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The Growth Puzzle - Outside View by Nitin Gregory

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The Growth Puzzle
Oct 5, 2015

We are surrounded by statistics on how countries, companies, and indexes grow. Information about GDP growth rates, EPS growth rates, and stock index movements are all around us and seem to be all-important. So where is this growth coming from? What are the big drivers of growth?

I want to start by focusing on the growth of countries, more commonly called gross domestic product or GDP - the sum of all output and services of a country. The growth of an economy is the result of interactions between various factors; however, we can isolate a few key elements as the big drivers.

The key factors of production are land, labor, and capital. Economic theory has tried to combine these factors into equations that can predict the future of growth. This type of growth accounting is a fairly complex and a divisive issue in economics (for those inclined towards more complexity, you can start by googling the 'Solow growth model').

I would like start with the broad-brush statement that growth is correlated to the above-mentioned factors of production (land, labor, and capital).

A country with growing population (labor) and enough savings to invest in machines, tools, and buildings (capital) should be able to grow at a decent clip. Different countries are at different stages in their growth curve and the factors of production have an impact on growth.

For example, Europe and Japan face the difficulty of an aging population. This means that the productive workforce is falling - labor is now on a declining trend. There are concerns that this will affect growth. Estimates of the aging trend in Europe have predicted a roughly 16% drop in the working age population of Europe.

Interestingly, in countries such as India, we speak of a demographic dividend. But we lack the capital to aid growth. Based on OECD estimates from 2012, the physical capital stock per worker is roughly 8% of the US counterpart. This means that there is significant room for growth with the addition of capital in the economy. A strong banking sector that can channel savings into the productive economy would help boost growth.

Attracting foreign capital by providing favorable and stable regulation is another measure that would help with our capital deficiency. The total amount of foreign direct investment (FDI) in the globe (that is, capital ready to move to countries other than its domicile) is around US$1500 billion. That's roughly the total yearly output of India. That's a lot of money!

One of the key functions of FDI is to supplement savings in the economy. It's almost like a company looking for funding. And one of the funding sources is foreign investors. The investment in the country can take many shapes - debt, equity, partnerships, etc. Nevertheless, it is a key funding source for growth.

Does this mean that all growth is linear? Is the growth limited by population growth and capital availability? Well, historical analysis has shown that there is a component of growth beyond these observable factors (like a magic sauce). The jargon for this is 'total factor productivity'.

Before I delve further into this, Let us start with a short story...

There are two people on a deserted island (best form of reductionism). They fish with their bare hands every day and are able to catch one fish each, which is their food. If this hypothetical deserted island were a country, its GDP per day would be two fish.

Now, one of them (let us call him E) wanted to try something new. His idea would require him to spend some time designing a new tool, which he would then build with the help of his cohabitant. He estimated it would take one day of tinkering and designing and one day of building with help from the second inhabitant. So every day for six days, E eats only half a fish, creating the first pool of savings on the island (three fishes).

These savings will now be deployed in creating productive capacity. On the first day, E sits on the shore experimenting with different ideas and finally decides on the best (he does not go to fish and dips into his savings). On the second day, he hires his cohabitant to help in return for one fish (wages), and they build the first fishing net on the island.

From the next day on, E is able to catch five fish a day with his net. He does so without an increase in labor (the population of island remains two). With some incremental capital (three fishes), the GDP per day of the island has gone up to six fish.

A conventional increase in the factors of production would not have given a similar increase. For example, if the population of the island increased by one person, it would mean a GDP increase of one fish per day.

This excess growth generated when labor and capital interact is called total factor productivity (or magic sauce - you choose). There are many reasons for this non-linear increase in output. When the scale of production is large enough, we can employ division of labor. This creates efficiencies and drives innovation. For example, a worker who is handling a specific process on the assembly line will become faster with repetition and is likely to find a better way to complete the task. Capital spent on technology (the fishing net on the island) also boosts productivity per worker.

We started by explaining the big drivers of growth. I think a more appropriate description would be that these are the necessary but not sufficient conditions for growth to manifest.

China is a prime example of growth aided by the key factors of production: labor (incredible demographic dividend) and capital investment (it has been investing close to 40% of its GDP in capital stock). It is estimated that, in the last three decades, China has raised close to half a billion people out of poverty! However, we are now seeing signs of slowing growth and, more importantly, the value of assets correcting.

How do capital and labor channel into the right sectors? What are the self-correcting mechanisms? These are important pieces of the puzzle...but for another day...

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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