The Secret to Growth? Not Shrinking

"When countries start to grow fast, 80% of the increase in growth rate can be explained by (previous) shrinking rather than growing."

Not shrinking - whether for a well-managed company or well-managed nation - is both more profound and more complicated than it sounds. And it is also more important than other explanations. JL


Brendan Greeley reports in FT Alphaville:

Countries that began sprinting in the 19th century didn't grow faster. They just shrank less often. To grow, it's not enough to provide labour, capital and ideas. You have to be able to co-ordinate exchange, to trust that when you extend credit, your counterparty will be there, and the plant you just bought won't be arbitrarily seized by the government. Institutions prevent countries from shrinking, because they provide a baseline guarantee of economic co-ordination. They create trust, which makes growth less fragile.
Spend enough time talking about economics and you are guaranteed to encounter the argument-ending chart in defence of capitalism. It shows global GDP per capita over the very long term.
The one below starts just before Danish conquest of England; sometimes it goes all the way back to Sargon of Akkad. There's little growth for a long time, and then suddenly in the 19th century: Richard Arkwright's water frame! James Watt's separate condenser! Ideas! Investment! Capital deepening! This is a story we tell ourselves about economic growth. It is true. But it is also insufficient.

Delong, 1998. Excerpted from a speech by Andrew Haldane, May 2018

In May Andy Haldane, Chief Economist of the Bank of England, showed this graph to a group of students at Oxford, then told them he had changed his own story on what creates economic growth. This is significant. He is among the world's more respected macroeconomists. Imagine Cookie Monster, appearing at Sesame Street to announce a new position on cookies. Mr Haldane has been convinced by an argument that seems obvious but is actually quite profound: it's not enough to just help the economy grow. You have to prevent it from shrinking.
We make sense of economic data the way we do everything else in our lives. We select, and then simplify. We tell stories. When we argue over economic growth, we're telling variations of a shared saga called the Solow-Swan model: growth comes from more workers, more machines or better ideas. If you've learned the saga, you immediately know how to make sense of Japan's decision to loosen rules on immigration to expand its workforce. Or the US decision to lower corporate tax rates to encourage capital spending. Solow-Swan is a flexible, powerful story — the Iliad of macroeconomics. But it doesn't explain why growth meandered for the first 5,000 years of human civilisation, then suddenly began to sprint.
Mr Haldane's new story of growth starts with two economic historians, Stephen Broadberry of Oxford and John Joseph Wallis from the University of Maryland. In a 2017 paper for the National Bureau of Economic Research, they collected growth data for several European countries back to the 14th century. They had noticed that poorer countries go through more frequent contractions. In other words, they shrink a lot. So Broadberry and Wallis decided to quantify not just periods of growth, but periods of shrinkage. They found the countries that began sprinting in the 19th century didn't grow faster. They just shrank less often.
See where the dark line pops up down there? That's England, not shrinking:

When economies start to grow fast, says Wallis, “80 per cent of the increase in growth rate can be explained by shrinking rather than growing.” It was his idea to look at shrinking, and he was surprised by how important it ended up being. That Solow-Swan story of how to grow isn't enough on its own. It needs a complement, the story of how not to shrink. Broadberry and Wallis point to what economists call “institutions” — customs and laws that create order and make regular transactions even possible. From Wallis (on the phone in Japan, where he's collecting more historical data):

Societies that are capable of getting rule of law, laws that are unbiased and enforced in an unbiased way, those tend to be the countries that are developed today, that are wealthy. The countries that are poor, the ones that have lots of shrinking and growing, tend not to be able to enforce rules that way. 

To grow, it's not enough to provide labour, capital and ideas. You have to be able to co-ordinate exchange, to trust that when you extend credit, your counterparty will be there, and the plant you just bought won't be arbitrarily seized by the government. In the post-colonial United States, for example, it was impossible to charter a bank in many states unless you were a patron of the right political party. Getting rid of that — moving towards equal treatment under the law — was as important to the American industrial revolution as the capitalisation of the mills in Lowell, Massachusetts.
Institutions prevent countries from shrinking, because they provide a baseline guarantee of economic co-ordination. They create trust, which makes growth less fragile. (Though Wallis avoids the word “trust,” which he finds too morally loaded.) Countries that fail to develop institutions fail to become rich countries:

They shrink much more often and much more frequently, probably because of things like political unrest. And the fact that when there’s a shock, the shock tends to be more disruptive to a weaker economy.

And this is the challenge now for developed countries. As the United States continues to figure out how to respond to the decades old shock of losing low-skilled manufacturing to China, for example, we've often wondered why the US wasn't better prepared — why it was so fragile. America has strong institutions: courts, charities, local governments. But in some towns, local and federal institutions weren't strong enough to prevent or even soften the misery of transition. America was brittle before the financial crisis. It should have been better at not shrinking.
And when the US political parties think about growth now, they both still rely on the Solow-Swan story. Help younger couples stay in the workforce with parental leave, say the Democrats. Index capital gains to inflation, to again encourage capital deepening, say the Republicans. Neither party sees institutions or equality under the law as part of the story of growth. And so strengthening institutions becomes the stuff we'll get to when we can, instead of the stuff we should be terrified to lose.