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—since 1820—real GDP per capita grew at 1.9% per year in Japan but at only 1.3% 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 through high savings and investment spending, upgrade their educational level, and make fast technological progress. Evidence also points to the importance of government policies, property rights, political stability, and good governance in fostering the sources of growth.

Savings and Investment Spending One reason for differences in growth rates between 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 did 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 2010, investment spending was 38% of China’s GDP, compared with only 18% in Canada.

Where does the money for high investment spending come from? From savings. In the next chapter, we’ll analyze how financial markets channel savings into investment spending. For now, however, the key point is that investment spending must be paid for either out of domestic (national) savings or out of foreign savings. Domestic savings refer to the savings within the country, which can come from households and/or the government. Foreign savings, as you might expect, are savings that come from foreign countries. If a country finances its investment with foreign savings, it is borrowing from abroad.

Foreign capital has played an important role in the long-run economic growth of some countries, including Canada, 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. In fact, China in 2010 saved an even higher percentage of its GDP than it invested at home. The extra savings were invested abroad, largely in the United States. In comparison, Figure 9-8 shows the levels of domestic savings and investment in Canada between 2000 and 2011. Between 2000 and 2008, domestic savings exceeded investment. Canada had saved enough to finance its own investment and the leftover was used to invest (lend) abroad. However, starting in 2009, domestic savings fell below investment and these shortfalls were financed by the inflows of foreign (i.e., borrowed) capital.

One reason for differences in growth rates, then, is that countries add different amounts to their stocks of physical capital because they have different rates of savings and investment spending.

Education 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 9-9 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, sixty 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 secondary and tertiary education, China has outstripped once-rich Argentina.

Research and Development The advance of technology is a key force behind economic growth. What drives technological progress?

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 apply them to practical use.

Figure 9-10 breaks down the shares of R&D performed by different sectors in Canada between 2000 and 2011. Although some research and development is conducted by the government and higher education sectors, the largest share of R&D is performed by the business sector. The figure shows that the business sector conducts more than half of the country’s R&D, while governments are only responsible for about 10% of the country’s R&D. The role of the higher education sector in R&D performance has become more important over time—its share of total R&D spending increased from 28% in 2000 to about 37.5% in 2011. The following For Inquiring Minds describes how the business sector contributes to R&D performance. Developing new technology is one thing; applying it is another. There have been been notable differences in the pace at which different countries take advantage of new technologies, as this chapter’s Global Comparison shows.

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. They can either affect growth directly through subsidies to factors that enhance growth, or by creating an environment that either fosters or hinders growth.

Government Policies Government policies can increase the economy’s growth rate through four main channels.

1. GOVERNMENT SUBSIDIES TO INFRASTRUCTURE Governments play an important direct role in building infrastructure: roads, power lines, ports, information networks, and other large-scale physical capital projects that provide a 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 is often cited as an example of the importance of government-provided infrastructure. After the government invested in an excellent telecommunications infrastructure in the 1980s, Ireland became a favoured location for high-technology companies from abroad and its economy took off in the 1990s.

Poor infrastructure, such as a power grid that frequently fails and cuts off electricity, is a major obstacle to economic growth in many countries. To provide good infrastructure, an economy must not only be able to afford it, but it must also have the political discipline to maintain it.

Perhaps the most crucial infrastructure is something we, in Canada 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.

2. GOVERNMENT SUBSIDIES TO EDUCATION In contrast to physical capital, which is mainly created by private investment spending, much of an economy’s human capital is the result of government spending on education. In Canada, all levels of government—federal, provincial, and municipal—play an important role in education. In primary and secondary education, more than 90% of the funding comes from governments. Although the share of funding from governments for college and university education has decreased in recent years, governments still finance about 75% and 60% of the direct costs of college and university education, respectively. Differences in the rate at which countries add to their human capital largely reflect government policy. As we saw in Figure 9-9, educational levels in China are increasing much more rapidly than in Argentina. This isn’t because China is richer than Argentina; until recently, China was, on average, poorer than Argentina. Instead, it reflects the fact that the Chinese government has made education of the population a high priority.

3. GOVERNMENT SUBSIDIES TO R&D Technological progress is largely the result of private initiative. Governments help promote R&D in the business sector through different programs and initiatives. For example, the federal government funds the Scientific Research and Experimental Development (SR&ED) tax incentive program, which allows businesses to receive cash refunds and/or tax credits and deductions for their spending on R&D in Canada. Governments also directly perform R&D; indeed, some important R&D projects, such as those on water/food safety, health, and environmental stress, are conducted by Canadian government agencies. In the upcoming Economics in Action, we describe Brazil’s agricultural boom, which was made possible by government researchers who made discoveries that expanded the amount of arable land in Brazil, as well as developing new varieties of crops that flourish in Brazil’s climate.

4. MAINTAINING A WELL-FUNCTIONING FINANCIAL SYSTEM Governments 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, especially its financial system. In particular, a well-regulated and well-functioning financial system is very important for economic growth because in most countries it is the principal way in which savings are channelled into 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 the mattress, where it cannot be turned into productive investment spending. As we’ll discuss later, a well-functioning financial system requires appropriate government regulation to assure depositors that their funds are protected from loss.

Protection of Property Rights Property rights are the rights of owners of valuable items to dispose of those items as they choose. A subset, intellectual property rights, are the rights of an innovator to accrue the rewards of her innovation. The state of property rights generally, and intellectual property rights in particular, are important factors in explaining differences in growth rates across economies. Why? Because no one would bother to spend the effort and resources required to innovate if someone else could appropriate that innovation and capture the rewards. So, for innovation to flourish, intellectual property rights must receive protection.

Sometimes this is accomplished by the nature of the innovation: it may be too difficult or expensive to copy. But, generally, the government has to protect intellectual property rights. A patent is a government-created temporary monopoly given to an innovator for the use or sale of his or her innovation. It’s a temporary rather than permanent monopoly because while it’s in society’s interests to give an innovator an incentive to invent, it’s also in society’s interests to eventually encourage competition. The Canadian Intellectual Property Office (CIPO), a federal government agency that is associated with Industry Canada, is responsible for the administration and processing of most of the country’s intellectual property. Canadians with new inventions can apply for their patent in Canada through the CIPO.

Political Stability and Good Governance There’s not much point in investing in a business if rioting mobs are likely to destroy it, or saving your money if someone with political connections can steal it. Political stability and good governance (including the protection of property rights) are essential ingredients in fostering economic growth in the long run.

Long-run economic growth in successful economies, like that of Canada, 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 laws don’t change capriciously.

Canadians 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.

Even when the government isn’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, subject to unnecessary monopolization, or otherwise insulated from competition, productivity tends to suffer because of a lack of incentives. As we’ll see in the next section, excessive government intervention is one often-cited explanation for slow growth in Latin America.