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Thought Leadership

How do we all get rich? The 3 paths to economic growth.

Understanding Expropriation, Exports and Accelerating flow. Sources of fast growth.

Date:
June 16, 2022
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American society has become obsessed with economic growth. 

Our newspapers cover it. Our leaders fixate on it to measure their performance. We use it to compare countries: who’s up, who’s down.

Most of us will have heard of the omnipresent “metric”: GDP. And many of us know its full form, Gross Domestic Product (though we would all equally struggle to explain how it is actually calculated, and it’s not so simple either).

So, why the obsession?

Growth is the single best indicator of whether we are moving forward as a society. Are we able to create more income and more wealth, so that peoples’ lives are improving?

It is far from perfect. It has many flaws. 

There are plenty of critiques, commentary on whether it is morally the right measure, and whether it is balanced.

Nonetheless, it is measurable, and it is decent…decent-ish enough. So it is relevant. 

Economic growth has been criticized through the years. Alternatives are put forward. Notably, the “Development as Freedom” concept advanced by Amartya Sen in the late 1990s, which gave rise to the Human Development Index.

Nonetheless, despite contenders, to this day economic growth - the metric - has held the pedestal. It is dependable to measure, and to guide our societies: are we actually moving forward, year after year?

If you can measure it well, that makes it matter. And sometimes - we have to accept this - it becomes a popular object of obsession. 

But what drives growth? 

If asked, many would say, “people buying more stuff,” “people working harder,” “producing more stuff,” “making more money from our work.” All of these answers carry some truth.

If economies are set up to encourage hard work, production, the meeting of real human needs, where people are willing to pay - generally, growth does happen. 

This is the circular flow model of growth. Every year, people want more stuff. Firms make them. People buy it. Making firms collect revenue, meaning wages are paid. People are a bit richer. People want more stuff. And so the cycle ensues. 

The circular flow of demand and production edges us forward, step by step, little by little. Our economy produces more. We consume more. We grow.

We compare countries often: US vs. Europe; Japan vs. South Korea; India vs. China. The history of economic reporting shows that some countries succeed in “supercharging” their growth performance, reaching more than 5%, even as high as 10%, per year growth.

That is a huge figure. It means - on average - we are each getting 10% more income every year. If you project this, within 7 years, we have doubled our income. Tremendous! In the course of just a generation, we’d get to 10x the income level. You are 10x richer than your own parents were.

Supercharge growth happens…

The original industrialization of Britain produced fast growth in the period of 1750 to 1850.

This was the fastest growth in the 12,000-year history of human civilization and human economy.

The US followed and grew very fast, post-Civil War, from the 1870s onwards. The period of Reconstruction with rapid industrialization: railways, steel, oil, banking and automobiles.

Japan grew fast from the 1950s to the 1990s, after their World War II disaster.

South Korea did too, from the 1970s to the 2000s.

China has followed the same path from the 1980s to the present day. They only took off once they restructured the economy, post-Mao with the under-recognized leadership of Deng Xiaoping.

Right now, India has a high growth rate in the 6% to 8% range and could maintain this for a decade, perhaps two.

So how has this happened? How is this happening? Why for some countries especially?

We see three ways to get fast growth: Expropriation, Export or Accelerating Flow. Or some combination of all of these.

This is a simplification, but like any good theory, it hits at the heart of the matter. And leads to better intuition building. Let’s explain:

Expropriation

A country gets cheap access to an input good or service, typically from another country, or from a recent fortuitous discovery. This can fuel their industries and markets. It leads to more accelerating flow (see below), and can lead to more exports, because of the cost advantage the country has.

This happened in the UK as it industrialized. The British Empire and its colonies gave the UK access to cheap, plentiful resources beyond its own borders - and also within its borders in the case of coal mining. 

These resources were put to use in the newly industrialized North-west and Mid-west of the country. Britain was then able to export - especially cotton and textiles - to the markets of its colonies. Empire of Cotton by Sven Beckert explains this history in colorful detail.

Export

When a country is able to produce a good or service that other countries want, it has an advantage in this product, whether cost, quality, or unique technology. What the economist David Ricardo called “comparative advantage.”

This is very effective as a method of growth, because trade revenue can be 20% to as high as 50% of GDP. 

Even at 20% of GDP (China’s level), this can be a “value-add” contribution of 5% to GDP. This is like bringing in 5% new income - immediately into an economy every year. Such an influx causes more economic activity within the economy, as it is spent on goods and services within the market. 

This is called the economic multiplier and can be as high as 2x to 3x. So a 5% value-add contribution GDP leads eventually to 10%-15% total economic value addition per year. That is an enormous increase within a year. Imagine doing it for a decade, year after year.

This is why export is such an effective way of getting fast growth, and the archetypal story of growth. An economy taps into foreign markets and gets immediate demand for its goods and services. It brings new money and new wealth fast into its domestic economy. It is like turning on a tap of income, without having to do the hard work to galvanize your own economy (see Accelerating Flow below).

This is the model that fuelled Japan in the 1970s as it exported cars and electronics deep into the US market. Americans love Japanese cars to this day.

South Korea in the 1980s and onwards became an export hub for shipping, electronics, and semiconductors. Another example: the famous Made-in-China story featuring the export of low-cost manufactured goods at tremendous scale.

Accelerating circular flow

We covered the circular flow model:

Every year, people want more stuff. Firms make them. People buy it. Making firms collect revenue, meaning wages are paid. People are a bit richer. People want more stuff. And so the cycle ensues. 

The challenge with this form of growth: it takes time. There is a limit to how fast people can produce, make money, and so demand more every year. New demand - driven by new income - takes time to notch up, step by step.

So to make this model of fast growth happen, it requires the ability to really accelerate the flow.

Typically an economy must have at least 5 key ingredients for this to happen:

  1. A large base economy, which means there is broad demand, across all industry areas.
  1. High consumption from its consumers. The core demand of any economy. People have to like buying stuff vs. wanting to save and invest. Consumption drives demand for production.
  1. An agile economy, which enables new private companies to set up fast and to produce fast to meet new demand. The catalyst of entrepreneurship.
  1. A financial system that supports fast transactions and money management, including efficient taxes. Money has to flow smoothly.
  1. A financial system that supports credit allocation and strong capital flows, so money flows to the right business opportunities and is meeting real consumer demand. Investment - and our excess savings - must allocate to where it makes the most difference.

These 5 elements constitute what we like to call a “capitalist economy.” It is why capitalism is most associated with fast growth, when it comes from this model.

As you can see, there are several elements that have to go right here. The real challenge is sustaining these conditions year after year, such that all participants (consumers, firms, investors) keep their confidence that these ingredients are here to stay.

So, a country that has an unstable political leadership, or enters into wars often, is unable to maintain this model of growth successfully.

The UK grew through this model post the 1850s. The US followed this model post the 1950s. India saw modest growth from 1950 to 1990 via this model, driven by relatively high domestic consumption (point 2). To this day, it continues to be a big part of India’s growth story, more so than China’s.

So fast growth has its formulas…

For 12,000 years of human settled civilization we have created economy. We invented agriculture and started to stay put, so we could make more than food and exchange more often among ourselves.

For 98% of that time, we have not had conditions for fast growth. We had periods of reasonable growth: the Roman Empire had 2 strong centuries, and so did the Tang Dynasty of China (7th-10th century).

But fast growth is very much a recent invention.

There is now a playbook and the models for it are finite and few: 1) expropriation, 2) export, or 3) accelerating flow.

Avi Patchava
Avi Patchava
Co-CEO & Co-Founder

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