# Economic Growth

The Gross Domestic Product (GDP) of an economy is a measure of total production. More precisely, it is the monetary value of all goods and services produced within a country or region in a specific time period. While the definition of GDP is straightforward, accurately measuring it is a surprisingly difficult undertaking. And attempts to make comparisons over time and across borders are complicated by price, quality and currency differences. This article covers the basics of GDP data and highlights many of the pitfalls associated with intertemporal and spatial comparisons.

From the long-term perspective of social history, we know that economic prosperity and lasting economic growth is a very recent achievement for humanity. In this section we will look at this more recent time and will also study the inequality between different regions - both in respect to the unequal levels of prosperity today and the unequal economic starting points for leaving the poverty of the pre-growth past.

Economic prosperity is measured as via growth domestic product (GDP) per capita, the value of all goods and services produced by a country in one year divided by the country’s population. Economic growth is the measure of the change of GDP from one year to the next. This entry shows that the current experience of economic growth is an absolute exception in the very long-run perspective of social history.

## Empirical View

### From poverty to prosperity: The UK over the long run

The UK is particularly interesting as it was the first economy that achieved sustained economic growth and thereby previously unimaginable prosperity for the majority of the population.

#### Output per capita of the UK economy

The chart below shows the reconstructed GDP per capita in England and the UK over the last 7 centuries.

Economic history is a very simple story. It is a story that has only two parts:

The first part is the very long time in which the average person was very poor and human societies achieved no economic growth to change this.

Incomes remained almost unchanged over a period of several centuries when compared to the increase in incomes over the last 2 centuries. Life too changed remarkably little. What people used as shelter, food, clothing, energy supply, their light source stayed very similar for a very long time. Almost all that ordinary people used and consumed in the 17th century would have been very familiar to people living a thousand or even a couple of thousand years earlier. Average incomes (as measured by GDP per capita) in England between the year 1270 and 1650 were £1,051 when measured in today's prices.

The second part is much shorter, it encompasses only the last few generations and is radically different from the first part, it is a time in which the income of the average person grew immensely – from an average of £1051 incomes per person per year increased to over £30,000 a 29-fold increase in prosperity. This means an average person in the UK today has a higher income in two weeks than an average person in the past had in an entire year. Since the total sum of incomes is the total sum of production this also means that the production of the average person in two weeks today is equivalent to the production of the average person in an entire year in the past. There is just one truly important event in the economic history of the world, the onset of economic growth. This is the one transformation that changed everything.

As this chart of total GDP in the England over seven centuries shows, the increase of the total output of the UK economy grew by even larger extent, because not only average incomes increased since the onset of the Industrial Revolution, but the number of people in the country increased as well.

### The economy before economic growth: The Malthusian trap

#### The pre-growth economy was a zero-sum-game: Living standards were determined by the size of the population

In the previous chart we saw that it was only after 1650 that living standards in the UK did start to increase for a sustained period. Before the modern era of economic growth the economy worked very differently. Not technological progress, but the size of the population determined the standards of living.

If you go back to the chart of GDP per capita in the England you see that early in the 14th century there was a substantial spike in the level of incomes. Incomes increased by around a third in a period of just a few years. This is the effect that the plague – the Black Death – had on the incomes of the English. The plague killed almost half(!) of the English population. The population declined from 8 million to 4.3 million in the three years after 1348. We even see it in the chart for the world population.

But those that survived the epidemic were materially much better off afterwards. The economy was a brutal zero-sum game and the death of your neighbour was to the benefit for those that did survive.

This happened primarily because farmers now achieved an higher output. While farmers before the plague had to use agricultural land that was less suited for farming, after the population decline they could farm on the most productive areas of the island.

In the very long time in which humanity was trapped in the Malthusian economy it was births and deaths that determined incomes. More births, lower incomes. More deaths, higher incomes.

We see this coupling of income and population in the chart below that plots the size of the population (on the x-axis) against the total output of the English economy (top panel) and against the income per person (bottom panel). Looking at the bottom panel we see the spike of incomes that was associated with the killing of half of the population in the Black Death. After this the population and the income per person stagnate until around 1500. In the following period we see the economy growing – total GDP increases by more than 280% from 1500 to 1650 – but this increase in output is not associated with an increase in income per person, but only an increase of the total population of the UK.

It is only after 1650 that the English economy breaks out of the Malthusian Trap and that incomes are not determined by the size of the population anymore. For the period after 1650 we see that both the population and the income per person are growing. The economy is not a zero-sum game anymore; economic growth made it a positive-sum game.

When Malthus raised the concerns about population growth in 17981 he was wrong about his time and the future, but he was indeed right in his diagnosis of the dynamics of his past. The world before Malthus was Malthusian and population increases were associated with declining nutrition, declining health, and declining incomes. The world after Malthus became increasingly less Malthusian. What Malthus did not foresee was that the increasing output of the economy will decouple from the change of the population so that the output available for all will increase over a long period. This decoupling of income and population is shown in the chart.

#### Technological change in the pre-growth economy

Technological innovation that increases productivity is the key to increased prosperity. But there were technological breakthroughs before the 17th century. Windmills, irrigation technology, and also non-technical novelties especially the new crops from the New World. Why did these not lead to sustained economic growth?

What happened as a consequence of these innovations were indeed increases in productivity, and the output increases led to increased prosperity. But only for a short time. Improvements in technology had a different effect in the Malthusian pre-growth economy. They raised living standards only temporarily and instead raised the size of the population permanently. The economic historian Gregory Clark sums it up crisply: “In the preindustrial world, sporadic technological advance produced people, not wealth."2

Technological improvements lead to larger, but not richer populations. If this analysis of the pre-growth economy is true than we would expect to see a positive correlation between productivity and the density of the population.

Ashraf and Galor (2011)3 studied the Malthusian economy theoretically and empirically in a paper published in the American Economic Review. The chart below is taken from their publication and confirms the theoretical prediction for the pre-growth economies in the year 1500.

All the data is reported in the current borders of the world. On the x-axis of both charts you find the same metric: The productivity of the agricultural land as measured by the quality of the soil and the climate.

On the chart on the left we see that those world regions with a low productivity of agriculture had very low population density. The regions with the highest population density on the other hand are all regions with very productive land.

And on the chart on the left we see that the higher productivity of the land did not matter for people’s living standards. The agricultural sector in Spain, India, or Morocco was much more productive than in Finland, Egypt, and Norway, but the people were not better off. The more productive regions were the more populous regions and the people there had to share with so many so that everyone remained at dismal levels of prosperity.

In the long history before modern economic growth, higher productivity lead to larger, but not richer populations.

#### Incomes were not flat - History saw several episodes of growth which were not sustained

Throughout history there were several episodes in which certain economies achieved economic growth, but in contrast to the sustained growth since the Industrial Revolution these episodes were all short-lived. What is new about modern times is that the growth of incomes lasted for a very long time – until today – and that this growth did not only increase the incomes in one economy, but instead spread to other economies as well.

The origin of this transformation is North-Western Europe. It was in England (and Holland) in the early 17th century where it became first possible to grow incomes over a sustained period of time.

#### Economic growth in all countries of the world over the last half century

The following chart plots, for each country, the national income in 1960 against the corresponding national income in 2014. GDP per capita is used to measure national incomes, and figures are expressed in 'real terms', which means they are adjusted for inflation.

In this chart, if incomes are stagnant, we should observe countries lining closely along the blue 45° line. Countries in which the income in 2014 is higher than the income in 1960, on the other hand, are above this 45° line. These are all the countries that experienced income growth over these 54 years.

As we can see, some countries such as Madagascar, Chad, Senegal, and Nicaragua stagnated in terms of incomes – they are right on the 45° degree line. And a couple of countries such as Niger and the Democratic Republic of Congo have even experienced negative growth over the reference period. But the large majority of countries, all those above the blue line, have experienced growth.

Those countries that are far above the blue line had the strongest growth. Botswana (38-fold increase), South Korea (30-fold), Romania (15-fold), China (11-fold), and Thailand (18-fold) are some of the countries with the strongest growth over these 54 years.

### Total output of economies

The discussion above focussed mostly on output per capita, the map below shows the total output by country.

## Correlates, Determinants, and Consequences

### Productivity is the driver of economic growth

There are two ways to increase output over time: Increase inputs or to increase productivity, the ratio of output to input. How it is possible to raise productivity can be most clearly seen when one considers a single industry only. Think about the production of books: Before the printing press was invented the only way to copy a book was for a scribe to copy it. Gregory Clark11 estimates that the scribes who were doing this work back then were able to copy 3,000 words of plain text per day. This implies that the production of one copy of the Bible meant 136 days (4.5 months) of work.

This changed fundamentally when Johannes Gutenberg adopted the technology of the screw-type wine presses of the Rhine Valley where he was from to develop a printing press. The hours of work a printer had to put in was now measured hours rather than months. Estimates are that a worker was able to produce around 2.5 books in a day. Over time printing presses were improved and during the Industrial Revolution they were mechanized and productivity of workers increased further. The Internet stands in this long tradition and as texts can now be seen by millions in an instant the productivity in the business of making texts available is off the charts.

### Rising productivity by sector

#### Rising output by industry

The visualization below shows the rising output of the economy by industry. Each time-series is indexed to the year 1700 so that the focus here is on the change over time as all changes are relative to that year.

The rising output of key industrial and service sectors is shown here.

### Growth at the technological frontier and catch-up growth

#### Growth at the technological frontier

The following chart shows economic growth in the USA adjusted for inflation.

GDP per capita in the USA at the eve of independence was still below $2,000, adjusted for inflation and measured in prices of 2011 it is estimated to$1,883.

### Religiosity and prosperity

A survey asked the question "How important is religion in your life?” and the possible answers were "very important", "somewhat important", "not too important" and "not at all important”. The following chart plots the share that answered "very important” against the average prosperity of the population for each country in the survey.

There is a clear correlation between poverty and religiosity. In poor countries the huge majority say that religion is very important in their life: in countries like Uganda, Pakistan, and Indonesia it is the answer of more than 90%. In Ethiopia it is the answer of 98% of the population.

In richer countries the share of the population for whom religion is very important is much lower. In the UK, South Korea, Germany, or Japan it is less than 1 in 5 for whom religion is very important.

The big outlier in this correlation is the USA, a very rich country in which more than 50% answer that religion is very important in their life.

### Retirement becomes possible when people get richer

The visualisation shows the very substantial decline in the labor force participation of men of 65 years and older in the USA since the end of the 19th century.

To allow saving and facilitate transactions access to financial services is important. We know that in poorer countries this access is often very limited.

We don't know much about how this access has changed over time and to understand this change better we have attempted to combine different sources – the result of which is shown in the world map below.

The World Bank Global Financial Inclusion data is available for 2011 and 2014. The data is very scarce on this pre-2011, but World Bank estimates provide an additional single point for countries. This has been represented as a point for 2005, however it’s important to note that this varies between 2000-2005 across countries.

The challenge is that it is not exactly the same measure as the 2011 and 2014 data, but instead a composite measure of access to a bank account and financial services. The World Bank define this composite indicator as measuring "the percentage of the adult population with access to an account with a financial intermediary. The indicator is constructed as follows: for any country with data on access from a household survey, the surveyed percentage is given. For other countries, the percentage is constructed as a function of the estimated number and average size of bank accounts as discussed in Honohan (2007). These numbers are subject to estimation error."

The use of composite measures is, of course, not ideal. However, we think it should still give a fairly reasonable basis of the early 2000s to use as an earlier estimate and the direction of progress trends.

We have combined this composite measure with 2011 and 2014 data in the following chart.

## Data Quality & Definitions

The most common measure for economic prosperity is the Gross Domestic Product or GDP for short. It measures the monetary value – the price – of all goods and services produced in a country. To allow for comparisons between countries and over time, the total economic output of a country is put in relation to the number of citizens in that country. This is GDP per capita.

The change from one year to the next is referred to as economic growth.

As everyone who had a beer or a haircut ten years ago will remember the price of goods and services usually increases over time, this is called inflation and is most commonly measured with the consumer price index (CPI). Comparisons of prosperity over time are therefore only meaningful when these price changes are taken into account so that the growth rate does not capture mere changes in prices. Measures of incomes are only meaningful when they are put in relation to measures of prices that these income receivers face. When incomes are adjusted for prices economists speak of the real value of a good or service. (But since comparisons only make sense when one adjusts for price changes, it is usually the case that adjustments for inflation have been made even when it is not explicitly said.)

#### The production boundary

GDP is published in a country's National Accounts. These statistics comply to protocols laid down in the 1993 version of the Systems of National Accounts, SNA93.

The SNA93 established the 'production boundary', a crucial definition of what is and is not included in GDP figures:

• included are all goods and services that are exchanged,
• included are all goods that are not exchanged (for example food produced for home consumption)
• but excluded are services that are not exchanged. Among these excluded services are food preparation, education of children at home, and minor home repairs.
• An important exception to the services that are included is the housing services consumed by owner-occupiers. This service is imputed (imputed rent) and included in the GDP figure.

### GDP per capita and average incomes

In principle there are three equivalent ways to calculate GDP:

1. Production: the value of final outputs produced in an economy less the value of all the inputs used in their production
2. Expenditure: the expenditure on final goods and services produced in an economy by households, corporations and governments
3. Income: the income earned by individuals and businesses from the production of goods and services in the economy

It theory these three measures should be equal; they constitute an accounting identity. A company's revenue is the income it generates from selling the goods and services it produces to consumers; yet that same revenue is also the expenditure of consumers on those goods and services. Paul Krugman makes the point that "our income mostly comes from selling things to each other. Your spending is my income, and my spending is your income."12 This symmetry allows us to use GDP to approximate average incomes by dividing GDP by the total population. In reality, average incomes and GDP per capita will not be equal.13

### How are incomes adjusted for inflation?

To make meaningful comparisons of prosperity over time it is necessary to adjust for inflation. But how is this actually done?

But to measure prices by relying on one product only has the obvious problem that you could end up picking a product that was not representative of the price changes of all the other products and services that consumers want to buy. While the price of bread may have increased, the prices of the majority of other goods could have decreased.

The idea for inflation adjustment for incomes is therefore to instead rely on a commodity bundle of goods and services that are representative of the consumption of the average household. By relying on a representative commodity bundle instead of bread alone allows you to adjust incomes not only for bread, but for the cost-of-living more broadly.

What does such a commodity bundle look like?

#### Composition of the commodity bundle of goods and services to measure the consumer price index

The following chart displays the composition of the commodity bundle of goods and services used in Germany. The basket used is chosen to reflect the expenditure of the typical household, so that changes of this bundle measure the changes to prices the typical consumer faces. What we are interested in is the price change of this bundle of good over time and the history of prices is then expressed in an index called the Consumer Price Index, which is indexed to 100 for a chosen base year.

As consumption differs in different countries, these household consumption baskets vary from country-to-country and over time as new technologies emerge which make new goods and services available and because consumption preferences change.15

###### Composition of the German CPI basket of goods

Only incomes in relation to prices gives us an idea about how the prosperity of a population changes. Incomes on their own or prices on their own cannot give us an idea about changing prosperity. The prices that we see on the price tags in the shop are the nominal prices and since we almost always have some inflation these prices tend to go up.

Nominal prices and incomes are expressed in terms of money, in this case British Pound, and in income statistics nominal incomes are reported as incomes in 'current prices'.

The inflation adjustment of income is done by expressing income relative to the price of a commodity bundle such as the one described before. The nominal income relative to the nominal price level as measured by the CPI is the real income. Real incomes measure the change to income, adjusted for the fact that nominal prices have increased (or decreased) and in income statistics real incomes are therefore reported as incomes in 'constant prices'.

#### An example: Adjusting wages for inflation in the UK

The chart below shows two series in current prices, nominal weekly wages and nominal prices in the UK, and a third series, which is constructed from the information in the nominal series: 'inflation adjusted wages' or 'real wages'.

Let's look at nominal prices first. The index that measures the typical consumption bundle of goods and services in the UK has a value of 100 in 2015 and a value of 0.66 in 1750. The ratio between these two observations is 100/0.66 = 152, which tells us that the nominal prices that consumers face have increase 152-fold in these 265 years.

But over the same period the nominal weekly wages paid in the UK economy increased as well. From £0.29 to £492 per week. This is a 1695-fold increase.

To calculate the real increase in wages we need to look at the nominal wage increase in relation to the nominal price increase.16 1695 divided by 152 is 11.2. This tells us that average real wages are 11.2-times higher today than for the average wage earner back in 1750. If their great-great-grandfathers in 1750 had to work for a year to buy a representative consumption bundle, Brits today have to work for only a bit more than a month to buy the comparable bundle of goods and services.

#### New products and services becoming available

It is not just prices that change over time. The very products and services that we produce and buy change. Technological progress has meant that the goods and services available today are invariably superior to those available several hundred years ago, with almost no example to the contrary. The introduction of new goods and services creates serious problems for intertemporal comparisons of wealth that are most relevant today; it is less of a problem for the long pre-modern world when almost all economic production consisted of food, shelter and clothing.

To emphasize this point consider the following example: In 1836 the richest man in the world was probably Nathan Rothschild. Rothschild could afford whatever he wanted - every good and service available in the world of 1836. Yet in that same year, the 56 year old died of an infection that is curable today by antibiotics, which are available around the world for even the poorest people today.17

#### Quality changes

The Stiglitz, Sen, Fitoussi report explains "Quality change can be very rapid in areas like information and communication technologies. There are also products whose quality is complex, multi-dimensional and hard to measure, such as medical services, educational services, research activities and financial services. Difficulties also arise in 1. Evidence and references in support of the claims presented in this Summary are presented in a companion technical report. 22 SHORT NARRATIVE ON THE CONTENT OF THE REPORT collecting data in an era when an increasing fraction of sales take place over the internet and at sales as well as discount stores. As a consequence, capturing quality change correctly is a tremendous challenge for statisticians, yet this is vital to measuring real income and real consumption, some of the key determinants of people’s well-being. Under-estimating quality improvements is equivalent to over-estimating the rate of inflation, and therefore to underestimating real income. For instance, in the mid-1990s, a report reviewing the measurement of inflation in the United States (Boskin Commission Report) estimated that insufficient accounting for quality improvements in goods and services had led to an annual overestimation of inflation by 0.6%. This led to a series of changes to the US consumer price index."18

#### Adjusting for incomes is to isolate volume changes from price effects

Instead of looking at price adjustment for incomes, we can also look at price adjustments for output.

Nominal GDP is a measure of the value of output produced in a country or region over a specified period (usually one year). The value of output is composed of two factors: the volume produced and the price,

where represents the price of output and represents the volume of output. Therefore increases to GDP are either the result of more output, higher prices or a combination of the two. When looking at the performance of a single economy over time it is important that we control for price effects since they can mask changes to the value of output. In these cases we adjust for the price changes and look at real GDP. The real GDP is constructed by 'deflating' the nominal GDP by a price index that tracks changes to prices in the economy relative to a chosen base year. This transformation attempts to isolate volume changes by eliminating price effects.

The two most common price indices used to deflate incomes and nominal GDP are:

1. Consumer Price Index (CPI): The basket is used measure the price changes of the goods and services consumed by the typical household. The typical household consumption basket will vary from country-to-country due to different preferences and income levels as well as over time as new technologies emerge and preferences change. CPI indices are produced by national statistical agencies, with one major exception being the European Union’s Harmonised CPI (HCPI). The HCPI uses consistent definitions for all Eurozone members to aid comparability.The CPI used to adjust household incomes tracks changes to the price of a basket of goods that the typical household purchases. It is measuring the price changes of consumption.
2. GDP deflator: The GDP deflator also called National Accounts deflator measures the purchasing power relative to the prices of all domestically produced final goods and services in an economy. It is measuring the price changes of domestic production.

#### Differences between CPI and GDP deflator

The CPI index measures price changes of consumption whereas the GDP deflator measures price changes of domestic production.

Consequently there are several important differences of the two price indices:19

• Unlike the CPI, the GDP deflator does not adjust for changes of goods that are imported from other countries and the price changes of import prices are not directly taken into account.
• Secondly, the GDP deflator covers capital goods, goods that are not bought by consumers.
• The CPI is also available monthly for most countries, while the GDP deflator is mostly available only quarterly.

### International GDP Comparisons: market vs. PPP exchange rates

In order to highlight the difficultly of making international comparisons between countries, consider the average income of somebody living in India compared with the US.

In 2011 the average Indian earned 72,000 rupees, while the average American earned $50,000. Since the average incomes are stated in different currencies, comparing the numerical value is meaningless and does not help us determine who is richer and by how much. Converting the rupee amount into US dollars using market exchange rates gives us an average income of$1,500 in India. This number is over 33 times smaller than the income of the average American!

##### Total Economy Database (TED)
• Data: GDP, population, employment, hours, labor quality, capital services, labor productivity, and total factor productivity
• Geographical coverage: Global – by country
• Time span: Since 1950
• Available at: It is online here.

#### Subnational data

Nicola Gennaioli, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer present subnational data of income in their publication28 The data covers 1,569 subnational regions from 110 countries covering 74% of the world’s surface and 97% of its GDP.

#### Spatial Data

Geographically based Economic data (G-Econ) by William Nordhaus and Xi Chen. The dataset covers "gross cell product" for all regions for 1990, 1995, 2000, and 2005 and includes 27,500 terrestrial observations. The basic metric is the regional equivalent of gross domestic product. Gross cell product (GCP) is measured at a 1-degree longitude by 1-degree latitude resolution at a global scale.