Growing the economy over time: Why do some countries do it better than others?

Of all the questions in economics, this is likely the biggest. In the early 1900s, Argentina was one of the richest countries in the world, with a per capita gross domestic product (GDP) that was 50 percent higher than Italy’s and far above those of Japan and South Korea. A little more than a hundred years later, Argentinian GDP per capita was less than half that of these other countries … and Japan’s rapid post-WWII growth had pushed it well beyond Italy.

What caused these disparities? How did some countries grow so fast while others foundered? These questions about economic growth are so pressing and so important that the Nobel Prize-winning economist Robert Lucas said, “once one starts to think about them, it is hard to think about anything else.”

Macroeconomists aren’t obsessed with questions about economic growth because they’re obsessed with money and riches in and of themselves. Instead, countries with high incomes tend to have other things that people care about: lower infant mortality, longer life expectancy, better healthcare and education, and so on. In surveys, people in richer countries also tend to report higher levels of life satisfaction. So although being richer isn’t the be-all and end-all, it certainly matters. In many poor countries — where large numbers of people live without basic needs such as enough food to eat, a roof over their heads, or basic sanitation — increasing people’s incomes is a necessary step towards improving their lives.

In order to become richer, countries need economic growth. An economy is said to grow when the total amount of goods and services that it can produce increases. Economic growth is usually expressed as a percentage change over a year: If the U.S. economy grows by 2 percent this year, that means it can produce 2 percent more “stuff” this year than the year before.

Small differences in growth rates can make a big difference over long periods of time. A very useful approximation in this case is the Rule of 70. This rule says that the number of years it takes for anything to double is equal to 70 divided by the annual growth rate. For example, if an economy grows at 2 percent a year, it takes about 35 years to double in size. But if it’s able to increase its growth rate to 3 percent a year, the economy doubles in only 23 years and 4 months. Think what this means. If two economies are the same size now and one grows at 2 percent while the other grows at 3 percent annually, the slower one will double in 35 years and then double again in another 35 years for a four-fold growth overall. Impressive as that is, though, the economy growing at 3 percent will double three times over the same 70 years for an eight-fold increase overall. Hence, it will be twice the size of the slower-growing economy within a single lifetime — all because of 1 percent extra annual growth!

So you can see why finding ways of boosting economic growth (especially in poor countries) is high on the agenda for macroeconomists.

Cycling through the short run: What causes recessions and unemployment?

Over the last 50 years, the U.S. economy has grown at an average annual rate of about 2.8 percent. Roughly 1.1 percent has come from population growth: We typically add more workers each year. But the majority of it comes from the fact that we get more productive each year — to the tune of about 1.7 percent annually.

If this progress had been steady and even, macroeconomists could just focus on the long-run growth questions. But, like true love, the course of GDP seldom runs smoothly. The Great Recession of 2007–09 is just the latest reminder that the economy often wanders far from the long-run trend, with GDP falling and unemployment rising. The GDP that those unemployed workers could have produced — such as more or better healthcare, more or better transportation services, more or better education, or a lot of other stuff that society values — is lost.

To be sure, given how we measure unemployment, some people are unemployed even in the best of times. Basically, you’re considered to be unemployed if: a) you don’t have a job, and b) you’ve been looking for one in the last few weeks. Yet over any month or quarter, some people lose or quit their jobs and look for new ones. Others, either new young workers or older ones who had been happy taking time off, enter the labor force and search for employment as well. Because it takes time to match each worker with a specific skill set to a firm looking for just those skills, these workers clearly meet the definition of being unemployed. Because such unemployment reflects the normal frictions in the job matching process, economists refer to it as frictional unemployment.

In addition, there are structural features of the labor market that also lead to positive unemployment even in overall good economic times, what economists call structural unemployment. Regulations, for example, that make it difficult to discharge workers once they are employed are also likely to make companies reluctant to hire workers in the first place.

State licensing policies and regulations can have a similar effect. It may surprise you to learn that virtually every state imposes a licensing requirement not only for professional occupations like doctors, dentists, and lawyers, but also for those such as manicurists, cosmetologists, HVAC contractors, and massage therapists. Some even impose requirements for being an upholsterer, a locksmith, or an interior designer. Often there is little reciprocity between states. So, in moving from one state to another, a worker frequently must repeat many of the exams and training necessary to regain her license. This expense can be enough to wipe out any gain from moving to a different state. Even if there is a surplus of, say, medical technicians in New Mexico and a shortage in California, those in New Mexico may choose to stay unemployed rather than move to California and incur the cost of regaining a license. Recent estimates suggest that such licensure requirements cost up to nearly 3 million jobs per year.

Minimum wage laws can also cause structural unemployment. By mandating a wage higher than the market would, such laws can attract a lot of workers while at that same time making companies less willing to hire. The excess supply will again be considered unemployed — not because there are no jobs but because they cannot get employed by offering to work for a lower wage. The law prevents that. To be sure, this view has been challenged in recent years as economists have found that such effects may be countered by the fact that a higher wage makes it easier to hire and keep workers, thereby paying for itself in lower turnover costs. But part of the reason for this is that, within the U.S., the current federal minimum wage is so low. In inflation-adjusted terms, the current federal minimum wage of $7.25 per hour would have to be about $9 to reach the peak reached in the late 1960s. At such low levels, it is perhaps quite plausible that even significant increases to, say, $12 or $15 an hour might still not create any unemployment. However, at some point, the traditional argument surely holds. Mandating a minimum wage of $30 an hour, for example, would definitely price large numbers of workers out of their jobs.

In the case of both frictional and structural unemployment, any solutions lie mainly in policies to improve the functioning of the labor market, that is, in microeconomic policies. These might include improving the information that workers and firms have about each other and reforming licensure practices.

By contrast, cyclical unemployment reflects more purely macroeconomic forces. It is, as its name implies, a short-run phenomenon associated with the business cycle. It usually stems from low demand for goods and services that leads firms to cut production and lay off workers. Those workers want jobs and are willing to work — there just aren’t enough jobs available to employ them.

Cyclical unemployment is very costly because it means not using resources to produce goods that the economy would produce if it were operating normally. The U.S. Congressional Budget Office estimates that in 2009 the U.S. economy lost about $1 trillion (nearly 7 percent) of GDP due to the unemployment associated with the recession. That’s a whole lot of healthcare, automobiles, education services, or whatever we wanted to use those unemployed resources to make. This is why understanding the reason that the economy periodically falls into recession is the second great macroeconomics question. The payoff to reducing the costs of cyclical unemployment is potentially very large.

Valuing money: What causes inflation?

Think back to when you were a kid (if you are one, ask your parents or grandparents about this). No doubt you remember that things were much cheaper in the past. After school you could walk into a corner store and buy a candy bar, soda, and a magazine for less than two dollars, depending on how old you are. Those were the good old days, when Coke meant cola and a joint was a cheap place to eat.

When prices rise on average in an economy, it’s called inflation. In the recent past in developed economies, inflation has only been a few percent per year, but some decades ago double-digit inflation, even in developed economies, wasn’t unusual. One of the reasons that inflation has come under control is that economists now have quite a good understanding of what causes it and how countries can go about reducing it.

Although inflation (increasing prices) is the norm, some countries (such as Japan) have experienced prolonged deflation, that is, falling prices, which mean that people and firms often put off spending in order to wait for a lower price. This behavior puts more downward pressure on prices. (We discuss deflation in more detail in Chapter 5.)

As noted in Chapter 1, in some cases inflation has become so extremely high that economists have a special name for it: hyperinflation. Germany after the First World War is a classic example, but the most recent extreme case is Zimbabwe where — at the peak in mid–2008 — prices doubled every day.

When inflation occurs, the domestic currency is losing value. The fact that a candy bar used to cost 10 cents in the early 1960s and now costs $1, is a way of saying that $1 used to buy ten bars but now only buys one. The dollar has lost value. Alternatively, we could say that in the early 1960s, you could get a dollar by giving up ten candy bars while today, you only need to give up one. That is, the candy bar price of getting a $1 bill has fallen tenfold. Either way, inflation means the domestic currency is becoming less valuable.

The good news is that there are really just two underlying causes of inflation. One is that the monetary authorities print too much money. Like anything else, when its supply becomes relatively abundant, money loses value. The second cause is the expectations mechanism noted in Chapter 1. If everyone expects money to lose value, everyone will try to get rid of it quickly, and the easiest way to do this is to spend it. But this is just a game of hot potato. Dick buys something from Jane and gives her money. But Jane doesn’t want to hold money either, so Jane buys something from Tom. Now Tom tries to get rid of the money by buying from Harry, and so on. Before long, all these purchases start to make prices rise, justifying everyone’s initial fear.

The two causes are not unrelated. Jane, Tom, Dick, and Harry may all expect inflation because they expect rapid money growth. Yet the two forces are logically distinct. Hyperinflations usually start with lots of money growth but are typically made worse by the expectations factor.

Relating interest rates, time, and capital

Inflation is concerned with prices. The interest rate is the price of credit. Yet the prices involved in inflation and the prices reflected in interest rates are very different. Even if inflation were zero, the interest rate would likely be positive in any long-run equilibrium. What is the source of this difference?

As we said earlier, inflation focuses on the value of domestic money. It starts by measuring the amount of currency it takes to buy a small bit of GDP — for example, $0.10 to buy a candy bar in 1963 or $1 in 2016. Thus, the fundamental variable is the rate of exchange between money and goods and services at a single point in time.

By contrast, the interest rate is a different kind of price because it looks at rates of exchange between different points in time. A bank offering an annual interest rate of 5 percent, for example, is promising to trade a deposit of $1,000 dollars today for a payoff of $1,050 one year from now. The trade is explicitly between dollars today and dollars in the future. The price is that $1 today “buys” $1.05 dollars in one year. That intertemporal price is what the 5 percent interest rate measures.

Notice that in that example, the trade is between dollars now and dollars later. Economists call this the nominal interest as opposed to the real interest rate. This is because unless you have a strange definition of a “green” diet, what the money is really good for is buying stuff — food (candy bars included), housing, transportation, and so forth. It’s these things that you really care about.

So, returning to our story, suppose you deposit $1,000 in the bank today and then withdraw the promised principal plus 5 percent interest of $1,050 in one year. Meanwhile, inflation over that year runs at 5 percent. That means that when you get the payoff of $1,050 it takes that much just to buy the same goods you bought with $1,000 a year earlier. In terms of the goods that really matter to your well-being, you haven’t gained a thing. That is, what economists call the “real” interest rate is, in this case, zero. We talk about nominal and real interest rates a lot in Chapter 6. For now, just remember the simple formula:

Real rate = Nominal rate – Inflation rate

The (real) interest rate is an important variable in macroeconomics. It can have a big impact on the behavior of consumers and firms:

• Individuals: Imagine that the interest rate is very high, so you get a large return on your savings. How would that affect your choices? Well, probably you’d think twice before spending your money. After all, if you spend it now, you give up the opportunity to save it and earn a high return. In this situation, economists say that the opportunity cost of consuming is high. Similarly, if you want to buy a car or a house and you need to borrow money, you’re much less likely to do so if the real interest rate is high.

• Firms: Large firms, especially, often have surplus cash lying around. What should they do with it? One option is to save it and earn the interest rate. Another option is to buy some more capital. If the interest rate is high, buying a new machine had better give the firm a really good return — otherwise it should have just saved the cash and earned the interest rate return.

  If the interest rate is high, not many firms want to invest in new capital. Conversely, a low interest rate makes capital investment very attractive.

We’ve been talking about how interest rates are important for making capital investments. But we need to be clear about how economists understand those two words, investment and capital. They may well be the most easily misunderstood terms that economists use (not counting efficiency, economic profit, elasticity, and about 100 others). What an economist and non-economist mean by them is very different.

Investment

To the non-economist, an investment means buying something in the hope that it will increase in value over time and/or yield some kind of income. For example, buying a Victorian terraced house can be considered an investment: You hope it rises in value and/or earns you a decent rental income. Similarly, buying shares is an investment: You hope they go up in price and that you get some healthy dividends along the way.

To economists, however, neither of these counts as investment. Rather, an investment is buying something new today that can be used to produce something in the future. Examples of investment include a firm building a new factory, buying a new machine, or even buying some new computers. All these things help the firm later to produce goods and services, which it can then sell to consumers.

An individual buying a house isn’t considered a form of investment by economists, except in the case of buying a newly built house. This is because you can think about a new house as “providing new housing services” in the future. This approach may sound like a strange way of thinking about this situation, but it makes clear why buying an already existing house from someone doesn’t count as investment: It doesn’t create any new housing services. Instead you’ve merely transferred the right to existing housing services from someone else to yourself.

Similarly, a firm buying a machine second-hand from another firm doesn’t count as investment, because the total number of machines hasn’t increased.

Capital

If you hear an entrepreneur complaining that she doesn’t have enough capital, she probably means she needs more money to get her business off the ground.

When economists talk about capital, they (usually) mean capital stock, meaning all the machines, offices, computers, and so on that are used to produce goods and services.

Investment and the capital stock are closely linked. Investment is the purchase of new capital goods (goods that can be used to produce other goods and services). Thus, the capital stock, as its name suggests, is a stock variable, and investment is the yearly addition to the capital stock, so it’s a flow variable (discussed in an upcoming section).

Does this mean that the capital stock in a country can only ever rise? No. As we saw in Chapter 1, machines and other capital goods get worn down (depreciate) each year. For the capital stock to rise, investment that year has to be more than the depreciation of the existing capital stock.

We’re sorry to inform you that economists often use mathematical equations in order to express ideas concisely. In this case, they express the relationship between investment and capital as follows:

In words, this equation says that the capital stock next period (K_t+1) is equal to the capital stock today (K_t), less depreciation (= δK_t), plus investment today (I_t), which is just the new capital purchased today. For example, if today’s capital stock is (in dollars) K_t = $100 million, and the depreciation rate is δ = 3 percent, an investment expenditure of I_t = $7 million over the year will result in a capital stock at the start of next year equal to $104 million.

Sorting levels from growth rates

Another source of confusion is the level of a variable versus its growth rate:

• Level: The value that a variable takes at a particular time.
• Growth rate: The percentage change in a variable over a period of time (usually a year).

Here’s an example: One of the economic success stories of the recent past is China. Over the last decade or more, the Chinese economy has grown by around 10 percent per year. At the same time, growth in the West has been a paltry few percentage points a year (if at all). No doubt China has made huge strides, and the living standards of its people have improved substantially. But does this mean that the Chinese economy is now “better” than the economies of the West?

Probably not. Although China has experienced substantial economic growth, it started off from a very low level: Average Chinese income in 2000 was around $1,000 per person, whereas at that time in the U.S. it was around $40,000. So, even though the Chinese economy has grown a lot since then, living standards in China are still far below living standards in the U.S. The average American today still earns over seven times what the average Chinese earns.

The lesson is that although growth rates of variables are important, don’t lose sight of the overall level of the variable.

Here are some other examples of variables that are levels: the amount of unemployment, the overall price level, the value of a stock index, and the average house price in Denver. The percentage change of these variables is a growth rate. For example, the percentage change in the price level over a year is called the rate of inflation: It’s the growth rate of the price level.

Stocking up and going with the flow

What makes someone rich: earning a high salary, having a big house, socking away a lot of money in the bank, or something completely different such as having a loving family?

Because of the ambiguity, economists don’t really like using the word rich. Instead, if someone has a large salary, economists say that they have a high income. If they have a lot of money in the bank or own a number of properties, they say that they’re wealthy.

Income and wealth are related but different concepts. Economists call income a flow variable. A bit like how a shower sprays a certain amount of water every minute, income pays a certain amount of money over a certain period of time. You see income quoted as an hourly, daily, weekly, monthly, or annual rate. Investment is also a flow variable. It measures the rate at which we are buying and building new capital goods per year.

Wealth, on the other hand, is a stock variable. A bit like how a bath has a certain amount of water in it at a point in time, your wealth is the total value of your assets (less total liabilities) at any given point in time. Capital is another stock variable. In fact, economists often refer to the capital stock when discussing the available supply of plant and equipment.

Unlike income, when you’re describing someone’s wealth you don’t need to say over what period of time. So John may say that his income is $65,000 per year, but for his wealth he’d just say $100,000.

Of course, an intimate relationship exists between stocks and flows. Wealth is the accumulation of a lifetime of income less expenditure. The capital stock is the accumulation of past investment flows less depreciation. Other examples of stocks and flows include the following:

• A person’s level of debt is a stock, whereas his borrowing from year to year is a flow.
• The total number of unemployed workers is a stock, whereas the weekly number of people finding (and losing their) jobs is a flow.
• The total number of houses in the U.S. is a stock, whereas the new houses that are built every year is a flow.

Knowing that what’s real counts

As we saw with interest rates, economists make a crucial distinction between real variables and nominal variables:

• Nominal: Variables quoted in terms of money. For example, the price of something or your hourly wage in dollars.
• Real: Variables that are quoted in terms of quantities. For example, the number of people unemployed or how much you are paid in terms of goods.

Imagine you’re offered a job in the exotic location of Econland. Before deciding whether to accept, you want to ask some questions. One is, “What’s the salary?” The firm tells you that the salary is 1 million ecos (the currency of Econland). You get very excited and picture buying a yacht. But wait a minute — before you accept and go on a spending spree, one important piece of information is missing. How much do things cost in Econland? Or equivalently, how much can you actually buy with 1 million Ecos?

Economists call the answer to the first question the nominal salary or wage, which is quoted in terms of money. The answer to the second question is the real salary or wage: It tells you how much you’re paid in terms of goods. The distinction is entirely analogous to that between the nominal and real interest rates. In general, it’s the real variables that really count for economic decisions.

Real GDP is still often quoted in dollar terms. Thus, the 2015 real GDP for the U.S. is quoted as about $16.6 trillion. But the dollars are not current 2015 dollars. These are dollar prices measured as if there has been no inflation since 2009. Economists do it this way because it’s nice to summarize all production in terms of a single number — real GDP — and that requires a dollar measure. Because the dollar values used for this purpose are corrected for any loss of value due to inflation, real GDP is often referred to as constant dollar GDP. Nominal GDP is measured in current dollars. For the U.S., it is roughly $18 trillion.

Discovering five important terms (though knowing one is enough)

Like all practices, economics has its own terminology. We aim to keep the jargon in this book to an absolute minimum, but this section explains five essential terms that economists use all the time.

When calculated for the economy as a whole, all these measures are equal:

• Gross Domestic Product (GDP): Value of final goods and services an economy produces in one year (a final good or service is one directly provided to the end user). Specifying that it’s only the value of final goods and services is important to avoid double counting. So, if you own a coffee shop, every time you sell a coffee for $3, that adds exactly $3 to GDP. The cost of coffee beans and milk and so on is already included in that $3, so it can’t be added again to GDP.
• Output: Aggregate output of an economy is also a measure of the value of the goods and services produced by an economy in a year. So, output is really just GDP by another name.
• Production: The aggregate production of an economy is just the total value of everything produced by firms and the government in one year. Pretty clearly, this means that production is really just GDP or output by another name. Perhaps you’re wondering why we say it’s the production by firms that yields private goods and services. What if you set up a market stall and sell handbags or do some babysitting for a neighbor? Economists bypass these questions by just calling anyone or anything that provides a good or a service traded in the market place a firm. As noted in Chapter 1, though, goods produced at home, such as meals and laundry, or produced for the underground economy, are not part of GDP.
• Income: Aggregate income is the sum of everyone’s income in an economy. And where does income come from? Well, it comes from selling the output/production/GDP of the economy. No surprise, then, that income must also be equal to those things; equal to production.
• Expenditure: Aggregate expenditure is just the sum of everyone’s expenditure, that is, their spending on goods and services. This can be different from aggregate income, and the difference is the trade balance. If aggregate income exceeds aggregate expenditure, the economy is running a surplus in its international accounts. If expenditure exceeds income, it’s running a deficit.

Modeling to understand the world

Many economic questions and problems are complex — for example, trying to work out the best way of reducing unemployment or analyzing the likely impact of boosting government spending on the economy or even understanding how geopolitical events in the Middle East will impact global economic growth. These issues are so complex, in fact, that economists believe that trying to think about these problems head-on in all their complexity is almost bound to fail.

Instead, economists create models. An economic model is a simplified representation of the real world. A good model is one that focuses on the particular variables of interest while moving irrelevant (or less relevant) details to one side.

An example of a model is a street map. A good street map includes useful details such as roads, along with their names; it probably also indicates a number of places of interest and perhaps train stations. You don’t expect the map to tell you where every tree is on your route or the location of each and every traffic light. In fact, you’d be positively annoyed if it did, because it would clutter up the map and make it much less useful.

The same idea applies with economic models: Cut the irrelevant stuff in order to focus on the things that matter. We use many different models in this book to help you understand different aspects of the economy.

Sometimes economists are criticized for making too many assumptions about people or the economy in their models — they’re told that their models are too simple and that the real world is more complex. That may be true, but economists prefer to have a simple model they can fully understand rather than a complicated one that they can’t make heads or tails of. Moreover, when they understand the simple model, they can slowly complicate it to see what happens. You need to learn to crawl before you can walk.

Ensuring that intuition doesn’t fail you

Another reason economists like working with models is that human intuition alone can often lead people astray. Here’s an example: A river flows between two cities, Coaltown and Playville. Coaltown has manufacturing business that release chemicals into the air that then come down in the river as acid rain. That’s bad news for Playville people because they use the river for fishing and recreational services. Everyone agrees that it costs Playville about $10 million per year to clean up the mess.

• Playville residents say Coaltown firms should either stop polluting or compensate Playville $10 million.
• Coaltown firms have a different idea. They say, “Pay us $10 million and we’ll agree to change our methods and stop polluting.”

Who’s right? In terms of stopping the acid rain, both are. Under Playville’s plan, Coaltown firms can avoid paying $10 million by switching to cleaner technologies. Under Coaltown’s proposal, not making that switch means its firms forego the same amount. So under either plan, Coaltown firms give up $10 million by not switching. The real difference in the plans is property rights. Playville’s plan basically says that Playville owns the river and Coaltown has to pay to “use” it. Coaltown’s plan implies just the opposite. So, choosing one plan or the other is equivalent to assigning ownership — but the effect on pollution is the same either way.

That’s a counterintuitive conclusion that you probably wouldn’t have reached without some economic modeling. But it’s true and supported by evidence.

The beauty of modeling is that it allows economists to find results that would be almost impossible to find otherwise.