Where does economic growth come from?

One of the simplest and yet most frustrating questions policymakers and economists must answer is how to fuel and sustain economic growth. Growth, the ability to produce more goods and services, does not simply make society wealthier, but it the economic term for the enrichment of the human condition that we witness with the progress of time.  More importantly, without growth, we see increased poverty and high unemployment.  But how is economic growth created? Where does it come from, and how does policy promote it?

While short term levels of production in the economy are influenced by many different factors, most economists agree that long-term growth arises from the accumulation of human and physical capital, as well as technological innovation. Physical capital (goods used in the production process, like machinery, factories, or offices) must be constructed just like any other good, using labor, time and other inputs.  Economists refer to this as economic investment.  However, labor or previously constructed capital is scarce, and time spent using these inputs to make more capital goods means less time making consumption goods, which include anything eventually purchased in stores, like TVs, food, clothing or even housing. In other words, economic investment allows for more goods to be constructed in the future, but   only at the cost of less consumption goods being made today. This can be understood as a decision by a business or supplier to spend money on investment, in order to produce more in the future, or to simply produce more.  While this is a general case and the specifics of different industries mean that varying ratios of investment and production have to weighed on hundreds of variables, what is true is that higher levels of investment lead to higher levels of growth in production capability. However, this is only one side of the equation; the ability and desire of the suppliers to expand production can only occur if consumers show a willingness to consume less at present and consume more in the future. Savings is a vital part of long-term growth, something that is often under-emphasized when policymakers focus on short run growth levels, where higher consumer spending demonstrate higher levels of GDP.  Nevertheless, without savings, there is no source of investment for businesses to push into new physical capital, and business expansion is hampered.

But of course, accumulated physical capital cannot guarantee economic growth, as there are diminishing returns to production, which is where technological growth comes in.  The advancement of technology allows for new capital to be produced which in turn allows for growth to overcome the problems of diminishing marginal returns to production.  How technological advancements occur is somewhat unpredictable.  There are certain things the government can do, but they mostly revolve around making sure patent policy maximizes innovation while allowing everyone access to new technology.  Government itself cannot be particularly good at creating innovation directly, as it simply does not have the same knowledge that market actors do, since government programs or agencies cannot respond as quickly to price information.

In fact, when discussing any part of economic growth, there is a strong argument that government doesn’t have a huge role to play. Even if government is involved in investment of new capital, it must pull from the same pool of savings that private investment does; the only difference being that government has no profit motive to direct its investments efficiently, while it does have a political motive which often decreases efficiency.  There are of course areas where positive externalities from investments in human capital and R & D mean the market often underfunds those areas. But even in these cases, economists desire government money with no strings attached and low overhead, something that almost never happens.  And in any place where government should spend on positive externalities, it can only be made possible with savings from consumers who give up immediate purchases for long term returns.

As a society, savings and risk-taking investments are vital to growing the production capacity of the economy.  While short term growth may swing wildly, long run growth simply requires a collective sacrifice of the present for the future.  And as long as incentives exist for progress, it likely that progress will continue.