ranking on a per-capita basis, the country has a lower human development ranking: 37th. The dissonance between these statistics is a function of what they are measuring. Qatar is a rich country due to rich natural gas deposits located in the country (EIU Qatar, 2011). At the same time, the country has a relatively small population (roughly average for other Gulf nations) that means a high per-capita GDP level built off the country’s large aggregate GDP. The Human Development Index, on the other hand, is a broad-based index that measures individuals’ access to education, health, and other social resources (UN,2011). Thus, the measure does not focus on the size of the economy, but rather the resources individuals can take advantage of in the country. The dissonance of Qatar’s three measures could have the following interpretation: Although Qatar is certainly a “rich” country in the aggregate, individuals do not have similar access to resources in the health, educational, and social sphere, or the ability to develop at the same rate. This difference gets a the operationalization of “standard of living” because such a measure does not simply measure a country’s economic output, but the goods and services that an individual enjoys, including public goods that make up a substantive proportion of .
Equatorial Guinea would provide a similar example. Equatorial Guinea is a country blessed with abundant oil resources. The country discovered significant oil reserves off the western coast of the country leading to significant economic growth after the discovery. The country shares a similar profile to Qatar: A country with a relatively small population (total population in the country is around 700,000) and abundant natural resources that registers a high per-capita GDP, although the two measures (UN and IMF) have greater distance (EIU Equatorial Guinea, 2012). The true economic level of the country is blunted by the cross-sectional nature of the data presented; looking at time-series data would show how economic growth has skyrocketed in Guinea. However, similar to the case of Guinea, the country ranks substantially lower in the Human Development Index: 136th. This significant dissonance might signify two things. First, the relative newness of the country’s riches where economic growth has led to a substantial boost, while government expenditures on public goods and other services have lagged behind (EIU Equatorial Guinea, 2012). Second, and somewhat related, the country likely suffers from the “Dutch Disease” where oil revenue essentially crowds out investment in other areas. In any sense, one could rightly say that Equatorial Guinea has economic development, but a low standard of living, particularly for those individuals
Finally, we have the two countries of the United Kingdom and South Korea. Of all the countries profiled in this exercise, the United Kingdom likely has the highest aggregate level of economic output. At the same time, however, the country also boasts a larger population (roughly 62 million in 2011). Thus, the ranking of 27th and 24th, respectively, demonstrate a mature economy with a substantial population- something not seen in the economic upstarts of Qatar and Equatorial Guinea (EIU UK, 2012). The UK, however, is the only country that boasts a Human Development Index roughly equal to the per-capita level. Overall, the UN ranks the country 28th, marginally on par with the rankings of the per-capital level. Although there is no rule that a country should rank similarly across the three categories, it may show a greater balance in how resources are distributed. That is, the government stepping in to actually provide infrastructure, health, and educational services roughly on par with the level of economic development.
South Korea is the last country examined, and the main anomaly. South Korea arguably registered the fastest rate of economic development in history during the 1960s and 1970s. However, since the “miracle on the Han (river)” during that time, the country’s economic growth rate has slowed down, entering a more mature phase of economic development (EIU South Korea, 2012). Overall, the country ranks 36th and 27th, respectively, for per-capita economic level; this level is below Qatar and the UK, while higher than the average of Guinea’s two per-capita measures. Unlike the other three countries, however, South Korea boasts a higher UN Human Development Index than its per-capita GDP scores. Since South Korea has a similar ranking to countries such as Canada and Japan, it might be interesting to take a look on which factors the country is ranked higher. The country’s strength in the rankings is predicated on four factors: 1) longevity (a function of the country’s single-payer health care system); 2) education level (a high mandatory education level); 3) high cellular phone penetration rate; 4) lower level of income equality than the other four countries (UN, 2012). Together, these factors lifted South Korea into a category of countries typically reserved for advanced economies.
Overall, the data show limited correlation between per-capita income level and the human development index. This is not to say that the two are not related: high standards of living, particularly those found in northern European countries, are predicated on strong economies. However, a high level of economic , whether it be aggregate or per-capita, is not a sufficient condition to ensure a high standard of living. Indeed, the government and private enterprise must work together to provide goods and services that improves an individual’s ability to live and succeed in society. This is particularly true in the age of increasing income inequality of countries. A simple improvement in economic growth will not translate to a better standard of living if the largesse from such growth is limited to only certain individuals in the economy. Countries should also be concerned about rapid increases in per-capita growth that does not translate into an increase in living standards for the population at large.
Economist Intelligence Unit. (2012). Equatorial Guinea. Available at: www.eiu.com
Economist Intelligence Unit. (2012). Qatar. Available at: www.eiu.com
Economist Intelligence Unit. (2012). South Korea. Available at: www.eiu.com
Economist Intelligence Unit. (2012). United Kingdom. Available at: www.eiu.com
International Monetary Fund (2011). Explanation of per-capita growth calculation methods.
Mankiw, G. (2008) Economics. Cengage: Boston.
Mankw, G. (2006). Macroeconomics. Cengage: Boston.
Nielsen, L. (2011). Classification of Countries Based on Their Level of Development: How It is Done and How it Could Be Done. IMF Working Paper. Available at: http://www.imf.org/external/pubs/ft/wp/2011/wp1131.pdf.
World Bank. Measurement of living standards and equality. Available at: http://siteresources.worldbank.org/ECAEXT/Resources/publications/Making-Transition-Work-for-Everyone/appendix+A.pdf.
United Nations. Human Development Index Explanation. Available at: http://hdr.undp.org/en/reports/global/hdr2011/.