Economic Policy and Theory - Development and growth theory

Economic growth theory remains the most difficult to master of all modern economic theories. It requires advanced mathematical skills (differential calculus) and, as a result, also introduces assumptions and limitations very difficult to account for or envision. Even if one excludes the possibility of perpetual disequilibrium—however close it may come to a precarious balance—the passage from one equilibrium state to another typically excludes any notion that underlying conditions may change with time as external variables exert change upon them. To do otherwise would be to require mathematical reasoning so complex and fragile that it would likely render all resulting models completely impractical by exposing them to the hidden, often increasing feedback effects of the most minute errors.

Although he was a leading biographer of John Maynard Keynes and a promoter of Keynesian economics, Roy F. Harrod was also among the first to leave behind Keynes's theoretical focus on a static economy. Although Keynes avoided taking a similar step on his own because he wanted to focus on existing problems of underutilization rather than apparent ongoing cycles of growth and recession, Harrod was more interested in the latter, effectively inventing growth economics in the process. His 1939 Economic Journal article, "An Essay in Dynamic Theory," gave rise to growth theory by introducing the notion of a steady-state equilibrium growth path from which actual growth most often diverged. Harrod also revealed how such a divergence fed upon itself, widening the gap between steady-state and actual economic trajectories.

Recognizing only a few years later (1946) that investment created additional productive capacity capable of being exploited only when further increments of investment gave rise to new income, Evsey D. Domar developed a simple model corroborating Harrod's theory. Known thereafter as the Harrod-Domar model of dynamic equilibrium, this model and accompanying theory were adopted by the International Bank for Reconstruction and Development (World Bank) immediately after World War II, setting the stage for the pending marriage of growth theory and third world economic development. Although intended for use in the analysis of advanced, developed economies like that of the United States, the World Bank quickly adopted it as a way to determine the amount of aid required to lift poor nations onto a more prosperous growth path. Aware in the 1950s that his model was being applied without questioning the relationship between aid and investment—or inequality, consumption, and investment—Domar disavowed its use. As decolonization proceeded apace after World War II, however, it was inevitable that growth theory would come to be employed in this fashion.

Nicholas Kaldor and Joan Robinson, both, like Harrod, among the first in the Keynesian camp, endeavored to highlight the importance of income distribution to economic growth. Mostly due to his 1960 presidential address to the American Economic Association, "Investment in Human Capital," Theodore W. Schultz publicized the work begun in the 1950s by Jacob Mincer and popularized the notion that education and training were as critical to development as technology and industrialization. Hollis Chenery, Simon Kuznets, and Irma Adelman all questioned the notions that growth depended solely upon industrial development and that growth automatically engendered greater equality, lessened poverty, and promoted a self-sustaining pattern of development. Kuznets's famous "inverse U relationship"—between national income per capita and inequality, positive in poor nations and negative in advanced national economies—sparked numerous rounds of debate, including Adelman's study of semideveloped nations that contradicted Kuznets's assertion.

Until Raul Prebisch, Hans Singer, Dudley Seers, and others criticized the assumption that poor nations were simply primitive versions of their more advanced, wealthier counterparts, however, few of these theoretical developments questioned the theoretical claim that investment in machinery, however effected, automatically engendered growth. Although Prebisch in particular seemed enamored of the possibilities for industrialization of the developing world and import substitution policy, he placed equal, if not overriding, emphasis on the elimination of unemployment, poverty, and inequality as a prerequisite for industry-led growth. Developing world debt crises of the 1970s and 1980s, evident in nations that had adopted the Prebisch-Singer theory and government intervention designed to implement it, spawned an even more vigorous countermovement marked by criticism of government intervention.

The "total factor productivity growth" approach, developed principally out of Robert Solow's groundbreaking work in capital theory in the 1950s, also questioned the primacy of capital formation in general or investment as a simple means to economic growth. Solow developed, for example, "vintage" models of growth that underscored not just the size of a given nation's capital structure, but also its age or vintage. The newer the technology, the greater its productive capacity, and—following Albert O. Hirschman on the "unbalanced" character of economic growth—the greater its linkage to key industries—on both the input and output sides. Research and development, scientific advances, and the processes of technology diffusion—all seemingly outside the scope of economic policy—evidently played as significant a role as policy itself. Vigorous debate on this issue ensued, most notably due to the emergence of empirical studies suggesting that government policy and high investment often appeared to spell the difference between nations that grew more or less rapidly. Joseph Schumpeter's earlier suggestion that oligopoly allowed firms to compete on the basis of technological innovation rather than price hinted at the role conceivably played by policy and burgeoning investment. Much like Kindleberger's lender of last resort—a nation that could afford to liberalize trade and share the wealth—Schumpeter's oligopoly capitalist could provide room for full employment and rising shares to labor as well as produce the profit margins with which to assume risky research or investment outlays. Unmitigated free market competition, it seems, would be incapable of the same. Amartya Sen posed theories of development, social choice, and inequality that suggested similar conclusions. Clarifying the conditions under which collective decisions can best reflect individual values and stressing the way in which poverty and inequality restrict economic choice and freedom, Sen forced economists and policymakers to consider general welfare and development in terms beyond reported changes in per capita income or gross national product.

Economic theory has for centuries remained a significant part of foreign affairs related to trade, money, and development. This is especially so for the foreign affairs of the United States, less dependent on international trade than many other nations but connected vitally to all by virtue of its dominant currency and ascendant role in international economic institutions. Since the emergence of stagflation in the 1970s, its history of adapting foreign policy to advances in theory has been marked by both indecision and a willingness to countenance only the most confident and simplistic versions of new economic theory. The debt crises of the 1980s and monetary turmoil of the 1990s did little to alter this course. And though heterodoxy remained distant and beyond the ken of most policymakers, the foreign affairs of the United States remained wedded integrally to the counsel of economists, both active and defunct.

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