Robert Solow on 'Why Economies Grow'

As a follow-up and companion piece to my previous post, I decided to publish a transcription of a lecture on economic growth by Robert Solow that I transcribed originally as an aid for friends and colleagues who were studying economics. Although the lecture was given by Prof. Solow a few years ago during the height of the financial crisis, it contains loads of timeless insights, some of which is useful to be reminded of in the current situation, as discussions about the output gap resume in the next few years (see chart).

However, it's extremely important to keep in mind that in our current predicament as a result of covid potential GDP will also likely take a huge hit, as businesses and employees require some catching up in terms of business practices (misaligned with changing consumer preferences) and job training (due to skills entropy from employees being on furlough), to name only a few aspects that are likely to be impacted. In many ways, the post-covid period will bring us back to the type of economic analysis that used to occur a long time ago when natural catastrophes had significant and frequent impacts on economies' productive capacities.

The video of the lecture is included down below, though the sound quality is very bad, which is why I recommend reading the transcription instead (and you'll get through the transcript much faster by reading it).

Key insights are highlighted in bold font. Enjoy!

The business of this course is the long run. What are the sources of economic growth in the national economy or in the larger economy? Where does growth come from? And the policy implication – well, not implication, but policy question – is ‘How do you get an economy to grow rapidly and to have that growth widely shared in the nation?’
But there is a problem – it is a problem that appeared in the slides that Prof Newstone showed. It is a problem about getting there from here. So I’m going to start by talking a little bit about right now – this is not going to be the usual stuff about the financial crisis and all that – I have something else in mind.

There is something very odd about our economic situation in the US today. I read just recently an estimate from the Federal Reserve that about $7 trillion worth of wealth has been destroyed in the last year or year in a half (in 2008-2009). The country, so to speak, is $7 trillion poorer than it was.

When I wasn’t having a conversation with Cathy in the car, I was trying to divide 7 trillion by 300 million--the population of the US--in my head. It comes to about $23,000 for every man, woman and child in the country. Some, of course, have lost more, some have lost less.

What I want to point out is how strange that is: $7 trillion of wealth has gone down the drain but the productive capacity of the US economy – the capacity of our system to produce goods and service for its people – hasn’t diminished at all. In fact, it is undoubtedly higher than it was a year ago or 18 months ago: the labour force is a couple percent larger, the skills and education and training of the population is certainly not deteriorating and have probably gained. The net investment in capital has been positive – it’s been declining – but has been positive.

So we have a bigger stock of productive capital in the economy now than we did a year ago or 18 months ago. So the productive capacity of this economy is bigger than it was, despite of this $7 trillion of disappearance of wealth. If you are thinking of buying the US economy as a gift for your boyfriend or girlfriend, it would be worth just as much as it was worth – you know, like a used car – it would be worth just about as much as it was worth a year ago.

So in that sense we haven’t lost anything at all. But, of course, the point is we are in a recession. It is one year old according to pundits. And according to other pundits, or the same pundits, it’ll continue for at least until the second half of this year and maybe beyond. And the point is we are not using the productive capacity that we have.

You saw the unemployment numbers that Professor Newstone showed you. It is a lot harder to measure excess capacity in industry than it is to measure unemployment, but there are such figures, and they show an increase in unused capacity. So we have this machine for producing the goods and services for the population and we are not making full use of it. And that under-use of economic capacity, of productive capacity will go on for a long time. Even if the economy turns up in the second half of this year we will undoubtedly finish 2010 still with some slack in the economy because the slack disappears only gradually. 

So if you are interested – now, this is the point, this is why I started this way – if we are thinking about the long run growth of the economy (which means the long run growth of its capacity to produce), it’s not a separate but it’s an analytically slightly different problem to make sure that that capacity is used.

As long as we are not using all of the capacity that we have, the economy and the decision-makers in the economy are not likely to be motivated to do the things that increase potential output, that increase the productive capacity very rapidly.

So the short-run order of business – policy business – for us and every other rich country in Europe or Asia right now is to close that gap or narrow that gap between productive capacity and actual output, which means fundamentally trying to increase the demand for goods and services. And to do that in a way that at least doesn’t create obstacles to the long-run growth of the economy once the gap is closed, and maybe does some things that will help it.

So, imagine it is now January 2011 and the American economy and the economies of the other rich countries – developed countries of the world – are prospering reasonably well, are using their capacity, have closed that gap. Then the question is: What makes them grow? What economic activities that take place have the effect of increasing the capacity of the economy to produce useful goods and services? 

Now, you won’t be surprised – in fact, I’m staring at this monitor here and it says: so what determines the rate of economic growth in the economy? And that’s the question that I want to come to now, and it becomes relevant after we have done the short run task of closing that gap. There isn’t any one word or two word answer to that question. 

And I should make it explicit that I am thinking now about what determines the rate of economic growth in a rich economy, in an advanced industrial economy. I am not thinking about developing economies where the answers are related but the answers are somewhat different.

And the truth is that for an advanced economy the answers to that question – what are the sources of growth of national output, of productive capacity – are really the usual suspects. They are things we have known about now for quite a long time. And basically, what matters is what you might describe as investment in a very broad sense. I have to emphasize “in a very broad sense”.

What increases the productive of an economy like ours is investment in physical capital, in machinery, in computers and all the rest of that, investment in what economists call human capital, meaning skills and capacities of workers and people who work in the economy, and investment in new technology.

And here there is a slight difference between the US and even most of the countries in Europe. Not quite across the board but in most branches of industry the US is the technological leader. The gap was very big at the end of the Second World War and has closed considerably. But still, if you look at sector by sector, with some exceptions, the US is the technological leader.

Other countries of the world, that were even fairly rich countries have the luxury of being able to acquire technology by innovation, essentially by adopting, using what is already known. This country (i.e., the US) is in the position of having – so to speak – to invent its own future.

So basically, if we are looking now at the US, the things we have to look after in order to have a successful fairly high rate of growth (we can talk about the equity issues later) are a high rate of savings and investment in plant and equipment. I’d rather have the saving done here than abroad so that, in effect, the capital equipment that is built by investment in this country is owned in this country, and the returns to it stay in this country. It’s not necessary but it’s probably desirable. 

We need an extraordinary amount of emphasis – and we’ll talk more about this later – on investment in human capital, on producing the labour force that has the skills that are necessary to successfully operate that plant and equipment. And that is especially important because a country like this also has to invest in new technology. There is no place it can copy from – it has to in most cases create it itself.

Now, when I say new technology, the phrase tends to have a “high tech” air about it. But I don’t mean it that way.  New technology needn’t be high tech. It turns out that – in many ways – the most important contributors to productivity in the US over the last decade or two have been the application of information technology to wholesale trade, retail trade and financial services.

In fact, there are studies trying to understand why the major, big European economies, Germany, France, UK and Italy have lagged behind the US in productivity terms, general productivity terms. And the common answer seems to be that they have been slow to adapt the information technology to the service sectors. In manufacturing, there is very little gap, if any. But the gap is in the service sectors. 

So, this is extremely important. And I want to emphasize it, even at the risk of some repetition. One of the standard, valid, almost universal generalizations about the way people behave economically is that technically the income elasticity of the demand for services is high. All over the world, as incomes rise, personal incomes rise, people want to spend, [and] choose to spend a larger fraction of that income on services rather than goods. And you can understand why that should be so.

So this means that most of the rapidly growing advanced economies grow more rapidly in the service-producing sectors than in the goods-producing sector. There are exceptions to that. A country like Germany – to a lesser extent Japan, or formally Japan, not so much anymore – has a strong bias toward trying to make its living from simply exporting high quality manufactured goods. You notice I said exporting because the population of Germany, like the population of anywhere else, wants to consume services as it gets rich, not goods.

So those are the things, the essentially important things that a country like the US needs to do to generate long-run growth of productive capacity. 

I should say, in terms of policy, that you should beware of any universal advice like “well, the market will take care of that”. You know, if the alternative to the free-market economy is some kind of central planning, there is no question to where the advantage lies. But there is absolutely no evidence in the historical record of the advanced economies that zero regulation or weak regulation of industry is somehow conducive to rapid growth, or that minimal involvement of the government in the economy is conducive to rapid growth.

The functions of the government in terms of long run growth are just what you would deduce from what I have already said: promoting research and development, providing incentives for investment when they are lacking, taking care of education, and looking after mobility. By the way, it is probably also true that a country – there is less evidence for this generalization, but it’s probably also true – that business cycle instability is bad for economic growth.

For countries that are given to wide fluctuations like the ones we were looking at a few minutes ago, that’s not helpful for long-run growth because it adds to uncertainty. The likelihood of broad fluctuations adds to uncertainty is bad for all forward looking activities, like investment, like mobility, like education.

I wanted to say one more thing about the issue of mobility. When I say mobility, I mean industrial mobility and occupational mobility. In a rapidly growing, technologically-based economy, people have to change the nature of their jobs frequently and capital has to flow freely from obsolescent industries to new industries.

It is very important when you come in this course to talk about issues of equity. I think it is very important to find ways so that the burdens that are associated with necessary mobility don’t fall on workers and other people who are ill-equipped to prepare them [for that eventuality].

Dislocation and sometimes dislocation is probably an inevitable part of fast, mainly technologically-based growth. But it is the task of economic policy to find ways of combining that with income security, up to now, where it’s mostly below the median for incomes.