Robust Growth And Economic Strength Are What Matter

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It’s essential for people to know how economic growth is encouraged in a market system, about its advantages and disadvantages. It’s also vital to realize the costs that accompany the benefits of economic growth.

If you spent all the money you have now, you might be able to buy many of the things you want. However, you probably would choose not to spend all of your money right now. You realize that by saving some now, you will save more for the future. Societies also must save some of what they produce capital goods as well as consumer goods to meet future economic needs. Long-range economic growth depends on the continued production of capital goods.

Everyone who works contributes to the growth of capital resources. Suppose you earn $72 a week, working evenings in an auto repair shop. How do you contribute to the growth of capital resources? If your manager paid you exactly what the customer paid the company, what would happen to the company? What would happen to the business if no money were saved to replace old tools and equipment? Your labour must be valuable enough to earn more than just the money to cover your wages.

When your manager bills customers for the work you did, the amount will be large enough not only to cover the company’s costs but also to invest in capital resources. Your labour may earn your company $100 a week. Since you are paid $72, you are helping the company to collect $28 a week. Some, or all, of this money can be used for capital resources. When your company uses this money to buy new equipment, it expects future returns from the equipment to justify the purchases. The manager may decide to replace the old tools, hire more help, or expand the shop, for example. The manager makes decisions based on how the company will earn the most profits.

In recent years, many people have argued that economic growth is a mixed blessing. The advantages of growth are fairly clear. As people produce more goods and services, the average standard of living goes up. Growth also keeps people employed and earning income. It provides people with more leisure time, since they can decrease their working hours without decreasing their income. Growth provides the government with additional tax revenues, which enable it to spend more on programs for education, eater and air purification, medical care, highway construction, and national defence.

What are the disadvantages, then? Four of them are: use of natural resources that cannot be replaced; generation of waste products; destruction of natural environments; uneven growth among different groups of society.

In the past, growth has allowed poor people to improve their economic conditions. During periods of growth, people have felt optimistic about their future. Nevertheless, continuing economic growth at the pace of today may permanently damage our world, polluting air, land and waters, and using up natural resources. In considering the benefits and problems of growth, it is necessary to recall that to survive, every economy needs people, capital and natural resources, that depend on one another. If these resources are overused to promote economic growth now, future growth may be much slower. Growth, however, sometimes provides solution to the problems.

Long-range economic growth causes more than just air and water pollution. Growth leads to the destruction of forests, wetlands, beaches, mountains, ocean beds. When the society tries to control destruction it takes money to cover the costs.

Thus the rate of growth may not be so fast as it would if we did not have to worry about the destruction. For example, strip mining, a cheap way of getting coal out of the ground, involves stripping away the surface of land. But the benefit of this method is lessened because, leaving ugly, barren hills, strip owners are required to restore the land, the cost of doing so turns up the price of coal. When coal is more expensive, industries that use it may cut back production or bill their customers at a higher rate in order to justify the purchase of coal. Either action can slow down economic growth.

Decisions about economic growth are not easy to make. In the past, growth has allowed poor people to raise the average standard of living.

To grow, an economy needs capital goods because they are used to produce other goods and services. Each company must reserve money to replace equipment and update its factories, as well as to expand in order to meet the demand. Thus everyone in some way pays the hidden costs of economic growth.

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Economic Growth

The economic growth of a country is the increase in the market value of the goods and services produced by an economy over time.

Economic Growth Definition

We define economic growth in an economy by an outward shift in its Production Possibility Curve (PPC). Economic growth is measured by the increase in a country’s total output or real Gross Domestic Product (GDP) or Gross National Product (GNP). The Gross Domestic Product (GDP) of a country is the total value of all final goods and services produced within a country over a period of time. Therefore an increase in GDP is the increase in a country’s production.

Growth doesn’t occur in isolation. Events in one country and region can have a significant effect on growth prospects in another. For example, if there’s a ban on outsourcing work in the United States, this could have a massive impact on India’s GDP, which has a robust IT sector dependent on outsourcing.

Most developed economies experience slower economic growth as compared to developing countries. For example, in 2020, India had a growth rate of 7.1% while the American economy was only growing at 1.6%. This statistic can be misleading because India’s GDP was $2.264 trillion in 2020, while the US was $18.57 trillion. It would be more appropriate to compare their economic growth rates during similar periods in their history.

Economic Growth is not the same as Economic Development. Development alleviates people from low standards of living into proper employment with suitable shelter. Economic Growth does not take into account the depletion of natural resources which might lead to pollution, congestion & disease. Development, however, is concerned with sustainability which means meeting the needs of the present without compromising future needs.

Why is Economic Growth Important?

Economic growth is one of the most important indicators of a healthy economy. One of the biggest impacts of long-term growth of a country is that it has a positive impact on national income and the level of employment, which increases the standard of living. As the country’s GDP is increasing, it is more productive which leads to more people being employed. This increases the wealth of the country and its population.

Higher economic growth also leads to extra tax income for government spending, which the government can use to develop the economy. This expansion can also be used to reduce the budget deficit.

Additionally, as the population of a country grows, it requires growth to keep up its standard of living and wealth.

Economic growth also helps improve the standards of living and reduce poverty, but these improvements cannot occur without economic development. Economic growth alone cannot eliminate poverty on its own.

Six Factors That Affect Economic Growth

The following six causes of economic growth are key components in an economy. Improving or increasing their quantity can lead to growth in the economy.

1. Natural Resources

The discovery of more natural resources like oil, or mineral deposits may boost economic growth as this shifts or increases the country’s Production Possibility Curve. Other resources include land, water, forests and natural gas.

Realistically, it is difficult, if not impossible, to increase the number of natural resources in a country. Countries must take care to balance the supply and demand for scarce natural resources to avoid depleting them. Improved land management may improve the quality of land and contribute to economic growth.

For example, Saudi Arabia’s economy has historically been dependent on its oil deposits.

2. Physical Capital or Infrastructure

Increased investment in physical capital, such as factories, machinery, and roads, will lower the cost of economic activity. Better factories and machinery are more productive than physical labor. This higher productivity can increase output. For example, having a robust highway system can reduce inefficiencies in moving raw materials or goods across the country, which can increase its GDP.

3. Population or Labor

A growing population means there is an increase in the availability of workers or employees, which means a higher workforce. One downside of having a large population is that it could lead to high unemployment.

4. Human Capital

An increase in investment in human capital can improve the quality of the labor force. This increase in quality would result in an improvement in skills, abilities, and training. A skilled labor force has a significant effect on growth since skilled workers are more productive. For example, investing in STEM students or subsidizing coding academies would increase the availability of workers for higher-skilled jobs that pay more than investing in blue-collar jobs.

5. Technology

Another influential factor is the improvement of technology. The technology could increase productivity with the same levels of labor, thus accelerating growth and development. This increment means factories can be more productive at lower costs. Technology is most likely to lead to sustained long-run growth.

6. Law

An institutional framework that regulates economic activity such as rules and laws. There is no specific set of institutions that promote growth.

Six Factors that Limit Economic Growth

1. Poor health and low levels of education

People who don’t have access to healthcare or education have lower levels of productivity. This lack of access means the labor force is not as productive as it could be. Therefore, the economy does not reach the productivity it could otherwise.

2. Lack of necessary infrastructure

Developing nations often suffer from inadequate infrastructures such as roads, schools, and hospitals. This lack of infrastructure makes transportation more expensive and slows the overall efficiency of the country.

3. Flight of Capital

If the country is not delivering the returns expected from investors, then investors will pull out their money. Money often flows out of the country to seek higher rates of returns.

4. Political Instability

Similarly, political instability in the government scares investors and hinders investment. For example, historically, Zimbabwe had been plagued with political uncertainty and laws favoring indigenous ownership. This instability has scared off many investors who prefer smaller but surer returns elsewhere.

5. Institutional Framework

Often local laws don’t adequately protect rights. Lack of an institutional framework can severely impact progress and investment.

6. The World Trade Organization

Many economists claim that the World Trade Organization (WTO) and other trading systems are biased against developing nations. Many developed nations adopt protectionist strategies which don’t help liberalize trade.

Types of Economic Growth

There are primarily four types of economic growth:

1. Boom and Bust Business Cycles

If economic growth is high-speed and inflationary, then the level of growth will become unsustainable. This could lead to a recession like the Great Recession in 2008. However, this type of growth is typical of a business cycle.

2. Export-led

The Japanese and Chinese economy have experienced export-led growth thanks to a high current account surplus. This is because they have significantly more exports than imports.

3. Consumer

The US economy is dependent on consumer spending to stimulate economic growth. As a result, they also have a higher current account deficit.

4. Commodity exports

These economies are dependent on their natural resources like oil or iron ore. For example, Saudi Arabia has had a very prosperous economy thanks to its oil exports. However, this can cause a problem when commodity prices fall, and there aren’t other industries to balance things out.

Costs of Economic Growth

There are two problems associated with economic growth:

1. Environmental Costs

Pollution and other negative externalities often accompany increased production or increased economic growth. Economists usually associate an adverse impact on the environment with rapid growth in developing economies.

2. Rising Income Inequality

Growth often leads to increased income inequality. Those not involved or related to the growth-generating sector of the economy get left behind. Usually, the rural population suffers the most.

Does democracy boost economic growth?

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A belief that democracy is bad for economic growth is common in both academic political economy as well as the popular press. Robert Barro’s seminal research in this area concluded that “more political rights do not have an effect on growth … The first lesson is that democracy is not the key to economic growth” (Barro 1997, pp. 1 and 11). Meanwhile, reacting to the rise of China, New York Times columnist Tom Friedman argues:

“One-party nondemocracy certainly has its drawbacks. But when it is led by a reasonably enlightened group of people, as China is today, it can also have great advantages. That one party can just impose the politically difficult but critically important policies needed to move a society forward in the 21st century […]”

In “Democracy Does Cause Growth”, we present evidence from a panel of countries between 1960 and 2020 challenging this view. Our results show a robust and sizeable effect of democracy on economic growth. Our central estimates suggest that a country that switches from nondemocracy to democracy achieves about 20% higher GDP per capita in the long run (over roughly the next 30 years). These are large but not implausible effects, and suggest that the global rise in democracy over the past 50 years (of over 30 percentage points) has yielded roughly 6% higher world GDP.

There are several challenges in estimating the impact of democracy on growth. First, existing democracy indices are typically subject to considerable measurement error, leading to spurious changes in the democracy score of a country even though its democratic institutions do not truly change. Second, as shown in Figure 1, democratizations are preceded by a temporary fall in GDP. A reliable estimate of the impact of democracy on future GDP therefore needs to model and estimate the dynamics of the GDP process. Finally, even with year and country fixed effects, changes in democracy may be correlated with other changes or respond to current or future economic conditions, raising obvious omitted variable bias concerns (Acemoglu et al. 2005, Brückner and Ciccone 2020).

We deal with all of these in our paper. We build on the important work by Papaioannou and Siourounis (2008) to develop a dichotomous index of democracy purged of spurious changes in democracy scores available in the standard datasets, and rely on this measure for most of our analysis. We use information from both the Freedom House and Polity data sets as well as other codings of democracies to resolve ambiguous cases. This leads to a 0-1 measure of democracy for 184 countries annually from 1960 (or post-1960 year of independence) to 2020.

Importantly, we allow for and estimate explicit dynamics of (log) GDP using a number of different strategies. Given the pattern in Figure 1, our first strategy is to control for lags of GDP in linear regressions, including a full set of country and year fixed effects. In order to overcome any possible Nickell bias owing to lagged dependent variables, we show our results hold with GMM estimators proposed by Arellano and Bond (1991) and Hahn, Hausman and Kuersteiner (2001). Our second strategy is to adapt to our panel context propensity-score-based matching estimators proposed in Angrist and Kuersteiner (2020) and Angrist, Jordà and Kuersteiner (2020), to correct for the effects of GDP dynamics. The propensity score reweighted data can be seen in Figure 2.

We predict the probability of democratizing based on four years of GDP, and then reweight country-years so that we are effectively comparing the path of GDP following a democratization with the path of GDP following an “almost democratization”, those countries that look likely to have a transition based on the trajectory of prior GDP. As Figure 2 shows, there is no difference in the years prior to the democratization (even those years not used to predict the propensity score) but the large difference in GDP in the subsequent years shows that the increase in GDP in Figure 1 is not merely an artefact of the dynamics of GDP in the years preceding a political transition.

Finally, in addition to controlling for country and year fixed effects, we use an instrumental-variables (IV) strategy to overcome omitted variable bias. Inspired by Samuel Huntington’s work documenting waves of democracy, we develop an instrument for democracy based on regional waves of democratization (Persson and Tabellini 2008 develop a similar instrument for “democratic capital”). Our identification assumption is that democratization in a country spreads to other nondemocratic countries in the same region, but does not have a direct differential impact on economic growth in these countries (at least conditional on lagged levels of country and regional GDP, and various covariates that could be correlated with country-level GDP at the year, region, and initial regime level). These IV estimates yield long-run effects quite close to our main estimates.

We also re-estimate our results using a variety of other democracy measures used in the literature. We find that when dynamics are not accounted for, the signs and significance of the coefficients vary widely. However, when lags of GDP are included as controls, all the other democracy measures yield positive coefficients. In addition, the IV coefficients are much larger than the OLS coefficients compared to our measure, suggesting that we have reduced the measurement error in the democracy variable.

What about the common view that democracy isn’t right for low-income countries? The pages of The New York Times are again a good guide to public opinion, this time in the words of David Brooks defending the Egyptian military coup:

“It’s not that Egypt doesn’t have a recipe for a democratic transition. It seems to lack even the basic mental ingredients.”

Judge Posner also agrees with this conclusion and writes:

“Dictatorship will often be optimal for very poor countries. Such countries tend not only to have simple economies but also to lack the cultural and institutional preconditions to democracy.”

Is there any evidence that democracy is only good for already developed economies? The answer is no. Though we do find that democratizations are associated with larger increases in GDP per capita in countries with higher levels of secondary schooling, there is no evidence that democracy is bad for economic growth in low-income economies or even in economies with low levels of schooling.

So why does democracy increase growth? Our strategy is not well-suited to disentangling particular mechanisms, but we attempt to disaggregate both dimensions of democracy and proximate determinants of growth. When we disentangle what components of democracy matter the most for growth, we find that civil liberties are what seem to be the most important. We also find positive effects of democracy on economic reforms, private investment, the size and capacity of government, and a reduction in social conflict. Clearly all of these are channels by which democracy can increase economic growth, and a great deal of further research is needed. Together with our previous work showing that democracy had no effect on inequality, these results suggest the interaction between democratic institutions and the level and distribution of income is more complex than the previous literature suggests.

Published in collaboration with VoxEU.

Author: Daron Acemoglu is Professor of Applied Economics at MIT. Suresh Naidu is Assistant Professor of Economics and Public Affairs, Columbia University. Pascual Restrepo is at the Massachusetts Institute of Technology and James A Robinson is the David Florence Professor of Government, Harvard University, and Research Fellow, CEPR.

Image: A worker stands at the site of a residential complex which is under construction in Kabul. REUTERS/Omar Sobhani

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