All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Why do we care about economic growth?

How much does growth matter? It turns out that it can matter a lot.  In this section we will look at two related questions.  The first has to do with growth differentials: Should we be worried about a difference of 1 or 2 percentage points in the growth rate? The second has to do with the significance of growth to world peace: Can economic growth make war obsolete?

Should we be worried about a difference of 1 or 2 percentage points in the growth rate?

To answer this question you can return to the simple mathematics of growth that is at the center of present value analysis. The equation of growth is:

FV = PV*(1 + g)^T

• PV = Present Value ( value at beginning of the period)
• FV = Future Value ( value at the end of the period)
• g = Average growth rate per period
• T = Number of time periods

To demonstrate the quantitative significance of the growth rate on the levels of future income, you simply substitute alternative values for g into the equation.  For example, let's look at future income of someone aged 20 earning $1,000 every two weeks. If we look only three years into the future, the difference between a 1 and 3 percent per year growth rate is approximately 6 percent ( 9.3 vs. 3.03 percent). At a growth rate of 1 percent, the $1000 will grow to $1030 while a 3 percent growth rate will result in an income level of $1090.  The $60 difference is a difference of 6 percent.

FV = 1000*(1.01)³ = 1000* 1.0303   = $1030
FV = 1000*(1.03)³  = 1000*1.0930 = $1090

When we move the time frame back to 30 years, however, the gap widens to more than 100 percent. If we expect income to grow at 1 percent, the $1,000 will reach $1,348 in 30 years, substantially less than the $2,427 which we would have at a three percent growth rate.

FV = 1000*(1.01)³⁰  = 1000* 1.348  = $1348
FV = 1000*(1.03)³⁰  = 1000*2.427 = $2427

The long-term significance of the growth differential can be seen in the diagram below.

The significance of small differentials can thus be rather significant when we take the long view.  One section is devoted to a brief review of the mathematics of present value.    This will be followed by a review of the 'facts' concerning where growth has occurred and a discussion of the determinants of growth - why countries grow at different rates.

Can economic growth make war obsolete?

Given the importance of growth, it is no surprise that growth has been a well discussed topic and if we extend beyond economics we find that it is an underlying theme in history. In a recent survey students were asked to identify important historical figures. On their short-list of people we had Alexander the Great, Napoleon, Hitler, Khan, and Caesar - all leaders who are remembered for their attempts at empire building as a means of acquiring greater wealth / income for themselves and their people. The students were then asked to consider the situation in China where one-fifth of the world's population lives and whose rulers are bent on expanding the possibilities open to its people. Should we be concerned about territorial grabs on the part of the Chinese?   Are there reasons to believe that they will follow in the tradition of other empires and set off on a program of territorial expansion?  Or are there reasons to believe that they will take an alternative route to expansion?

Possibility Curves provide us with an opportunity to visualize the issue of growth and alternative means of expansion in national income which will provide some insight into the 'China problem.' The possibility curve allows us to describe graphically the options open to decision makers / society. To begin let's constrain ourselves to a focus on the ability of the nation / empire to provide food and shelter for its people. The key issue facing the 'boss' is how to produce shelter, the food. You also know that the output of each product depends upon the level of resources devoted to production and on the productivity / efficiency of the production process. What we would like to know is: what are the choices open to the 'Boss' who is allocating resources.

To demonstrate the choices graphically, we will construct a 'grade' possibility curve. On the two axes we will measure the outputs, in this case they will be the level of production of two outputs - shelter and food. The green line represents all the possible combinations of shelter and food which this nation could produce given full employment of existing resources and technology.  Points B and C represent two of the possibilities while point A represents the situation where there are unemployed resources and point D represents an unattainable position given existing resources and technology.

The tasks confronting the Boss are:

• how to ensure full utilization of resources (point B and not A)
• how to allocate goods: choose between points B and C
• how to expand the possibilities: move from point B to D

While all three of these tasks are important and daunting, at this time we will focus our attention only on the last of these - how do we expand the possibilities open to the nation. We will explore three options.

Option I: Resource Acquisition

In the pre-industrial, zero-sum society in which Alexander and Caesar lived, the only means to expand the empire's income (shift out the possibility curve) was the acquisition of resources through territorial expansion.  As we saw in the grade possibility example, if we increase our resources the possibility curve will shift outward.  The acquisition of resources extends the nation's production possibility curve outward so that E is now attainable, but D is not yet attainable. For those aware of China's size and ambitions for growth, this is an uncomfortable view of the world. It is also a view of the world with a fundamental flaw if you believe Paul Kennedy's view of the rise and fall of empires. In Kennedy's view, the expansion in size necessary to raise the possibility curves also creates the need for greater expenditures on 'unproductive' ventures designed to defend and control the territory. Stated somewhat differently, the territorial expansion sets on a path where the empire eventually outgrows its ability to control itself and it implodes.

Option II: Production Efficiency

This is, however, not the end of the story. Adam Smith, an English economist whose view of the world appeared in his 1776 book An Inquiry Into the Wealth of Nations, offered an alternative model of progress / growth. According to Smith, the key to economic growth was productivity growth - the more efficient use of resources. Territorial expansion was no longer viewed as necessary for economic growth since a nation could expand its possibilities by getting more output from existing resources. If we look closer at Adam Smith's work we find that the key to productivity growth was specialization - the division of labor. Smith used the example of the pin factory to demonstrate the potential growth associated with specialization. If we could break down the production of pins be into separate tasks where people could get 'real good' at what they do, then they could produce far more pins then they could working alone. In the diagram below we have demonstrated the impact on the possibility curve of an increase in productivity in the production of food. With existing resources we can now attain what was previously unattainable (pt E). Smith went beyond this observation and suggested that there was an economic system that was well suited for producing this productivity growth, but for now let's simply look at the picture of his view.  If we had productivity growth that affected both sectors, then the curve would shift outward and the situation would look very much like the one that we saw with territorial expansion.

Option III: Trade

No surprise, but we are not at the end of the story yet. In this view of the world we would expect to find a set of self-sufficient countries with little interaction between them. But have we tapped all the possibilities of growth? Why not carry the specialization concept further-beyond national borders which economists often tend to view as somewhat arbitrary? David Ricardo, following the logic of Smith, identified trade as another means to expanded possibilities. We will look only briefly at the impact of trade on the possibility curve here, a warm-up for a more thorough treatment of trade.

The key to understanding the trade situation is recognizing that we can have a distinction between the production possibility curve (what the people of the country can produce) and the consumption possibility curve (what the people of the country can consume). Without trade the two curves are the same, but with trade we can see a wedge driven between the two.

In the example below, the possibilities open to the country in isolation are represented by the red line. The combination of shelter and food at point B are attainable if resources are used efficiently, but point A and E are unattainable. Or are they? What if someone (another country maybe) came along and said that you could specialize in the production of Shelter and then trade the shelter for food along the green possibility curve. Clearly we could now get to point E and the country now has a second possible means for expanding the possibilities open to its people. To understand why this deal might be on the table, we would need to delve further into the trade model.

So what about China?  There is always the concern for territorial expansion, but the prospects for growth offered by increased efficiency and trade break the link between territorial expansion and economic growth.  Economic growth is possible as a result of increasingly productive uses of resources and international trade and now we will turn our attention to the patterns and determinants of growth.

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