What drives long-term economic growth?

Published: October 24, 2019 2:03:00 AM

The challenge before India is to sustain both economic and social development simultaneously. There are areas where India has done well. Quality of business environment has improved, investments in physical infrastructure continue in earnest, Poshan Abhiyaan has been launched. These are productivity-enhancing measures that will support growth over the next decade.

To answer the second question, I look at what the economic growth theory says. Broadly speaking, the literature on economic growth can be divided into two strands: exogenous growth and endogenous growth.

By Ranveer Nagaich  

Recently, the term ‘middle-income trap’ has made a comeback in the Indian context as fears that the country may find itself caught in this trap loom large. Conceptually, the ‘middle-income trap’ refers to the phenomenon where countries attain certain ‘middle-income’ levels after which growth stagnates. Can this trap be avoided? What explains rapid growth in countries and then slowdowns?

Economists have explained rapid growth in low-income countries through the idea of convergence (or catch-up growth). The idea is simple—the larger the gap between the ‘leader’ and the ‘follower’, the faster the catch-up growth. However, once income levels begin to converge with that of the leader, i.e. the gap becomes smaller, growth slows down as well. This implies that there is a certain ‘advantage to backwardness’.

However, renowned economist Lant Pritchett notes that a feature of modern economic history is that of divergence in the productivity levels and living standards of economies. Of course, there have been exceptions—consider Japan and other East Asian Countries as examples. These countries were successfully transitioned from low-income to high-income countries in the span of a few decades.
He demonstrates that being technologically behind is not enough to sustain ‘catch-up’ growth, implying that convergence may be conditional. Pritchett leaves us with four important questions to ponder over when considering the dynamics of India’s growth story:

First, what accounts for continued per-capita growth and technological progress of those countries leading the frontier? Second, what accounts for the few countries that are able to initiate and sustain catch-up growth? Third, what accounts for why some countries lose growth momentum? Fourth, what accounts for why countries remain in low growth for a long period?

Pritchett’s second and third questions are relevant to India’s growth story, going forward. To answer the second question, I look at what the economic growth theory says. Broadly speaking, the literature on economic growth can be divided into two strands: exogenous growth and endogenous growth.

Central to the exogenous growth theory is the idea of ‘total factor productivity’ (TFP), popularly known as the Solow Residual. According to the Solow-Swan Model, factor accumulation (capital, labour) and TFP determine output. Given the underlying assumption of diminishing marginal returns to capital, technological change is the driving force behind growth in this model. However, the model stops short of telling us what the determinants of TFP growth are, assuming it to be exogenous. In essence, this theory implies that growth is fuelled by technological progress, independent or ‘exogenous’ of economic forces. This assumption of exogenous technological change led to the development of endogenous growth theory, popularised by Nobel Prize winning economists such as Robert Lucas Jr. and Paul Romer.

Endogenous growth models also see technology as the driver of long-run growth, but also hypothesise that technological progress is dependent on the decisions of economic agents, in contradiction to exogenous growth theory. So, growth in this model comes as a result of our usual factors of production (land and labour), but also knowledge accumulation.

However, both of these models (along with their various extensions) have been unable to fully explain the large differences in cross-country incomes. The conditional convergence hypothesis implies that being behind on the technological frontier is not enough to kickstart catch-up growth. The Solow-Swan Model implies that differences in capital account for little of cross-country income differences. Endogenous growth models further imply that technology is non-rival, therefore differences in technology are unlikely to explain cross-country income differences.

Despite different approaches in accounting for growth, the primacy of productivity is clear. This leads us to answer Pritchett’s third question—why countries lose growth momentum? Could cross-country income differences potentially be explained by how well countries are able to utilise the given level of technology?

A World Bank working paper titled ‘Avoiding Middle Income Traps’ demonstrates that 85% of the slowdown in growth is explained through declining TFP growth. The hypothesis here is that the factors that generated growth at low-income levels tend to lose relevance as a country moves up income levels. This implies that the factors that support growth must evolve along with growth to take advantage of the new opportunities on offer.

We need to dig deeper to understand these differences. Social infrastructure, or social capability, has been identified as a key determinant. Here, the hypothesis is that social capability defines the ability of a country to absorb and exploit new technologies. It can also be thought of as the institutions and policies that align private and social returns to activities. In essence, social capability and infrastructure can be thought of as national competitiveness à la Michael Porter.

How does one go about estimating productivity? In a recent World Bank working paper, Kim & Loayza (2019) estimate the determinants of TFP through a panel of countries. Education emerges as a key driver of productivity in developing countries, supported by infrastructure, institutions, market efficiency and innovation. Missing, however, from their analysis is the role of health and nutrition.

The recently released Global Competitiveness Index (GCI) by the World Economic Forum (WEF) measures competitiveness or productivity through 12 pillars: institutions, infrastructure, ICT adoption, macroeconomic stability, health, skills, product market efficiency, labour markets, financial systems, market size, business dynamism and innovation capability. Both approaches include similar indicators to measure competitiveness or productivity.

The challenge before India is to sustain both economic and social development simultaneously. There are several areas where India has done well. Quality of the business environment has improved substantially, as evidenced by our performance on the Ease of Doing Business. Whilst macroeconomic stability has been achieved, the current growth slowdown has spurred reforms in key areas, such as the reduction in corporate tax rates. Investments in physical infrastructure continue in earnest, with the current regime committing `100 lakh crore worth of investments in infrastructure. Poshan Abhiyaan has been launched to improve nutritional outcomes. These are all productivity-enhancing measures that will support growth over the next decade.

A key takeaway from the GCI 2019 is that a balance needs to be struck between technology integration and human capital investments. Growth-enhancing structural reforms need to be complemented with investments in human capital. In terms of education, a focus on outcomes, along with raising public investments, emerge as macro-level goals. The focus on primary health and nutrition must continue.

For example, as per World Bank data, India’s current expenditure on health (as a percentage of GDP) stood at 3.7% in 2016. In comparison, upper-middle income countries spent 5.9% of GDP on current health expenditures. China spent close to 5% in 2016 as well.
India must increase its social capability to enhance our ability to absorb and exploit current technologies. Only then will we witness sustained productivity growth that will drive our growth story.

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