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[edit] Chapter 2: Why Economic Growth Matters

We are interested in entrepreneurship because we hope to explain and ultimately contribute to facilitating economic growth, which is traditionally measured by the increase in a country’s output of goods and services (what economists call gross domestic product or GDP). When each of the present authors was trained as an economist, the importance of economic growth was assumed to be self-evident. One of us studied the subject immediately after the Great Depression, when the entire thrust of teaching in the field understandably was how to stimulate growth.^[1] After World War II and until the late 1960s and early 1970s, when the other two authors studied the subject, it was still widely assumed that the priority given to economic growth was not controversial and that it was even on a par with the ideals of motherhood and apple pie. Faster growth in the output of goods and services in an economy meant higher incomes for everyone (even though some people would, inevitably, earn more than others). Higher incomes would make it possible for more people to purchase, use, and enjoy more things (and services) in life. So how could anyone question the value of faster growth? In recent years, some observers have done just that, and now (and surprisingly, at least to economists) economic growth needs some defending.

Most people—those who are unemployed and want jobs, or who fear that they may lose their jobs, or who are poor and want the higher wages that faster growth will bring—have no doubts about the benefits of economic growth. But for reasons we hope will be clear shortly, there continues to be a need to persuade many who question the virtue of growth, and it is their criticisms that we will address here.

Before considering their specific critiques, it is useful to consider the big picture. At bottom, economic growth is essential not because humans are greedy or excessively materialistic, but because they want to better their lives. This is a natural aspiration and only with more economic output can more people live a more enjoyable and satisfying existence. Of course, economic growth is not the only goal in life. As economists will be the first to point out, there are always trade-offs: More work leaves less time for play and for family. More output often is accompanied by an increase in unwelcome side effects, such as pollution. But at the end of the day, the richer societies are, the more resources they will have to address the side effects of growth as well as the various maladies that shorten lives or make them less satisfying. Later in this chapter, we will provide some additional reasons why continued growth is especially important for both developing and developed countries in this century and beyond.

[edit] Are There Limits to Growth?

One line of skepticism about growth arises from individuals and groups who worry that as the world’s population increases and economic growth continues, societies will use up scarce resources and, at the same time, degrade the environment. In the early 1970s, a group called the “Club of Rome” expressed such worries, fearing that eventually (and rather soon) the world would run out of energy and some commodities, so that growth couldn’t continue at anything like the existing pace. Today, there are those who believe, for similar reasons, that growth shouldn’t continue.

The doomsayers who projected that economic growth would come to a standstill were wrong. Since 1975, total world economic output has increased more than sevenfold.^[2] On a per capita basis, world output is more than five times higher than it was thirty years ago. Growth in output, and therefore income, per person throughout the world advanced at a far more rapid pace (nearly ninefold) in the twentieth century than in any other century during the previous one thousand years (to the extent these things can be measured).^[3] Per capita output continues to increase because firms around the world continue to make more use of machines and information technology that enable workers to be more productive and because technology itself continues to advance, making it possible for consumers to use new products and services. There is good reason to hope that this process can and will continue, though there are some lurking dangers, including foolish actions by governments.

But should growth continue? What about the supplies of energy that will be depleted in the process or the pollution that will be generated as ever more things are produced and used? Curiously, economists who tend to be quite rational in their lives urge the worriers to have faith—faith that continued technological progress powered by market incentives will ease these concerns. As it turns out, however, economists’ faith has roots in historical fact. In the early 1800s, Thomas R. Malthus famously predicted that the world’s population would eventually starve or, at the least, live at a minimal level of subsistence because food production could not keep pace with the growth of population. Technological advances since that time have proved him wrong. Through better farming techniques, the invention of new farming equipment, and continuing advances in agricultural science (especially the recent “green revolution” led by genetic engineering), food production has increased much more rapidly than population, so much so that in “real terms” (after adjusting for inflation), the price of food is much lower today than it was two hundred years ago, or for that matter, even fifty years ago. Farmers, who once accounted for more than 50 percent of the population at the dawn of the twentieth century in the United States, now comprise less than 2 percent of population— and are able to grow far more food at the same time.

The same process of technological advance that undermined Malthus’s dire predictions may be able to quiet the concerns of the modern-day Malthusians who worry about disappearing energy, although more active involvement by governments may be necessary to address concerns about global warming. As some sources of energy are depleted—fossil fuels, in particular—their prices will rise, setting in motion several developments that will keep economies from stagnating. For one thing, consumers will cut back on their demand for fossil fuels directly (taking fewer trips, carpooling, or even moving closer to work) or indirectly by buying things (cars, houses, and appliances) that are more energy-efficient. This occurred after the first postwar “energy crisis” of 1973. Energy use as a percentage of GDP in the United States has been cut in half largely as a result of higher prices, and it will continue to drop if fossil fuel prices (adjusted for inflation) rise in the future. Equally important, if prices of fossil fuels increase, the backers of substitute forms of energy (nuclear power, fusion, geothermal, biomass, solar, and possibly other sources) will have stronger incentives to perfect their technologies so that they can be readily used instead.^[4]

As for global warming, there is a consensus among scientists that the problem is real and growing. Indeed, some scientists attribute the intense hurricane activity that devastated the Gulf states and parts of Florida during the 2005 season to warmer waters due to global warming. At the same time, there is an emerging consensus among economists and policy makers around the world that the best way to curb the carbon emissions that are contributing to global warming is to employ a mixture of rules and marketlike incentives, perhaps the most promising being the establishment of ceilings on pollution by allocating suitably restricted limits on unavoidable emissions by producers and allowing these rights to be traded in markets. Thus pollution can be capped and growth can nevertheless continue. The “cap and trade” approach, applied globally, was the linchpin of the Kyoto agreement reached in the late 1990s but not yet implemented (due in large part to opposition by the United States). Although political and practical problems may inhibit the adoption of cap and trade on a global scale, it may be feasible on both grounds to implement the idea on a national basis.^[5]

Those who doubt whether economic growth can continue if resources are devoted to reducing pollution need only look to the U.S. experience— where both the air and water are far cleaner today than thirty years ago, even with a substantially higher production of goods.^[6] If the same political energy that has so far fueled the “no growth” or “limits to growth” movements were channeled instead to persuading governments around the world to accept less socially damaging approaches, including a tradable emissions permit system, there is good reason to believe global warming concerns would be much attenuated.

[edit] Growth and Globalization

A second line of attack on growth, though not directly labeled as such, stems from the antiglobalization movement. Some of those who object to the increasing economic integration among nations around the world—and who have mounted protests in various places around the globe to make their point—have done so out of the belief that even if this process of “globalization” enhances overall growth, it also contributes to rising economic inequality and even to poverty. Some critics of globalization have followed this reasoning to its logical conclusion, advocating higher barriers to trade, capital flows, and immigration as a way of reversing economic integration and thus ostensibly reducing inequality and poverty in the process, regardless of what it does to growth.

Figure 1. Real GDP per Capita for Advanced, Middle-, and Low-Income Countries, 2000, in Adjusted 1996 Constant Dollars. Abbreviations: USA United States, JPN Japan, GER Germany, FRA France, IRN Iran, CRI=Costa Rica, COL=Colombia, DOM Dominican Republic, GNB Guinea-Bissau, ETH Ethiopia, BDI Burundi, TZA Tanzania, CHN China, IND India. Source: Alan Heston, Robert Summers, and Bettina Aten, Penn World Table Version 6.1, Center for International Comparisons at the University of Pennsylvania (CICUP), October 2002. Available at http://pwt.econ.upenn.edu/php_site/pwt61_form.php.

A look at the bare facts validates the concerns about inequality—at least among countries. Figure 1 displays the per capita real incomes (adjusted for price level differences and exchange rates between countries) of three groups of countries as of the year 2000: four “rich” economies (including the United States), four “middle-income” countries, and four poor countries. The differences among the three groups are vast, with residents of the rich countries earning roughly five times what those living in the middle-income countries earn, and more than twenty-five times the average earnings of residents of the poor countries.

What is especially disturbing about these disparities in per capita incomes among countries, however, is that in the four decades from 1960 to 2000, they generally grew, implying that income inequality has become worse. This can be discerned from figure 2, which displays the growth rates in per capita incomes over this period. Although not all the differences in national growth rates are as clear as those shown in figure 2, a distinct pattern does emerge: on average, rich countries grew faster than those in the middle and even faster than those at the bottom. In other words, levels of income or output per capita are diverging rather than converging. Note that at this point, we are simply presenting facts, making no statements about whether and to what extent increased globalization has contributed to this trend or, as Martin Wolf has persuasively argued, has in fact ameliorated it (Wolf, 2004).

Figure 2. Annual Growth Rate of Real GDP for Advanced, Middle-, and Low-Income Countries, 1960–2000, in Adjusted 1996 Dollars. Abbreviations: USA United States, JPN Japan, GER Germany, FRA France, IRN Iran, CRI=Costa Rica, COL=Colombia, DOM Dominican Republic, GNB Guinea-Bissau, ETH Ethiopia, BDI Burundi, TZA Tanzania, CHN China, IND India. Source: Alan Heston, Robert Summers, and Bettina Aten, Penn World Table Version 6.1, Center for International Comparisons at the University of Pennsylvania (CICUP), October 2002. Available at http://pwt.econ.upenn.edu/php_site/pwt61_form.php.

In subsequent chapters, we will discuss the continuing controversy over whether income disparities among countries inevitably must converge toward rich country levels of per capita income. But it is important at this point to distinguish differences in the average welfare of citizens among countries from differences in incomes of all individuals around the world, wherever they may reside. In particular, if one takes account of India and China, where roughly 40 percent of the world’s population reside, income inequality among individuals appears to have narrowed over time due to the rapid income growth in heavily populated parts of those two countries (Bhalla, 2002).

Moreover, of particular relevance to the debate about globalization, both India and China have achieved rapid growth while opening themselves up to the rest of the world: trading more extensively and accepting more investment from rich countries. Openness to trade and investment, as we will discuss in later chapters, can be critical to facilitating entrepreneurship and, hence, growth. For now, it is essential to note only that growth and poverty reduction go hand in hand (Dollar and Kraay, 2002). Indeed, it is difficult to think of examples of countries where poverty has declined without economic growth. A rising tide truly does usually lift even the boats at the bottom. From 1978 to 2000, in particular, while the world population grew by 1.6 billion people, the number of people with incomes below $1 per day—the lowest threshold of poverty—declined by more than 300 million (Barro and Sala-i-Martin, 2004, 9).

But even if globalization did worsen inequality (as it may within certain countries, especially because it often disproportionately benefits the mosteducated individuals who have skills or products to sell in a global marketplace), steps to slow down or reverse economic integration clearly would reduce growth and very likely lead to lower incomes and average standards of living around the world.^[7] A simple thought experiment should demonstrate why. Imagine if residents in each of the fifty states of the United States were limited to doing business only with other residents of their states. Is there any serious question that total output, and therefore incomes, in such a “disunited” America would be lower than it is now, with Americans freely able to buy and sell goods and services, send money to and receive money from, and move to any part of the “united” states, rather than being limited to conducting business only with individuals and firms in a single state? Expanding the size of the market in which individuals and firms can do business enhances prosperity, enabling individuals and firms to specialize in what they do best, insights contributed more than two hundred years ago by Adam Smith and David Ricardo. This is just as true for the United States, as it is for other countries throughout the world.^[8]

[edit] Growth and Happiness

A third critique of continued growth arises out of the oft-stated aphorism that “money cannot buy happiness.” Of course there is plenty of truth to this. Religious leaders constantly remind us, for example, that spiritual health is more important than wealth. At a more mundane level, although the average American household clearly is better off financially today than before, many individuals may be no happier as a result. One obvious reason: With both parents working in many families, the constant struggle to do a good job at work and to spend “quality” (if not “quantity”) time with their children makes many Americans feel as though they were on a treadmill. Cornell University economist Robert Frank adds another reason why many Americans may feel no happier, even though they have higher incomes. While most “consumption goods”—houses, cars, and clothes—may make individuals temporarily feel better, that effect is not likely to be permanent. After the “newness” of these items wears off, individuals tend to take them for granted. Moreover, when people look around and find that others have the same or better consumer goods as they do, they may eventually be less happy than they were before (Frank, 2004). Clearly it seems that relative wealth or income may be more important to a sense of well-being than absolute wealth or income (Graham and Pettinato, 2002).^[9]

Still, economic growth may matter more than people may realize. What individuals report to interviewers in a survey will not necessarily capture the progress that people may take for granted but nonetheless objectively makes them better off. For example, consider the fact that over the past several decades, average life expectancies around the world, even in most developing countries, have been rising.^[10] This remarkable result has been made possible by more plentiful supplies of food and better health care, both of which are the products of economic growth. Or consider the significant gains that rich countries, such as the United States, have made over the past several decades in controlling pollution and enhancing the safety of a variety of products (especially dangerous ones, like automobiles). None of these developments would have been possible without growth in incomes that lead people to demand and afford cleaner and safer environments.

Respondents to surveys may not fully be aware of all of these facts when asked for immediate answers. Indeed, as journalist Gregg Easterbrook has noted, one of the “paradoxes of prosperity” is that many individuals in rich countries don’t realize how good things really are (Easterbrook, 2003). Instead of assessing the benefits of growth by asking individuals to compare the way things are to the way they were, we believe it is more revealing if the question were asked prospectively—that is, if they would be happier if they had more income in the future, even if everyone else in their neighborhood, city, or country also enjoyed the same increase (whether in absolute or percentage terms). We suspect that not many individuals would question growth if put this way. We are especially confident that the roughly two billion people living on the equivalent of less than $2 a day throughout the developing world would have little trouble answering that they would feel better off.

[edit] GDP: Is That All There Is?

A fourth line argument, related to the one about growth and happiness, is that the growth of output as it is conventionally defined does not accurately represent the growth of human welfare. By definition, GDP counts only goods and services that are traded in the market or, if supplied by the government, have prices attached to them. GDP does not measure a whole series of activities that are not traded in the market but that nonetheless contribute to or detract from our overall sense of well-being, including: household activity, human health, selected activities of nonprofit organizations (especially those relying on volunteer labor), and environmental conditions. By focusing exclusively only on what can be found in the market, citizens and policy makers come to have too narrow a view of what really counts in life. A 2006 report by the Organization for Economic Cooperation and Development adds that measures of gross output do not take account of its distribution among an economy’s residents (or the degree of income equality or inequality) nor do they count the value of leisure time. Thus, depending on the value society attaches to income equality and leisure, for example, “adjusted” income per capita in some countries in Europe actually may be higher than in the United States (OECD, 2006).

We agree that GDP has its limits, as economists have long recognized. More than three decades ago, two prominent American economists— William Nordhaus and James Tobin of Yale University (the latter a winner of the Nobel Prize)—provided an alternative set of accounts that included various forms of nonmarket activity to arrive at a more comprehensive measure they called “Measured Economic Welfare” (Nordhaus and Tobin, 1972). More recently, a National Academy of Sciences panel has recommended that the federal statistical agencies develop a set of “satellite accounts” to measure these various nonmarket activities, as a way of supplementing the information conveyed by current measures of GDP (Abraham and Mackie, 2005).

None of this should detract from the fact that growth of market GDP is still something to be valued for two reasons. First, the goods and services that make up GDP are valuable to people in and of themselves since they enable people to enjoy a higher standard of living. Second, incomes and output most likely are positively correlated with a number of the nonmarket activities or outcomes that are not currently included in GDP. For example, as we have noted, as economies grow richer, their people can afford more health care and are able to invest in improving the environment (and, indeed, are likely to demand more of these nonmarket goods).

As for income equality or inequality, the value one places on this is inherently subjective, and thus measures of GDP “adjusted” for differences in the distribution of income should not be given undue weight. Nonetheless, extremes in either direction are undesirable. A society where all have the same incomes, for example, would provide no incentives for growth. Conversely, societies where incomes are highly unequal are prone to political instability and backlashes that are also inimical to growth. No one knows where the happy medium lies, and like beauty, where that point is lies in the eyes of the beholder. The key is not so much how incomes are currently distributed but rather the ease or difficulty that individuals have of climbing to higher economic stations and thus to earning higher incomes. In short, it is opportunity that matters most—both for growth and for social and political stability.

There has been some debate in recent years, however, about the distribution of the gains from added productivity in the United States, in particular, whether workers as a whole have received their historic share (about two-thirds of the increase in output) or have suffered an erosion in that share. The debate arises from the apparent discrepancy between the faster rate of growth in productivity and that in real wages. But wage income alone does not account for benefits, specifically health insurance, that are included in the compensation of most American workers. Taking this into account, total compensation has been rising at roughly the same rate as productivity (Dew-Becker and Gordon, 2005). Of course, even this fact does not account for the long-run trend toward greater income inequality (pretax) in the United States among workers in different parts of the income distribution. This trend is widely known and accounts for the rising returns to education over time, reflecting increased employer demand for (relative to the supply of) skilled workers (Lazear, 2006).

[edit] Is Growth a Zero-Sum Game?

A key premise of this book is that economic growth is good not just for rich countries like the United States, but for all countries, since it is only through growth that people’s living standards, whatever they may now be, can improve. But this premise does not seem to be as widely shared as we would like. In recent years, we have heard mounting objections among some political and opinion leaders in the United States who fear economic growth in other countries, especially in less developed countries— China and India, in particular.

To be sure, these fears typically are not expressed as directly as that. Instead, they are often couched as objections to the low labor costs in poorer countries that enable them to provide goods and services more cheaply than can the rich countries like the United States. The suggested remedy to this situation, through one means or another, is for rich countries not to buy as much from poorer countries. To some ears, this may sound like “fairness,” but those in the developing world see it as telling them they shouldn’t be able to grow as fast as they can or as they would like. Is it true that economic growth somehow is a zero-sum game, meaning that every additional dollar that accrues to a poor country must come out of our own (Thurow, 1980)? If so, doesn’t assisting other countries to grow arm our future economic enemies who will take away our jobs or reduce our wages? The answers to these questions are “no” and “no.”^[11]

Again, the fifty-state example should make the point. New Yorkers benefit when incomes in other states go up because richer citizens elsewhere provide a broader market for goods and services generated in New York. The same is true for each of the other states. The same logic applied after World War II when the United States launched the Marshall Plan to rebuild Europe and supplied extensive aid to Japan to get its economy back on its feet. As per capita incomes in these countries grew, more people could afford the products and services the American economy was able to produce and deliver. That America nonetheless ran trade deficits through much of the postwar era does not contradict this point; it only demonstrates that as Americans’ incomes grew, their wants for foreign goods grew at a faster pace than U.S. exports. These new products, services, and production methods find their way to other parts of the world and thus can contribute to rising living standards there. In short, as economists would put it, there are “beneficial externalities” associated with entrepreneurship that crosses national boundaries.

In some minds, perhaps many, the rapid rise of China and India poses a different sort of problem. It is one thing for countries at lesser stages of economic development to advance on the strength of their lower labor costs, making essentially the same things as were once manufactured in rich countries. But there is growing evidence that in some spheres—information technology, biotechnology, and in certain types of electronic equipment—China, India, and their richer neighbors in Southeast Asia have moved beyond mere manufacture or service delivery into research and development, the highest value part of the so-called value chain. Indeed, as we will discuss in chapter 8, some major U.S. corporations have expressed growing interest in supporting university research in these countries rather than in the United States—and not solely for reasons of cost, but because gaining access to and using the results of the research may be easier in these other locales. Should rich countries like the United States be worried about “losing” some of their R&D base to other countries?

In one sense, yes, and in another sense, no. On one hand, as R&D moves abroad, other countries stand to gain some of the profit that would have accrued to United States–based companies and their investors (although some of these may be foreign in any event). Furthermore, R&D success is likely to lead to other successes down the road. Scientists may move to locations where other cutting-edge researchers are located. Moreover, armed with the insights of their initial discoveries, innovators are likely to have a head start on the next wave of related innovations. The net effect of all this is that the countries that are host to the R&D breakthroughs grow more rapidly than they otherwise would, while countries that do not host such breakthroughs will grow somewhat more slowly.

On the other hand, as we will highlight in later chapters, innovation is an inherently “leaky” process. Even with well-enforced intellectual property rights, the vast majority of the profits from innovations accrue to society as a whole rather than the inventor or the initial entrepreneur. That is because innovations lead to new and cheaper products and services, which benefit all who purchase them, improving their standard of living. Thus, even if the “next big thing” should be invented in China or India, Americans and others in the world end up benefiting. That is how the world worked when Americans seemingly were inventing all the “next big things.” It will be the way the world works in the future, even if some of those breakthroughs emerge in foreign locations.

There is yet another reason why it is in the economic interest of poor countries to grow more rapidly in the years ahead. As we will discuss shortly, and again in the last chapter, the United States and other rich economies will experience a wave of retiring baby boomers over the next several decades. Those retirees who have been lucky or fortunate enough to have saved for their retirement certainly are counting on the value of their financial assets (as well as their residences and other real estate) not to fall and ideally to continue rising at a rate faster than the growth of their economies. This is unlikely to occur, however, unless investors from emerging markets have the wherewithal to buy the securities that the retirees certainly will be selling, since it is unlikely that the younger generations within the richer countries will have the incomes, and thus savings, to purchase these assets. But investors from abroad will not have the resources themselves unless their economies continue growing. For this reason, investors in all rich but aging economies have a strong economic interest in the continued growth of economies in the rest of the world.

We confine our argument about the benefits of global growth to economics, and not politics. But it could well be that certain countries might use their new-found wealth to enhance their offensive military capabilities and thus increase the chances of conflict. For example, as China’s economy continues to grow, its people and its government may not give up on the dream to reunite the mainland with Taiwan. Under the wrong circumstances— in particular, if Taiwan acted too independently—China could move militarily to accomplish that objective. A richer China would be better positioned to finance such a military campaign. The same could be said for a richer India, Pakistan, or any other country in the world where grievances with neighbors are all too common.

Fortunately, economic growth also is accompanied by a countervailing force, which may moderate, though not necessarily eliminate, any impulses toward military action. As we will discuss in chapter 5, there is compelling evidence that as economies grow richer, their propensity to embrace democratic values and institutions is greater. In turn, as societies embrace democracy while also becoming wealthier, they have in the past been less likely to turn to military action to advance their interests. If true, then entrepreneurial capitalism, by advancing growth, may help to diffuse tendencies toward armed conflict in different parts of the world.^[12]

[edit] Growth and the Demographics of Aging

There is an old saying that there are only two certain things in life: death and taxes. But one of these certainties—death—is getting pushed back, with advances in medical science and nutrition, both made possible by economic growth. As economies grow richer, however, other demographic trends are set in motion. Families have fewer children because they have less need for them as breadwinners. Fewer children and longer life spans mean only one thing: over time, the average age of individuals in society increases. The aging of populations in advanced countries, some with fertility rates below replacement rates, has been known for some time. But what many people may not realize is that the average age in developing countries is rising as well. Indeed, as both the International Monetary Fund and the United Nations have reported, the entire world is aging, and the effects will be even more noticeable in the developing world than in countries that are already rich. Whereas nearly 60 percent of the world’s elderly (those over sixty-five) live in developing countries today, that share is projected to increase to 80 percent by 2050 (IMF, 2004; United Nations, 2004).

So what does economic growth have to do with all this, other than helping to make it possible? The short answer is that while growth certainly helped contribute to the aging of the world, it is going to be desperately needed to help pay for the medical care and income support promised to the elderly. To be sure, this is a problem now confined primarily to rich countries, whose governments already have made these promises and have acted on them to a degree. But many developing countries have established similar, though less generous, systems of their own and, indeed, are being encouraged to do so by the World Bank.

The financing problem just for richer countries is enormous. Consider the United States, where the challenge is the least acute among developed economies. As shown in figure 3, in 2004, benefit payments under the United States Social Security and Medicare programs totaled roughly 5 percent of GDP, accounting for about a quarter of all federal spending (which, in turn, is about 20 percent of GDP) and roughly 30 percent of federal tax revenue. In 2010, the earliest baby boomers will begin retiring, a trend that will pick up speed as the years pass. As it does, the promised income and medical benefits will soar.

Thus, the Congressional Budget Office (CBO), the United States government’s neutral and official government scorekeeper, has projected spending on these two programs, together with Medicaid (another entitlement program that supports health care for low-income individuals and families) to rise to 13 percent of GDP by 2025 and to 19 percent of GDP by 2050 (CBO, 2003). Compare these figures to the roughly 17 percent of GDP the federal government collected in taxes in 2004—the lowest share since 1960—or even the roughly 20 percent of GDP tax share that has prevailed in the United States for the past quarter century, and without major policy reforms, a fiscal disaster seems inevitable.

In our view, therefore, some combination of tax increases and budget cuts (especially in entitlements programs) eventually will be required to address this problem.^[13] However politically painful these steps may be, they pale in comparison to the economic pain that the country would suffer if, at some point, investors fear they will not be taken and then refuse to buy the mounting federal debt required to finance our government except at much high interest rates, which could throw the U.S. economy (and other economies) into deep recession.

Figure 3. Social Security, Medicare, and Medicaid Expenses as a Percentage of GDP. Source: Testimony by Douglas Holtz-Eakin, director of the Congressional Budget Office, on the economic costs of long-term federal obligation, July 24, 2003. Available at http://www.cbo.gov/showdoc.cfm?index=4439&sequence=0.

In any event, the magnitude of the required fiscal correction, and thus the political pain that decision makers must be prepared to absorb, will depend to a significant degree on how fast the economy grows. The Congressional Budget Office projections assume that output per worker will rise in the future at roughly 2 percent annually, which is a bit above the disappointing 1.5 percent rate of increase during the dark years of the 1973– 93 period but considerably below the roughly 3 percent growth in annual labor productivity that the United States has achieved since then. Economists aren’t very good at predicting the future rate of productivity growth since, at bottom, this requires projection of the future rate of innovation, which essentially is impossible to do with any accuracy. That is why organizations like the CBO, and most economists, when confronted with the need to make long-run projections adopt a technique called “reversion to the mean.” This principle, which many stock market analysts employ, suggests that if the growth of any variable strays too far away from its historical average, it eventually will bounce back toward that average, though it may overshoot it. In the case of productivity growth, the long-run average for the United States since the mid-1900s is about 2 percent, so reversion to the mean implies that our future productivity growth, over the long run, will plausibly be somewhere in that neighborhood. Hence the CBO’s long-run projection.

But it doesn’t have to be that way. What if the economy changes in some fundamental way so that past history is not a good guide to the future? For example, productivity advanced at 2.5 percent annually from the end of World War II until 1973, when the first “oil shock” occurred. There followed the dismal 1.5 percent growth rate experience for the subsequent two decades before something kicked in, sending U.S. productivity growth soaring beyond even the fast pace of the first quarter-century after the war.

The point of this brief recitation of productivity facts is that economies are not stagnant. Things change, and when they do, history may well not be a guide to the future. Here is where growth comes in. What if the United States were to find a way to continue or even exceed the remarkable post-1993 productivity growth rate of 3 percent rather than settle down to the 2.1 percent projected by CBO? Over the next forty-five years, that nearly one-percentage-point annual difference would mean that by 2050 per capita output would be roughly 60 percent higher than the CBO has projected. With the GDP denominator that much larger, the ratio of Social Security and Medicare spending to GDP would be substantially lower. The decline in the spending ratio would be mitigated to some extent by the fact that, under current law, Social Security payments rise as real wages rise, and wages would increase roughly one percentage point faster if productivity grew that much more rapidly. But faster productivity growth certainly would make Medicare spending more affordable, since wages and salaries of health care workers, which would also rise with higher productivity, account for only a portion of overall medical costs. Similar effects would follow if Europe and Japan somehow found a way to increase their rather anemic rates of productivity growth in the future.

In short, growth matters to aging societies because it makes it easier to afford government promises of support made to the elderly, among others. Aging, in turn, has two very different effects on the growth process. On the positive side, aging labor forces—up to a point—mean that the typical worker has more experience. More experienced workers, in turn, are more productive, so that as societies age, they should display faster productivity growth, other things being held constant.^[14] But in aging societies, not everything can be held constant. As societies grow older, they are likely to have a lower proportion of young adults without families or children to support, and thus the cohort of individuals that are more likely to take the risks that lead to the formation and growth of high-impact enterprises will be smaller. After some point, aging societies are likely to be less entrepreneurial, in the sense of the term that we are using it in this book: developing and growing enterprises that have high-growth potential. True, many senior citizens or near retirees in the United States are jumping off the corporate ladder to start their own consulting operations or specialty stores, the traditional retirement pursuit of the elderly in Japanese societies. But, other things being equal, it is difficult for older individuals to have acquired the knowledge needed to come up with and commercialize the kinds of breakthrough technologies and services that drive economic growth. That is one of the reasons why, we will argue in chapter 7, countries like Japan and those in Western Europe face an even steeper uphill economic climb than the United States in financing the income and medical needs of their retiring populations in the future.

[edit] Economic Growth and Domestic Civility

Finally, economic growth is like a social lubricant that eases tensions while giving hope to populations. Societies with stagnant or, even worse, declining per capita incomes by definition cannot convince younger people that their economic fortunes will improve as they grow older. And without hope there is little or no entrepreneurial spirit to strive to change the existing order or to improve one’s own standard of living, let alone the living standards of neighborhoods, cities, or entire countries. In short, the lack of growth itself can become an obstacle, holding back economic progress, or even worse.

As Harvard University economist Ben Friedman has persuasively argued, slow growth, especially when coupled with widening inequality, can provide the environment that breeds distrust and often hate (Friedman, 2005). It is not an accident, he points out, that some of the worst periods of intolerance toward African Americans and immigrants in post–Civil War United States history (the late 1800s, the 1930s, 1970s, and early 1980s) occurred during periods of slow or negative growth. The worstcase example of this was, of course, the rise of Nazism in Germany following World War I, when that country was mired in both hyperinflation and stagnant growth (and eventually depression). In more recent times—for example, in the last decades of slow growth and high unemployment— Continental Europe has again flirted with anti-Semitism, while hosting a strong strain of anti-immigrant sentiment.

The reverse is much more likely to be true for economies that are growing. These have the good fortune to take advantage of a virtuous cycle, since the young can count on a better life, assuming they work hard to achieve it. Visitors to India or China or Ireland or Israel, for example, report a vibrancy and sense of excitement that one doesn’t hear about in Western Europe, at the rich end, or much of Latin America or Africa, at the lower end of the world income distribution. Growth opens up opportunities, which in turn unleash not only hope but also the work ethic that helps turn opportunities into reality. Much of this same energy and optimism can be found in pockets of the United States—in high-technology clusters and in parts of some American cities. The challenge will be to maintain this combination of energy and hope in coming decades, when the United States also begins to deal with the many challenges of its retiring babyboom generation.

[edit] Conclusion

The criticisms of growth have some validity but are fundamentally misplaced. Economic growth is and continues to be important, indeed, morally necessary if individuals and society care about improving the living standards of peoples around the world. Michael Mandel, the chief economist for Business Week, has written about technology-driven growth in particular in a way that summarizes much of what we have tried to convey in this chapter:

Such technology-driven growth is essential, I believe, if we are not to drown in our own problems. . . . Without breakthroughs in medical science, it won’t be possible to supply the health care to a generation of aging Americans without bankrupting the young. Without breakthroughs in energy production and distribution, it won’t be possible to bring Third World economies up to industrialized living standards without badly damaging the environment and stripping the world of natural resources. Without rapid economic growth powered by new technologies, it won’t be possible to reduce poverty or ensure the next generation a better life than we have. (Mandel, 2004, xi–xii)

Just citing the hope for improvements in future technology begs the question: who comes up with it and, just as important, how does it get introduced into economies? As for the first question, economists generally agree that technological development is at least loosely tied to investment in the process of discovering new technologies, or research and development (R&D). But the more interesting question that so far has not been well studied, in our view, relates to the conditions under which new technology is introduced and used in economies. The answer to this puzzle turns very much on how an economic system is organized. We will address that critical question in chapter 4, after pausing in chapter 3 to survey what economists have concluded so far about what generates economic growth and why those efforts still leave room for further improvement through analysis and research.

[edit] Notes

1. ↑ At that time, economists focused on increasing the demand for goods and services and not necessarily on the rate of growth in their supply, a distinction about which we will say more in chapter 3.
2. ↑ Based on data in the IMF’s World Economic Database.
3. ↑ By comparison, per capita world output advanced by 248 percent in the nineteenth century, but by meager double-digit amounts in the eleventh through eighteenth centuries. See DeLong, 2000.
4. ↑ The enthusiasm about hydrogen replacing oil and gas may be misplaced. It takes energy to produce hydrogen. Though hydrogen may be “clean,” the process of generating it—through electricity power plants—may not be. For a controversial but compelling case that the world faces no imminent shortage of energy, see Huber and Mills, 2005.
5. ↑ For one of the more thoroughly thought-out approaches along these lines, see McKibbin and Wilcoxen, 2002.
6. ↑ The pollution reductions so far have been brought about through command-and-control mandates rather than more market-oriented approaches, such as cap and trade. One reason for moving in the market direction, however, is that it is cheaper—that is, one can gain the same pollution reduction at lower cost by using techniques that simulate the market.
7. ↑ For a compelling discussion of how ethnic elites within many countries have benefited disproportionately from globalization, see Chua, 2003.
8. ↑ For a superb discussion of all of the arguments surrounding the controversial issue of “globalization” one couldn’t do better than to read Wolf, 2004.
9. ↑ For more recent summaries of the economics of “happiness,” see Kahneman and Krueger, 2006, and Di Tella and MacCulloch, 2006.
10. ↑ As Martin Wolf has noted, life expectancy in the developing world has risen from two-thirds of the level in rich countries in 1950 to 82 percent of that level in 2000 (Wolf, 2004, 164).
11. ↑ As has recently been shown, however, the gains from trade may not be as great when other countries are growing as rapidly as (or more rapidly than) one’s own country (Baumol and Gomory, 2005; Samuelson, 2004). Still, trade can generate gains.
12. ↑ Of course, nationalism and ethnic and/or religious allegiances may triumph over economic growth and democracy and result in military action. All we are claiming is that growth, which should lead to democracy, should also reduce the probability that a nation will choose military over diplomatic means of resolving disputes with neighboring countries.
13. ↑ For one outline of possible measures to fix the long-term budget problem, see Rivlin and Sawhill, 2005.
14. ↑ For example, in one of the pioneering studies of economic growth in the United States, the late Edward Denison calculated that a more experienced workforce raised the annual growth rate of labor productivity by 0.13 percent between 1909 and 1957. See Denison, 1962, 148.

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