9. Paul Romer and Modern Endogenous Growth Theory

Barro and Sala-i-Martin (2004, p. xv) also note: “This combination of theory and empirical work is the most exciting aspect of ongoing research on economic growth”.

One of Kaldor’s (1961) stylized facts of growth is that capital-output ratios remain steady over long periods of time with no clear long-term rising or falling trend. Over long periods, output and capital tend to grow at the same rate.

“Popular enthusiasm about Asia’s boom deserves to have some cold water thrown on it. Rapid Asian growth is less of a model for the West than many writers claim, and future prospects for that growth are more limited than almost anyone now imagines” (Krugman 1994, p. 64). See also Alwyn Young (1995) who shows that factor accumulation, rather than total factor productivity, has played a larger part in the growth story of newly industrializing economies of East Asia such as Hong Kong, Taiwan, Singapore and South Korea during 1966–1990/1991. While growth rates of 6–7% per annum in these economies were unprecedented, productivity performance was not.

In the 1960s, because such questions were avoided, and each of the bothersome questions was assigned an exponential trend term, growth theory came to be viewed as a sterile exercise. Growth theory had little to offer in terms of policy advice, and in models of exogenous technological change or exogenous population growth government’s actions did not really matter. “Partly in reaction, development branched off as a separate endeavor, designed to offer the direct policy advice that growth theory could not” (Romer 1989, p. 51).

More recently, Barro and Sala-i-Martin (2004, p. 516), based on a sample of 112 countries, draw scatter plot between the log of per capita GDP in 1960 on the horizontal axis and the growth rate of per capita GDP during 1960–2000 on the vertical axis, and find that the correlation between the two is weakly positive at 0.19. “Thus there is no evidence from the broad cross-country sample of absolute convergence”.

See, for example, Gomulka (1971, 1990), Abramovitz (1986), Dowrick and Nguyen (1989), Dowrick and Gemmell (1991), and Amable (1993).

One of the first attempts to endogenise technical progress was made by Arrow (1962) in his ‘learning by doing’ model.

Thirlwall (2006, p. 157) points out that Kaldor’s technical progress function, as a critique to the neoclassical production function, precisely anticipates the “new” growth theory. The technical progress function relates the rate of growth of output per worker (on the vertical axis) to the rate of growth of capital per worker (on the horizontal axis). The position on the function depends on the exogenous rate of technical progress which is embodied in capital. Along the 45⁰ line, the capital-output ratio is constant. An equilibrium is reached at the intersection of the technical progress function and the 45⁰ line. In Thirlwall’s (ibid., p. 157) words: “Kaldor’s technical progress function is the true progenitor of endogenous growth theory”. Thrirlwall (1987, p. 175) further states: “Kaldor rejected the notion that it is possible to distinguish, at least empirically, between movements along a production function (the substitution of capital for labour) and movements in the whole function due to technical progress. There cannot be capital deepening without some technical progress embodied in new capital, and most new ideas need capital accumulation for their embodiment. Society’s ability to absorb new knowledge depends on capital accumulation”.

Solow (1970) in his book Growth Theory: An Exposition stated that while his model of growth satisfied five of the six facts, the last one, namely, wide dispersion of growth rates, was a problem for him.

Romer (1989) observes that Kaldor’s fact five that capital’s share in total income is constant has increasingly been disputed. He conceded that after accounting for the uncertainties involved, capital’s share may be falling.

Aghion and Howitt (1998) point out that an early variant of the AK model is the Harrod-Domar model, which assumes that labour grows automatically in proportion to capital. The other variant is Frankel (1962) which assumes that it is technological knowledge, rather than employment, which grows automatically with capital. It is based on the idea that technological knowledge is a kind of capital good. He derives the aggregate model from the micro production functions using a scale factor. As capital increases output increases in the same proportion even in the presence of full employment because knowledge automatically increases in proportion. However, Frankel’s contribution went unnoticed till the basic idea of the AK model was rediscovered by Romer (1986). Romer made use of Ramsey’s (1928) model of intertemporal utility maximization by an individual, and the assumption that individuals do not internalize externalities associated with the growth of knowledge. Romer’s contribution was popularized by Lucas (1988), and became a benchmark in the modern endogenous growth theory.

As Aghion and Howitt (1998, p. 1) in their book Endogenous Growth Theory explain: “The approach put forward in this book is based on Joseph Schumpeter’s notion of creative destruction, the competitive process by which entrepreneurs are constantly looking for new ideas that will render their rivals’ ideas obsolete. By focusing explicitly on innovation as a distinct economic activity with distinct economic causes and effects, this approach opens the door to a deeper understanding of how organizations, institutions, market structure, market imperfections, trade, government policy, and the legal framework in many domains affect (and is affected by) long-run growth through their effects on economic agent’s ability to engage in innovative (or more generally knowledge-producing) activities”.

Describing his Marshall-Young-Romer model of growth, Romer (1989, p. 108) stated: “The degree of specialization, or equivalently, the number of different firms that are available at any point in time or location, is limited by the presence of fixed costs. In this model, these different goods are assumed to be intermediate inputs into production, and the technology is such that having more available goods is useful. Surely a large part of what distinguishes Silicon Valley from the cross-roads in Nebraska is the set of specialized goods and services immediately available for sale at each point… Although Marshall and Young choose to describe specialization in terms of competitive equilibrium with externalities, it is now clear that a more rigorous way to capture the effects they had in mind is in a model with fixed costs. In an equilibrium with non-negative profits, price must exceed marginal cost to be able to recover these fixed costs, so the model must therefore contemplate some form of market power”.

Jones (2019) considers Romer’s 1990 paper as a watershed. “It stands as the most important paper in growth literature since Solow’s Nobel-recognized work” (p. 859). Further, the paper makes three key contributions. “1. It identifies the non-rivalry of ideas as crucial to economic growth; (2) it highlights the role of profit-maximizing entrepreneurs and imperfect competition; (3) it places the key AK linearity in the idea production function” (p. 864).

In Schumpeterian models, since innovation is associated with creative destruction, new firms are created and old destroyed in the process of growth. Recently this dynamic, as also noted by Jones (2019), has been explored incorporating the firm level data by Aghion et al. (2014, 2017), Akeigit and Kerr (2018) and Atkeson and Burstein (2019) among others.

As Warsh (2006) notes, Lucas greatly simplified the mathematics of Romer’s Ph.D. dissertation (p. 243) and replaced his knowledge variable (which has externalities) with human capital (p. 257) which has spillovers.

“What is new is that the ideas are being modeled in a more rigorous way for a different purpose. The purpose is not to supplant the neoclassical growth model as a conceptual framework for the analysis of growth, but rather to rehabilitate the neoclassical model to make it compatible with the observation that living standards in the world are not converging. Most new growth theorists are neoclassical economists in disguise e.g. Barro, Mankiw, Lucas and Romer (for a survey of early studies see Thirwall and Sanna1996)” (Thirlwall 2003, p. 45).

Aghion and Howitt (1998, pp. 407–16), however, claim that this finding does not challenge the augmented Schumpeterian model presented by them.