In 1820, according to estimates by the economic historian Angus Maddison, Mexico had somewhat higher real GDP per capita than Japan. Today, Japan has higher real GDP per capita than most European nations and Mexico is a poor country, though by no means among the poorest. The difference? Over the long run, real GDP per capita grew at 1.9% per year in Japan but at only 1.2% per year in Mexico.

As this example illustrates, even small differences in growth rates have large consequences over the long run. So why do growth rates differ across countries and across periods of time?

As one might expect, economies with rapid growth tend to be economies that add physical capital, increase their human capital, or experience rapid technological progress. Striking economic success stories, like Japan in the 1950s and 1960s or China today, tend to be countries that do all three: rapidly add to their physical capital, upgrade their educational level, and make fast technological progress.

Adding to Physical Capital One reason for differences in growth rates among countries is that some countries are increasing their stock of physical capital much more rapidly than others, through high rates of investment spending. In the 1960s, Japan was the fastest-growing major economy; it also spent a much higher share of its GDP on investment goods than other major economies. Today, China is the fastest-growing major economy, and it similarly spends a very large share of its GDP on investment goods. In 2013, investment spending was 54.4% of China’s GDP, compared with only 19% in the United States.

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Where does the money for high investment spending come from? We have already analyzed how financial markets channel savings into investment spending. The key point is that investment spending must be paid for either out of savings from domestic households or by an inflow of foreign capital—that is, savings from foreign households. Foreign capital has played an important role in the long-run economic growth of some countries, including the United States, which relied heavily on foreign funds during its early industrialization. For the most part, however, countries that invest a large share of their GDP are able to do so because they have high domestic savings. One reason for differences in growth rates, then, is that countries have different rates of savings and investment spending.

Adding to Human Capital Just as countries differ substantially in the rate at which they add to their physical capital, there have been large differences in the rate at which countries add to their human capital through education.

A case in point is the comparison between Argentina and China. In both countries, the average educational level has risen steadily over time, but it has risen much faster in China. Figure 39.1 shows the average years of education of adults in China, which we have highlighted as a spectacular example of long-run growth, and in Argentina, a country whose growth has been disappointing. Compared to China, 60 years ago, Argentina had a much more educated population, while many Chinese were still illiterate. Today, the average educational level in China is still slightly below that in Argentina—but that’s mainly because there are still many elderly adults who never received basic education. In terms of high school and college education, China has outstripped once-rich Argentina.

Technological Progress The advance of technology is a key force behind economic growth. What drives technology?

Scientific advances make new technologies possible. To take the most spectacular example in today’s world, the semiconductor chip—which is the basis for all modern information technology—could not have been developed without the theory of quantum mechanics in physics.

But science alone is not enough: scientific knowledge must be translated into useful products and processes. And that often requires devoting a lot of resources to research and development, or R&D, spending to create new technologies and prepare them for practical use.

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Although some research and development is conducted by governments, much R&D is paid for by the private sector, as discussed in the FYI box. The United States became the world’s leading economy in large part because American businesses were among the first to make systematic research and development a part of their operations.

Developing new technology is one thing; applying it is another. There have often been notable differences in the pace at which different countries take advantage of new technologies. America’s surge in productivity growth after 1995, as firms learned to make use of information technology, was at least initially not matched in Europe.

Governments can play an important role in promoting—or blocking—all three sources of long-term economic growth: physical capital, human capital, and technological progress.

Governments and Physical Capital Governments play an important direct role in building infrastructure: roads, power lines, ports, information networks, and other parts of an economy’s physical capital that provide an underpinning, or foundation, for economic activity. Although some infrastructure is provided by private companies, much of it is either provided by the government or requires a great deal of government regulation and support. Ireland, whose economy really took off in the 1990s, is often cited as an example of the importance of government-provided infrastructure: the government invested in an excellent telecommunications infrastructure in the 1980s, and this helped make Ireland a favored location for high-technology companies.

Poor infrastructure—for example, a power grid that often fails, cutting off electricity to homes and businesses—is a major obstacle to economic growth in some countries. To provide good infrastructure, an economy must be able to afford it, but it must also have the political discipline to maintain it and provide for the future.

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Perhaps the most crucial infrastructure is something we rarely think about: basic public health measures in the form of a clean water supply and disease control. As we’ll see in the next section, poor health infrastructure is a major obstacle to economic growth in poor countries, especially those in Africa.

Governments also play an important indirect role in making high rates of private investment spending possible. Both the amount of savings and the ability of an economy to direct savings into productive investment spending depend on the economy’s institutions, notably its financial system. In particular, a well-functioning banking system is very important for economic growth because, in most countries, it is the principal way in which savings are channeled into business investment spending. If a country’s citizens trust their banks, they will place their savings in bank deposits, which the banks will then lend to their business customers. But if people don’t trust their banks, they will hoard gold or foreign currency, keeping their savings in safe deposit boxes or under their mattresses, where it cannot be turned into productive investment spending. A well-functioning financial system requires appropriate government regulation that assures depositors that their funds are protected.

Governments and Human Capital An economy’s physical capital is created mainly through investment spending by individuals and private companies. Much of an economy’s human capital, by contrast, is the result of government spending on education. Governments pay for the great bulk of primary and secondary education, although individuals pay a significant share of the costs of higher education.

As a result, differences in the rate at which countries add to their human capital largely reflect government policy. For example, East Asia now has a more educated population than Latin America. This isn’t because East Asia is richer than Latin America and so can afford to spend more on education. Until very recently, East Asia, on average, was poorer than Latin America. Instead, it reflects the fact that Asian governments made broad education of the population a higher priority.

Governments and Technology Technological progress is largely the result of private initiative. But much important R&D is done by government agencies. For example, Brazil’s agricultural boom was made possible by government researchers who discovered that adding crucial nutrients to the soil would allow crops to be grown on previously unusable land. They also developed new varieties of soybeans and breeds of cattle that flourish in Brazil’s tropical climate.

Political Stability, Property Rights, and Excessive Government Intervention There’s not much point in investing in a business if rioting mobs are likely to destroy it. And why save your money if someone with political connections can steal it? Political stability and protection of property rights are crucial ingredients in long-run economic growth.

Long-run economic growth in successful economies, like that of the United States, has been possible because there are good laws, institutions that enforce those laws, and a stable political system that maintains those institutions. The law must say that your property is really yours so that someone else can’t take it away. The courts and the police must be honest so that they can’t be bribed to ignore the law. And the political system must be stable so that the law doesn’t change capriciously.

Americans take these preconditions for granted, but they are by no means guaranteed. Aside from the disruption caused by war or revolution, many countries find that their economic growth suffers due to corruption among the government officials who should be enforcing the law. For example, until 1991 the Indian government imposed many bureaucratic restrictions on businesses, which often had to bribe government officials to get approval for even routine activities—a tax on business, in effect. Economists have argued that a reduction in this burden of corruption is one reason Indian growth has been much faster in recent years than it was in the first 40 years after India gained independence in 1947.

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Even when governments aren’t corrupt, excessive government intervention can be a brake on economic growth. If large parts of the economy are supported by government subsidies, protected from imports, or otherwise insulated from competition, productivity tends to suffer because of a lack of incentives. As we saw in Module 38, excessive government intervention is one often-cited explanation for slow growth in Latin America.