The Mystery of Economic Growth

Published by EH.NET (March 2005)

Elhanan Helpman, The Mystery of Economic Growth. Cambridge, MA: Harvard University Press, 2004. ix + 223 pp. $25.95 (cloth), ISBN: 0-674-01572-X.

Reviewed for EH.NET by George K. Davis, Department of Economics, Miami University, Oxford, Ohio.

In The Mystery of Economic Growth Elhanan Helpman makes a sharp point. Economic growth is in large part driven by innovation and institutions that have evolved in rich countries that promote innovative activity and allow change to take place. It is therefore of primary importance that economists continue their investigation of the nature and functions of institutions. Helpman is himself a master of the art of economics and his master’s hand is evident on each page. In making his point, he takes the reader on a fast, yet detailed tour of some of the most important writing on economic growth in the last twenty years. He reviews the emergence of endogenous growth theory, the interaction of international trade and economic growth, the relationship between inequality and growth, and the role of the institutions that provide the fundamental groundwork for economic growth.

Helpman begins with a review of the facts. The salient facts are well documented. Incomes across countries differ by large margins. For example, per capita income in the United States is roughly three times higher than per capita income in Argentina, sixteen times higher than the per capita income in Pakistan, and thirty times higher than the per capita income in Mozambique. Growth rates of per capita income also vary widely, and, unfortunately, it is not always the lower income countries that grow rapidly. Some countries with relatively low incomes in 1960, such as the Asian Tigers, have grown rapidly, converging towards the income levels of rich countries. Other low income countries have grown slower than rich countries, widening the divide between rich and poor. What are the forces that drive convergence and what are the factors that stifle material progress? These are the questions that Helpman sets for himself.

Helpman adopts a historical approach to discuss the evolution of the explanations of the key growth facts. He begins with a very brief discussion of Solow’s model. He uses Solow’s model to examine the role of capital accumulation, both physical and human, in the growth process. The diminishing marginal product of capital implies that countries will converge to the given rate of technological growth and that countries with relatively low initial capital-to-labor ratios should grow relatively fast. The second implication predicts that the level of per capita income in poor countries will converge to the level of per capita incomes in rich countries.

The failure of such convergence to take place is one of the key facts to be explained. Helpman describes the efforts to rehabilitate Solow’s model. These efforts rest on the observation that savings rates, population growth rates, and the like differ across countries. These differences lead different countries to have different long-run capital-to-labor ratios. After controlling for these differences, many studies find what Barro and Sala-i-Martin (1992) called conditional convergence. A particularly important example of such a study is Mankiw, Weil, and Romer (1992) who conclude that Solow’s model explains the data well.

Helpman does not accept this conclusion. His objection rests on the interaction of technological progress and capital accumulation. Technology is exogenous and common across countries in Solow’s model, so variations in technology cannot explain differing growth experiences. Helpman’s review of the literature on growth accounting shows that growth in total factor productivity accounts for a large part of growth. However, even if these methods are reliable in measuring total factor productivity growth, Helpman emphasizes the inability of these methods to identify causality. For example, technological change may, and probably does, raise the productivity of capital, and so spurs capital accumulation. Technological progress is the ultimate cause of the subsequent output growth, but growth accounting will attribute at least part of this growth to capital accumulation. The failure to account for this correlation between investment and total factor productivity growth will lead researchers who assume that total factor productivity does not vary systematically across countries to attribute too large a role in the growth process to capital accumulation. Helpman argues that the analysis of Mankiw, Romer, and Weil is subject to such bias.

Once it is established that total factor productivity growth is an important, and perhaps the most important, factor in accounting for economic growth, models that focus on input accumulation will not do. In Helpman’s next chapter, he reviews the emergence of new growth theory that changed the focus of growth theory from accumulation to knowledge creation and innovation. The renaissance in growth theory was led by Paul Romer and Robert Lucas. Romer and Lucas argued that externalities in the accumulation of knowledge generated increasing returns that could offset the diminishing returns inherent in input accumulation. In Romer’s first generation model, knowledge accumulation took place passively in the accumulation of capital. Lucas focused on externalities in human capital accumulation. Rather rapidly, Romer produced a second generation of models that placed the purposeful accumulation of knowledge at the forefront. The knowledge created provides a source of profit for the innovators, but also produces a spillover that helps innovators who come later. If the spillovers are sufficiently large, growth can be self-sustained.

An interesting feature of these “idea driven” models is scale effects. An increase in the size of an economy generates higher growth rates. For example, an increase in population raises the number of people who may have good ideas, and this raises the growth rate of output. Michael Kremer’s well-known paper provides some empirical support for this idea. However, Kremer’s evidence is in the minority. Others, in particular Charles Jones, have argued persuasively that scale effects are absent from the data. Jones and others have been able to modify new growth models by introducing diminishing returns to idea creation or an ever increasing variety of goods that can offset scale effects while still generating persistent growth.

Countries are linked through their terms of trade, the diffusion of knowledge, and the interaction of the two. Helpman, along with his frequent coauthor Gene Grossman, pioneered the analysis of this interdependence and this chapter is particularly rich in detail and insight. A brief summary of his discussion of the relationship between trade and research and development will give the reader a flavor of the chapter and will highlight an important point that Helpman emphasizes throughout the chapter and the book. Opening international trade between countries may affect research and development and so total factor productivity growth through several different channels. The increase in the size of the market, the reduction in redundancy, the sharing of knowledge, and the increase in specialized inputs all spur the process of research and development, and so increases the rate of technical progress. On the other hand, increases in competition and changes in factor prices may act to slow technical progress. In general, international trade does not necessarily lead to convergence of incomes or growth rates, and it is plausible that for some countries trade will lead to a lower growth rate. Instead, trade unleashes a complex set of forces with many subtle avenues of causation.

This complexity suggests that the interpretation of empirical results should be done cautiously. For example, regressions that show a positive correlation between, say, openness and growth are at best averaging the various effects. We cannot be sure if it is spillovers from research and development or knowledge created by learning-by-doing that is behind the correlation. If it is increased research and development, we don?t know if the elimination of redundancy or the increase in the size of the market is driving the result. We also cannot be sure if this result will hold for all countries. In general, empirical results have been unable to disentangle the various channels through which a particular variable affects growth, and, as a result, interpretations of correlations, conclusions about welfare, and policy prescriptions should be made with a great deal of caution and humility.

We are fortunate that Helpman is willing share his own, necessarily tentative, conclusions about some of the more important issues. He concludes that the positive effects of increasing trade volume on growth appear to have dominated on average. Protection may well have promoted growth in the late nineteenth century, but in the post World War II era, protection has tended to slow growth. Finally, research and development in rich countries appears to benefit poor countries through spillover effects. However, the gains to rich countries exceed those of poor countries, so research and development leads to divergence in the incomes between the rich and poor.

Helpman next considers inequality. He reviews the work of Bourguignon and Morrisson (2002) that documents an increase in inequality in the world’s distribution of personal income from 1820 to 1992. There was a particularly sharp increase in the first ninety years of the sample. Since World War II, inequality has risen, but only modestly. How does inequality affect growth? Like trade, the potential avenues of causation are several and in differing directions. Helpman concludes, again tentatively, that the negative forces have dominated and inequality slows growth. Also like trade, the contribution of the various factors remains to be discovered. Although conclusions with respect to inequality must be tentative, the effect of growth on the poor is much clearer. Growth may raise or lower income inequality, but the majority of people and the poor in particular share in the gains.

In his last chapter, Helpman discusses the role of institutions and he gives them the lead role in the growth process. In earlier chapters, he argued that growth is driven in large part by innovation, but why have some countries been so successful at innovating and adapting to change, while others have not. Helpman looks to institutions for an answer. Work on institutions is associated with economic historians, such as North, Mokyr, and Rosenberg, with recent innovative empirical analysis exemplified by the work of Acemoglu, Johnson, and Robinson (2001), and with the theoretical work of Greif (1993), and Glaeser and Shleifer (2002). Institutions can be defined as a system of rules, beliefs, and organizations. These rules, beliefs, and organizations can protect property rights and allow change to take place, or they can be confiscatory and protective of the status quo, or they can be somewhere between these two extremes.

The evidence in support of a key role for institutions comes in large part from the work of Acemoglu, Johnson, and Robinson. They showed that regions with higher mortality rates during the colonial period had lower per capita incomes in 1995. The connection between the two is good institution. In areas with low mortality rates, settlers imported and maintained good institutions. In areas with high mortality rates, resources were extracted and institutions suited for exploitation were created. Institutions persist and incomes in areas with good institutions grew relatively rapidly, while those with poor institution grew slowly.

Helpman details this argument, criticisms of it, and rejoinders to the criticisms. A particularly important critique of these results by Sachs argues that geography has a direct impact on growth. Acemoglu, Johnson, and Robinson (2002) counter this argument by noting that countries that were relatively wealthy in 1500 fell in their relative fortunes by 1995. Since geography does not change much over such a short span of time, it cannot explain this “reversal of fortune.” It can be explained by Europeans colonizing poorer regions centuries ago and leaving institutions that were supportive of economic growth. Regions that were relatively wealthy were not ripe for colonization, and so did not inherit good institutions. Institutions emerge as the fundamental building block of economic growth. Indeed, Helpman closes his book by observing that we have just begun to study institutions and that we are now in a position to delve more deeply into how institutions evolve and how they matter for economic growth. A better understanding of this relationship will equip economists to better craft reforms and so be more successful than we have been in the past in helping the poor grow rich.

Helpman provides a very a high ratio of substance per page. In just 142 pages of text he tells an exciting story and develops his characters in remarkably rich detail. I have not even mentioned insightful discussions of the college wage premium, Greif’s analysis of the Maghribi traders, or the workings of the terms of trade. The Mystery of Economic Growth is best read by a reader already familiar with general literature. I would recommend Easterly’s Elusive Quest for Growth (2001) or Rosenberg and Birdzell’s How the West Grew Rich (1986) to a general reader interested in economic growth. The depth of Helpman’s insight is best appreciated by someone already familiar with the theoretical and empirical tools of economists.

Works cited:

Daron Acemoglu, Simon Johnson and James A. Robinson, 2001. “The Colonial Origins of Comparative Development: An Empirical Investigation,” American Economic Review 91, pp. 1369-1401.

Daron Acemoglu, Simon Johnson and James A. Robinson, 2002. “Reversal Of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution,” Quarterly Journal of Economics 117, pp. 1231-1294.

Robert J. Barro and Xavier Sala-i-Martin, 1992. “Convergence,” Journal of Political Economy 100, pp. 223-258.

Francois Bourguignon and Christian Morrisson, 2002. “Inequality among World Citizens: 1820-1992,” American Economic Review 91, pp.1369-1401.

William Easterly, 2001. The Elusive Quest for Growth: Economists? Adventures and Misadventures in the Tropics, Boston: MIT Press.

Edward L. Glaeser and Andrei Shleifer, 2002. “Legal Origins,” Quarterly Journal of Economics 117, pp. 1193-1229.

Avner Greif, 1993. “Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders’ Coalition,” American Economic Review 83, pp. 99-118.

N. Gregory Mankiw, David Romer and David N. Weil, 1992. “A Contribution to the Empirics of Economic Growth,” Quarterly Journal of Economics 107, pp. 407-438.

Nathan Rosenberg and L.E. Birdzell, 1986. How the West Grew Rich, New York: Basic Books.

Among George K. Davis’s recent publications are “The Emancipation Proclamation, Confederate Expectations, and the Price of Southern Bank Notes” (with Gary Pecquet and Bryce Kanago), Southern Economic Journal (2004).