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What makes economies grow?

By John Mills

'This article originally appeared in the June 2018 edition of Standpoint'

The 14th April 2018 UK edition of The Economist contained an article whose title read “Economists understand little about the causes of growth”. The body copy which followed amplified this theme.

Prospect devoted a substantial part of its May 2018 issue to “The case for a new economics”, advocating “Rip it up and start again”, but with barely a mention of economic growth anywhere in the revised agenda which readers were asked to consider.

Clearly, there is a gap which very badly needs to be filled. The fact that economics as taught and practiced, especially in the West, has no clear explanation of what produces economic growth, and what policies are required to ensure that it materialises, is extremely damaging.

Here is how this gap might be bridged.

The starting point is to recognise that economic growth stems very largely from a very narrow range of sources. It comes almost entirely from investment in mechanisation, technology and power - and from very little else.

It does not come to any significant extent from public sector investment – in schools, hospitals, road, rail, public buildings and housing. Nor does it come from private sector investment in office blocks, retail parks, new restaurants, housebuilding, or generally from capital expenditure in financial, legal and related services.

It also does not - again to any significant extent – spring from better education and training, more finance being made available for investment in industry, better infrastructure and less short-termism, although all these things help in the right circumstances. Nor does it come from more competition, deregulation, privatisation, lower taxation and a smaller state, although a strong, well organised government is always a strong plus. These factors are all largely consequences or attributes of faster economic growth, rather than among its primary causes.

If, on the contrary, the only truly efficacious generator of economic growth is investment in machinery, technology and power – and little else – what makes investment of this sort different from the rest? It is its capacity to produce much larger volumes of output value per hour than was available before - and the scale on which it is capable of doing so. It is using a bulldozer instead of a shovel, a truck instead of a wheelbarrow, a computer rather than a multiplication table, and a robot rather than doing complicated repetitive jobs by hand. It is the benefit of key computer code applications being used millions of times. It is transformations like this which created the Industrial Revolution, and which made possible the huge increases in living standards we have seen over the past 250 years.

The key difference between the types of investment which lead strongly to economic growth and those that do not can be measured and encapsulated through their respective Social Rates of Return. This a measure of the total increased output – or Gross Value Added - achieved per unit of investment. It is spread over higher wages and salaries, better and more valuable products and services, higher volumes of output, a larger tax base and higher profitability. Whereas the Social Rate of Return on most types of investment in both the public and the private sectors is barely above the rate of interest used to finance them, for mechanisation, technology and power, it can typically be many times higher – up to 50% or even 100% per annum.

The areas of the economy where these very high returns tend to be available are particularly clustered around light industry although not exclusively so. Some, though not much, of the service sector can also achieve similar outcomes. Very high Social Rates of Return also typically involve processes with rapidly falling costs as production volumes mount and very often they involve products which are internationally traded.

 

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Diversified modern economies which grow faster than average therefore tend to be ones with both substantial manufacturing sectors and reasonably stable governments, such as many of those on the Pacific Rim, but also including countries such as Singapore and Germany. The table above shows, for a number of different countries, the proportion of their GDP coming from manufacturing, their aggregate growth rates over the years from 2006 to 2016, the increases they achieved in GDP per head, and the proportion of GDP which they devoted to investment instead of consumption.

If the key determinant of any modern diversified economy’s growth rate is very largely determined by the proportion of its economy devoted to key investments with very high rates of return, what determines what that these proportions will be - and how effectively such investment will be used? Rapid growth is a function not only of how much highly productive investment there is in the economy but also the intensity with which it is utilised. These are both functions of the competitiveness of the economy which – other things being equal - in turn depends almost entirely on the exchange rate. This is so for two separate reasons. These are:

1.A    To attract the types of economic activity which achieve very high rates of economic return, the exchange rate must be at a sufficiently competitive level to make it worthwhile siting new production facilities to exploit them in the domestic economy, rather than elsewhere. Because this investment will almost invariably be in the private sector, it has to be profitable, otherwise it will not take place, so profitability is key. Manufacturing involves machinery, raw materials and components comprising typically about one third of total costs, generally sourced at world prices. All other costs, including direct labour, management salaries and other overhead costs, including interest and taxation, are incurred in the domestic currency. The rate at which all these domestically incurred costs are charged out to the rest of the world, and hence the competitiveness of the domestic economy on world markets, depends almost entirely on the exchange rate. This needs to be low enough to make production profitable given whatever the prevailing level of productivity and wage costs per unit of output actually is – in turn, largely determined by a combination of the amount of capital behind each employee and his or her level of skill.

1.B    The domestic economy must have a sufficiently stable balance of payments position to be able to expand without constraints on growth being imposed by foreign payments deficits. Major deficits, such as those currently being borne by the UK, siphon unsustainable amounts of demand out of the economy, which has to be replaced by unfunded expenditure to stop the economy contracting. This generates the need for government and consumer borrowing, which in turn is all too likely to lead to deflationary policies being implemented to contain them from becoming unsustainably large. Deflation and the consequent austerity, if they are allowed to materialise, undermine the returns on investment. Since most exports are goods rather than services, a thriving manufacturing sector is a prerequisite for foreign payments weakness not being a constraint on economic expansion.

Why don’t countries like the UK, which suffer acutely from very slow growth, recognise the problems and solutions set out above? Why do they so resolutely refuse to implement policies, particularly those relating to the exchange rate, which would get the economy growing much faster? It is mainly because public opinion and hence the governance of the UK is dominated by its service sector, which has huge natural advantages – our language, geography, legal system, universities and pools of talent - and is thus competitive and profitable, especially as it is not very price sensitive, even if the exchange rate is relatively high – at, say, $1.50 to the pound. For manufacturing, on the other hand, where growth potential is much greater and on which the UK largely depends to pay its way in the world, an exchange rate of $1.50 to the pound is lethal.  Taking into account the actual state of training and capital equipment backing in the UK, manufacturing, with no natural advantages to those the UK has in services, needs an exchange rate of around parity with the dollar and about £1.00 = €0.85 to make the sort of investment we need, and on the required scale, profitable in the UK.

What are the policy implications of these perceptions? Here are some numbers:

2.A    If we had an exchange rate – around £1.00 = $1.00 - which made it highly profitable to invest in low- and medium-tech industry, we could over a five year period increase the proportion of GDP coming from manufacturing from 10% to 15%.

2.B    If, by doing this, we shifted 4% of UK GDP out of consumption and into investment with a Social Rate of Return of 50%, this could increase the growth rate by 2% per annum – 4% x 50% -  raising it from its current 1.5% to 3.5% per annum.

2.C    If, over the same period, we could complement increased industrial investment by moving another 4% of GDP into lower return types of investment in the public and the private sector, we could make a huge difference to our environment and infrastructure.

2.D    If, as the proportion of GDP derived from manufacturing rose from 10% to 15%, we increased our exports of manufactured goods pro rata – allowing for one third of inputs being imports and our existing manufactured exports being around  £250m a year -  we should be able to reduce our balance of payments deficit by 1/2 x 2/3 x £250bn, i.e. by  just over £80bn per annum, thus enabling us to come much closer to paying our way in the world.

Entirely feasible changes along these lines would enable the UK economy to expand on a sustainable basis at 3.5% per annum. They would increase our rate of investment from barely 16% to somewhere near 26% of GDP - the world average. They would eliminate our trade deficit. They would reduce our balance of payments deficit to easily manageable proportions. They would remove most of the need for the government to run a deficit, since government borrowing is largely the mirror image of our huge foreign payments deficit, which would no longer be a problem. They would provide new manufacturing opportunities outside London and the South East, thus starting to redress the huge imbalances between the regions of the UK. They would help to close inter-generational imbalances by producing much better employment and housing prospects for millennials. They would provide an environment in which income, wealth and life chance disparities could be contained and hopefully reduced. They would provide rising living standards for everyone.

Why don’t we do it?

Labour Leave shares a number of viewpoints from external commentators, both Leave and Remain, without necessarily endorsing any of the viewpoints therein.


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