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The Growth Imperative

Tuesday, February 24, 2009

Missing from the discussion of the economic crisis is the most important variable of all.

The impact of the stimulus and bailout plans on long-run economic growth has received little attention so far. This is unfortunate. Barring a complete meltdown of the global financial system the possible loss of GDP for most countries is in the range of a couple of percentage points. In contrast, modest changes in economic growth will compound into a much larger percentage within a decade or two. From a policy and welfare perspective, it should be self-evident that sacrificing economic growth to deal with the current crisis is a bad option.

Economic growth deserves our attention not only because of its significance for human welfare, but also because many aspects of growth, including its main sources, are reasonably well understood. There is broad theoretical and empirical agreement on the role that innovation and reallocation play in propagating economic growth. We also understand the rough outlines of the institutional framework that makes innovation, reallocation, and long-term growth possible.

Technology, Reallocation, and Institutions

We have enjoyed prosperity during the past two decades because of rapid innovations—quite independent from financial bubbles and troubles. We witnessed a breakneck pace of new innovations in software, hardware, telecommunications, pharmaceuticals, biotechnology, entertainment, and retail and wholesale trade. These innovations are responsible for the bulk of the increases in aggregate productivity and wealth creation that we had in the past 20 years.

From a policy and welfare perspective, sacrificing economic growth to deal with the current crisis is a bad option.

Even the financial innovations, which are somewhat in disrepute in the recent crisis, are in most cases socially valuable and have contributed to growth. Complex securities were misused to take risks with the downside borne by unsuspecting parties. But when properly regulated, these innovations also enable more sophisticated strategies for risk sharing and diversification. They have enabled and will ultimately again enable firms to reduce the cost of capital.

Technological ingenuity is the key to the prosperity and success of the capitalist economy. It is worthwhile thinking about the importance of new innovations and their implementation and marketing because they will play a central role in renewed economic growth in the aftermath of the crisis.

Another pillar of economic growth is reallocation. Innovation often comes in the form of Schumpeterian creative destruction—production processes and firms relying on old technologies are replaced by the new.

Volatility that is part of the market economy also incessantly changes which companies and which services have greater productivity and greater demand. Such volatility is possibly larger than ever because of greater global interconnection.

But reallocation and volatility are not curses against which we should defend ourselves. By reallocating resources to where they meet market demand and yield more productivity, the capitalist system can exploit its volatile nature to raise prosperity for all.

The developments of the last two decades again highlight the importance of reallocation, since economic growth took place in concert with output, labor, and capital moving away from many established companies toward their competitors—often foreign competitors—and from sectors in which the United States and other advanced countries ceased to have comparative advantage.

The Thorny Politics of Growth

Long-term and sustained economic growth also requires certain institutional foundations. These involve secure property rights to encourage economic activity, a level playing field that enables new firms and technologies to replace the old ones, and regulations to support the functioning of free markets.

We have enjoyed prosperity over the past two decades because of rapid innovations—quite independent from financial bubbles and troubles.

Alas, the politics of growth is no simple matter, and the emergence and persistence of such institutions is not automatic. Creative destruction and reallocation not only harm established businesses but also their workers and suppliers. The process can destroy the livelihood of millions of workers and peasants. This dynamic can reduce the enthusiasm that many people have for economic growth and for its institutional foundations.

It is easy for impoverished populations suffering from adverse shocks and economic crises—particularly in societies where the political process never generated an effective safety net—to turn against the market system and support populist policies that will create barriers against economic growth. These threats are extant for advanced economies as well, particularly in the midst of the current economic crisis.

It is vital that governments affirm the regulations necessary to limit opportunistic behavior and increase transparency. And in many less-developed economies, the most consequential aspect of the politics of growth is ensuring that incumbent producers, elites, and politicians do not hijack the political agenda and create an environment inimical to economic progress and growth.

New innovations and their implementation and marketing will play a central role in renewed economic growth in the aftermath of the crisis.

The centrality of the politics of growth has been underscored by recent events. It is impossible to tell the story of the failures of investment banks and the financial industry at large over the past two decades, nor of the subsequent policy response, without some reference to politics.

The image currently projected to Americans and the world is one in which those with money and connections can make colossal mistakes and will still be bailed out. We should not be surprised if such perceptions lead to a backlash against capitalism itself—rather than the specific practices that were problematic—and if current and future policies are shaped by this backlash.

Considerations for Policy

The perception of political problems cannot be ignored. Policymakers must bear this in mind as they seek to craft wise responses in this tumultuous environment. The design of policies to contain and end the global crisis ought to pay special attention to the implications of policies for both long-run economic growth and for the politics of growth as well.

When the talk is of bailing out and protecting selected sectors, more systematic proposals featuring trade restrictions and industrial policy that can stymie competition, reallocation, and innovation may be around the corner.

For example, market signals strongly suggest that labor and capital should be reallocated away from the Detroit Big Three and highly skilled labor should be reallocated away from the financial industry towards more innovative sectors. The latter reallocation is critically important considering that Wall Street attracted many of the best minds over the past two decades; we now realize that though these bright young minds have contributed to financial innovation, they also used their talents for devising new methods of taking large risks, the downside of which they would not bear.

Steps taken in Washington should specifically refrain from policies that create barriers against necessary reallocation and reduce incentives to innovate. Worrying signs of bad policies are already apparent, however. For example, restrictions on trade in goods and services are on the agenda. When the talk is of bailing out and protecting selected sectors, more systematic proposals featuring trade restrictions and industrial policy that can stymie competition, reallocation, and innovation may be around the corner.

While greater regulation is likely and in some areas necessary as we move forward (particularly in the financial sector), the regulation pendulum can easily swing too far as voters and policymakers become more convinced that free markets are responsible for the economic ills of today.

Bailout and stimulus plans should specifically refrain from policies that create barriers against reallocation and reduce incentives to innovate.

Despite the present turmoil, there are many reasons to be hopeful about the future. The innovative dynamism of the United States and world economies is still strong. We can hope that experts and policymakers have learned from the mistakes of the past decade or so and will strive for smart regulations (rather than rhetoric-driven partial deregulations or regulations that slow the reallocation innovation process of the economy).

But since the rhetoric of the past two decades equated capitalism with lack of regulation, this optimistic outlook and the distinction between effective free markets and unregulated markets will be overlooked by many who have lost their houses and jobs. And there will be plenty of politicians only too happy to exploit the frustration of those who are bearing the brunt of the crisis. We are not out of the woods yet.

Daron Acemoglu is the Charles P. Kindleberger Professor of Applied Economics at MIT. He received the John Bates Clark Medal from the American Economic Association in 2005. His most recent book is Introduction to Modern Economic Growth.

Image by Darren Wamboldt/The Bergman Group.

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