Wednesday, August 17, 2022

Wealth of nations: Why some are rich, others are poor – and what this means for future prosperity

Why are some nations rich and others poor? Can the governments of poor nations do anything to ensure that their nations become rich? These kinds of questions have long fascinated public officials and economists, at least since Adam Smith, the prominent Scottish economist whose famous book from 1776 was entitled “An Inquiry into the Nature and Causes of the Wealth of Nations.”

Economic growth matters to a country because it can raise living standards and provide fiscal stability to its people. But to get the recipe consistently right, both nations and economists have evaded it for hundreds of years.

As an economist studying regional, national and international economics, I believe that understanding an economic term called total factor productivity can provide insight into how nations become rich.

Growth theory

It is important to understand what helps a country grow its wealth. In 1956, Robert Solow, an economist at the Massachusetts Institute of Technology, wrote a paper analyzing how labor – also known as workers – and capital – also known as physical items such as tools, machinery and equipment – could be combined to make goods and to produce services that ultimately improve people’s living standards. Solow later won a Nobel Prize for his work.

One way to increase a country’s overall amount of goods or services is to increase labor, capital, or both. But it does not continue to grow indefinitely. At some point, the addition of more labor simply means that the goods and services that these workers produce are divided between more workers. As a result, output per worker – which is one way of looking at a nation’s wealth – tends to decline.

Similarly, it is also useless to add more capital such as machinery or other equipment endlessly because those physical items tend to wear out or depreciate. A company will need regular financial investments to counteract the negative effects of this wear and tear.

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In a later paper in 1957, Solow used American data to show that ingredients in addition to labor and capital were needed to make a nation richer.

He found that only 12.5% ​​of the observed increase in U.S. output per worker – the amount each worker produced – from 1909 to 1949 could be attributed to workers who became more productive during this period. This implies that 87.5% of the observed increase in output per worker was explained by something else.

Total factor productivity

Solow called it something else “technical change”, and today it is best known as total factor productivity.

Total factor productivity is the portion of goods and services produced that is not explained by the capital and labor used in production. This could be, for example, technological advances that make it easier to manufacture goods.

Another way to understand total factor productivity.

It is best to think of total factor productivity as a recipe that shows how to combine capital and labor to obtain output. Specifically, cultivating it is similar to creating a cookie recipe to ensure that the largest number of cookies – which also taste good – are produced. Sometimes this recipe gets better over time because, for example, the cookies can bake faster in a new type of oven or workers become more informed on how to mix ingredients more efficiently.

Will total factor productivity continue to grow in the future?

Given how important total factor productivity is for economic growth, asking about the future of economic growth is basically the same as asking whether total factor productivity will continue to grow – or the recipes will always get better – over time.

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Solow assumed that TFP would grow exponentially over time, a dynamic explained by economist Paul Romer, who also won a Nobel Prize for his research in this field.

Romer argued in a prominent 1986 article that investments in research and development that result in the creation of new knowledge could be a key driver of economic growth.

This means that each earlier piece of knowledge makes the next piece of knowledge more useful. In other words, knowledge has an overflow effect that creates more knowledge as it washes out.

Despite Romer’s efforts to provide a basis for the supposed exponential growth of TFP, research shows that productivity growth in the world’s advanced economies has slowed since the late 1990s and is now at historically low levels. There are concerns that the COVID-19 crisis may exacerbate this negative trend and further reduce overall factor productivity growth.

Recent research shows that declining TFP growth can have a negative impact on living standards in the US and other rich countries.

A very recent paper by economist Thomas Philippon analyzes a large amount of data for 23 countries over 129 years, and finds that TFP is not actually growing exponentially, as Solow and Romer thought.

Instead, it grows in a linear, and slower, progression. Philippon’s analysis suggests that new ideas and new recipes do contribute to the existing stock of knowledge, but they do not have the multiplier effect that previous scholars thought.

Ultimately, this finding means that economic growth used to be fairly rapid and is now slowing down – but it is still happening. The US and other nations can expect to get richer over time, but just not as fast as economists once expected.

Nation World News Desk
Nation World News Desk
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