The most fundamental issue involved is that of the tendency of the contribution of investment to economic growth to increase with economic development. This trend was first analysed by Adam Smith and affirmed by other economists including Keynes.(3)However, it was rejected in analyses of economic growth put forward by various mid 20th century theorists. The latter asserted, against the analysis flowing from Adam Smith, that the division of the economy between investment and consumption remained constant with economic development – this is, of course, a central assumption of the widely employed Cobb-Douglas production function, of the economic growth model put forward by Solow (Solow, 1957), and continues to be repeated in many(4), although no longer all,(5) economic textbooks.
As discussed in detail elsewhere (Ross, 2009), the present author from the early 1970s concluded, on the basis of the long term historical data on growth that was then beginning to be published, than Adam Smith and those who followed his analysis were clearly correct. Despite the fact that the theories of Solow et al of a constant contribution of investment to GDP growth were the prevailing orthodoxy they were clearly contradicted by the historical data. Jorgenson has outlined more general reasons for the breakdown of such econometric models. (Jorgenson D. W., 2009) The theory that the proportion of the economy devoted to investment remained constant, rather than rose with economic development, was erroneous and classical economics was correct.
Initial statistical unclarity in this discussion was undoubtedly aided by the fact that the US is untypical in that, unlike the great majority of other economies, the proportion of the US economy devoted to fixed investment has indeed not risen for the approximately 150 year period for which reliable statistical data exists. (Ross, 2008a) (Barro & Sala-i-Martin, 2004).(6) Analyses based on generalisations from the US, therefore, arrived at the erroneous generalisation of a constant, rather than rising, share of investment in GDP.(7)
A consequence of the difference between the pattern in the US economy and the general international trend of a rising share of investment in GDP, is that the US share of fixed investment in GDP, which was above the international average in the 19th and first halt of the 20th century, has now fallen below the international average – in particular the US level of investment in GDP has fallen below the level of rapidly growing Asian economies. This contributes to the slow growth of the US economy compared to Asian competitors, the US balance of payments deficit with Asia, and present international financial developments. (Ross, 2008b)
The question of whether the role of fixed investment in economic growth rises with economic development, or remains constant, has numerous practical economic implications. The key pieces of evidence demonstrating the rising contribution of fixed investment to GDP growth with economic development, prior to the publication of the database of Jorgenson and Vu, included:
1. Trends in leading international growth economies. The analysis of leading growth economies, in successive historical periods of economic development from the 18th century, carried out by the present author from the 1970s onwards, showed that each such leading economy – in chronological succession the UK, the US, West Germany, Japan, South Korea and now China – was characterised by a higher percentage of fixed investment in GDP than the preceding lead growth economy. This trend is shown in Figure 1.
2. The comprehensive comparative analyses, published by Angus Maddison, of economic growth in developed economies since World War II, including his Phases of Capitalist Development (Maddison, 1982) and Dynamic Forces in Capitalist Development (Maddison, 1991), demonstrated that capital investment was the largest contributor to post-World War II GDP growth in a wide range of advanced economies. Maddison demonstrated over a longer time frame than the post-World War II period that both non-residential fixed investment rates and savings rates, which were correlated with fixed investment rates, rose with time in most advanced economies – the US, as already noted, being an exception and not a rule. (Maddison, 1992)
While these studies analysed a wide range of developed, and a number of leading developing, economies they were however not entirely comprehensive in coverage – in particular they did not include a comprehensive range of developing economies. The publication by Jorgenson and Vu (Jorgenson & Vu, 2007b) of a comprehensive growth accounting base for up to 122 economies, constituting more than 95% of world GDP, therefore provides an opportunity to fill this major gap.
A striking trend that may be analysed in its data, in addition to those drawn attention to by Jorgenson and Vu themselves, is that GDP growth in developed economies is capital-intensive while GDP growth in most developing economies is labour- intensive. The path of economic development is therefore a transition from labour intensive growth to capital intensive growth. The East Asian developing economies may be seen as an intermediate group between the majority of developing economies and the developed economies.
Such a pattern is, of course, consistent with the other evidence showing the rising contribution of investment to GDP growth with economic development. However, such a comprehensive database for evaluation of these trends has not previously been available – in particular it allows an integration of trends in developing economies with those in developed economies. It is for this reason that these three analyses of trends in the data of Jorgenson and Vu for capital and labour inputs in different stages of economic development have been published.
It is clear on the basis of the above data that there is overwhelming evidence of a tendency for the contribution of investment to GDP growth to rise with economic development. In light of such clear evidence it is evident that the assertion that the contribution of investment to GDP growth remains constant with time, rather than rising, is erroneous.
Economic models and theories therefore must take into account that the contribution of investment to GDP growth increases with economic development - Adam Smith and those who followed him on this issue were correct.
The implications of this for economic theory and practice of such a trend are numerous as has been analysed elsewhere (Ross, 2008a).
The normal disclaimer must, of course, be made that while these papers utilise calculations based on data produced by Jorgenson and Vu they do not bear responsibility for the conclusions drawn.
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Since this analysis was carried out Jorgenson and Vu have extended their data to 2008. (Jorgenson & Vu, 2010) The new data does not alter the main trends analysed above. A detailed analysis from the angle of approach in this article will be published.
(3) In The Wealth of Nations, Adam Smith analysed that the role of capital and intermediate inputs, which he jointly termed ‘stock’, would increase as an economy developed. Smith noted: ‘As the accumulation of stock must, in the nature of things, be previous to the division of labour, so labour can be more and more subdivided in proportion only as stock is previously more and more accumulated… As the division of labour advances, therefore, in order to give constant employment to an equal number of workmen, an equal stock of provisions, and a greater stock of materials and tools than what would have been necessary in a ruder state of things must be accumulated beforehand.’ (Smith, 1999, p. 372) Keynes, arrived at the same conclusion of an increasing role of capital investment in economic development via a somewhat different chain of reasoning related to savings behaviour: ‘the richer the community, the wider will be the gap between its actual and its potential production… For a poor community will be prone to consumer by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members.’ (Keynes, 1983, p. 31) For a wider discussion see (Ross, 2009).
(4) Romer for example asserts ‘The growth rates of output and capital has been about equal (so that the capital-output ratio has been approximately constant).’ (Romer, 2006, p. 17) Blanchard asserts: ‘the savings rate does not appear to systematically increase or decrease as a country becomes richer.’ (Blanchard, 2006, p. 226)
(6) The initial data on which the present author arrived at the conclusion of confirmation of a rising share of investment in GDP was based on calculations from (Deane & Cole, 1967), (Feinstein, 1972), (Mitchell, 1980), (Economist, The, 1982), (Lister, 1989). Barro and Sala-i-Martin note: ‘For the United States, the striking observation… is the stability over time of the ratios for domestic investment and saving… The United States is, however, an outlier with respect to the stability of its investment and saving ratios; the data for the other seven countries [analysed] show a clear increase in these ratios over time… The long-term data therefore suggest that the ratios to GDP of gross domestic investment and gross national savings tend to rise as an economy develops, at least over some range. The assumption of a constant gross savings ratio, which appears… in the Solow-Swan model, misses the regularity in this data.’ (Barro & Sala-i-Martin, 2004, p. 15) Baro and Sala-i-Martin do not, however, draw out all the implications of this.
(7) Similar assertions were, however, also made by those who were centred on the UK economy - despite the fact that the UK economy showed a clear tendency for the proportion of investment in GDP to rise with time. Kaldor for example, in a widely cited paper, claimed as one of his ‘stylised facts’ on economic growth: ‘Steady capital-output ratios over long periods; at least there are no clear long term trends, either rising or falling, if differences in the degree of utilisation of capacity are allowed for. This implies, or reflects, the near identity in the percentage rates of growth of production and the capital stock – i.e. that for the economy as a whole, and over long periods, income and capital tend to grow at the same rate.’ (Kaldor, 1961, p. 178)
(8) See for example (Jorgenson & Yip, 2001), (Jorgenson D. W., 2003). Other authors have, of course, also noted the rising proportion of investment in GDP growth – see for example (Jones, 1995) and (De Long & Summers, 1992).
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