EVERYONE WAS RIGHT, EVERYONE WAS WRONG
Where does all of this leave us in our understanding of economic growth? Well, Robert Solow was right. Growth seems to slow down as countries get to a certain level of per capita income.
At the technological frontier, that is to say in the rich countries, TFP growth is largely a mystery. We do not know what propels it.And Robert Lucas and Paul Romer were right too. For the poorer countries, convergence is not automatic. This is probably not mainly because of spillovers. It is more that TFP is much lower in poorer countries, to a significant extent because of market failures. And therefore to the extent that business-friendly institutions have something to do with fixing market failures, Acemoglu, Johnson, and Robinson were right too.
And yet all of these economists were also wrong, because they thought of economic growth and of a country’s resources as aggregate things (the “labor force,” the “capital,” the “GDP”), and in doing so they probably missed the key point. Everything we have learned about misallocation tells us we have to step beyond the models and think of how the resources are used. If a country starts by using its resources very badly, like China did under communism or India did in its days of extreme dirigisme, then the first benefits of reform may come from moving resources to their best uses. Perhaps the reason why some countries, like China, can grow so fast for so long is that they start with a lot of poorly used talent and resources that can then be harnessed. This is neither Solow’s nor Romer’s world, in which a country would need either new resources or new ideas to grow. It might also suggest the growth could slow down rapidly, once those wasted resources have all been put to good use, and growth becomes dependent on additional resources. Much is being written about the economic slowdown in China; growth is definitely slowing down and that is probably to be expected.
This trend will almost surely continue, whatever Chinese leaders do now. China accumulated resources rapidly, as it had plenty of room to catch up; in the process, the most blatant sources of misallocation were eliminated, which means there is less room to improve now. The Chinese economy relied on exports to provide know-how, investment, and endless (for a while) global demand. But now they are the largest exporter in the world, so they cannot possibly continue to grow their exports much faster than the world is growing. China (and the rest of the world) will have to come to terms with the reality that their era of breathtaking growth is likely coming to an end.In terms of what is to come, it looks like the United States can relax a bit. In 1979, Harvard professor Ezra Vogel published a book, Japan as Number One, that predicted Japan would soon overtake all other countries to become the number one economic superpower. Western countries, he argued, needed to learn from the Japanese model. Good labor relations, low crime, excellent schools, and elite bureaucrats with long time horizons was the new recipe Vogel identified for permanently faster growth.119
Indeed, had it continued to grow at its average growth rate over the decade 1963–1973, Japan would have overtaken the United States in terms of GDP per capita by 1985, and in overall GDP by 1998. It did not happen. What happened instead is enough to make one superstitious. The growth rate crashed in 1980, the year after Vogel’s book came out. And it never really recovered.
The Solow model suggests a simple reason. Due to a low fertility rate and the near complete absence of immigration, Japan was (and still is) aging rapidly. The working-age population peaked in the late 1990s and has been declining. This means TFP must grow all the more rapidly to keep fast growth going. Another way to say this is that Japan would have to find some miracle for its existing labor force to become more productive, since we still have no reliable way to boost TFP.
In the euphoria of the 1970s, some believed this to be possible, which may explain why people continued to save and invest in Japan in the 1980s, despite the slowdown. Too much good money chased too few good projects in the so-called bubble economy of the 1980s, with the consequence that banks ended up with many bad loans and a huge crisis in the 1990s.
China faces some of the same problems. It is aging fast, partly as a result of the one-child policy, which has proven difficult to reverse. It might still eventually catch up with the United States in per capita terms, but the slowing growth means it will take quite a while. If China slows to 5 percent per year, which is not implausible, and stays there, which is perhaps optimistic, and the United States continues to bounce around 1.5 percent, it will take at least thirty-five years for China to catch up with the US in terms of per capita income. Meanwhile, the Chinese authorities may also want to relax and accept the writ of Solow. Growth will slow.
They are aware of it, and have made a conscious attempt to alert the Chinese people to this fact, but the growth targets they have set may still be too high. The danger is that it could put the leadership in a bind and lead them to make bad decisions in an effort to make growth come back, as Japan did before them.
If a fundamental driver of economic growth is resource misallocation, it opens the door to various unorthodox strategies to make growth happen. Such strategies are meant to respond to the particular way in which resource use in a country is distorted. The Chinese and the South Korean governments did a good job of identifying sectors that were too small and therefore not meeting the economies’ needs (they tended to be heavy industry providing basic raw materials to other industries, like steel and chemicals) and directed capital toward them through state investments and other interventions. This might have sped up the transition to efficient resource use.120
That it worked in those two countries does not necessarily mean it is something every country should emulate.
Economists tend to be very wary of industrial policy, for good reasons. The history of state-directed investments is not one that inspires confidence; judgments are frequently bad even when they are not actually deliberately distorted to benefit someone or some group, which is often. These are “government” failures just as there are market failures, and there are so many instances of these that it would be very dangerous to blindly rely on governments to pick the winners. But there are also so many market failures that it makes no sense either to rely on the market alone to allocate resources to the right use; we need an industrial policy designed that keeps in mind these political constraints.Another implication of the idea that growth is slowed down by misallocation is that countries like India that are growing fast right now should fear complacency. It is relatively easy to grow fast, starting from a spectacularly messed-up economy, because of the gains from better resource use. In Indian manufacturing there was a sharp acceleration in technology upgrading at the plant level, and some reallocation toward the best firms within each industry after 2002. This appears to be unrelated to any economic policy, and is described as “India’s mysterious manufacturing miracle.”121 But it is no miracle. At its root, it is a modest improvement from a dismal starting point, and one can imagine various reasons it happened. Perhaps a generational shift, as control passed from the parents to their children, often educated abroad, more ambitious, and savvier about technology and world markets. Or the effect of the accumulation of modest profits that eventually made it possible to pay for the shift to bigger and better plants.
But as the economy sheds its worst plants and firms, the space for further improvement naturally shrinks. Growth in India, like that in China, will slow. And there is no guarantee it will slow when India has reached the same level of per capita income as China.
When China was at the same level of per capita GDP as India is today, it was growing at 12 percent per year, whereas India thinks of 8 percent as something to aspire to. If we were to extrapolate from that, India will plateau at a much lower level of per capita GDP than China. The growth tide does raise all boats, but it doesn’t lift all boats to the same level—many economists worry that there may be such a thing as the middle-income trap, an intermediate-level GDP where countries get stuck or nearly stuck. According to the World Bank, of 101 middle-income economies in 1960, only 13 had become high income by 2008.122 Malaysia, Thailand, Egypt, Mexico, and Peru all seem to have trouble moving up.Of course, there are many pitfalls in any such extrapolation, and India should treat it as what it is: no more than a warning. It is quite possible that India’s growth, in spite of all of its problems, has very little to do with some special Indian genius. Instead, it has a lot to do with the flip side of misallocation: the opportunities of being an economy with a large pool of potential entrepreneurs to draw upon and lots of unexploited opportunities.