Why do economies stop growing?

May 25, 2012, Friday/ 17:50:00

MILAN –- Over the years, advanced and developing countries have experimented, sometimes deliberately and frequently inadvertently, with a variety of approaches to growth. Unfortunately, many of these strategies have turned out to have built-in limitations or decelerators -– what one might call elements of unsustainability. And avoiding serious damage and difficult recoveries requires us to get a lot better at recognizing these self-limiting growth patterns early on.

Here are some of the items in a growing library of decelerating growth models.

In developing countries, import substitution as a way to jump-start economic diversification can work for a while; but, over time, as productivity growth lags and comparative advantage is over-ridden, growth grinds to a halt.

Small, open economies are naturally somewhat specialized, which leaves them vulnerable to shocks and volatility. But, in terms of growth and living standards, the cost of economic diversification, when implemented by protecting domestic industries from foreign competition, eventually outweighs the benefits. It is better to allow specialization, and build effective social safety nets and support systems to protect people and families during economic transitions. Such “structural flexibility” is better adapted to enabling the broad changes that rapidly evolving technological and global economic forces require.

Mismanagement of natural-resource wealth underpins an especially potent self-limiting pattern of growth and development. If invested in infrastructure, education, and external financial assets, natural-resource revenues can accelerate growth. But, too often, such revenues distort economic incentives, which come to favor rent-seeking and interfere with the diversification that is essential for growth.

More recently, many advanced countries have discovered a “new” set of growth models with built-in structural limitations: excessive private or public consumption, or both, usually accompanied and enabled by rising debt and inflated asset prices, and a corresponding decline in investment. This approach appears to work until domestic aggregate demand can no longer sustain growth and employment, at which point it ends in either gradual stagnation or a violent financial and economic crisis. (In fact, many developing countries have learned this the hard way, but the lessons seem not to have crossed over to advanced countries.)

But the opposite of the excessive-consumption model –- excessive reliance on investment to generate aggregate demand –- is also a self-limiting growth pattern. When the private and social returns of investment diminish too much, growth cannot be sustained indefinitely, even though rising investment rates can sustain aggregate demand for a while. Altering this growth pattern is a significant part of the challenge that China now faces.

Rising inequality in either opportunity or outcomes (and often both) also poses threats to the sustainability of growth patterns. While people in a wide range of countries accept some degree of market-determined income variation, based on differential talents and personal preferences, there are limits. When they are breached, the typical result is a sense of unfairness, followed by resistance and, ultimately, political choices that address the inequality, though sometimes in counter-productive, growth-impeding ways.

Perhaps the largest long-run sustainability issue concerns the adequacy of the global economy’s natural-resource base: output will more than triple over the coming two or three decades, as high-growth developing economies’ four billion people converge toward advanced-country income levels and consumption patterns. Existing economic-development strategies will require significant adaption to accommodate this kind of growth.

Some adaptation will occur naturally, as rising energy and other commodity prices generate incentives to economize or seek alternatives. But the un-priced environmental externalities – global warming and water depletion, for example – will require serious attention, not myopic, reactive mindsets and approaches.

All of these self-limiting growth patterns tend to have three things in common. First, in one or several dimensions, some part of the economy’s base of tangible, intangible, and natural-resource assets is being run down. I would include social cohesion as part of the asset base: it is the one that is depreciated by excessive inequality.

Measurement issues play an important role here. It is easier to run down something that is partly invisible because it is not regularly or effectively measured. Expanded measurement of the dimensions of economic, social, and environmental performance is necessary to broaden awareness of sustainability issues.

Second, unidentified self-limiting growth patterns produce very bad results. Expectations come to exceed reality, and resetting the system to a sustainable growth pattern is difficult. After all, past investment shortfalls have to be made up and future-oriented investments undertaken simultaneously –- a double burden that must be borne by the current generation. An inability to resolve the distributional and fairness problem can produce gridlock, paralysis, and prolonged stagnation.

Finally, many of these flawed growth patterns involve fiscal distress. Contrary to the prevailing wisdom nowadays, some degree of Keynesian demand management in the transition to a more sustainable growth pattern is not in conflict with restoring fiscal balance over a sensible time period. On the contrary, applied both individually and together, fiscal stimulus and consolidation are necessary parts of the adjustment process.

But they are not sufficient. The crucial missing pieces are a shift in the structure of accessible aggregate demand and restoration of those parts of the economy’s asset base that have been run down, implying the need for structural change and investment.

Michael Spence, a Nobel laureate in economics, is professor of economics at New York University’s Stern School of Business, distinguished visiting fellow at the Council on Foreign Relations, academic board chairman of the Fung Global Institute in Hong Kong and senior fellow at the Hoover Institution, Stanford University. His latest book is “The Next Convergence -– The Future of Economic Growth in a Multispeed World” (www.thenextconvergence.com).© Project Syndicate 2012