Growth Without Inequality

Reinventing Capitalism

Henry K. H. Woo

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351812009
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

Many years on after the 2007–8 financial crisis, most developed nations still find themselves in a state of weak recovery, high debt pile-up and distributive disparity. The intriguing question that we face is whether the golden days of modern capitalism are over, or if capitalism is just undergoing another period of adjustment characteristic of its past. What is disheartening is that the twin economic goals of sustainable growth and equality, which the world has now come to recognise as of paramount importance but mutually conflicting, remain, more now than ever, illusive and unattainable.

Growth Without Inequality attempts to address this issue and to provide a pragmatic solution especially for nations in the current policy gridlock. By offering a unified framework of factors that drive growth, it shows how growth also gives rise to an array of "anomalous market forms" (defined by different degrees of value and risk visibility) that subvert distributive equity between labour and capital. It debunks both the pure free market solution and the mixed economy approach on the ground that they fail to arrest the growth propelling yet subversive power inherent in the "corporate forms" under the present capitalistic regime.

Having shown that effective reform can hardly take place within the system itself, this book proposes to build a separate sector (Economy II) and partition it from the existing system (Economy I). The solution is easy to implement and quick to take effect. By one single stroke, this "Non-Marxist" solution can happily achieve the ideals of both "competitive capitalism" and "egalitarian socialism".

Part I

Diagnosis

1 Growth and Its Drivers

1.1 A Critique of the Standard Growth Theory

The Deficiency of the Neo-Classical Growth Theory

I take the standard growth theory to consist broadly of the neo-classical growth theory and its descendants, including those competing growth theories that attempt to make up for the former’s weakness. The neo-classical growth theory itself takes as its point of departure the aggregate production function, a concept borrowed from the production function at the level of the firm.

Assuming away population growth as well as technological progress, the only remaining growth driver for the neo-classical growth theory is capital accumulation, which is taken to be a function of the level of savings. But by assuming diminishing marginal productivity, national income will not grow as fast as the capital stock. As a result, savings will not grow as fast as depreciation. Eventually, depreciation will catch up with savings. At this point, the capital stock will stop rising and growth in national income will come to an end. That is to say, any attempt to boost growth by encouraging people to save more will ultimately fail.

But here we face an empirical problem. Since we observe sustained long-run growth in output per person in advanced countries since the Industrial Revolution, there must have existed something that offsets the law of diminishing marginal productivity. By the logic of common sense, the neo-classical growth theorist infers that this something must be technological progress. In his scheme of things, technological progress is brought about by some unspecified process that generates scientific discovery and technological diffusion. And by implication, growth is driven and sustained by technological progress in the long run. Some stronger version even posits that the rate of growth is determined by the rate of technological progress (Harrod, 1939).

Since the aggregate production function itself does not provide a place for technological progress as a core factor of production, the ingenious (and face-saving) repair work that the neo-classical growth theorist does is to assign it the status of an exogenous factor (of production), an allegedly important input but one which is outside the regular production system.

The “Endogenisation Project”

But common sense also tells us that technological progress is not entirely a factor outside the production system, for there are good reasons to believe that technological progress also depends on economic decisions within the production system. To resolve the problem, the more enlightened growth theorist makes an attempt to bring technological progress into the system itself, under the high-sounding banner of “endogenisation”.

Arrow (1962), for example, argues that technological progress takes place in the process of producing capital goods because people learn by doing. That is, when people and firms accumulate capital, their learning process engenders knowledge externalities and thereby technological progress as an unintended consequence. This results in raising the marginal productivity of capital, thus offsetting the tendency for marginal productivity to diminish when technology remains unchanged. This set of hypothesis, also known as the AK theory, posits new and positive links between physical capital and human capital (e.g. Lucas, 1988).

The AK model, representing an earlier version of the “endogenisation” effort, is only half-baked, for it does not make an explicit distinction between capital accumulation and technological progress. According to the AK paradigm, knowledge accumulation leading to technological breakthrough is a serendipitous by-product of capital accumulation. Thrift, efficiency of resources allocation and capital accumulation still occupy centre stage in driving the long-run growth of an economy. The best way to sustain high growth rates is to save a large fraction of GDP, some of which will find its way into financing a higher rate of technological progress, thus resulting in faster growth.

Second-wave and more fully-fledged “endogenised” growth theories include innovation-based growth models (e.g. Romer’s product-variety model (1990)), according to which, innovation causes productivity growth by creating new varieties of products. Another branch, also known as Schumpeterian growth theory, developed by Aghion and Howitt (1992), focuses on quality-improving innovations that render old products obsolete. The latter enjoys the advantage of presenting an explicit analysis of the innovation process underlying long-run growth.

All in all, the “endogenisation project” consists of two key features. First, it emphasises the more qualitative dimensions of growth and second, it espouses the operating principle of increasing returns.

Interestingly, and as may well be expected, the debate between the original neo-classical growth theory and its descendent AK theories which focus more on capital accumulation, i.e. the quantitative aspects of growth, as well as the competing product varieties and Schumpeterian school, which emphasise innovation that raises productivity, focuses logically on how much growth is attributable to the accumulation of physical and human capital and how much to innovation and technological progress.

Interpreting the “Solow Residual”

To answer this question, growth economists devised an indigenous method to ascertain the relative contributions of different factors to economic growth under the term “growth accounting” (Solow, 1957). The surprising result from the many studies using this method is that a sizeable portion of national growth fails to be accounted for by the growth of the capital stock and the growth of the workforce. The residual which is commonly called the “Solow residual”, is what is left after netting out the effects of labour and capital (i.e. the portion of growth that cannot be explained by these quantifiable factors¹). A study shows that as much as two-thirds of the growth rate in the OECD countries goes unexplained (Aghion and Howitt, 2009).

The magnitude of the residual takes growth economists by surprise. There are generally three lines of responses. The most direct one is to assume that the residual, or the “magic factor”, is identical with technological progress, thus logically extending the widely received and common-sense view of taking technological progress as the driver of growth.

To the more cautious economists, interpreting the residual as “total factor productivity” (TFP) (which focuses on how an economy uses its factors of production productively or in short, as a “catch all” factor) seems more appropriate. For poorer nations, since they have a small capital stock per capita, a high savings rate would substantially increase investment and growth. But for rich and mature nations, which have already a large capital stock, how productively an economy uses it matters a lot. In this interpretation, “total factor productivity”, despite the vagueness and almost mythical connotation of the notion, is taken to be the principal contributor of economic growth. Curiously enough, although it remains methodologically a semi-finished and a half-way-house concept, it has been complacently assumed to be a fully fledged causal growth factor. The advantage of taking this semi-finished concept as a final explanatory variable is, of course, that there is no further need to make causal enquiry into other engines of growth.

There are sceptics who are not prepared to commit to any position. The “magic factor”, as Abramovitz (1993) famously puts it, is in effect a “measure of our ignorance”. But alas, the residual is too big to be ignored. And the ignorance is simply unforgivable.

Perhaps being too pre-occupied with identifying the residual with technological progress which itself is a causal factor, the above interpretations including that of total factor productivity fall under the category which I would call the “causal factor interpretation”. That is, instead of first enquiring into the very nature of the residual as revealed in the growth accounting studies, the economists concerned jump the gun to enquire into the causal factors that account for the residual. This is not a bad idea, because at one stage or another, we have to seek causal explanations. But before that, it is perhaps more appropriate to find out, from the accounting point of view, what that residual actually consists of in the first place. This approach I would call “the factor receipt” or “factor payment” approach.

The difficulty with the technological progress explanation or any other causal factor explanation is that these causal factors must have been significantly if not already fully reflected in the factor payments already received by both labour and capital. For it is simply inconceivable that labour and capital receive payments for their contribution independent of the knowledge or the technology they respectively embody. The market prices upon which the growth accounting statistics are compiled must have fully reflected the currently applied knowledge and technology respectively embodied in labour and capital. For otherwise, such labour and capital would fail to stay competitive in the market. Simply put, when aggregate output rises, is it either because we have employed more capital goods or because we have employed better ones? The truth is, of course, both. Hence the Solow residual can hardly reflect some disembodied technologies or some vague and mythical factors over and above the technologies currently in use. Disembodied technology is, in short, incompatible with growth accounting statistics. The same argument also applies to labour.

If the causal factor approach is not a viable line of enquiry, a sensible option is to return to the more fundamental question, i.e., what is the nature of the residual as a factor receipt. Bluntly put, who gets this residual receipt? On this, I will revert in a later chapter.

The Flaws of the Standard Growth Theory

That the standard growth theory, in particular the neo-classical growth theory, is flawed, is beyond dispute. The interesting question though, is how the flaw comes about. There are two dimensions to this analysis, namely, the methodological dimension and the metaphysical dimension.

The neoclassical growth theory takes as its point of departure the neo-classical aggregate production function, where output is assumed to be governed by labour and capital stock as well as the operating assumption of diminishing marginal productivity. This point of departure, borrowed straightforwardly from the product function at the level of the firm, is merely an expedient. The neo-classical growth theorist has apparently not given sufficiently careful consideration to whether or not the “wholesale” transplantation is legitimate or appropriate. For it is quite obvious that the aggregate production function at the level of the economy can hardly match, in almost every respect, the production function at the level of the firm. The latter is chiefly of an engineering nature, whereas the former is more of a managerial one, hence more plastic and sensitive to a wide array of external influences. Thus from the very beginning, the neo-classical growth theory focusing exclusively on labour and capital as its core variables is too narrowly based. Moreover, the amenability of these two core variables to easy measurement renders the theory susceptible to quantitative bias, ignoring unwittingly qualitative factors that may have a role to play in economic growth.

The consequence of the narrow focus reinforced by a quantitative bias is that the theory seriously omits other important causal factors driving growth. As can be expected, this omission results subsequently in a series of patchwork repairing. Some of such repair work resorts to a “reverse engineering” approach (witness the many guessworks offered to explain the source of the Solow residual²). Needless to say, piecemeal engineering and reverse engineering are not good enough tools to save a theory or carry it very far.

Methodological difficulties apart, the neo-classical growth theory also makes an embarrassing metaphysical assumption. Since Euler’s theorem tells us that it will take all of the output of an economy to pay capital and labour their marginal products in producing final output, nothing is left over to pay for the resources used in improving technology. Subscribing to the law of diminishing marginal productivity, the theory tacitly commits itself to the equilibrium paradigm. In so doing, it is compelled to treat technology as an exogenous factor. Alternatively put, a theory of endogenous technology cannot be comfortably based on the usual theory of competitive equilibrium. This puts the neo-classical theorist in a theoretical dilemma.

Even if we discount the technology factor, history tells us that the growth paths of many nations are beset with unpredictable outcomes brought about by contingent factors or events. There must exist certain pre-conditions that facilitate the kicking off of an economy onto a particular growth trajectory and making it “growable”, as well as other contingent factors that alter its course of development. While we can concede that there are universal driving forces, which of necessity include factors such as technology (which is characterised by increasing returns), growth often remains a path-dependent and contingent phenomenon. Even if we succeed technically in incorporating technology into a broader equilibrium framework, growth as a complex phenomenon still requires more explanatory variables over and above technological progress. The diversity of growth experiences of different nations suggests that multiple factors are at work, some of which stretch beyond the economic domain, shaping a developmental pathway in a manner sometimes not easily repeatable. This is not to say that there are no universal laws that govern growth, but it is obvious that capital accumulation and technological progress are just among some of them.

1.2 Growth Driver I: Institution

Back to Growth Fundamentals

In spite of the numerous efforts to throw light on the phenomenon of growth, most of the findings are of limited scope or narrow interests. Some of them deal with issues of an empirical nature and are inescapably of local or piecemeal interests. Others theorise chiefly on the interactions among secondary level variables without challenging the fundamental inadequacies of the neo-classical core variables. As has already been pointed out, a lot of subsequent theorising revolves around the theme of “endogenisation” aiming to make up for the deficiency of the neo-classical model. Predictably, there is a limit to the usefulness of these efforts, for as long as these theories spring from or still stick to the original and narrowly based neo-classical arch-framework as a reference standard, major breakthroughs are not easy to come about.

Diametrically opposed to the orthodox theory is the heterodox institutional school. Institutional economics, instead of assuming stable preferences, rationality and equilibrium, challenges these concepts and replaces them by new assumptions of learning, bounded rationality, disequilibrium and evolution. The traditional institutional school emphasises the legal foundations of an economy (e.g. Commons, 1934) or the evolutionary, habituated and volitional processes by which institutions are erected and changed (e.g. Veblen, 1898). In spite of their valuable insights, they emphasise often on socio-economic rather than purely economic variables. Furthermore, they do not offer a systematic theory of growth, although one may cite examples, such as Marx, seen from the light of the institutionalist tradition, describing capitalism as an evolving and historically bounded social system, or Galbraith who examines the impacts of an evolving affluent society and big business (1958, 1963). Similar to the standard growth theories, this batch of “institutionalists” do not address directly the fundamental issue of the “grow ability” of nations.

Clearly, if we were to meaningfully connect the fragmented or local insights developed by the numerous researches in growth and development economics, or to provide more comprehensive or universal yardsticks by which future studies of these kinds are to be appraised, it would perhaps be more fruitful to re-start from a zero-base to build a new, general and unifying framework. The first step to take is to go back to the fundamental facts about growth.

Growth Fundamentals and their Operating Derivatives

As a point of departure I outline three fundamental statements about the conditions of sustainable growth.

Proposition One: Growth is a mass phenomenon characterised by mass participation at all levels of society.

Proposition Two: Growth is an inter-temporal phenomenon. Economic actors of different descriptions are supposed to possess the capability and the will to abstain from present consumption to invest for a return in the future.

Proposition Three: The future is and seen to be “investable” by economic actors. The operating environment must, to different extents, seen to be and turn out to be investment-friendly. Only when an economy whose future is seen to be “investable” is it in a position to become “growable”.

From these three propositions, we can identify three operative concepts governing growth. From Proposition One, we have the concept of scale. From Proposition Two and Proposition Three, we can derive the concept of institution. From Proposition Two, we can derive the concept of productivity. Together, I will show that the joint effects of these three growth drivers go a long way to explaining many growth phenomena (which also cover development phenomena) and predicting the growth pathways of nations.³

Institution: An Introduction

The importance of the institutional architecture of an economy to its growth is widely studied and generally accepted, although the orthodox growth economist still prefers to treat it, similar to technology, as an exogenous variable. As a matter of fact, one fatal flaw of the neo-classical theory and its competing descendants is that they are deliberately ignoring the role that institutions play in fostering growth. One consequence of this approach is that growth and development are taken as quite independent areas of study, with development largely confined to the emerging nations.

Institutions, according to Douglass North, are the “rules of the game” consisting of both formal legal rules and the informal social norms that govern individual behaviours and structure social interactions (North, 1990). This is clear enough. But in the context of economic growth, I would suggest taking a step back and offer a more functional elaboration. As a point of departure, I would first relate the notion of institution to the growth fundamentals mentioned earlier. In this connection, I attempt to outline several important propositions.

Proposition One: The institutional architecture of an economy can promote but can also obstruct growth.

Proposition Two: The influence of institution on human behaviour in general and economic behaviour in particular, is highly pervasive, infiltrating and dominating. Conversely put, much of human and economic behaviour is governed by the characteristics of an institutional regime and is sensitive to any institutional change.

Proposition Three: The reason why the influence of institution on human behaviour is so pervasive is that the institutional architecture of a society or economy is not only hierarchically but also seamlessly organised at different levels of social and economic operations. This ranges from rules (constitutional, legal, regulatory) to organisations (the state, the government, the firm, industry and trade associations, unions), to other operating mechanisms (for example, the market, the franchise system) as well as to tacit factors (conventions, norms, codes of conducts, mutual trust).

Proposition Four: The reason why economic actors are sensitive to institutional arrangements and changes is that they are value seeking and property rights seeking indi...