Economic Growth: How it works and how it transformed the world

By Edward A. Hudson

How does economic growth work? Beginning with the history of leading countries over the past 2000 years, Economic Growth finds which countries have achieved sustained growth and how they did it. The effects of growth are examined on a human scale. The benefits of growth are enormous in terms of life, health, education, leisure and opportunity, w

• Language: English
• Publisher: Vernon Press
• Release date: Apr 20, 2016
• ISBN: 9781622730445

Edward A. Hudson

Edward A. Hudson (PhD, Harvard), working with Harvard's Dale Jorgenson, pioneered computable general equilibrium models in the 1970s. He applied these models to understanding the "energy crisis" and to analyzing energy policies. Dr Hudson then moved to strategy consulting, advising corporations and governments in the United States and New Zealand. This included advising on the great deregulation carried out in New Zealand in the 1980s and 90s. He has now returned to researching and writing on economic growth.

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Economic Growth

How it works and how it transformed the world

Edward A. Hudson

Copyright © 2015 Vernon Press, an imprint of Vernon Art and Science Inc, on behalf of the author.

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Library of Congress Control Number: 2014958349

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Preface

I spent my childhood in New Zealand. As a youngster in the 1950s I was amazed at the ever expanding stream of new products which appeared on the market and which made life easier, for my parents, and more fun, for me. The washing machine and the refrigerator, I remember, transformed my mother’s life. The automobile transformed my life. I was aware, as was everyone in New Zealand, that this wave of plenty flowed from the sheep’s back, as the saying went. New Zealand’s farms grew sheep and cows, exporting wool, meat and cheese to Britain and to the United States. I was also aware of the corollary – this prosperity depended on the prosperity and growth of Britain and the United States.

I moved to the United States in the 1960s. I was struck by the even greater prosperity I found there. I was equally struck by the attitude of Americans – friendly, helpful, optimistic and, above all, striving to improve themselves and their economic position. This was, it seemed to me, a dynamic country like no other. America was (and is) a land of plenty, partly because it is so blessed with natural resources but mainly because of its people. America is a land of change as its people work to improve their lot and, in so doing, move everyone forward in opportunity and prosperity. My story, of moving to America in search of opportunity, and of working and investing to grasp those opportunities, is also the story of America.

I studied at Harvard and got a Ph.D. in Economics. My thesis was on economic growth, applying a mathematical growth model to investigate the properties of the so called turnpike. The feature of the turnpike is that, like the highway, there is just one efficient growth path and, if the planning horizon is long enough, efficient growth always travels along this one path, no matter what the beginning point and the target destination. This research was intensive in mathematics and computation. One thing I took from this research was not so much about economic growth but rather the value of systematically working towards a defined target. In addition I learned from Dale Jorgenson, my thesis adviser, and from three other Harvard professors – Otto Eckstein, Hendrik Houthakker and Wassily Leontief – that the answer to most questions comes from careful analysis of the FACTS. One implication for understanding the world is – look for the theory that fits the facts, not the facts that fit the theory. This is the philosophy that I have applied in this book.

I chose not to go into academia; I was interested instead in working on practical problems and trying to improve practical outcomes. This began with some heavy duty modeling. Working with Dale Jorgenson, I operationalized Dale’s 9 sector (later expanded to 36 sector) general equilibrium growth model. This was the time of the first energy crisis (the price of oil went up) and we applied the model to investigating energy-economy interactions. Public opinion was shocked – the price of gasoline had doubled! Politicians, eager to be seen to be doing something, did something and transformed a normal economic adjustment into an ongoing problem. The problem was not solved until the 1980s when President Ronald Reagan removed Federal controls on petroleum and also by which time the normal economic forces of supply (expanding supply in response to higher prices) and demand (reducing demand due to higher prices) were starting to come into full play.

President Reagan said: The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help’. There is a certain amount of truth in this. So, disillusioned with governments I began a new career in management consulting. I have been doing this, mainly in strategy consulting, ever since. I have always kept an interest in economic growth but, until now, I have focused my work on strategy. During my career I was working on, observing and analyzing business - how businesses work, what makes them succeed, what makes them decline. And, all the time I was accumulating facts which, with my thinking framework as a highly trained economist, led to an understanding of how economies work – how they grow or, in the opposite case, how they stagnate.

Now that I have retired and have a little time to do other things, I have returned not so much to thinking about economic growth but to distilling everything I have learned and observed and analyzed about economic growth into a coherent system. I started active research and writing about four years ago. I knew my target end point, a book about economic growth, but I didn’t know what would end up in the book. I was surprised. Analyzing the facts brought me to the realization that there was a clear logical framework concerning growth – what happens and how it happens. This framework is what I have tried to set out in this book.

Economists have dabbled for decades in thinking about economic growth. This dabbling turned into serious theory in the 1950s when Robert Solow (1956) led the development of so called neoclassical growth models. Academic thinking since then has pretty much stayed within the framework initiated by Solow. These models attribute growth to increases in inputs of capital, labor and everything else – the residual, often characterized as technical change. This type of model does broadly describes the results of U.S. growth although it does less well for many other countries. Fundamentally, though, this approach describes the result but not the causes or the processes of growth. The approach set out in the present book has a different objective - to find the mechanisms of growth, how growth works, how economic growth comes about. My approach extends the academic model into causes rather than just effects.

The analysis of the mechanisms and processes of growth set out in this book can be applied to forecasting the future. These forecasts are separate to my analysis of growth itself but it is irresistible not to try to look into the future. I think that the outlook for continuing economic growth is reasonably good; I am optimistic. This optimism comes down to the character of the American people and the nature of the capitalist system. There is no reason to think that all the new products that can be developed have been developed; to the contrary, there is every reason to think that there is no shortage of desirable new products which can be developed even though we do not know today what these will be. The dynamism of the American people surely sets the stage for continued development of new and better products. The dynamism of American business similarly sets the stage for improvements in production efficiency, development of new production technologies, new management tools and other things which reduce costs/increase productivity, sustaining the growth in demand and generating increasing incomes.

There are serious risks though. First, there is the risk that governments will interfere with trade, restrict change, diminish incentives and add to costs, thereby threatening the human drivers of growth. Second, there are non-economic risks which currently are not being managed. I am thinking here of global environmental dangers from the loss of the world’s fisheries, from the contamination of the oceans and, in particular, from climate change resulting from ever-increasing emissions of greenhouse gasses. Third, there are the risks of armed conflict and religion-fuelled terrorism. Our institutions are not up to the task of effectively managing these risks. Economically, the future looks bright but humankind faces the challenge of managing the global physical and security environment so that everyone on Earth can benefit from this bright economic future. I wish I could be as optimistic about these matters as I am about efficacy of the market/capitalist system.

My purpose in writing this book has been to clarify the practical features, processes and effects of economic growth. I hope that this view of economic growth will be of interest to economists, public policy-makers and those in the population in general who are concerned about how the world operates and how lives can be improved. I hope that these people find this book informative and, most of all, stimulating.

Contents

Chapter 1      Introduction

1.1      If there had been no growth

1.2      What is economic growth?

1.3      Measuring growth

1.4      A history of income

1.5      A broad history of economic growth

1.6      The growth leaders

1.7      Growth rates

1.8      The conventional theory of growth

1.9      Our objective

Chapter 2      The world before economic growth

2.1      The Roman Empire

2.1.1      Course of the Empire

2.1.2      Innovations

2.1.3      Production

2.1.4      Economic growth

2.2      The Renaissance

2.2.1      The Italian states

2.2.2      Venice

2.2.3      The Black Death

2.2.4      The Renaissance

2.2.5      Economic performance

2.3      The Spanish Empire

2.3.1      Course of the Empire

2.3.2      Economic performance

2.3.3      Reasons for this performance

2.4      The Netherlands

2.4.1      Growth of trade

2.4.2      Economic performance

2.5      Imperial China

2.5.1      Expansion

2.5.2      How was the expansion used?

2.6      Other countries

2.7      Why no growth?

Chapter 3      The start of growth - Britain

3.1      A succession of changes

3.2      British agriculture

3.2.1      The Agricultural Revolution

3.2.2      Climate

3.2.3      Land

3.2.4      Mechanization

3.2.5      Crop rotation

3.2.6      Selective breeding

3.2.7      Agricultural output

3.2.8      Advances in technology

3.2.9      Agriculture and growth

3.3      The cotton industry

3.3.1      The starting point

3.3.2      Cotton production

3.3.3      Market growth

3.3.4      Technological change

3.3.5      Nature of the innovation process

3.3.6      Productivity in the cotton industry

3.4      The woolen industry

3.4.1      Slow growth

3.4.2      Innovation in the woolen industry

3.4.3      The nature of growth in the woolen industry

3.5      The steam engine

3.5.1      Steam technology

3.5.2      The nature of innovation

3.5.3      Steam power and economic growth

3.6      Coal

3.6.1      Growth of the coal industry

3.6.2      Markets for coal

3.6.3      Productivity in coal production

3.6.4      The role of coal in Britain’s growth

3.7      Iron and steel

3.7.1      Forms of iron

3.7.2      Production technologies

3.7.3      Nature of technical change in iron and steel

3.7.4      Growth in iron and steel production

3.7.5      Iron and steel and economic growth

3.8      Railways

3.8.1      Development of railways

3.8.2      The market for railway services

3.8.3      Isambard Kingdom Brunel

3.8.4      Railways and economic growth

3.9      Shipping

3.9.1      Technical change in shipping

3.9.2      The market for shipping

3.9.3      Shipping and the economy

3.10      Economic growth in Britain

3.10.1      Sustained growth

3.10.2      When did growth start?

3.10.3      Getting ready

3.10.4      The breakthrough

3.10.5      Growth consolidates

3.10.6      Innovation

3.10.7      Accounting for growth

3.10.8      Creating the conditions for growth

3.10.9      Analytical features

Chapter 4      The leader – United States

4.1      The new leader

4.2      Agriculture

4.2.1      Importance

4.2.2      Development of agriculture

4.2.3      Capital

4.2.4      Biology

4.2.5      Chemicals

4.2.6      Chickens

4.2.7      How did agriculture grow?

4.2.8      Agriculture in economic growth

4.3      Electricity

4.3.1      Electricity supply

4.3.2      Generation productivity

4.3.3      Demand for electricity

4.3.4      Electricity and economic growth

4.4      Telecommunications

4.4.1      Development

4.4.2      The market for telecommunications

4.4.3      Telecommunications and economic growth

4.5      Motor vehicles

4.5.1      The producers

4.5.2      Development of the market

4.5.3      Productivity growth in automobiles

4.5.4      Motor vehicles and the economy

4.6      Aircraft

4.6.1      Development of the technology

4.6.2      Aircraft productivity

4.6.3      Aircraft and the economy

4.7      Transportation

4.7.1      Waterborne freight

4.7.2      Growth of railroads

4.7.3      Railroads and the economy

4.7.4      Trucking

4.7.5      Passenger transportation

4.7.6      Airlines

4.7.7      Transportation and the economy

4.8      Consumer appliances

4.8.1      Major appliances

4.8.2      Smaller appliances

4.8.3      Appliances and the economy

4.9      Steel

4.9.1      The market for steel

4.9.2      Steel-making technology

4.9.3      Contribution to economic growth

4.10      Petroleum

4.10.1      A visible industry

4.10.2      Growth of the industry

4.10.3      Petroleum and economic growth

4.11      Chemicals

4.11.1      Development

4.11.2      Demand for chemicals

4.11.3      Chemicals and economic growth

4.12      Retailing

4.12.1      The development of retailing

4.12.2      Contribution of retailing to economic growth

4.13      Advertising

4.14      Marketing

4.14.1      Marketing and economic growth

4.15      Entertainment

4.15.1      Growth of entertainment

4.15.2      Entertainment and economic growth

4.16      Finance

4.16.1      Size

4.16.2      Residential investment

4.16.3      Consumer durables

4.16.4      Business investment

4.16.5      Investment and economic growth

4.17      Information technology

4.17.1      Development

4.17.2      Demand for computers

4.17.3      Productivity

4.17.4      Extent of information technology

4.17.5      Computers and economic growth

4.17.6      Computers in the growth process

4.18      Health care

4.18.1      Demand for health care

4.18.2      Productivity in health care

4.18.3      Health care and economic growth

4.19      Economic growth in the United States

4.19.1      Economic growth

4.19.2      The start of growth

4.19.3      Accounting for growth

4.19.4      Industry growth

4.19.5      The growth sequence

4.19.6      The keys to economic growth

Chapter 5      Other countries, other systems

5.1      Maintaining growth

5.1.1      The early leaders

5.1.2      Growth in the 20th century

5.1.3      The growth implications

5.2      Coat-tail growth

5.3      Communism

5.3.1      Communist government

5.3.2      Government control of the economy

5.4      Empire

5.4.1      Past empires

5.4.2      The course of empires

5.4.3      Inefficiency and efficiency

5.5      Japan

5.5.1      The growth record

5.5.2      Manufactures and exports

5.5.3      The growth process

5.6      Republic of Korea

5.6.1      The growth record

5.6.2      Manufactures and exports

5.6.3      Growth strategy

5.7      China

5.7.1      Early China

5.7.2      Government policies

5.7.3      Growth in China

5.8      Catch-up growth

Chapter 6      Effects of economic growth

6.1      Population

6.1.1      The Malthusian trap

6.1.2      Population

6.1.3      Children

6.1.4      Health

6.2      Higher incomes

6.2.1      In Britain

6.2.2      Growth

6.2.3      Household income

6.2.4      Household spending

6.2.5      Food

6.2.6      Housing

6.2.7      Investment by households

6.2.8      Government activity

6.2.9      Income distribution

6.3      Education

6.3.1      Before growth

6.3.2      Provision of education

6.3.3      Content

6.3.4      Inputs

6.3.5      Outputs

6.3.6      The principles

6.3.7      Benefits from education

6.4      Time

6.4.1      Hours worked

6.4.2      Retirement

6.4.3      Leisure

6.4.4      Choices open to women

6.4.5      Creating time

6.5      Mobility

6.5.1      Industrialization

6.5.2      Transport has become cheaper

6.5.3      International trade

6.5.4      Cars

6.5.5      The shape of cities

6.5.6      Travel

6.5.7      Moving information

6.5.8      Shrinking the world

6.6      Urbanization

6.6.1      Rural starting point

6.6.2      Economic development

6.6.3      Growth of the cities

6.6.4      General trend to urbanization

6.7      Natural Resources

6.7.1      Coal

6.7.2      Aluminum

6.7.3      Oil

6.7.4      The Limits to Growth

6.7.5      Resources and growth

6.8      Local environmental effects

6.8.1      The problem

6.8.2      U.S. Clean Air Act

6.8.3      Air quality improvement

6.8.4      Effective environmental management

6.8.5      Other environmental effects

6.8.6      Economic effects

6.9      Broad environmental effects

6.9.1      The commons and externalities

6.9.2      Atlantic cod

6.9.3      New Zealand fisheries management

6.9.4      Greenhouse gasses and climate change

6.9.5      Ozone holes

6.9.6      The problem

6.9.7      Super-national environmental effects of growth

6.10      Well-being

6.10.1      Does economic growth help?

6.10.2      Surveys of well-being

6.10.3      The OECD better life approach

6.10.4      Economic growth is good

Chapter 7      Past theories of economic growth

7.1      Adam Smith

7.2      David Ricardo

7.3      Karl Marx

7.4      John Maynard Keynes

7.5      Milton Friedman

7.6      Wassily Leontief

7.7      Simon Kuznets

7.8      Walt Rostow

7.9      Modern growth theory

7.9.1      Frank Ramsey

7.9.2      The stylized facts

7.9.3      The Solow Growth Model

7.9.4      Extensions to the Solow approach

7.9.5      Assessment of Solow-type models

7.10      Growth accounting

7.10.1      Growth accounting

7.10.2      John Kendrick

7.10.3      Dale Jorgenson

7.10.4      Assessment of growth accounting

7.11      Economic theory in the world

Chapter 8      The mechanics of growth

8.1      Breaking through constraints

8.2      Industry growth

8.3      Different types of industry growth

8.4      The growth path for leading industries

8.5      The logistic model

8.6      Creating industry growth

8.7      The consumer society

8.8      Example - automobiles

8.9      Sequence of leaders

8.10      Sustaining the leading industries

8.11      Capital

8.12      Process innovation

8.13      Productivity in industry growth

8.14      What drives innovation

8.15      Some innovation leaders

8.16      Innovation Hall of Fame

8.17      Demand and supply

8.18      Creative destruction?

8.19      The mechanics of growth

Chapter 9      Extending the theory  of economic growth

9.1      Three types of growth

9.2      Overview of the theory

9.3      Pre-conditions for growth

9.4      Growth in potential output

9.5      Increasing productivity

9.6      Growth in total spending

9.7      Growth industries

9.8      Mainstream industries

9.9      Declining industries

9.10      The vital sequence

9.11      Micro foundations to growth

9.12      Resource mobility

9.13      Growth accounting

9.14      Changing structure

9.15      Incomes

9.16      The role of government

9.17      Stability

9.18      Relationship to existing theory

Chapter 10      Conclusions

10.1      What, when, where, how and why

10.2      Freedom

10.3      A good thing

10.4      Can economic growth continue?

10.5      Risks to economic growth

10.5.1      Various risks

10.5.2      Attitudes

10.5.3      Business

10.5.4      The environment

10.5.5      Government

10.5.6      Overview of the risks

10.6      Will economic growth continue?

Appendix 1    Units of Measurement

Appendix 2    The United Kingdom

Appendix 3    Sources of data

References

Most things about our day-to-day lives are due to economic growth. Without growth we would be living in the manner of people in England in 1700. A few would live in large houses, be looked after by servants, dress in fine clothes and eat high protein diets. Most, though, would work on the land, live in one or two room houses with no water supply or sewerage system, be illiterate and have no teeth. Women would cook, clean and have children; men would labor. Diet would be dominated by grains and beer. Mobility would be by walking. People would live and die in the village in which they were born. As life expectancy was less than 40 years there would be no concern about retirement. Food supply was so limited and death rates from infectious diseases were so high that most of us would simply not be here – populations would be a small fraction of what they are today.

Today, most people in high income countries are educated and in good health, have a life expectancy of around 80 years, live in comfortable houses with energy supply, water and sewerage systems, eat well (or even too well), be in paid work for less than half of their waking hours, have machines which drastically reduce the time and effort needed for household tasks, and have machines which provide entertainment, communication and mobility. And there are more of us – food supply, sanitation and health care are such that populations are many times greater than in 1700. These changes are all due to sustained increases in production (and its dual, income) over the past three centuries; in short, these changes are due to economic growth.

Economic growth is the continuing increase in per capita incomes or purchasing power.

These are increases continuing for many decades or for centuries. Economic growth has now been going on for 300 years. Some countries in earlier eras achieved rising per capita incomes but, when the source of the rise had been played out, were unable to continue the increase. The central feature of economic growth is that the increase is ongoing – once one source of growth has been played out another source emerges to take per capita incomes forward again, and so on and so on.

Increasing production which is totally absorbed in population increase is expansion but not growth; this is simply more people living the same way and doing the same things. Economic growth is about increasing average incomes. This allows people to increase their material standard of living, to enjoy more of more things, to be better educated, have better health, more leisure time, more entertainment and so on. Economic growth is about increasing the range and depth of choice available for people’s consumption.

Economic growth always involves change. New goods and services are introduced, patterns of spending and consumption change, production expands, new production processes are developed, production takes place in new locations, people choose to live in new locations and so on. The pre-growth world featured static economies, or economies which increased in scale or extent but not structure, whereas growth economies involve continuing structural change. In a growth economy, the only constant is change.

Economic growth conventionally is measured by the growth rate of constant price Gross Domestic Product (GDP) per capita. Constant price means that production is valued in different years in the prices of the base year; this takes inflation out of account, thereby indicating movements in the overall quantity of production of goods and services.

GDP is a measure of the value created in the production of traded goods and services. (Some non-traded production also is included such as the value of accommodation services from owner-occupied residential property.) This value added is the total income generated in an economy. This income is then spent on finished goods and services. Most of this final demand spending is by people consuming finished goods and services, some is by governments on producing public goods, some is directed to investment to provide increased productive capacity for the future and some (exports less imports) is spending by people in other countries. The value added in production, net incomes and final demand spending are different ways of looking at the same thing; numerically they are equal.

GDP is part of a measurement system called the National Accounts. GDP and related measures in the United States are also referred to as the National Economic Accounts. Table 1.1 shows the broad spending and income indicators of the National Economic Accounts for the United States for 2010. Total spending is Gross Domestic Expenditure (GDE), total income is Gross Domestic Income (GDI) and the value added (income created) in production is GDP. Numerically, GDE is equal to GDI and also to GDP. (The values in this Table are in current dollars, the dollars actually spent or received. For considering economic growth, production, expenditure and income are measured in constant dollars.)

These different views also show the structure of economic activity. For example, final demand is dominated by personal consumption, labor income is greater than capital income, and spending is dominated by services.

GDP growth can also be separated into its sources in terms of productive inputs – labor, capital and everything else, the productivity of converting factor inputs (factor inputs are labor and capital) into outputs. This is called growth accounting. Growth accounting typically finds that most growth in GDP per capita is due to more and better capital per worker along with increases in productivity.

As England, part of the United Kingdom, was the birthplace of economic growth, we show in Figure 1.1 the graph of U.K. per capita GDP for the past 2,000 years.

Average income today is more than 50 times larger than in the first millenium. Incomes did not change for a thousand years then very slowly began to rise. The rise accelerated in the 16th century, following the Black Death and coinciding with the European Renaissance and the Reformation. However, people were still doing the same thing, just doing it a little better, until the first half of the 18th century. This was the start of the Industrial Revolution, the application of capital to the production of manufactured goods. Growth rates slowly accelerated. There are only two significant blips in the growth curve – disruptions associated with the aftermath of World War I and with the Great Depression of the 1930s. Economic growth has been going on now for 300 years.

Economic growth started in England in the early 18th century. Agricultural productivity had been rising for some time, leading to increasing production of food and, as food accounted for most of the household budget, to increasing incomes. This began to create some discretionary income – income left over after buying the basics of life (mainly food and shelter) and so available for non-basic purchases. People wanted in particular to buy cotton goods such as underclothes, shirts, dresses, towels and sheets. The rising demand for cotton goods running up against the restricted supply of costly, hand-made cottons stimulated the invention and development of mechanical ways of cleaning, spinning and weaving cotton. The machine age was born. Mechanical power initially was obtained from muscles and from water wheels.  The new machines were made out of iron; this stimulated the development of low cost iron-making based on coke made from plentiful coal (in place of earlier, high cost iron using charcoal made from scarce wood). Steam engines were adapted from running mine pumps to powering machines. Mechanical power was most efficiently applied at scale so the factory was born. Conglomerations of factories gave rise to the new industrial cities. Steam engines were later applied to mobile uses – the railway and steamship ushered in the age of mobility. Low cost ways were developed for making steel and steel replaced iron in most uses. Growth was underway.

The locus of new products and processes went from cotton spinning to iron to the steam engine to the locomotive to weaving to the steamship then to steel. These changes took time. It took more than 100 years to go from the first mechanization of cotton spinning to the full mechanization of cotton weaving. It took around 100 years to go from Arkwright’s cotton mill, which made low cost thread, to Bessemer’s converter, which made low cost steel. But, by the 1870s, the age of the machine, the industrial age, had well and truly arrived.

The breakthrough into industrial growth took place in Britain. However, economic leadership gradually passed to the United States, based on a new set of growth industries such as electricity, household appliances and the automobile. These drove America forward until the 1970s. Different products then took over as growth drivers – the computer, health care, entertainment and recently the internet. The United States passed from the age of agriculture to the age of heavy industry and then to the age of services.

Economic growth continued by means of a succession of new products which found growing and ultimately massive demand. Some of the new products were goods, some were services, most involved new technologies but it was not the novel technologies which made the difference as much as the creation of new products which satisfied a previously unmet, or even unknown, consumer demand. This growth in demand was sustained by a growth in supply as more capital and increasing productivity expanded production capacity.

The growth process was so gradual and complex that there is no clear starting date. The initial impetus to growth was increasing agricultural productivity. Two indicative dates are 1701 when Jethro Tull invented his seed drill, and the 1730s when Charles Townshend introduced to England the four-field crop rotation system using wheat, barley, turnips and clover. The age of the machine might be said to start with Richard Arkwright’s water frame, patented in 1769, which spun cotton into yarn. The age of the factory might be dated from the first cotton mill, also created by Arkwright, the Cromford Mill, which opened in 1771. Efficient mechanical power might be related to the high pressure boiler, introduced by Richard Trevithick in the early 1800s. Effective mobile mechanical power started with Robert Stephenson’s locomotive, the Planet, built in 1830. The Bessemer converter, making low cost steel, was introduced from the 1860s. Electricity was introduced late in the 19th century, the landmark being when George Westinghouse opened the first alternating current system, from generation through transmission to customers. The age of the automobile really began with Henry Ford’s low-priced car, the Model T, introduced in 1908. Modern commercial entertainment began in the 1930s while modern health care began in the 1950s.  Modern computers and consumer electronics date from the 1960s with the internet starting in the 1990s.

This sequence illustrates one crucial feature of economic growth – the succession of new products which met huge consumer demand, creating growth industries which pull the economy forward. The enabling side of this process is the ongoing increase in production capability with more physical capital, more human capital and more efficient production processes allowing the increasing spending to be sustained and allowing incomes to increase.

A different feature of economic growth has been the increasing role of government. From the traditional roles of law and order and defense, government activity first expanded to encompass transportation and sanitation infrastructure, public health and education. More recently, governments have moved into income redistribution. People, through the political process rather than the market process, have chosen to devote a considerable part of the fruits of economic growth to government activities and to providing support for those at the lower end of the income distribution.

But government activity has been grafted onto the market system. A central feature of economic growth in Britain and the United States has been its decentralized nature, based on individual initiative operating within the market system. Economic growth has flourished only when the market system remains dominant and economic decisions are made by individual people and businesses, not by governments.

The leading countries since 1850, in terms of GDP per capita, are shown in Figure 1.2.

Britain led the way until early in the 20th century. World War I then brought Britain’s leadership to a close. Australia led for a few years but rode on Britain's coat-tails, supplying agricultural products to the British market. The United States took the lead early in the century and has held it ever since. Switzerland showed higher GDP per capita for some years but this was due to supplying specialist goods and services to high income European and American customers. The United States has been the engine of growth for the past century.

Growth rates of the two leading countries, Britain and the United States, are shown in Table 1.2.

We note first that growth rates for each country accelerated as the growth process got underway. Also, growth rates in the United States have been more rapid than those in Britain. The United States early in the 20th century surpassed Britain in terms of the level of incomes; since then, United States growth has further accelerated.

But the main feature of this Table is the magnitude of the growth rates. All these growth trends are numerically low, in the range 1% to 2%. However, economic growth operates over long periods of time. Over these long periods, compound interest works its magic. Britain’s growth, averaging 1.4% a year since 1820, doubled GDP per capita every 50 years. For the United States, with growth at 2.0% a year since 1890, GDP per capita doubles over just 35 years. 2.0% growth over 120 years (such as 1890 to 2010) will increase GDP per capita by a factor of 11. It is by continuing growth operating over the long run that economic growth has created huge increases in average incomes and has transformed the world.

People have long recognized the importance of economic performance. In the first century and a half of the Industrial Revolution attention was focused on how the economy worked, in particular how markets worked. This was understandable since, in the buzzing economies of western Europe and the United States, markets and the capitalist system seemed to generate ever rising incomes. World War I and its aftermath followed by the Great Depression brought this confidence to a halt; attention turned to the question of economic stability. World War II and the adoption of Keynesian ideas on the management of aggregate spending appeared to solve the stability problem. Attention then turned to trying to understand economic growth and to transplant growth from western Europe and North America to the low income countries of the world.

Today’s conventional theory of growth started with the work of Robert Solow (1956). Solow-type models view the economy as a single entity and explain GDP in terms of the inputs of labor, capital and the remainder, labor effectiveness (often referred to simply as productivity). In these models, GDP growth results from increasing inputs of labor and capital and from increases in productivity.

Solow-type models have been expressed in compact mathematical form, allowing elegant examination of the properties of the predicted growth path. The economy is predicted to converge to a steady growth path on which GDP per capita increases at the steady rate g, the rate of growth of labor effectiveness. Investing a greater share of GDP raises the level of the growth path but not the growth rate; the steady state growth rate is determined entirely by increases in productivity.

Although this conventional theory describes the outcome of GDP growth it does not really explain the growth process. As the steady state growth rate, g, is external to the model, Solow models in effect describe growth after it happens. These models do not reveal the mechanisms of growth, the nature of the changes which create growth and result from growth. And, by focussing on supply or production potential these models do not look at consumers or spending, the demand side of growth. This conventional theory of growth represents a huge achievement in describing economic growth but it is not the whole story. This theory calls out for extension to cover the processes rather than just the results of growth.

Our aim in understanding growth is to pick up where the conventional theory leaves off, to extend the theory of economic growth to encompass more of the processes and mechanisms of growth. In particular, we will look at:

The role of spending and demand;

The structure of the economy;

The nature of change and innovation;

The human features that drive the growth process.

We approach economic growth from a practical point of view. To do this we look at the history of growth to work out the causes and mechanisms of continuing growth. We then systematize these mechanisms so as to extend the conventional theory.

We start by going back 2,000 years. There were successful civilizations in Rome, China and later in western Europe. These leading countries expanded by exploiting their natural resources and their particular technologies. However, they could not break through these limits; they could not break away from their agricultural and trading foundations; they did not achieve economic growth. These countries went as far as they could go with their particular products and technologies but did not develop new products and new industries to move into sustained growth.

England achieved the breakthrough to growth. England’s growth followed from agricultural advances which increased incomes sufficiently that people started to demand more manufactured goods. Supply of these manufactures, based on hand crafting, was severely limited. Some people, today we would call them entrepreneurs, responded to these economic opportunities by seeking and eventually finding ways of producing these goods in volume and at low cost. They did this by using machines. Physical capital embodied the changes. In time, additions to human capital - resulting from experience, training and education - accelerated the growth in production capability. Demand increased as people spent their rising incomes. New products were to the fore in attracting spending from the rising level of incomes. The result was introduction and adoption of a sequence of new products. These new products started off small but, tapping the huge potential markets created by rising discretionary income, grew rapidly. This process created the growth industries that pulled the economy forwards. Economic growth took place at the product and industry level; growth was driven by demand and enabled by supply expansion.

The United States adopted the British breakthroughs. Then, the United States grew in exactly the same way as Britain - by developing a sequence of successful new products, creating new markets and new industries. As one growth industry matured, essentially as its market became saturated, another growth industry emerged. Simultaneously, increases in production capability, from investment and from more productive management and processes, sustained the growth in spending and generated rising incomes. At a high level, this process saw the economy move from agriculture to manufacturing to services. At the industry level this process went, for example, from cotton, tobacco and wheat through railroads and automobiles, household appliances and electrical goods, to entertainment, computers, health care and the internet. The structure of the economy kept changing as productivity gains and market saturation slowed employment in old industries and resources followed spending into new industries. Employment and location followed this evolution, industry by industry.

This record shows how economic growth operates. Clearly, growth processes operate at the market level, not the economy-wide level. This requires us to look at growth industry by industry. It also requires us to look at spending (or demand) industry by industry, as economic growth is characterized by continuing introduction of new products, emergence of growth industries and slowing of mature industries. At the same time production capability increases through investment and productivity gains, allowing supply to expand to sustain the growing demand and to generate increasing net incomes. The structure of the economy keeps changing as spending patterns change, as industries move through their life cycle and as production effectiveness increases. Two kinds of innovation are always associated with these changes - product innovation (on the demand side) and process innovation (on the supply side). Economic growth proceeds through the interaction of demand changes (the driving force) and supply changes (the sustaining force). The key players on the demand side are creative, bold, driven individuals seeking to increase their incomes by creating new products and, on the supply side, individuals and businesses seeking to increase their incomes by improving production effectiveness.

This leads to important extensions to the conventional theory of economic growth. These extensions are first, to introduce demand (whereas the present theory focuses on supply) and second, to bring the analysis down to the industry level (whereas the present theory looks just at the economy as a whole). This theoretical extension is not mathematical but rather a systematic, logical summary of the causes and mechanisms of growth, based on careful interpretation of how growth actually works.

The extended theory focuses on markets and industries and shows how new products pull the economy along a continuing growth path. Demand features – product design, marketing, credit and the consumer society - are central to this process.  Demand drives growth while supply expansion (from investment and productivity gains) permits growth. As in the rest of economics, demand and supply both are vital and both must be considered. And, by operating at the industry level, the extended theory allows the changing structure of the economy to be explained.

Then, looking at actual growth recorded by different countries in the past century, we distinguish three types of growth. Frontier growth, typified by the United States, keeps pushing out the economic boundaries with new products, new production and new processes. Next, coat-tail growth is where countries with fortunate resource endowments, such as oil or in food production, grow by supplying these products into the markets of the leading economies. And catch-up growth is where a country applies existing technologies and exploits its low costs to export to the high income countries, thereby growing rapidly until either it saturates the markets for these particular goods or it loses its cost advantage to another catch-up country. The extended theory of growth applies to frontier economies; rapid growth in other countries is due simply to the coat-tail process or the catch-up process.

We spend most of our time on GDP growth, and its industry and spending composition, rather than growth of GDP per capita. This is because the processes involved operate at the industry level. Then, once we understand GDP growth it is straightforward to convert this to growth in average incomes, or GDP per capita.

Rome was the dominant force in the western world for more than 500 years. Rome was founded, supposedly in 753BCE, as a settlement on the banks of the Tiber River in central Italy. It expanded geographically, in population and economically to a zenith around 14CE, the end of the reign of the first emperor, Augustus. The Roman Empire remained strong and wealthy until 164CE when a smallpox pandemic killed a sixth of the population; the Empire then entered into a slow decline. The Empire in 330CE was split into two administrative regions – the west, based in Rome, and the east, based in Constantinople (modern Istanbul). Both empires disintegrated over the course of the following two centuries.

Rome expanded from the original settlement by military force. At its peak, the Roman Empire encompassed some 45 million people in the lands surrounding the Mediterranean. Rome conquered the Italian peninsular relatively early. To the west, Rome conquered the Iberian Peninsula and then expanded north. This expansion stopped at Hadrian’s Wall, the northern border of Britannia (approximately England and Wales), and at the Rhine. The lands of northern England and of Germany were of marginal economic value to Rome and the cost of defending the frontiers was significant. These frontiers in effect represented an equilibrium – the line along which the net benefit from territorial expansion became zero. The zero net benefit boundary went along the Rhine, through the Balkans and the Danubian provinces, along the eastern boundary of what is now Turkey and across the deserts of north Africa.

Why did Rome embark on empire? After all, expansion by conquest is costly – armed force must be used, infrastructure must be constructed, colonial governments must be maintained and the imperial territories must be policed and defended. The answer is that Rome gained economically from empire. In fact, exploitation of conquered lands and peoples was the basis of the Roman economy.

The expansion of Rome and its Empire was based on three key innovations – in military organization, governmental organization and civil engineering.

It appears that the Roman military had comparable equipment (in arms and protection) and comparable resources (in men, horses and ships) to contemporary states such as Carthage (based in what today is Tunis in north Africa) and the Gauls (in France). However, the Roman management system was superior. This system covered the organization of the infantry into effective fighting units, the introduction of an effective command structure, the organization of cavalry into effective forces, the coordination of infantry and cavalry, and the maintenance of a professional standing army which was well trained and highly disciplined. In addition, logistics were well organized with movement of troops along an extensive network of all-weather roads, movement of supply trains along these same roads, and a network of well-resourced and secure camps. The Roman military was almost invincible. The ultimate overrunning of the Empire by hordes from the north did not reflect Roman military defeat so much as the fact that the Empire gave up trying seriously to defend itself.

Government in republican Rome was structured so as to limit the power of the leaders. Two elected Consuls headed the government; each Consul was limited to serving a one year term and each had veto power. A Senate of 300 leading citizens, each appointed for life, had advisory power. An Assembly approved or rejected legislation. Officials in the administration of the government were elected. The provinces were led by governors in a decentralised administrative system. This system brought the rule of law, property rights, a judicial system, widespread literacy and a reasonable degree of personal security.

However, the political ambitions of Julius Caesar in the first century BCE ushered in a period of civil war which ended with the establishment of imperial government. The rule of the first emperor, Augustus, which ended in 14CE, saw Rome reach the height of its power and income. Rome added new provinces after this time but income per capita levelled off, never again to increase. Whether coincidentally or not, incomes ceased to increase after the establishment of imperial government.

In technology, the Romans excelled in civil engineering. The key innovations were knowledge of structural design, the arch and water-proof cement. These were used for structures – buildings, roads, bridges, ports, aqueducts and freshwater systems, stormwater systems and sewerage systems. This allowed Rome to construct and operate cities and also provided the transportation and communications infrastructure for the Empire.

The provinces supplied Rome with wheat and other foodstuffs (such as wine and olive oil), metals and minerals, cloth, utensils and precious metals. The provinces paid Rome annual tributes (taxes) of grain. Egypt was the most valuable province with agricultural output per hectare some 2.5 times as large as in Italy because of watering and soil renewal by the Nile. Its annual tribute was around 135,000 tonnes, corresponding to 70% of the grain consumption of the city of Rome.

Large numbers of slaves were taken from conquered territories. For example, the 50,000 survivors from the defeated city of Carthage were sold into slavery in Rome and some 500,000 slaves were captured in Caesar’s Gallic Wars. Slaves from Greece were highly valued because their education made them good in teaching and administrative tasks. Slaves provided a large part of labor input. Angus Maddison (2007) estimates that in 14CE, slaves provided 55% of labor input in peninsular Italy and 40% for the Empire as a whole.

Maddison estimates that consumption in 14CE absorbed around 87% of the output of the economy with investment accounting for only 6.5%. He estimates that this investment was almost entirely in structures, infrastructure and shipping. This suggests highly labor-intensive methods of production. This is not surprising in view of the relatively large supply of low-cost slave labor. Furthermore, what we know about Roman production techniques suggests that there was little equipment used in the productive processes.

The highest incomes were in peninsular Italy. Maddison estimates