Story Of The Week

TWO VIEWS OF ECONOMIC GROWTH

Written by : Rajeev Anantaram

Professor of Economics

International Management Institute

The Sveriges Riksbank Prize in Economic Sciences for 2018, more commonly known as the Nobel Prize in Economic Sciences, was jointly awarded to Paul Romer of New York University and William Nordhaus of Yale University, for their work on the long-run dynamics of economic growth. While their work addressed different aspects of the triggers of economic growth and its consequences, Romer and Nordhaus need to be credited for reinvigorating an area of study that was considered settled, even though extant theories left several questions unanswered.

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Paul Romer

            Paul Samuelson, Nordhaus’ coauthor of the now classic introductory textbook, ‘Economics’, that spurred millions of students around the world to take up economics as a profession, often said that the book was probably ‘his best contribution to the field’.  Professional economists would disagree, given Samuelson’s seminal contribution to various sub-disciplines within economics.  The same could be said of Nordhaus, whose principal contribution is introducing the formalism of economic theory to economic growth with constraints.  His contributions extend to other areas of economic growth as well.  For example, in an unusual study on how consistently improving technical efficiency had improved standards of living, he showed in a 1994 paper that factoring in changes in quality and efficiency, the price of light had decreased by a factor of almost 3500, between 1800 and 1992.  In another seminal paper, he conclusively showed that 98 percent of the social surplus from innovation was captured by consumers, with only two percent being retained by producers.

            It was, however, Nordhaus’s pioneering work on the Economics of Climate Change that the Nobel prize Committee chose to acknowledge when awarding him this year’s Nobel prize. This forms the basis of the broader field of Ecological Economics that evolved as a counter-narrative to more ‘mainstream’ theories of economic growth and development. Nordhaus (along with Martin Weitzmann, Herman Daly and Partha Dasgupta) were among the first to recognize the deleterious consequences of climate change and apply economic theory towards measuring its consequences on long-term economic growth.  Nordhaus, in particular, is the driving force behind the Dynamic Integrated and Regional Integrated climate models (known as DICE and RICE) respectively that explicitly include climate change in their estimation of economic growth.

            As legend has it, it was a graph that led Paul Romer to switch from mathematics to economics as a graduate student at the University of Chicago. While technology and by extension productivity had been formally introduced into the production function first by Solow and then others,  beginning the 1950s, they had been taken as ‘given’—exogenous, informal parlance. Romer questioned that basic assumption and in what became a seminal doctoral dissertation treated technology as endogenous—determined by the actions of firms and individuals.  A series of influential papers with his mentor Robert Lucas disrupted the existing paradigm and laid the foundation for New Growth Theory, with endogenous growth as its fulcrum.

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William Nordhaus

        The development of new growth theory in the early to mid-1980s corresponded neatly with the emergence of the knowledge economy, first in the United States. The focus of the knowledge economy was more on ideas and less on ‘bricks and mortar’ as in previous years.  A fundamental difference in the new paradigm was in the non-exclusivity of ideas: ideas could be simultaneously used in multiple locations to generate growth, which allowed for ‘increasing’ returns to scale.  If ideas could be freely transmitted in an open economy, it followed that far more people would benefit from them, not just the people who produced them.  Consequently, an economy where a larger proportion of the labor force was engaged in producing ideas than goods would do better than an economy where the converse was true.

            New growth theories offered new insights into why some countries grew faster than others, though its principal focus on long-run growth, meant it had little applicability for underdeveloped and developing countries, whose primary concerns were the short and middle term.  However, a review of the drivers of economic growth in the Asian ‘Tiger’ economies with a dedicated focus on ‘innovation-led’ growth confirms the central tenet of Romer’s work:  long-run sustainable growth can only be achieved by a shift away from more capital and labor and towards more efficiency.

            How would an economy that relies more on ideas than goods look like? In the short-run, more people producing ideas would mean fewer people producing goods. With increasing global incomes and a global population that is steadily increasing (even if at a lower rate), how would demand for material goods and services be met?  Can the focus on ideas and more traditional methods of enhancing productivity be reconciled?  These are questions that transcend academic discourse and have profound implications globally.

            The contributions of Romer and Nordhaus have a common thread running through them.  In studying economic growth, they have shifted the emphasis from process to people. People can determine processes by the choices they make and are hence central to the process of economic growth. In doing so, they have in their own way made the discourse on economic growth more people-centric, unlike traditional theories with their sole emphasis on process.  Above all, it is heartening that crucial issues that concern us all have been brought center-stage.  That is exactly what trailblazers do and for that alone Nordhaus and Romer deserve all the accolades that come their way.

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