“When learning is purposeful, creativity blossoms. When creativity blossoms, thinking emanates. When thinking emanates, knowledge is fully lit. When knowledge is lit, economy flourishes.”
By A.P.J. Abdul Kalam.
Economy of Development Towards the Economy of Growth
Traditional societies have been characterized by having a stationary per capita income. The first Industrial Revolution is a term used to represent the period of transition between traditional society and industrialized society characterized by having a growing per capita income. This Industrial Revolution did not affect all countries equally. Two poles were created, one with very advanced economies and the other with very backward economies. Development economics is a term used to represent the effort of many economists who developed theories and conceptual models to explain how backward countries or regions could accelerate their per capita income growth. In turn, the economy of growth is the area of thought that has tried to explain how the industrialized countries managed to get out of the poverty trap.
In its beginnings, both paradigms, the economy of development and the economy of growth coexisted at the same time. Rosenstein-Rodan, Hirschman and Myrdal theorized in the same period that Samuelson formalized the Heckscher-Ohlin model of international trade and Solow elaborated the neoclassical model of economic growth.
However, the economics of development disappeared from the scene in 1980 when modern ideas about growth just took off. Although there were many factors responsible for this change, it is important to underline that ideas now in vogue in the growth texts were already developed in the development paradigm. Concepts as important as those of economies of scale, strategic complementarity and supply economies were at the center of the thinking of the development economists. Perhaps this points to the break between one paradigm and another since development economics was based on the assumptions of the competitive market and it was required to model imperfect markets for which they did not have either the mathematical instruments or the principles of industrial organization or with the computer systems of today.
This was the limitation of the Big Push theory of Rosenstein-Rodan, which relied on two important assumptions for its idea of the coordination of investment programs:
1) Economies of scale internal to the company.
2) Unlimited supply of the labor that is extracted from agriculture to industry. There is an interaction between the supply of labor and the economies of scale that create an externality of demand. The coordination failure was presented when these assumptions failed. Hirschman’s ideas go the same way. His ideas on inter-industry linkages and demand externalities implicitly allude to economies of scale.
The most famous work was the one of Arthur Lewis with the assumption of “surplus labor”. The supposed basis is that the opportunity cost of the salary is close to zero, consequently the migration field-city creates a social benefit greater than the private benefit since industrial wages are higher than the field, thus, justifying the protection of the industry incipient.
However, the most controversial idea was the one from Albert Hirschman on interindustry linkages, back and forth. Backward linkages are created when the demand of one industry makes possible the existence of another industry or sector with the minimum scale of production. The forward linkages occur when an industry, by its efficiency, reduces the costs of potential claimants of its products or inputs. It is an interaction between scale and market size. Other economists argued that vertical interactions were more important than horizontal ones by Rosenstein-Rodan.
Hirschman’s ideas, which imply externalities in the supply chain, led to the identification of strategic industries that supply inputs to other industries and led to the input-output tables and development planning, so popular in the 1960s. controversy lies in the interpretation of the linkages. It may be that company A buys the product in company B; or, that the investment in A, by boosting the market size of B, induces a more efficient scale of production. The important thing is to think the hypothesis in terms of scale and not of simple demand, that is, in terms of strategic complementarity.
All these important ideas were not forgotten, as Krugman suggests, but they went unnoticed when the planning and development aid schemes failed. It was the time of the great Kennedy-Johnson-style aid plans. The main reason is that they could not separate themselves from competitive models, those with constant returns to scale and diminishing returns at the level of capital. With the work of Roberto Solow, in the 1960s, modern versions of economic growth begin.
Nicholas Kaldor had presented a series of “stylized facts”, that every model of growth should explain, among others:
1) Product per capita grows in the long term.
2) Capital/labor ratio grows continuously.
3) Labor and capital maintain constant proportions in GDP.
4) There are large differences in the growth of GDP and global productivity between countries, especially between advanced and backward countries.
The Solow model had other characteristics:
1) GDP growth is partially explained by labor and capital and mainly by a residual factor that called global productivity or of all factors.
2) This residual factor is exogenous to the model, which means that it excludes any pro-growth policy. The residual factor only responded to basic scientific discoveries.
3) As with the developers, Solow’s theory assumes constant returns to scale but decreasing at the level of the factors, so that in the long term the productivity of capital decreases and also its profitability.
4) This implies that in the backward countries the productivity of capital is greater than in the advanced countries and also their profitability.
5) The flow of external capital increases towards the backward countries due to the greater profitability of capital.
These characteristics originated the discovery of a very important new concept: convergence. There were two questions to be answered:
1) Why do countries grow over time ?
2) Do countries in arrears converge to the level of income and the standard of living of the advanced?
The Solow model answers both questions unsatisfactorily.
The assumption of diminishing returns leads to the steady state, ie when there is no growth and contradicts the economic reality in both cases. As Robert Lucas maintains, at the moment there were two theories of production: one consistent with the characteristics of the backward economies and another consistent with those of the most advanced economies. But what was needed was to understand the period of transition, that is, convergence.
In the backward countries, the fertility rate is high, so that increases in production are absorbed by population growth and not by per capita income. Solow in his model keeps the fertility rate constant and, therefore, the job offer. With a steady growth in the labor supply, the accumulation of capital does not guarantee the sustained growth of per capita income. That is, the growth of capital is inversely related to the level of capital per worker. This leads to the Solow model to a negative relationship between the initial income and its growth rate, a relationship known as convergence: economies with a capital stock per person employed low will have a GDP per worker growing faster than advanced economies, that is why there are so many incentives for capital to flow from rich countries to poor ones.
This prediction of convergence derived from the neoclassical model is valid only when the only difference between countries is due to their initial capital stocks. If the difference is due to the technology used, to savings, or to the growth of the population, convergence will not occur.
As we will see in a second installment, the breakdown of the diminishing returns to capital is the key to the current versions also called endogenous of economic growth.