SOLOW’S HUNCH
This should not come as a complete surprise. Remarkably, at the height of postwar growth, in 1956 Robert Solow wrote a paper suggesting growth would eventually slow down.23 His basic point was that as per capita GDP goes up, people save more, and therefore there is more money to invest, and more capital available per worker.
This makes capital less productive; if there are now two machines in a factory where there was only one, the same workers will have to operate both at the same time. Of course, a single factory can hire more workers if it gets more machines. But the whole economy cannot (assuming migration remains unchanged), once its reserve of underused workers is exhausted. Therefore, the extra machines bought with the additional savings will have to be worked with fewer workers. Each new machine and as a consequence each additional unit of capital will contribute less and less to GDP. Growth will slow down. Furthermore, the lower productivity of capital lowers its financial return, which in turn discourages savings. So eventually people will stop saving and growth will slow down.This logic operates in both directions. Capital-scarce economies grow faster because new investment is highly productive. Rich economies, which are, in general, capital abundant, tend to grow more slowly because new investment is not as productive. One implication of this is that any large imbalance between labor and capital should get corrected. Economies overabundant in labor grow faster, and since incomes grow faster, savings do as well. So these economies accumulate capital faster and become more capital abundant. By the reverse argument, economies with too much capital relative to labor accumulate capital more slowly.
As a result, a sharp divergence between the rates of growth of capital and the labor force is not sustainable over the long haul because if, say, capital grows faster than the labor force, then the economy will have too much capital relative to labor, which will slow down growth.
There can be imbalances in the short run (as we are witnessing today in the United States where the share of the GDP paid to the labor force is falling24), but in the long run there is a natural tendency for economies to stay close to a balanced growth path, where labor and capital grow at roughly the same rate, and so does human capital—the part of capital embodied in the skills of the workers, for very much the same reason. Solow argued that GDP (which is after all the product of labor, skills, and capital) would also grow at the same rate as well.Now, the growth of the effective labor force is determined by past fertility and how much people want to work, both factors that seemed to Solow to be more driven by demography than economics, and therefore more related to a country’s history and culture than to the current state of its economy or economic policy. However, there is also the improvement of TFP—if one worker becomes so productive that he can do the work of two, because of improvements in technology, then the effective labor force would have doubled. Solow assumed such transformations were also unrelated to contemporary economics and policies of the country, in effect placing the growth rate of the effective labor force outside the realm of economics. This is why he called it the “natural rate of growth,” and from his theory, we know that GDP must also grow at the same rate as the effective labor force in the long run; that is, at the natural rate.
A number of implications follow from Solow’s theory. First, growth is likely to slow down after a phase of fast growth that follows a dramatic transformation, once the economy is back on the balanced growth path. This is clearly consistent with what happened to Europe after 1973. After the wartime destructions, capital was scarce and Europe had a lot of catching up to do; by 1973 the era of catch-up growth was over. In the United States, the kind of investment-driven growth Solow had in mind clearly slowed down after the war, but conveniently its place was taken by rapid TFP growth until 1973. Since then, as we already discussed, there has been a slowing trend even in the United States. Interest rates have been falling throughout the West, reflecting, it seems, an abundance of capital, exactly as in the Solow model.