Are we being stupid? – Part 1: Growth Economics 101

Over the past couple of months a number of things have been happening, which made me want to start writing a blog. So, when I finally sat down and started writing on one of them I realised that the topics are all linked and can be wonderfully put together under one question: „Are we being stupid?“ If I had to give this series a more technical title then it would be something along the lines of „Are Europe’s efforts to stay competitive appropriate to ensure the future growth of the region“, but, let’s face it, „are we being stupid?“ is a much more catchy title and regarding some of the things I’ll be talking about also way more appropriate. I wanted to jump right in, but some of you may have very little background in economics or economic growth, so I’ll use part I to put the whole debate into context (by heavily oversimplifying things!!!). By the end of this blog you should know why Western economies are innovation-driven and why that matters. In part 2 we’re getting more to the core of the issue about how innovative Europe is in comparison to other developed countries. Part 3 is a proposal for the changes I consider necessary. Let’s get started…

Growth theory 101

If you’ve never seen a model of economic growth, then don’t stop reading. This is easy, I promise! If you’ve seen a couple of growth models, I’m sure you’ve seen the Solow-Swan model illustrated below (I just took a random picture from this page).

 For now, we do not care at all about the dynamics of the model, what we care about is the solid black line, denoting potential output as a function of capital (here labour is fixed). This line could also be called the production possibility frontier. That means that with the given inputs (here just capital and the fixed amount of labour), this is the maximum we can produce, given the technology we have. Two main things are important here: firstly, if we are for whatever reason inefficient or incapable to use these inputs in the optimal way, we could end up at a point below the frontier. Secondly, whenever „technology“ improves, our frontier moves upwards, meaning that we can produce more with a given amount of inputs. When looking at the graph you can also see that one of the Ys is Y*, meaning that this is the steady-state (this is a long—run model). It is determined by the intersection of the colored lines (nevermind how and why) and it is an attractor (meaning that the dynamics of the model will make capital rise when we are below K* and fall when we are above it). The key point is that once we have reached the steady-state level of capital K* then the highest output we can produce is Y* UNLESS we change the parameters that determine the intersection of our coloured lines OR unless we somehow increase technology and push the black line upwards. In many cases the latter option will be more feasible as the coloured lines are determined by some deeply structural parameters of the economy (i.e. the savings rate).

Classifying countries

This means that we can separate our group of countries into four very basic categories1:



K < K*

Efficient (Y on the frontier)

Group A: to grow, these countries need to constantly push the technology frontier outwards

Group B: More factor (capital) accumulation leads to growth

Inefficient (Y below the frontier)

Group C: more investment (i.e. Into infrastructure) is needed to fully exploit the available technology

Group D: needs more factor accumulation and more investment in infrastructure etc. to exploit the available technology fully

Most developing countries will be in group D. They haven’t reached their steady-state level, their infrastructure and input use is inefficient and they do not have technologies available to them that are suitable to their context. These emerging countries, like China, for instance, are factor-driven. Their growth is still driven by capital accumulation and their technology growth is driven by the technologies embodied in imported capital goods and imitation. Most developed countries belong either into category A or C. The USA are generally considered the most innovative country and in cross-country estimations the US will often turn out as the country at the frontier. Europe, for instance, clearly has the same technology available as the US, however, due to its economic and political structure, it may not be able to exploit these technologies as innovatively as the US does.

Having discussed this very rudimentary model, it should be clearer where categorizations such as the Global Entrepreneurship Monitor model come from. The GEM model classifies countries into three categories according to the main aims for their governments. In factor-driven economies, governments should focus on providing the basic requirements for development, such as institutions, education, health care and macroeconomic stability. In efficiency driven economies, the government’s domain is the development of higher education systems, competitive goods and labour markets and ensure an environment conducive to the adoption of new technologies. The most advanced countries are classified as innovation-driven, which means that the government should strive to improve the entrepreneurial framework and foster economic growth through innovation and technological improvements. The (Western) European countries are certainly innovation-driven, which means that to flourish, we need to keep our economies flexible, dynamic and innovative.

I’m not sure how you feel, but “flexible, dynamic and innovative” is not necessarily what comes to my mind when I think about Europe, but we’ll look into all this in more detail in part II and part III of this blog series.

1Note that I am assuming for simplicity that we only have one technology frontier. In fact, every country will have its own frontier, which may be very context-specific due to the inputs and infrastructure avalaible, etc.. See my previous blog for some intuition.   

4 thoughts on “Are we being stupid? – Part 1: Growth Economics 101

  1. Interesting post. I like the way you use the Solow Model for your categorization of the different development regimes. I just wished you wouldn’t have used the horrible c-word, ‘competitiveness’. It is one of the words that really should be banned from public discourse, because it conjures up this extremely misleading image of nations being caught in a constant struggle of survival against each other. If there is something we can do to make our economy more productive, we should do it for our own sakes, not out of fear of being run over by the Chinese or some other ‘global competitor’. Whether their economies grow faster than ours or not is quite irrelevant for our standard of living. (I know, sort of off-topic, but I feel it needs to be said from time to time.)

  2. I think competitiveness is a pretty important thing actually. Not in the sense that I am arguing for mean competition between nations (i.e. begging thy neighbour). Of course it affects our living standards if other countries grow faster than we do. I guess I could blog about that again in more detail (when the series is finished), but for now you could look at a previous blog of mine
    for some intuition on how happiness is affected by comparison. The argument that if we stay put, but others advance, comparatively we do worse, translates 1:1 to living standards.

    In principle I agree: it would be nice if we did things because they are right and we believe in them rather than any other reason. Honestly, though, other incentives are often so much more powerful (in all parts of live).

    • Thanks for the link. But I beg to differ. What happiness studies show according to your own summary, which is very nice, is that people care about their income relative to that of reference group. The question is, of course, who is the reference group? My neighbors? My coworkers? My fellow countrymen? Or the world population at large? Only in the latter case is it true that faster growth abroad makes domestic residents worse off. Do we have evidence that the reference group is indeed the whole world population?

      (I am aware that foreign growth can affect domestic welfare via the terms of trade. But as far as I know ToT effects are usually small.)

  3. Good point 🙂 .I agree, what your reference group is an interesting discussion.
    The reason I mentioned this is because a reference group has two important effects: firstly, it is an effect on our perception of our wealth and, I agree, apart from people who travel a lot and particularly the further away the country is, this effect may be small. However, there is also a tangible effect that if we fall behind compared to our reference group we are also objectively worse off. If everybody gets a wage raise every year except for me, then at some point I will not be able to afford the same standard of living as everyone else. Similarly, if Europe doesn’t innovate while everyone else does, at a certain point we are going to feel the impacts regarding how attractive we are as nations for innovative and fast-growing firms and how competitive national products are in foreign markets and also compared to available import “substitutes” from other countries.

    I’m not trying to say that these problems in any way outweigh other problems we are creating and which have little to do with competitiveness in global markets.

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