Economists should rethink the role of government in promoting investment as a way of
improving economic growth and social welfare, according to Professors Roger Farmer and
Amartya Lahiri. Their research, published in the October 2006 issue of the Economic
Journal, argues that the economics profession has erred in favouring the neoclassical
model of growth over so-called ‘endogenous growth’ theory.
Why do some countries grow faster than others? Is there anything that governments can or
should do to promote growth? These are important questions, but they are ones that
economists know much less about than they would like to. In the 1970s, economists didn’t
have much to say about growth; instead, they were more concerned about what causes
business cycles. In the mid-1980s, a series of papers by Paul Romer and Robert Lucas
changed the direction of the profession.
Romer and Lucas argued that growth is the issue if one is interested in economic welfare
and they proposed a new way to think about growth that suggested that governments can
and should do something about it. In the dominant paradigm that predated Romer and
Lucas, due to Robert Solow, growth was left unexplained as an exogenous increase in
productivity. In the world after Romer and Lucas, growth was explained ‘endogenously’.
The new paradigm spurred a spate of research that tried to test the Romer-Lucas theory of
endogenous growth. Empirical work was aided by the emergence of a new data set, due to
Robert Summers and Alan Heston, which compiled comparable cross-section and time
series data for hundreds of countries over a span of 30 years.
When researchers examined the data through the lens of their model, they found that the
Romer-Lucas model did not seem to provide a good explanation of the facts. In particular,
they found that countries within similar groups appeared to be converging in per capita
income. This prediction follows from the Solow model that predated Romer-Lucas but it is
not an implication of the Romer-Lucas theory.
The convergence finding caused opinion to swing back towards Solow’s explanation and
most economists are now of the view that by promoting higher investment nationally, a
country cannot do much to improve its long-run growth rate.
The paper by Farmer and Lahiri challenges the new orthodoxy. As in the Romer-Lucas
theory, they construct a model of endogenous growth that allows for two kinds of capital.
One kind they call human capital to represent the stock of skilled workers in a country and
the other they call physical capital to represent the stock of factories and machines. Their
innovation is to permit international trade in physical capital and to follow its implications for
convergence.
Like the Romer-Lucas model, the theory permits endogenous growth but by allowing for
free international trade in physical, but not human, capital, the researchers are able to
replicate the convergence facts that caused economists to favour the Solow model over the
endogenous theory of Romer-Lucas.
Moreover, the model has the advantage that it can accommodate international trade in
capital without implying implausibly high flows of capital across countries. In contrast,
versions of the Solow model where countries are allowed to trade with each other predict
implausibly high levels of international trade in capital that are typically not observed in the
data. Most researchers subscribing to the orthodox view avoid this problem by constructing
models where the world is thought of as a collection of economies that do not engage in
international trade.
Farmer and Lahiri conclude:
‘The economics profession erred in favouring the neoclassical model over
endogenous growth theory. Economists should rethink the role of government in
promoting investment as a way of improving social welfare.’
ENDS
Notes for editors: ‘Economic Growth in an Interdependent World Economy’ by Roger
Farmer and Amartya Lahiri is published in the October 2006 issue of the Economic Journal.
Roger Farmer is at the University of California, Los Angeles. Amartya Lahiri is at the
University of British Columbia.
For further information: contact Roger Farmer on +1-310 825-6547 (email:
rfarmer@econ.ucla.edu); or Romesh Vaitilingam on 07768-661095 (email:
romesh@compuserve.com).