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Jump to Chapter 2 Sections:
>> New thinking on drivers of growth >> Income inequality is declining >> More trade and investment mean faster growth >> Increasing U.S. imports through the African Growth and Opportunity Act >> A microeconomic agenda for development >> How can the U.S. support growth in developing countries >> Background papers >> References
Economists have conceptualized the process of economic growth around three basic models: specialization and trade, investment in machines, and increasing returns to knowledge. At different
points in the history of economic thought, each model has been advocated as the fastest road to riches. Yet all three have a contribution to make. Adam Smith was highly optimistic about prospects
for raising living standards through the higher labor productivity that results from specialization.
Because specialization requires trade, low trade barriers are required so that manufacturers can
access larger markets. Competition-the invisible hand-then induces greater specialization, raising
labor productivity and living standards.
This trade-intensive strategy for economic growth requires many transactions, often at long distances
and over time. Thus institutions that defend property rights and lower transaction costs, such as the rule of law, have come to be seen as the foundations of a market economy. This is why economic governance is considered an essential starting point for economic growth, not something
to be tackled later.
The success of the industrial revolution in the 19th century, first in Britain and then in France and
Germany, added technological change to strategies for growth. Such change was seen as embodied in
machines using mechanical power. It was recognized that not all countries could invent and
produce machines. But all were free to import them and reproduce the factory system that was
making Europe so rich and powerful. This capital fundamentalism stressed accumulating savings
and investing in machines that embodied the latest technologies. Investment and production did not have to rely on the profit motive of private investors, but instead could be directed by national
planners. This model was used for German industrialization in the late 19th century and Soviet industrialization in the mid-20th century.
But the "machine model" could go only so far. It raised productivity but did not create selfsustaining
growth. The machines involved were good at producing a fixed set of products but not at adapting to changing technologies and consumer desires. Only markets and capitalism can accomplish these tasks. With accelerating scientific innovation in advanced countries, productivity growth came to depend more on knowledge than on machines. Economies such as Brazil, Israel, the Republic of Korea, and Taiwan
had institutions that could support the absorption of Western knowledge rather than just machines and moved to modern economic growth. Economies without these institutions, including the Soviet bloc, nearly all of Africa, and most of the Islamic world, could not. As a result, they have slipped into economic stagnation or decline. Some have slipped even further, into chaos and conflict.
The model of economic growth that explains this performance is based on increasing returns to
knowledge. Instead of diminishing returns as more of the same machines are used in a given labor force, returns to knowledge increase because of spillovers to additional users. Large payoffs from new knowledge, especially where there is patent protection, encourage entrepreneurs to develop it, in some cases by adapting findings from research universities and research centers.
Economic growth is now seen as an endogenous response to incentives throughout the economic system. The modern concern for enforcing intellectual property rights as well as property rights for land, goods, and financial assets is easy to understand from this perspective. Lack of protection for intellectual property rights will slow the search for new knowledge and hence economic growth.
Self-sustaining growth is difficult for developing countries because generating knowledge and developing sophisticated human capital depend at least as much on institutions that ensure strong
property rights and low transaction costs as on specialization and trade. The belief that there are
shortcuts to the gradual evolution of such institutions is now seen as mistaken. For many developing
countries, the quest for growth is quite elusive.
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