5. Approaches to Economic Growth: Implications for Policy Analysis
Author: Arthur Grimes (Motu Economic and Public Policy Research, and University of Waikato)
5.1 Introduction
The purpose of the Approaches to Economic Growth series is to expose analysts to a range of ways of thinking about the processes underlying economic growth. This purpose implicitly admits that there is no single "right" model, or way of thinking, about the factors driving growth. The growth process is context dependent, reflecting each country's institutions, endowments, individuals, firms, geography, and interactions with others beyond the country.
An understanding of different growth approaches is required in order to be able to proffer advice on policies which may assist the growth process. The purpose of this paper is to take insights from earlier presentations and consider their relevance for policy-making that supports sustainable economic growth. The paper suggests how and when it may be appropriate to apply these insights to policy situations. Relevant historical experiences are referred to in line with Santayana's admonition (cited by Brian Easton21) that
"those who do not learn the lessons from history are doomed to repeat them".
Easton's paper is particularly useful in spelling out key historical patterns pertaining to economic growth in New Zealand. His chart 6 depicts the rise in GDP per capita in New Zealand since 1861. Figure 1 uses the Easton data to plot trends in New Zealand per capita GDP over 140 years (the slope of the line represents the trend per capita growth rate).22
As Easton discusses, New Zealand's growth rate relative to its OECD peers suffered some key post-war hiccups – notably after the collapse in wool prices in 1966, and during the policy deregulation period of 1984-1991. As indicated by Andrew Coleman in questioning, the latter period may, at least in part, have been a delayed negative reaction to previous events (such as the two oil crises in the 1970s) that policy had sought to hold at bay. As discussed later in this paper, the wool collapse may also have been a delayed reaction to earlier trends that domestic policy had sought to ameliorate.
Figure 1: Trend New Zealand GDP per Capita23
Insights from Previous Papers
The papers by Easton, Maré24, Carlaw25 and Sautet26 : each has important insights for thinking about the economic growth process. Many of the insights are complementary to one another. There are few differences in broad approach, but there are differences in emphasis.
Brian Easton emphasises important process issues of which analysts should take cognisance in considering the growth process. In particular, he emphasises that anyone interested in the growth of the economy cannot look just at aggregate GDP.
GDP is simply an aggregation of developments amongst individuals, firms and sectors. These developments arise as a result of a myriad of forces. Two key forces are developments in (disaggregated) output prices and factor prices (driven by both domestic and international forces). Together, these developments interact with institutional and other forces (domestic and international) to determine profitability of firms. Ultimately, profitability provides a vital incentive for investment and thence for growth.
Frédéric Sautet also emphasises that economic growth cannot be viewed just as an aggregate process. He goes a step further, considering that "sectors" are an artificial aggregation – a product of the statistician's mind rather than a concept meaningful for firms. Within the "Austrian" view of entrepreneurship that he adopts, growth arises as a by-product of the profit-seeking actions of firms and individuals. Institutions affect these actions but are not the instigating force for them; the instigating force is instead individuals' desire to increase their wellbeing ("psychic profits").
This view of the growth process leads Sautet to five propositions. Together, these propositions emphasise that in a constantly changing and uncertain world, the decentralised search for profitable opportunities creates new products, new technologies and new production processes. Economic growth is an accidental (but socially important) by-product of this search for profitable opportunities. Production growth per se is not the goal of the (private sector) actors; profits (and other determinants of wellbeing) are the goal of these actors. It is important, therefore that growth-oriented policies support the search for profitable opportunities.
A related policy insight is that institutions and/or policies which stifle this search for profit opportunities will inhibit the creation of new products, new technologies and production processes, and thereby stifle economic growth. Since part of the search process is to discover and then to exploit profit opportunities, policy-makers need to be careful not to limit the degree to which profit opportunities are discoverable by entrepreneurs. Policy must also ensure that once profit opportunities are discovered they can be exploited by the discoverer. 27
Further, penalties for entrepreneurs who search for profit opportunities, but who fail in that search, must not be so draconian that the profit search is unduly stifled. This observation has implications for insolvency policy.
This "Austrian" view of the growth process has a number of similarities to the "evolutionary" approach to growth. Ken Carlaw notes that "growth is best understood as an evolutionary, historical process driven by endogenous innovative activity". He emphasises that new technologies arise largely as a result of activities of profit motivated agents acting under uncertainty. Even though agents live in an uncertain world, their desire to create profits leads to a search process that, in aggregate, has positive profit – and growth – spin–offs. Carlaw sums up the search process as follows:
The job of the market is to direct behaviour towards more value-creating activities by rewarding successes and punishing failures … those who … get it right are awarded big profits, much larger than the normal return on capital … those who get it wrong lose and [may] disappear.
A number of corollaries flow from Carlaw's approach. First, as implied also by Sautet's analysis, seemingly "excessive" profits on certain activities are required to compensate entrepreneurs for the risky search for profitable opportunities in an uncertain world. Such profits are observed ex post – i.e. only after success is confirmed; ex ante the expected profit on the search may not be abnormal. This observation is important for thinking about the framing of competition law.
A second corollary of the evolutionary view is that scientific/technological knowledge is often cumulative. Technological advances – including advances that subsequently have extremely widespread impacts (General Purpose Technologies, "GPTs") – enable future technological advances to occur that build on the initial innovation. Often, the potential future innovations are unknown, and unknowable, at the time of the initial innovation. The profit motive (within an uncertain world) helps guide later entrepreneurs to the "Eureka" moments that involve application of earlier advances to new ends.28 One implication of this corollary is that small countries do not necessarily have to be fully up with the play on advances in basic science. Adaptation of others' advances to new ends may be more appropriate to the scale and opportunities of entrepreneurs in such countries.
A third corollary of the evolutionary approach is that outcomes are not reversible; the arrow of time points only one way. Once a discovery, or a policy innovation, has occurred it is virtually impossible to return to the prior state. A number of lessons for policy analysis flow out of this observation.
One lesson is that care must be taken with regard to encouraging, or possibly even allowing, innovations that embody major irreversibilities and large risks that are not fully internalised by the innovator. Introduction of genetically modified crops to a country may be an example. At the same time, however, an over-precautionary approach can also be damaging. If the innovation is ultimately approved and if domestic entrepreneurs have been denied access to adapting it while entrepreneurs elsewhere have such access, the result may be missed profit and growth opportunities. There is no easy way around this trade-off in designing policy. As emphasised by the evolutionary literature, policy (as well as the profit search) is made in an uncertain world and mistakes will be made. Decisions must be informed as fully as possible, especially where the future (positive and negative) stakes are high; but they cannot await attainment of complete certainty. Waiting for certainty would rule out too many profit opportunities. However, where major negative externalities could arise, a higher threshold than is normal for approval (or encouragement) of innovations is appropriate.
There are implications of irreversibility for the policy-making process in other situations as well. One issue is how "experimental" public growth-oriented policies should be. One view is that a (small, distant) country, such as New Zealand, should exhibit an "openness to experimentation in policy" in order to bolster economic development. Some countries appear to have experimented successfully with such policies while other countries (at times including New Zealand) have experimented unsuccessfully with growth policies. Further, from the international and domestic historical record, the fact that a country is different from others – or similar to others –does not appear to be correlated with success or failure of experiments.29 What counts most for the success of experimental policies are:
- quality of ex ante analysis (based on problem identification, assessment of alternatives, and cost-benefit analysis of likely outcomes of different alternatives under conditions of uncertainty with agency costs);
- ability and willingness to discontinue programmes that were expected ex ante to be successful but ex post were not; and
- luck.
Not much can be done about (c), but conditions (a) and (b) both need to be met for experimentation to be considered. Further, the risk (variance of outcomes) surrounding each policy experiment needs to be considered as well as the expected (mean) return attributable to the experimental policy. Finally, the potential for reversibility (and irreversibility) both of decisions and outcomes needs to be carefully assessed prior to implementation of experimental policy.
Endogenous growth theory (summarised by Dave Maré) emphasises a number of mechanisms that are shared by the Austrian and, especially, the evolutionary approaches. Endogenous growth theory emphasises that knowledge is cumulative, with spillover benefits. New knowledge builds on past knowledge advances, and the benefits of past advances may accrue to unrelated people in future. As well as building on past ideas, new ideas may complement existing (and new) capital, making capital more productive. Thus new ideas can raise the productivity of capital, inducing new investment. Capital accumulation is the result, with benefits to overall living standards. New ideas support the emergence of new intermediate goods (and final goods) and this expansion in the choice of inputs and final products is a vital cog in expanding production opportunities and thence growth.
The spillovers that arise from new ideas – from whatever source – promote an environment in which there are ongoing profit opportunities. According to this approach, the stimulation of new ideas is critical to the growth process. These new ideas do not have to be "fundamental" scientific discoveries. Indeed many of the processes suggested by this approach are adaptive in nature; for example, "learning by doing" (e.g. development of on-the-job skills).
Policy, under this approach, has the role of supporting the discovery of new ideas. This insight has a number of implications, for example, for patent policy. The Austrian and evolutionary approaches emphasise that the search for profit opportunities through the discovery of new ideas must be rewarded with expected profits. However, if patent law were perfect in terms of awarding all future profits of a discovery (including indirect profits due to spillovers) to the initial discoverer, the search for new discoveries would be stifled. The reason for this is that there would be no profit opportunity for future entrepreneurs arising from discoveries that are adaptations of past advances. A balance therefore has to be struck between rewarding the initial innovator while at the same time leaving in place incentives for future innovators (building on past innovations) to benefit.
Uncertainty, Knowledge and Profits
Three consistent themes come through the presentations. One is that all decision-making, whether by private entrepreneurs or public policy-makers, is made within a climate of uncertainty. Decision-makers do not know the "true" model of the world and may not even be able to form an accurate probability distribution over potential states of the world. A second theme is that the search for profit opportunities, even within this uncertain world, is a vital ingredient in the growth process. A third theme is that the search for, and the creation of, new knowledge is an important component of the search for profit opportunities.
Even though knowledge is scarce, this scarcity does not logically imply that policy can assist to overcome the scarcity. The particular circumstances will dictate whether such assistance is possible. In some circumstances publicly-provided knowledge provision may be helpful; at other times it may be harmful.
To illustrate these ideas, consider the analogy of the role of publicly-provided advice to prospective speliologists. Advice to novice cave explorers about dangers, recommended equipment etc may help to prevent accidents, thereby promoting overall welfare. However, publicly-provided knowledge dissemination may be counter-productive; prior advice to novice cavers may unnecessarily embolden a potential explorer to go where they would (and should) not otherwise go; or it may persuade them to take a particular route out when the explorer's instincts tell them that an alternative route is preferable.
As with other areas of economic activity, incentives are important. The growth theories, summarised above, emphasise that it is important to have the correct incentives to obtain, process and impart knowledge. The successful pursuit and implementation of knowledge must be rewarded (whether by profits or by glory). Correspondingly, acquisition and use of knowledge that is not driven by a clear incentive process may result in poor outcomes as the knowledge turns out to be inappropriate for the situation. An example of this latter situation may be where a public agency disseminates knowledge to users who place undue emphasis on it; for instance, by regarding the knowledge as providing a profit opportunity when in fact the public nature of the knowledge means that prior profit opportunities have already been exploited.
Another issue in terms of public policy involvement in the knowledge-creation process is the extent to which, and the nature by which, public agencies assist the knowledge creation process. Almost inevitably, through its interaction with tertiary (and other research) institutions, public policy will impact on the nature and the directions of knowledge creation. R&D and related tax policies will impact on who conducts the search for knowledge, how it is conducted (e.g in response to incentives for different types of knowledge creation) and how much is conducted. In this respect, knowledge creation may be more suited to some types of firms than others. Baumol30, for instance, argues that there are considerable economies of scale in the process of sustainable knowledge creation; large corporates can afford to undertake an ongoing portfolio of R&D whereas small firms are more opportunistic and piecemeal in their innovation approaches. Care must be taken before public incentives are provided to encourage knowledge creation by some types of firm ahead of others in case the search for knowledge is diverted towards less efficient searchers.
Lessons from History
In accordance with Easton's emphasis on the need to learn from history, it is useful to consider whether New Zealand could have escaped the worst of the adjustment consequences to past shocks. Here we consider the example of the 1966 wool shock. Wool prices collapsed by 40% in December 1966, leading to a prolonged period of New Zealand under-performance compared with other OECD nations in terms of GDP growth per head (documented in Easton's presentation).
It is instructive to examine events leading up to the wool price collapse. The New Zealand Wool Board was established in 1944. Sir John Acland became its Chairman in 1960. In its entry on Sir John Acland, the Dictionary of New Zealand Biography, described events under his chairmanship as follows:
Wool was experiencing competition from synthetic fibres, and Acland presided over the industry's vigorous response. Woolgrowers accepted greatly increased levies for promotion and research, the Wool Research Organisation of New Zealand was established in 1961, young scientists were sent abroad for training, there was technical help for mills using New Zealand wool and the board stepped into freight arrangements.
Acland ensured that New Zealand wool received a fair share of promotion and product development. He travelled widely visiting International Wool Secretariat branches and meeting with trade representatives. The 1960s saw improved wool packing and transport to ship-side, and research that was to lead to scientific measurement and sale by sample. Eventually, the board proposed setting up a corporation to market wool.
From this account, Acland had a remarkably modern approach to development. He:
- Promoted a wool cluster with joint market promotion and research.
- Ensured there was government facilitation of the cluster (funded through compulsory farmer levies).
- Established a CRI-type research organisation (Wool Research Organisation).
- Took actions to promote applied science related to the wool cluster.
- Provided technological assistance to domestic customers (wool mills).
- Established international networks through both trade representatives and international bodies.
- Provided marketing co-ordination of the product.
This policy approach built on New Zealand's natural advantages and resulted in wool comprising over 30% of the country's exports in 1966. This high share of exports (and production) was "despite years of increasing competition from synthetic fibres". From the analysis in the earlier presentations, this concentration on wool arose from a combination of (subsidised) knowledge creation within the wool sector and a concentration of profit opportunities in the wool sector arising from the Wool Board's approach.
The 40% drop in the wool price, on a product then constituting 30% of exports, meant a direct drop of 12% in New Zealand's overall export prices. The resulting terms of trade decline led to major falls in farmer incomes which fed through elsewhere to the economy, retarding growth for a significant number of years. The facilitation of this situation by policy actions and official support – which may have looked sensible prior to 1966 – proved, ex post, to be disadvantageous.
It is often easy to look retrospectively and see that policy settings at a particular time were not sensible (in the light of subsequent events). So was this situation possible to foresee? It turns out that there were signs, spotted previously, that indicated not all was right with the then approach to economic policy.
In 1963, Professor Wil Candler (Massey University) wrote a paper in The Economist magazine analysing the effects of New Zealand's economic policies on economic growth.31 He argued that New Zealand provided a model for how to retard economic growth. Key elements responsible for this retardation included:
- The removal of growth from the political agenda.
Promoting and facilitating growth requires hard "pro-growth" decisions to be made at times. By removing per capita growth from the political agenda, these hard decisions can be avoided; growth is the casualty.
- The "Individual project" argument.
Concentration on specific projects diverts policy-makers' sights from the big picture towards publicly visible (but essentially minor) projects. "By claiming to have initiated thirteen new industries in three years, or promising to build a cotton mill (or not to build it), the politicians of New Zealand have managed to create the impression that economic change is synonymous with economic progress."
- Divorcing decision-making from incentives.
Import licensing and public export facilitation divorce production decisions from market-based incentives. "The remuneration of the staffs of these agencies is quite unrelated to the prices received for the product, or to their ability to predict the development of future prices."
- Disincentives to production & promotion of cottage industry scale.
A combination of licensing and taxation of returns from production act to reduce the incentive to increase production. The divorce of major decisions on scale and method of production from those who actually benefit from a right decision results in "the reappearance of cottage-type industrial activity" which may not be appropriate to a modern economy.
Candler would be pleased to see that growth is back on the political agenda. However, his other warnings remain apposite. Policy-makers need to be wary not to concentrate on specific "individual projects" in place of an over-arching growth perspective. Further, there is still a disconnect between explicit incentives facing officials involved with business facilitation and the results of the businesses themselves. Taxation and other disincentives to production still abound; they are inevitable in a modern society, but need to be minimised to the extent possible, consistent with attaining other objectives. Finally, care must be taken to ensure that policy is neutral with respect to the scale of production in New Zealand. If Baumol's hypothesis is correct that sustainable innovation comes mainly from larger corporates, policies that assist small and medium enterprises, but that do not similarly assist larger firms, may be counter-productive to the search for innovation-based profit opportunities that lead to economic growth.
5.2 Concluding Thoughts
Each of the preceding contributions emphasises the importance of knowledge creation in the presence of uncertainty; they also emphasise the role that the profit motive plays in guiding the knowledge creation process. Policies that reduce the ability to spot unexploited profit opportunities, and/or reduce the returns from doing so, can be detrimental to growth outcomes.
Many policies will impact on the profit search process. For instance, bankruptcy penalties that are imposed on those who take risks but fail need to be carefully balanced so as to create incentives for responsible behaviour without unduly discouraging risk-taking. Policies that support those who would not take risks (unless underwritten externally) may also water down the search for opportunities with the highest profit prospects. The profit search process may be affected by policies that affect firm scale decisions and/or a firm's (or investor's) choice of activity.
While the previous contributions provide cautions for policy, they also provide insights about types of policy that may assist the growth process. Policies that assist the knowledge creation process by raising capability and/or by raising the rewards to knowledge creation are consistent with key elements of each of the approaches. These policies may include promotion of educational attainment and promotion of research activities by tertiary and similar institutions. Broad-based promotion of research and development, and of staff training, in private sector firms is likely to facilitate the profit search, investment and thence growth. Support for investment in capital equipment embodying new technologies may also facilitate the profit search since staff are likely to "learn-by-doing" through using the new equipment, taking this knowledge beyond the boundaries of an individual firm.
These types of policies are, in the main, broad-based. Knowledge that underlies development of new projects and sectors is inevitably fleeting. By the time it is processed centrally and then disseminated it is often out-of-date. Those with the incentives to obtain and process the information are generally best placed to decide whether and how to make use of it. Support for the generic profit-search process is a key role that policy can play in order to assist the achievement of higher rates of sustainable economic growth.
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