The Copernican Revolution in the Study of Economic Growth

John Ross (Chongyang Institute for Financial Studies, Renmin University of China)G20 China Kickoff Meeting -14 December 2015)

Present policy in many countries is based on boosting TFP growth – why this won’t work

A ‘Copernican revolution’- measurement and observation typically play a revolutionary role in science

• Science states that if the facts and a theory do not coincide it is the theory that has to be abandoned not the facts

• When Galileo turned the newly invented telescope on Jupiter and saw its moons the earth centred theories of the universe collapsed

• Darwin’s observations in the Galapagos Islands and Latin America led to the theory of evolution: "such facts undermine the stability of Species“, "one species does change into another"

From the 1950s-1990s there was a contradiction between the theory of economic growth and the facts of

economic growth

• A theory of economic growth said that growth was primarily due to Total Factor Productivity (TFP) – Solow (1957)

• The facts of rapidly growing economies, above all in Asia, showed rapidly growing economies were dominated by factor accumulation of capital and labour – Young (1995)

• The prediction was therefore that the Asian economies would drastically slow down – Krugman (1994)

• The facts were that they didn’t!

• Science demands that where facts and theory don’t coincide the theory has to change not the facts

Solow’s quantitative errors in the original growth accounting framework

• The well known problem TFP is calculated as a residual – a ‘measure of our ignorance’- Abramovitz (1956)

• An omission from the growth accounting framework

• Did not include intermediate products

• Errors with the growth accounting framework

• Did not control for changes in quality of labour

• Did not control for changes in the quality of capital inputs

• Therefore an erroneous conclusion – TFP was the main source of economic growth

The steps to the official revolution in the measurement of the driving forces of economic growth

Study of the causes of economic growth over the long term

The work of Maddison

• Already by the 1970s Maddison had demonstrated via study of long term economic growth that fixed investment was the decisive ‘factor of production’ in economic development and he extended this in later studies.

• Maddison’s analysis of why the US attained first place among economies. ‘The rate of US domestic investment was nearly twice the US level for the sixty year period 1890-1950. Its level of capital stock per person employed was twice as high as that of the UK in 1890, and its overwhelming advantage in this respect over all other countries continued until the early 1980s. ‘ (Maddison 1991)

Conclusion of the study of long term trends in economic growth

The historical rise in the proportion of investment in GDP – England/UK

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1680 1720 1760 1800 1840 1880 1920 1960 2000

Gross Domestic Fixed Capital Formation% of GDP

UK

The historical rise in the proportion of investment in GDP – United States

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1680 1720 1760 1800 1840 1880 1920 1960 2000

Gross Domestic Fixed Capital Formation% of GDP

UK

US

The historical rise in the proportion of investment in GDP – West Germany

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1680 1720 1760 1800 1840 1880 1920 1960 2000

Gross Domestic Fixed Capital Formation% of GDP

UK

US

Germany

The historical rise in the proportion of investment in GDP - Japan

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1680 1720 1760 1800 1840 1880 1920 1960 2000

Gross Domestic Fixed Capital Formation% of GDP

UK

US

Germany

Japan

The historical rise in the proportion of investment in GDP – the ‘Asian Tiger Economies’

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1680 1720 1760 1800 1840 1880 1920 1960 2000

Gross Domestic Fixed Capital Formation% of GDP

UK

US

Germany

Japan

South Korea

The historical rise in the proportion of investment in GDP - China

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1680 1720 1760 1800 1840 1880 1920 1960 2000

Gross Domestic Fixed Capital Formation% of GDP

UK

US

Germany

Japan

South Korea

China

The historical rise in the proportion of investment in GDP - India

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1680 1720 1760 1800 1840 1880 1920 1960 2000

Gross Domestic Fixed Capital Formation% of GDP

UK

US

Germany

Japan

South Korea

China

India

The historical rise in the proportion of investment in GDP - Vietnam

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1680 1720 1760 1800 1840 1880 1920 1960 2000

Gross Domestic Fixed Capital Formation% of GDP

UK

US

Germany

Japan

South Korea

China

India

Vietnam

Why Asia grew so fast - world distribution of rates of fixed investment

Source: World Bank

Development of statistical methods for study of economic growth over the short term

The work of Jorgenson and the official change in the US/UN/OECD methods of calculation of factors in

economic growth

On basis of work of Jorgenson at Harvard University and collaborators

• 1979 Panel to Review Productivity Statistics of the National Research Council, chaired by Albert Rees.

• 1983 US Bureau of Labor Statistics (BLS) adopts constant quality index of capital input

• 1994 BLS adopts constant quality index of labour input as well

• 2001 OECD adopts written Measuring Productivity

• 2007 UN incorporates price and quantity of capital services into the revision of the System of National Accounts (SNA)

• 2009 OECD manual Measuring Capital.

Therefore official transformation in the official method of calculation of national accounts

The factual results of the ‘Copernican Revolution’

• Solow’s ‘finding’ that TFP was the main factor in economic growth was simply based on wrong methods of measurement

• The order of importance of factors of production, proceeding from the most important to the least important is

(i) Intermediate products

(ii) Capital investment

(iii) Labour inputs

(iv) TFP

Intermediate products

Intermediate products - Jorgenson’s findings on the US

US – Sources of Output GrowthGDP

Growth TFP Labour Capital

Intermediate

inputs

Average annual change

1977-2000

(median) 2.7%

1985-19952.4% 0.3% 1.0% 1.2%

1996-20004.3% 0.9% 1.3% 2.1%

2000-20062.8% 1.0% 0.3% 1.4%

Source: Calculated from (Jorgenson and Vu, 2007) Table 2 and (Jorgenson, Mun

and Stiroh 2005) Table 4.8

Intermediate products - the conclusion for Asian economies

• For South Korea, Hak K. Pyo, Keun-Hee Rhee and BongchanHa found regarding material intermediate inputs: ‘The relative magnitude of contribution to output growth is in the order of: material, capital, labour, TFP then energy.’

• For Taiwan Province of China, analysing 26 sectors in 1981-99, Chi-Yuan Liang found regarding intermediate material inputs: ‘Material input is the biggest contributor to output growth in all sectors during 1981-99, except… seven’.

• For mainland China, Ren and Sun found that in the period 1981-2000, subdivided into 1984-88, 1988-94 and 1994-2000: ‘Intermediate input growth is the primary source of output growth in most industries.’

The ‘Solow factors’ of production

The ‘Solow factors’ of production

2.9%

1.6%

0.8%0.5%

4.3%

2.5%

1.2%

0.6%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

GDP Capital Labour TFP

Sources of GDP Growth 1992-2014Average annual % increase for advanced and development

economies

AdvancedEconomies

DevelopingEconomies

Source: Calculated from The Conference Board. The Conference Board Total Economy Database 2015

‘Solow factors’ of production in developing economies

Capital60%

TFP10%

Labour Quantity

27%

Labour Quality3%

% Contribution to Growth in Developing Economies 1992-2014

Capital

TFP

Labour Quantity

Labour Quality

Source: Calculated from The Conference Board. 2015. The Conference Board Total Economy Database, May 2015

‘Solow factors’ of production in advanced economies

Capital63%

TFP10%

Labour Quantity

15%

Labour Quality11%

% Contribution to Growth in Advanced Economies 1992-2014

Capital

TFP

Labour Quantity

Labour Quality

Source: Calculated from The Conference Board. The Conference Board Total Economy Database 2015

Large economies are more dominated by capital investment than small ones

Average Contributions to GDP Growth 1992-2014

% of

World

GDP1 Annual % growth

% contribution to GDP

growth

Economic groups2 GDP Capital Labour TFP Capital Labour TFP

All economies 94 3.6 2.1 1.0 0.5 61 29 10

20 largest

economies 75 3.2 2.1 0.8 0.4 67 24 9

G7 32 1.6 1.0 0.4 0.2 69 17 14

Smaller economies3 19 3.7 2.1 1.1 0.6 60 30 10

Correlation to GDP growth

- R2

All economies .44 .27 .18

20 largest

economies .78 .19 .33

G7 .86 .86 .04

Smaller economies .35 .31 .15Starting year adopted as the earliest available data for Russia, however a control calculation from 1990 excluding Russia shows no significant difference

in pattern.1 Calculated in World Bank current dollar PPPs 2 Groups ranked by World Bank current dollar PPPs3 All economies excluding the 20 largest economies

Source: Calculated from The Conference Board Total Economy Database™, May 2015

For a detailed study specifically of the Asian economies see Vu (2013)

So n light of the development or more accurate methods of measurement now no contradiction of the facts and

economic theory!

But the policy that economic development can primarily be driven by TFP has to be abandoned

Or to put it simply Solow quantification was wrong and it is necessary for economic policy and theory to

understand this and its implications

Works cited

• Abramovitz, M. (1956), “Resource and Output Trends in the United States since 1870,” American Economic Review, V. 46: 5-23.

• Jorgenson, D. W. (2009). Introduction to The Economics of Productivity. In D. W. Jorgenson (Ed.), The Economics of Productivity (pp. ix-xxviii). Cheltenham, UK: Edward Elgar.

• Jorgenson, D.W., Mun S. Ho, Stiroh K.J. (2005), Growth of U.S. Industries and Investments in Information Technology and Higher Education : http://www.nber.org/chapters/c10627

• Jorgenson, D. W. & Vu, K. M. (2007). Information Technology and the World Growth Resurgence, German Economic Review, Volume 8, Issue 2, pages 125–145, May 2007

• Krugman, P. (1994). The Myth of Asia's Miracle. Foreign Affairs, 73(6), 62-78.

• Maddison, A. (1991). Dynamic Forces in Capitalist Development. Oxford, UK: Oxford University Press.

• Solow, R. M. (1957, August). Technical change and the Aggregate Production Function. Review of Economics and Statistics(3), 312-320.

• Vu, K. M. (2013). The Dynamics of Economic Growth - Policy Insights from Comparative Analyses in Asia. Cheltenham, UK and Northampton, M.A., US: Edward Elgar.

• Young, A. (1995, August). The tyranny of numbers: confronting the statistical reality of the East Asian growth experience. Quarterly Journal of Economics, 110, 641-680.