The Role of Government in Promoting Economic Growth

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.

Roads, power lines, ports, information networks, and other underpinnings for economic activity are known as infrastructure.

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 favored 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 an advanced country, 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. Government pays for the great bulk of primary and secondary education. And it pays for a significant share of higher education: 75% of students attend public colleges and universities, and government significantly subsidizes research performed at private colleges and universities. As a result, differences in the rate at which countries add to their human capital largely reflect government policy. As we saw in Figure 9-7, 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. But in the more advanced countries, important R&D is done by government agencies as well. For example, the internet grew out of a system, the Advanced Research Projects Agency Network (ARPANET), created by the U.S. Defense department, then extended to educational institutions by the National Science Foundation.

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 channeled 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.

FOR INQUIRING MINDS: The New Growth Theory

Until the 1990s, economic models of technological progress assumed that what drove innovation was a mystery—unknown and unpredictable. In the words of economists, the sources of technological progress were exogenous—they were outside the models of economics and assumed to “just happen.” Then, in a series of influential papers written in the 1980s and 1990s, Paul Romer founded what we now call “the New Growth Theory.” In Romer’s model, technological progress was explainable because it was in fact endogenous—the outcome of economic variables and incentives. And because technological progress was endogenous, policies could be adopted to foster its growth.

At any point in time, an economy has a stock of knowledge capital—the accumulated knowledge generated by past investments in research and development, education, and skill enhancement, as well as knowledge acquired from other economies. And that stock of knowledge capital is spread throughout the economy, so all firms benefit from it. According to the New Growth Theory, a rising stock of knowledge capital creates the foundation for further technological progress as innovation, shared by firms throughout the economy, makes further innovation possible. For example, touchscreen technology—developed in the 1970s and 1980s—became the basis for later developments such as smartphones and tablets.

Yet, as Romer pointed out, there is a severe wrinkle in this story: because knowledge is shared throughout the economy, it may be very difficult for an innovator to capture the rewards of his or her innovation as others exploit the innovation for their own interests. So in the New Growth Theory, government protection of intellectual property rights is critical to furthering technological progress. In addition, governments, institutions, and firms can enhance technological progress by subsidizing investments in education and research and development, which, in turn, can increase the stock of knowledge capital.

By giving us a better model of where technological progress comes from, the New Growth Theory makes clear how important the policies of government, institutions, and firms are in fostering it.

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.

Political Stability and Good Governance There’s not much point in investing in a business if rioting mobs are likely to destroy it, or in 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 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 laws don’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.

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.

!worldview! ECONOMICS in Action: Why Did Britain Fall Behind?

Why Did Britain Fall Behind?

It’s one of the classic questions in economic history: Why did Britain, the home of the Industrial Revolution, by far the world’s leading economy for much of the nineteenth century, end up falling behind other nations at the start of a new century? It’s not a tragic story: the British economy continued to grow, and it remained a rich country by international standards. Still, by the early twentieth century it was obvious that British industry was no longer at the cutting edge. Instead, the United States and Germany had come to supplant Britain as the new economic frontier. What happened?

Now catching up, Britain fell behind the United States and Germany largely due to barriers to education.

That’s not an easy question to answer. Robert Solow, an MIT economics professor and Nobel laureate who pioneered the theory of economic growth, once memorably declared that all efforts to explain Britain’s lag end in “a blaze of amateur sociology.” Indeed, among the reasons often given for the lag are such things as the excessive influence of the landed aristocracy, social barriers that prevented talented individuals from the wrong class from rising, and a cult of amateurism that was good enough for people running small family firms but not for the managers of large modern corporations.

There were, however, other factors in Britain’s relative decline that were more easily measured. Of special importance was education. Britain was much slower than other industrial countries, the United States in particular, to establish universal basic education. Moreover, its universities, for all their ancient glories, remained too focused on preparing young gentlemen for their role in society; college education was for a long time restricted to a narrow segment of the population. And Britain was late in developing the close ties between academics and industry that did so much to drive the Second Industrial Revolution in both America and Germany. These barriers to education and skill acquisition placed Britain at a human capital disadvantage.

The good news for today’s British residents is that most of these problems lie well in the past. Currently, young Britons are slightly more likely than their American counterparts to receive a college education. British real GDP per capita is still below U.S. levels, but it has made up part of the gap. And nobody walking around London today would consider it a backward-looking city.

Quick Review

  • Countries differ greatly in their growth rates of real GDP per capita due to differences in the rates at which they accumulate physical capital and human capital as well as differences in technological progress. A prime cause of differences in growth rates is differences in rates of domestic savings and investment spending as well as differences in education levels, and research and development, or R&D, levels. R&D largely drives technological progress.

  • Government actions can promote or hinder the sources of long-term growth.

  • Government policies that directly promote growth are subsidies to infrastructure, particularly public health infrastructure, subsidies to education, subsidies to R&D, and the maintenance of a well-functioning financial system.

  • Governments improve the environment for growth by protecting property rights (particularly intellectual property rights through patents), by providing political stability, and through good governance. Poor governance includes corruption and excessive government intervention.

9-3

  1. Question 9.7

    Explain the link between a country’s growth rate, its investment spending as a percent of GDP, and its domestic savings.

  2. Question 9.8

    U.S. centers of academic biotechnology research have closer connections with private biotechnology companies than do their European counterparts. What effect might this have on the pace of creation and development of new drugs in the United States versus Europe?

  3. Question 9.9

    During the 1990s in the former Soviet Union a lot of property was seized and controlled by those in power. How might this have affected the country’s growth rate at that time? Explain.

Solutions appear at back of book.