Borrowing and building technology: How the poor get rich and the rich get richer

Why are some parts of the world rich and getting richer? Why are some nations mired in poverty? And what explains the differences in prosperity among states and regions in the United States? In a white paper issued this month, economics Professors Arthur Blakemore and Berthold Herrendorf examine these questions — among the most fundamental in economics — with an eye toward policy. After all, if economists can discover how economies improve their living standards, then the logical next step is to craft policies to make it happen.

Why are some parts of the world rich and getting richer? Why are some nations mired in poverty? And what explains the differences in prosperity among states and regions in the United States? Researchers at the W. P. Carey School of Business have been examining these questions — among the most fundamental in economics — with an eye toward policy.

After all, if economists can discover how economies improve their living standards, then the logical next step is to craft policies to make it happen. In a white paper issued this month, economics Professors Arthur Blakemore and Berthold Herrendorf contend that a thorough understanding of economic growth can yield important conclusions.

"Through research, both theoretical and empirical, an understanding is developing about how rich economies remain rich, how some poor countries remain poor, and how others enter a 'catch-up' phase that eventually turns them into rich economies," they write.

Why Growth Matters

The first step in figuring out why growth occurs — a step sometimes overlooked by policymakers — is to define the term. The measure accepted by economics researchers is the rate of change of real Gross Domestic Product per capita, or real GDP per unit of labor. Real GDP is the total output of an economy adjusted for inflation. Measuring growth in per capita terms is necessary to avoid misperceptions that occur when GDP growth is not adjusted for population changes.

Rapidly increasing GDP can be impressive, but it can be a result of population growth alone. In such a case, GDP per capita stays the same. Research has found that as GDP per capita improves, per capita wages increase and the number of jobs grows, according to Blakemore and Herrendorf. In the absence of economic growth, as conventionally measured, the aggregate standard of living will stagnate.

Dennis Hoffman, economics professor and director of the Center for Competitiveness and Prosperity Research, says the distinction between GDP growth and per capita GDP growth is important for Sunbelt areas of the United States, where population growth is strong. "We should aspire to be more than just the leading job growth engines in the country," says Hoffman. "We should improve our standing in wage growth."

Key to growth: Technological change

Synthesizing decades of research of world renowned economists, from Joseph Schumpeter to Nobel Laureates Robert Solow and Edward C. Prescott, Blakemore and Herrendorf conclude that success at adopting or developing new technology is the key to growth.

A backward economy can vault ahead by copying techniques used by more advanced societies, while economies already on the cutting edge can keep growing and deliver ever higher standards of living by inventing and applying new technologies. "The most basic model predicts that growth eventually ends without technological progress," Blakemore says.

Catching up fast

For countries or regions at the lowest level of development, the initial challenge is to shift out of what is usually a subsistence economy by borrowing technology from more advanced societies. Once this process begins, growth rates can be extraordinary. Blakemore and Herrendorf cite the example of China, which grew very little in the first half of the 20th century, then saw per capita income grow by a factor of nine — from $614 to $5,530 — with most of this occurring in only the last 25 years.

"From a technology perspective, it's actually sort of easy," says Blakemore of the catch-up phase.

"You don't have to invent anything. You don't have to be on the technological frontier." Says Hoffman, "If you can break through in some of these areas and mix education and improvements in worker skills with adoption of current technology and upgraded capital equipment, you can get growth trajectories that are truly remarkable."

Finding the frontier

Eventually, though, the catch-up is complete, and growth slows or stops. Additional inputs in capital fail to yield substantial gains in productivity or output. Then, according to the researchers, if a country or region wants to continue its quest for growth, its focus must shift to innovation.

"New technology requires invention and implementation. As a consequence, new technology arrives at a slower pace than does old technology in emerging economies," Blakemore and Herrendorf write. "It follows that leading economies grow at slower rates than emerging economies." They cite the United States' slow but steady growth rate of around 2 or 3 percent for many decades.

For societies on the leading edge of innovation, gains are hard won, according to the researchers. Maintaining even modest levels of growth requires substantial investment in research and development, as well as a constant upgrading of the skills of the labor force. What Schumpeter called "creative destruction" — replacement of old industries with new ones — is an essential part of growth in advanced societies.

Blakemore and Herrendorf note that creative destruction, while desirable in the long run in terms of aggregate wage growth and employment gains, causes short-term pain in the form of economic dislocation for individuals: failed businesses, jobs lost, and skills honed over a lifetime suddenly made obsolete.

Trying to stop it, though, by adopting policies that prop up dying industries or save obsolete jobs, will only lead to more trouble, according to the authors. "Resisting the forces of creative destruction apparently comes with a cost — lower productivity growth, and hence, lower standards of living in the aggregate," they write.

Hoffman says that for individuals, the prudent course of action is reeducation and updating of skills. "It is an underlying tension in today's society. And it is going to remain a tension for the next generation. People now entering the labor force for the first time are probably going to have to retool their careers two or three times in their lives," Hoffman says.

What government can do

Understood in this fashion, economic growth is primarily a result of market dynamics, but growth trajectories can be altered (either positively or negatively) by government policy, according to the researchers. They stress that competition must be preserved, so that resources can be allocated efficiently by markets.

"Governments should promote competition. Some of the activities might involve regulation, but it has to be economically sensible regulation," Blakemore says. Antitrust measures may be needed to preserve competition, he adds. Other important functions of government are providing infrastructure and education, preserving property rights, and maintaining the rule of law.

Taxes must not be allowed to significantly impede the private sector, according to the authors. "The act of diverting resources from the private sector and high tax rates go hand-in-hand," they write, adding that economies with high taxes tend to have slower growth rates.

Research and development is critical for a country or region trying to stay on the forefront of technological change, and it presents a special problem for policymakers, according to Herrendorf and Blakemore. For a firm, investments in R&D are a difficult proposition because the commitment required often is great, time horizons long, and when the payoff finally comes, competitive advantage is soon lost because rivals can borrow the knowledge embedded in the innovation.

Here, government can play a role, according to the authors. "… direct subsidy of basic research is another form of intervention, often performed at universities and other non-profit research institutions. The subsidy is meant to offset the wedge between the market rate of return to society and the rate of return to the inventor." So government's role is to encourage basic research that may be underproduced in the market place.

While this way of looking at economic growth and technological change is most often applied to nations, it also seems applicable to regions and states in the United States, according to the authors. The same pattern of catch-up found among nations is evident among the states as well. The high technology centers, such as Silicon Valley and Route 128 in Boston, tend to lead the way in innovation, while other regions are playing catch-up.

The high rates of economic growth across the Sunbelt are not simply a result of population growth, according to Blakemore. Many parts of the country are in the high-growth phase of adopting technologies already being applied elsewhere in the country. "Arizona and other states in the catch-up phase should grow faster than the states that had been growth leaders in the past. We're catching up," he says, “while they are in the more difficult phase of advancing the technological frontier”.

But as the catch-up phase ends, a high priority must be placed on technological advancement for all regions, according to the authors. Lagging behind will mean a perpetually lower standard of living and also will expose the region to low-wage competitors from abroad. "Competition will come from above and below. It is important for regions within the U.S. to push on the technological frontier," write the authors.

Bottom Line

• GDP growth alone does not accurately reflect the standard of living in an economy. Real GDP per capita — economic output on a per person basis and adjusted for inflation — is a better gauge.
• Countries or regions playing technological catch-up tend to experience extraordinary growth rates. Once they close the gap, growth slows dramatically.
• Creative destruction — Schumpeter's term for what happens when new industries replace old ones — is essential for economic growth to occur. While the consequences are painful for firms that go out of business and individuals who lose their jobs, the economy as a whole will benefit with higher growth rates and improved standard of living.
• Economies that promote competitive practices find their economies have a faster pace of creative destruction but also are believed to recover more quickly from the losses in the destruction process.
• Governments can promote growth by pursuing policies that foster technological advancement. These include promotion of competitive practices, and support for modest tax policies. They also include provision of infrastructure and education, judicious regulation, and investment in research and development.