Mystery Growth Theory

from Peter Radford

I have been reading Gregory Clark’s brief history of the world economy “A Farewell to Alms” as part of my continuing reading on inequality. Somehow I think I need to know more about the entire arc of growth in our modern era and inevitably that means reading more about the great mystery of the surge in living standards since about 1750. Clark gives me a fairly standard view. He divides history into two distinct positions. An older “Malthusian” era, where growth was negligible, and a modern era dominated by “innovation”.

On page 197 he tells us:

“For, although modern economies are deeply complex machines, they have at heart a surprisingly simple structure. We can construct a simple model of this complex economy and in that model catch all the features that are relevant to understanding growth.”

That ought to encourage us all.

A simple model – how economists love those – but all inclusive.

Read on:

“The simple model collapses the immense complexity of all economies down to just five variables: output Y, labor L, physical capital K, land Z, and the level of efficiency A.”

Great.

This all leads us to something called the fundamental equation of growth:  g_y = ag_k + cg_z + g_A

So important is this equation that Clark feels the need to italicize it to drive home its stature.

Later we learn that we can remove, or ignore as trivial, the middle variable because land “no longer matters in economic growth”.

And so:

“Thus, despite all the complexities of economies since the Industrial Revolution, the persistent growth we have witnessed since 1800 can be the result of only two changes: more capital per worker and greater efficiency of the production process. At the proximate level all modern growth in income per person is that simple.”

 But wait.

That last variable, the one referring to efficiency is known as the residual. Once again Clark puts it in italics to let us know how important it is.

Why the residual?

Let Clark explain:

“This is because, while the other terms in the equation can be directly measured and calculated, efficiency is simply a balancing quantity thrown in to make the sides equate.”

Really? A plug-in to balance the equation.

That’s OK I assume. It can’t be very significant can it?

Well not exactly. It turns out that this immeasurable and incalculable plug-in accounts for a full 70% to 75% of all modern growth.

The fundamental equation seems to explain nothing. Or, at least, only a quarter of what we are seeking to explain.

This is fundamental?

This is a triumph of economic theory?

Finally we are told:

“Note, however, that when we arrive at this final truth as to the nature of modern growth we have lost all ability to empirically test its truth. It is a statement of reason and faith, not an empirical proposition.”

Typical.

Absolutely typical.

Economics delivers a piece of reasoning pulled out of thin air in order to explain what is, to many people, the central fact of economic history that demands an explanation. In other words it resorts to faith. Economic theory falls so short that it looks, to outsiders, like an absurdity. Economic theory explains little. But it sure looks clever.

A fundamental equation that requires faith and, presumably, the suspension of any and all critical faculties to regard it as fundamental.

Only in economics.

How come I always feel like I know less after reading books by economists than I did before?