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  • Writer's pictureSergio Focardi

Economic growth: once again the mainstream economic theory is anchored in the past

In some previous posts I have shown how the concept of inflation seems to be a simple and well-founded concept when, in reality, it is a vague, partly arbitrary notion. Yet, decisions of great economic importance depend on the measure of inflation. In this post I would like to discuss the concept of economic growth. This concept also seems intuitive and well-founded while in reality it is fundamentally ambiguous and partly arbitrary.

Growth is a fundamental concept for man. It is a concept applied in many different contexts. Biological systems are subject to growth processes. The amount of data accumulated from various sources grows and knowledge grows. It is natural to think that economies can and should grow. Those born in the first post-war period in the United States or in European countries had an immediate and direct perception of growth. They witnessed an increase in the number of houses built, the number of cars in circulation, the number of washing machines, dishwashers, televisions.

Growth seemed unstoppable and obvious. Every innovation, such as the washing machine, the dishwasher, the color television, immediately brought a proliferation of objects. These phenomena of numerical growth of objects were intensified by the growth of the population that in advanced countries has practically doubled since the end of the Second World War to the present.

Many have begun to wonder if an exponential growth of goods and services is compatible with the finite resource world in which we live. And some researchers have given negative answers. In 1971 the report The Limits to Growth drawn up at MIT for the Club of Rome under the leadership of Donella Meadows warned against the depletion of natural resources while Nicholas Georgescu-Roegen observed, on the basis of the entropy law, that the processes of product creation are irreversible processes and therefore exponential economic development is irreversible.

Today the 'official' conceptual framework has changed. While it is recognized that global warming is due to human activity and governments seek to reduce greenhouse gas emissions, the depletion of natural resources is fundamentally denied by the concept of green growth espoused by industry and governments. Green growth means that technology will solve all environmental problems without the need to act on consumption. But many accademics are skeptical. If we want to avoid degrowth, we need to rethink the concepts of economic growth.

So let's get to the basic problem. What is economic growth? How can we measure it?

Here we immediately come up against a problem: products and services are extremely heterogeneous and constantly changing. New products and services are introduced continuously. Innovation is disruptive. We cannot put bananas, cruises, laptops and thousands of other products together with a single quantitative measure and create a measure of economic output. It is another instance of the problem we have described in relation to inflation.

One might think of building growth indices, replacing output with their individual growth rate. Growth rates are pure numbers and can be aggregated by constructing weighted averages. But how do we establish weights if we can't compare heterogeneous quantities? And how we take innovation into account. No, indices cannot represent economic growth. No number can represent the aggregation of heterogeneous quantities and their change. There is no observable that directly corresponds to economic growth.

The theoretical representation of growth

How did seventy years of mathematical models of economics solve the problem of representing economic output? Essentially there are two answers.

1) Parsimonious models representing an economy with a small number of variables have adopted fundamental idealizations. In particular, they hypothesized that an economy produces only one commodity or, equivalently, an aggregate commodity.

2) Multi-agent models, and before them input-output models, represent the economy with a large number of agents, and therefore the economic output is represented by a large number of heterogeneous variables.

Multi-agent models are very useful simulation tools but they are not theories in the classical sense. They can simulate an economy under different assumptions and possibly calculate the distribution of various parameters by performing a large number of simulations. In this post we are interested in parsimonious models that are used, for example, to make economic forecasts.

Macroeconomic models are not approximations of economic reality but are idealizations. They describe the behavior of an idealized economy that produces only one commodity. There is a profound difference between an approximation and an idealization. An approximate model approximately describes an observable. An idealization is an abstract relationship that connects other observables.

This brings us to the second point. Macroeconomic models are abstract relationships between idealized quantities. But how do you measure the amount of output in practice? How can you say that an economy is growing in practice? The quantity that is used in practice is the Gross Domestic Product GDP is the sum of all final consumption transactions in a given period. GDP does not consider intermediate expenditures such as purchases of machinery or design services.

GDP was introduced conceptually by Kuznets in 1934 and was adopted soon after World War II by virtually all nations as a measure of the size of an economy. GDP measures the value of economic output over a given period. GDP, calculated at current prices is called nominal GDP. Since prices are relative prices, nominal GDP is defined at less than a multiplicative constant. In other words, if we multiply all prices and wages by the same factor nothing happens.

This mathematical fact requires fixing the factor necessary to compare GDP at different times. Moving from one moment to another, we can't expect all prices to change by the same factor. We have to find a factor that expresses the average price of products and services. This is the problem of calculating inflation. As we have seen, the problem of inflation does not have a strict solution due to changes in the quality of products and services and because of innovation that creates new products and services.

Over long periods, inflation as it is currently calculated, does not represent the evolution of prices because it does not take into account qualitative changes and innovation. Yet real GDP is calculated by discounting nominal GDP by the factor of price change.

This process leads to underestimating economic growth because it does not take qualitative growth into account. If we compare real GDP and nominal GDP of industrialized nations we see that real growth is small relative to nominal growth and inflation largely exceeds real growth. For example, in the USA, in the period 1950-2020, nominal per-capita GDP grew 36-fold. This growth translates into 9 times inflation and only 4 times real growth.

This decomposition is not credible. It means that we do not consider qualitative growth and innovation as real growth. Excluding qualitative growth, economic growth is underestimated.

This problem will become very serious if and when we try to arrive at a real decoupling of economic growth from the exploitation of natural resources. Then it will absolutely be necessary to factor qualitative growth as true growth.

How can a macroeconomic model of qualitative growth be built? We have indicated the broad theoretical lines in the article The theory of qualitative green growth, signed by Focardi, Fabozzi, Ponta, Rivoire, Mazza, published in Structural changes and economic dynamics, 2022. To represent qualitative growth, we need to abandon the notion that a macroeconomic model is descriptive of the real economy. We can only look at financial quantities and structural quantities such as the level of employment.

We must adopt an abstract point of view in which the economic system is described by observable financial quantities such as nominal GDP and by two abstract quantities that we call Quality and Quantity. These are abstract amounts that can be combined with financial amounts in a Stock Flow Consistent model of the kind introduced by Godley and Lavoie. In the cited article we also indicate a possible estimation procedure based on the economic complexity indices of Hidalgo and Haussmann.

To conclude, economic growth represented by real GDP growth calculated by current methods is misleading and can lead to bad economic decisions. In fact, current methods do not take into account that modern economies are complex evolutionary systems. The speed and depth of the evolution of products and services and of the economic structure is neglected by current methods. Yet this rapid change in the economy is a key feature: neglecting it will make it impossible to properly address the green transition.

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