Economics in Minutes

by Niall Kishtainy

  A graph of post-war GDP per head in several Asian economies shows how growth is fastest in the early years of development, and then tends to flatten out, allowing other countries to catch up.

  Endogenous growth

  Investment in improved technologies such as automated production lines allows growth to continue in rich countries.

  In early growth theories, economists assumed that the technological progress that helps generate long-run economic growth came from outside of the economy: growth was said to be ‘exogenous’. In the mid-1980s, a new wave of theories argued that technology was generated by forces within the economy, and hence that growth was ‘endogenous’.

  Under the older approach, all countries have access to the same exogenous technology. Because extra capital investment has less of an impact the more capital a country has, growth slows down as countries develop, so poorer countries tend to catch up with richer ones. Endogenous theory weakens this conclusion – here, technology is recognized as coming from innovation that is influenced by economic incentives. New technology and knowledge produced by one firm can help the productivity of others. This can offset the diminishing impact of capital as economies get richer, so growth doesn’t necessarily have to slow down.

  Technology

  Technological change is critical to raising living standards over the long run. Improvements in technology allow a greater volume and variety of goods to be produced, although some worry that new technology causes unemployment if mechanization makes labour obsolete. In fact, by making each worker more productive, technology can increase the demand for labour. It can even create entirely new sectors of the economy, bringing with them new employment opportunities.

  Some ‘general purpose technologies’, such as electricity, are revolutionary: they raise the productivity of every sector of the economy. Other kinds of technological improvement – for example, more efficient ovens – raise productivity in specific sectors. The introduction of a new general purpose technology is a leap that fundamentally transforms economies and can lead to new patterns of economic growth. In the 18th and 19th centuries that leap arose from steam power, while today it is coming from information and communication technologies.

  Population growth

  Modern concerns about our planet’s capacity to support an ever-rising population hark back to the prediction of English demographer Thomas Malthus in the 18th century that England’s prosperity was threatened by population growth. He argued that higher living standards could never be sustained. Firstly, they would cause a lower death rate because people would be better nourished. Secondly, they would allow people to have more children. The result would be an ever-increasing population. With more people on a fixed amount of land, food production would not be able to keep up and living standards would decline, dooming people to subsistence or worse.

  Of course, Malthus’s prediction didn’t come to pass, because technological improvements in England allowed more food to be produced so that both living standards and population grew. Today, some very poor countries do seem to be caught in a Malthusian trap in which higher population translates into poverty. However, the richest nations exited it long ago.

  Industrialization and modern growth

  On the path to high growth and advanced development, countries inevitably industrialize, moving away from largely rural, agricultural societies. The Russian economist Simon Kuznets summarized the set of economic and social changes that this involves in the term ‘modern economic growth’.

  Societies undergoing this form of growth see rising living standards alongside a growing population: higher population no longer means lower income. The driver is ‘structural transformation’: workers move from fields and family firms to big companies and factories in the cities. The share of industrial production in national income starts to rise, accompanied by broader cultural trends such as secularization. Britain achieved modern economic growth with the Industrial Revolution of the 18th and 19th centuries. European nations, the United States and others followed soon after. However, many countries have yet to make the transition and an explanation of the precise factors that trigger it remains elusive.

  Creative destruction

  The term ‘creative destruction’ encapsulates the insight that the progress of capitalism is bumpy – to create anew, the old has to be destroyed. The Austrian economist Joseph Schumpeter argued that economic development is powered by entrepreneurs who innovate and take risks. Entrepreneurs come up with new products and create markets for them. Think, perhaps, of the laptop or the compact disc player – unprecedented products whose inventors created with no guarantees of success. The firm that introduces a new product earns high profit for a time – the promise of this return is what drives the innovative effort – but eventually other firms start to produce similar products and the market plateaus.

  In this way of thinking, recessions are necessary to weed out old, stagnant businesses and make way for a new generation of entrepreneurs. This is different from the standard economic view of the market’s ‘invisible hand’ (see The invisible hand) smoothly allocating resources to the best possible uses.

  Development economics

  Development economics is the study of how the economies of poor countries function, and how they might become richer. Some economists question whether there are really fundamental differences in the economic laws governing poor and rich countries, but others believe the problems facing poor countries are so specific that special theories are required. An early idea was that poor economies needed a ‘big push’. A new port might only help trade if a road was built, but for the road to be worthwhile it would have to lead somewhere like a port. This circularity could only be broken if the state coordinated a range of simultaneous and complementary investments – something private markets would be unable to do. By the 1970s, this view began to fall out of favour – economists argued that too much state and not enough market hobbled developing economies. In the 1980s, the World Bank and International Monetary Fund brought in free market reforms. These, too, had patchy results, and attention has now turned to the challenge of encouraging states to function better.

  Poverty lines

  One way of measuring the degree of poverty in a society is to define a minimum level of income below which a person is said to be in poverty. One example of such a ‘poverty line’ is the often-cited dollar-a-day, but how should a poverty line be set? Economists are more concerned with well-being or ‘utility’ than with money itself, so one might try to define a line that delivers some basic level of utility, perhaps by using subjective measures of well-being. An alternative approach is to use a more objective criterion, such as a minimum calorie level.

  An important distinction is between relative and absolute poverty: while an absolute line might be set according to a biological criterion, a relative measure is stated as a minimum proportion of average income. With a relative income line, there will always be some people living in poverty, even if they own televisions and mobile phones. Poverty lines have their drawbacks, however: increased deprivation among those far below the poverty line doesn’t register in a higher poverty rate.

  Entitlement theory and famines

  It is often believed that famines are caused by shortages of food such as those following harvest failures. In the early 1980s, Indian economist Amartya Sen developed his entitlement theory, showing that the causes of famines are in fact more complex. In this theory, ‘entitlements’ are the set of goods and services that households are able to obtain either through producing them, buying them or receiving them from the government. Even in poor countries many people do not produce their own food – they earn wages which they use to buy food, and the balance of wages against the price of food largely determines their entitlements to food. Famines can occur when entitlements fall below the minimum amount of food needed to survive. This can be caused by falling wages or rising prices, rather than by actual reductions in local food production. This is what happen
ed in a famine in Bengal in the 1940s where wages fell behind food inflation – the price trends were more important than changes in overall food supply.

  Debt relief

  Debt relief is aimed at enabling poor countries to spend money on schools rather than interest payments.

  During the latter decades of the 20th century, many poor nations amassed huge amounts of debt. Such debt becomes a problem when growth is insufficient to generate the resources needed to repay, and by the 1990s, with a large debt burden alongside poor economic performance, many nations were unable to meet their interest payments. Debt relief was a large-scale cancellation and rescheduling of debts in response to these countries’ economic crises. Many economists argued that Western nations and international organizations that made the loans should cancel them. The debts were so large that repaying them in full would require cuts to essential investments needed for development. Cutting the debts would help these nations grow. Another case for debt relief was that many of the debt obligations were taken on by earlier corrupt or illegitimate regimes – should post-apartheid South Africa have to pay the debts of the apartheid government? However, debt relief has not been without its critics: some say that it rewards bad policy and corruption.

  Dependency theory

  Most economists believe that trade between countries is ‘win-win’. Dependency theory, which emerged after the Second World War, was a radical alternative approach. Its central idea was that trade between developed and developing countries is inherently unequal and exploitative. Rich countries buy raw materials from poor countries to fuel manufacturing, producing goods that are traded mainly with other developed nations. Investment in poor countries by rich ones tends to exploit rather than develop the local economy, it is argued. A related idea is that the ‘terms of trade’ – the imports a country can buy with its exports – often move against poor countries as the prices of raw materials fall relative to those of manufactured goods. Dependency theorists argue that the result is a ‘core’ of ever richer industrialized nations alongside a ‘periphery’ of marginalized ones falling further behind. The rise of the ‘Asian Tiger’ economies (see The Asian Tigers), has perhaps put paid to the dependency story, or at least suggested that there are important caveats.

  Inequality and growth

  The links between growth and inequality have engrossed economists and fired popular debate. One view is that economic development implies rising inequality: when industries emerge in predominantly agricultural countries, inequality rises at first, because the new sectors offer higher wages but only make up a fraction of the economy. Others have argued that in the latter half of the 20th century economic growth drove the reduction of poverty and reduced inequality.

  A different way of looking at things is to consider how the level of inequality itself affects economic performance. Some economists have suggested that inequality stifles economic growth. Inequality means that the capital stock is in the hands of an elite. The mass of the population, who own no capital, want a high rate of tax to fund public services. Because they form the electoral majority, governments end up placing a high rate of tax on capital, but because growth is reliant on the accumulation of capital, this actually slows the rate of growth.

  This chart compares the typically unequal distribution of income across population, with the line of distribution if everyone had the same income.

  Human capital

  Capital is made up of goods such as machines and factories, investment in which allows future output of products and services. Economics has extended this idea from physical capital to human beings. Human capital is the productive capacity of people – the skills and aptitudes that allow them to drive tractors, design skyscrapers and draw up balance sheets.

  Just as a firm builds up its physical capital by installing new machines, people invest in their human capital by undertaking education and training. A firm buys a new machine if it will earn a return in the future, and similarly, workers invest in education if it is rewarded with a higher wage. Workers get paid a wage equal to the extra amount of production they create. Hence, because more human capital makes them more productive, employers will be willing to pay them more. The gap in wages between skilled and unskilled workers is known as the skill premium. Human capital is needed for economic growth, and a lack of it can seriously hamper economic development.

  The Asian Tigers

  One of the most dramatic economic developments of the 20th century was the transformation of the so-called Asian Tigers – Hong Kong, South Korea, Singapore and Taiwan – from marginal economies into advanced, developed nations with standards of living to match those in Europe and the United States. Some contend that their success was due to the state getting out of the way and allowing free markets to operate. Others argue that these countries had ‘developmental states’ – governments that deviated from orthodox recommendations to provide only basic public goods and not to meddle with the markets. This second explanation stresses the authoritarian, interventionist nature of these governments, which although embracing markets, also shaped them – for example, by directing production towards particular industrial sectors. Whatever the truth, it is certainly the case that these countries had unique kinds of economic organization. More recently, China’s economy has also taken off. It, too, has crafted its own mix of state intervention and market incentives.

  The informal economy

  Like grass between paving stones, economic life sprouts among the cracks in the formal economic sector of private companies and state bureaucracies. Pedlars hawking bric-a-brac from makeshift stalls, shoeshine boys and even currency black marketeers all make up what has come to be known as an informal economy. Such economies have emerged in many eras, and still exist in a wide range of societies.

  Recently, there has been interest in the informal sectors of developing nations. In such countries, the informal economy makes up a large share of economic activity. Because it is not part of the formal structure of legal regulation and taxation it is hard to measure. The urban populations of many developing countries have swelled as rural migrants arrive looking for work, and many of these people end up in the informal sector. Some development policy is aimed at helping people in this part of the economy – for example, by providing them with loans, which they would otherwise be unable to obtain from banks.

  Exhaustible resources

  Exhaustible resources are those whose stocks are finite, such as coal and oil – with continual use they will run out. Economically, exhaustible resources are like financial assets: one theory says that the profit (price minus cost) of an exhaustible resource should rise at a rate equal to the interest rate. If the profit from oil were to rise slower than this, then oilfield owners would pump and sell their entire stock, putting the revenues into a bank to earn interest. This would reduce today’s price so that given future prices, profits would grow again at the rate of interest. Hence, the price of an exhaustible resource should gradually rise as it gets used up. But instead, prices of natural resources have often shown long-term falls.

  Commonly, the point at which a resource is going to be used up is unknown, and technological advances that allow for more efficient extraction or use of the resource can push this point further into the future. Perhaps the real unknown, though, is whether such deferral faces an ultimate limit.

  The environment and collective action

  With climate change, the world faces a gigantic collective action problem. Imagine a business in Spain which produces greenhouse gases. It might limit emissions if they reduce its own profits, but like other businesses, it will not take into account the impact of its emissions on other firms, whether Spanish, French or German. Another aspect of the collective action problem is that protection of the environment is what economists call a ‘public good’ (see Public goods and free riding), and raises the question of why one should contribute to the costs of protection when one can free ride on the efforts of others. For climate change, the problem is
acute because the greatest costs will be borne in the future rather than the present. One solution is to set pollution quotas, although these are hard to enforce. Another is to tax pollution. Carbon-trading schemes attempt to create a market for pollution, forcing firms to face the full costs of their pollution production. This allows firms who can easily cut emissions to make the biggest reductions.

  Glossary

  Balance of payments

  A record of the transactions between residents of one country and those of other countries, including imports and exports of goods and services and capital flows, such as investments and loans.

  Barter

  The direct exchange of goods – the trading of a fish for a tomato, for example – without the use of money. Barter is less efficient than exchange using money, since it requires that both parties have access to tradable goods.

  Bond

  A financial security issued by a company or government in order to raise money. The buyer of the bond lends money to the issuer in exchange for interest payments.

  Capital

  Goods for production, such as machines and factories, that are used to make goods for consumption, such as tinned soup and shoes.