Working Notes: Robert E. Lucas Jr. (2003) - The Industrial Revolution

Robert E. Lucas Jr. (2003) - The Industrial Revolution Past and Future

Referenced on Alpha.Sources November 7th 2006.

See also the book from which the essay is taken:
Robert E. Lucas Jr. (2003) - Lectures on Economic Growth.

So in short, what are the important lessons to take away from this:

•  The transistion dynamics as explained by Lucas represent the real important points here and what I immediately want to get across the table is the following. Lucas talks about the transition from the agricultural society (Malthus) to industrial/modern society (Solow) and more specifically how we can reconcile this transition in terms of a theoretical response/explation of the change in population and growth dynamics which essentially changed during the course this period. This is in iteself very interesting but has these transition dynamics ended? By linking the transition from the agricultural society to the industrial/modern society itself with the demographic transition Lucas (more or less deliberately) opens up the flank for a simple yet crucial ... what happens if in fact the demographic transition is not over?    
  

• Another question which we need to ask at this is simply how the Solow growth model or indeed its derivatives treat the transition mechanism from demographics to economic growth. An intial important is whether we are we speaking of ageing or population decline? For laymen this might seem as the same thing but this is very far from the truth. As such it is safe to say I think that by holding population dynamics as an exogenous increasing factor any model based on Solow's framework is incapable of reacting to the dynamics of an ageing population which after all is a long term process. Regarding the question of population decline it is pretty obvious that if growth is constant due to a process of capital deepening and technological progress (productivity gains) the GDP per capita would increase as a function of a constant rate of GDP growth relative to fewer people. This might in itself be unlikely but in a theoretical sense this is an important point once we get into the idea of a 'balanced growth path' and international capital flows. Moreover, this is essentially a theoretical cheapshot since how we might potentially (!) get to such a situation (i.e. the process of ageing) is much more important since this at some point very well could entail decreasing GDP per capita not to mention a heavy domestic debt/finance burden operationalized as a function of dis-favorable depedancy ratio. This brings us to another important point about the process of ageing and indeed the demographic transition, namely the concept of path dependancy which essential means (from Wikipedia):

This dynamic vision of economic evolution is very different from the neo-classical economics tradition, which in its simplest form assumed that only a single outcome could possibly be reached, regardless of initial conditions or transitory events. With path dependence, both the starting point and 'accidental' events (noise) can have significant effects on the ultimate outcome.

One of the best way to conceptualize is incidentally the idea of a changing dependancy ratio as country ventures through the DT. Consequently, one of the first phases in the DT where mortality declines relative to a stable fertility rate is traditionally called the demographic dividend and signifies a period where the dependancy ratio in a country declines as the labour force grows relative the 'dependant' part of the population. India is a prime example here. However, as a country ages and thereby moves through the DT this changes and indeed at some point the dependancy ratio increases to such an extent that we might speak of another demographic dividend which is the mirror of the first; a penalty if you will. Now the point here is that the decisions and actions taken during the initial DD have implications for how you get to the second DD and ultimately how you are able to deal with the challenges associated with an ageing population. The idea of path dependancy suggests two potential considerations towards traditional growth theory: 1) It fundamentally questions the idea of a steady state, and 2) it suggests that demographics should be included as an endogenous variable to growth in the long run

• Lastly, I will like to mention the idea of international capital flows and how they might illunimate further the issues at hand here. Let us revert back to the idea of a balanced growth path operationalized as a growth path along the steady state where output and capital per worker is constant; that is to say that the relationship between capital deepening and capital widening is equal in the long run. However, this idea of a steady becomes very difficult to sustain in the long run if we factor in demographics and crucially the idea of how demographics affect the international capital flows by acting as an anchor to gauge whether a country is running an external surplus or deficit. As such, ageing societies such as Japan will be biased towards a growth path characterized by high capex (investment) and thus also highly dependant on exports which then translates into an external surplus. This also means that the saving/investment dynamics in such a society only will lead to growth depending on whether the excess supply in the domestic market (i.e. the current account surplus) can be offloaded.
  

PS ...

Please do not see the above as a thrashing of Solow as an economist. I am not out to disfavor anyone or anyone's thoughts. I am merely trying to point to the issue of how demographic trends can change the way we look at economic growth in the long run. 

Let us begin with an outline ...

In essence Lucas' piece consists of two parts.

Firstly, Lucas sets out to describe the different periods of global growth which he breaks up into three distinct periods. 1; what comes before the 1750/1800, 2; 1800-1950 (The Industrial Revolution), and finally 3; 1950 (Post war economic growth).

Secondly, Lucas engages in discussion of the theoretical responses of growth theory/growth accounting theory to the empirical and factual nature of global growth in a historical perspective. Lucas' focus is to juxtapose what he coins as the theoretical response to economic before the Industrial Revolution (Smith, Ricardo and Malthus) and after the Industrial Revolution (Solow). The key point for Lucas is that the transition from the classical economic growth theory to Solow's Neo-Classical model to a large extent is determined by demographic transistion (DT) itself. More specifically Lucas demonstrates how the difference between the Classical and Neo-Classical growth theories initially can be seen through the lense of the DT.

Detailed notes and discussion available under the fold ...      

As I noted above Lucas sets out with a descriptive account of global economic growth divided into three periods and although Lucas does not procede chronologically I will follow his lead in order to make these working notes as accessible as possible in relation to the main source. Consequently, Lucas begins with an account of economic growth in a post-war era, that is 1950+ ...

Looking at the period of 1950 to now the most striking feature of advanced economies is the sustained growth in real income per capita. As such, this is the dividing difference between the last 60 years of global economic growth and earlier periods. What is important here is that the nature of growth exhibited globally in the post-war era effectively counters the Malthusian dictum that population growth would outpace economic growth (growth in production) to induce a sustained slide path towards global poverty.

Over the 40-year period from 1960 through 2000, world population grew from about 3 billion to 6.1 billion, or at an annual rate of 1.7 percent. These numbers are often cited with alarm, and obviously the number of people in the world cannot possibly grow at 2 percent per year forever. But many exponents of what a friend of mine calls the “economics of gloom” go beyond this truism to suggest that population growth is outstripping available resources, that the human race is blindly multiplying itself toward poverty and starvation. This is simply nonsense. There is, to be sure, much poverty and starvation in the world, but nothing could be further from the truth than the idea that poverty is increasing. Over the same period during which population has grown from 3 billion to 6.1 billion, total world production has grown much faster than population, from $6.5 trillion in 1960 to $31 trillion in 2000. (All the dollar magnitudes I cite, from the Penn World Table or any other source, will be in units of 1985 U.S. dollars.)

Clearly, we are losing important details by looking at the whole world and if we take the post-war era it is obvious that some countries still exhibit Malthusian characteristics through which they are caught in a so-called poverty trap. This also tell us a subtle yet important fact about the 'in-build' theory of growth convergence in the Neo-Classical growth model as a result of diminishing returns to capital accumulation. Capital accumulation rests on saving and investment dynamics and there is indeed evidence that saving rates are correlated with long term growth. However, as the Malthusian Trap is characterized by an economy where all income is consumed (i.e. no saving and investment/capital accumulation) we need something to set the train in motion sort to speak before we can assume a process of convergence from the developed world. Yet as Lucas concludes we have indeed on a whole become richer ...

These are numbers for the world as a whole. The entire human race is getting rich, at historically unprecedented rates. The economic miracles of East Asia are, of course, atypical in their magnitudes, but economic growth is not the exception in the world today: It is the rule.

Leaving the economic realities of the post war era Lucas turns to the period before the industrial revolution. As I noted above the striking nature of growth in the post-war era was that the global economy has seen sustained growth in per capita GDP. Looking at the agricultural society before the industrial revolution this feature of economic growth is exactly what is missing. As such, Lucas argues that up until 1750/1850 which mark the beginning of the industrial revolution there was no sustained growth in income per capita.

Moreover, it is fairly clear that up to 1800 or maybe 1750, no society had experienced sustained growth in per capita income. (Eighteenth century population growth also averaged one-third of 1 percent, the same as production growth.) That is, up to about two centuries ago, per capita incomes in all societies were stagnated at around $400 to $800 per year. 

And why is this? Get ready for a key quote(!) Notice especially the idea that population dynamics obey to the Malthusian law of population growth; i.e. fertility follows increases in production (i.e. economic growth) and factors out the income per capita component or perhaps even surpasses it the latter point representing the core of Malthus' thoughts on population dynamics and economic growth.

Between year 0 and year 1750, world population grew from around 160 million to perhaps 700 million (an increase of a factor of four in 1,750 years). In the assumed absence of growth in income per person, this means a factor of four increase in total production as well, which obviously could not have taken place without important technological changes. But in contrast to a modern society, a traditional agricultural society responds to technological change by increasing population, not living standards. Population dynamics in such a society obey a Malthusian law that maintains product per capita at $600 per year, independent of changes in productivity.

So if the difference between the post-war era and agricultural society is that the former period has seen a sustained growth in global GDP per capita whereas the latter has not what happens in between then or more specifically how to describe what happens in the transition?

Lucas presents solid empirical data for his thesis of what happened in the Industrial Revolution so I won't discuss this here. The key distinction for Lucas' argument are figure 2 which show developments in global population and production growth between 1000 and 2000 and figure 3 which plots global GDP per capita (i.e. five regions) from 1750 to 2000. 

Lucas on figure 2 ... 

The difference between the two curves [i.e. population and production] is about constant up until 1800, reflecting the assumption that production per person was roughly constant prior to that date. Then in the 19th century, growth in both series accelerates dramatically, and production growth accelerates more. By 1900 the two curves cross, at which time world income per capita was $1,000 per year. The growth and indeed the acceleration of both population and production continue to the present.

 Lucas on figure 3 ...

As shown in Figure 3, per capita incomes were approximately constant, over space and time, over the period 1750–1800, at a level of something like $600 to $700. Here and below, the modifier “approximately” must be taken to mean plus or minus $200. Following the reasoning I have advanced above, $600 is taken as an estimate of living standards in all societies prior to 1750, so there would be no interest in extending Figure 3 to the left.

What we essentially have here in these two figures is the evidence of the industrial revolution in the two figures as the point where income per capita sets off or more specifically the point at which the growth and population dynamics change character awar from a Malthusian state of increased population growth which 'eats' up the growth rates in terms of per capita gains. In figure 3 this is simply shown when graphs begin to take off to the north at about 1800-1850 (note also the divergences) and in figure 2 this is shown as the point where the line for production growth crosses and essentially surpasses the line for population growth.

So what happended then?  

Lucas' argument here is subtle yet very important. In essence, we can see that the industrial revolution did not materialize itself as a result of a sudden leap in sustained production growth. In fact, we can see from figure 2 that growth in global production did indeed rise at a steady state but that at some point production growth relative to population growth started to pick up. Consequently, it is not a coincidence that the point in figure 2 where the line for production growth crosses the line for population growth at the same point in time (i.e. about 1800-1850) as the GDP per capita picks up as shown in figure in figure 3. As such, growth in income per capita becomes the defining economic characteristic of the industrial revolution but the underlying dynamic which leads to this sudden change in economic growth is the fall in fertility associated with demographic transition; see also figure 4.

What occurred around 1800 that is new, that differentiates the modern age from all previous periods, is not technological change by itself but the fact that sometime after that date fertility increases ceased to translate improvements in technology into increases in population. That is, the industrial revolution is invariably associated with the reduction in fertility known as the demographic transition.

This basically takes care of the bracket number 1 mentioned in the outline above and you could stop here since Lucas' essay up to this point essentially is represents a finite argument. However, Lucas also engages in a very interesting discussion about the general theoretical repsonses to the economic realities described above.

The essence of Lucas' argument here is that we have two theories of economic growth which each are coined in their specific context before and after the industrial revolution (demographic transition). 

I think it is accurate to say that we have not one but two theories of production: one consistent with the main features of the world economy prior to the industrial revolution and another roughly consistent with the behavior of the advanced economies today. What we need is an understanding of the transition.

The first theory is represented by the work of the classic economists such as Ricardo, Smith and Malthus. In this theoretical framework we have a situation which reflect the economic reality before the industrial revolution where growth dynamics kept income per capita at a constant level because of the (perceived) 1:1 correlation between increase in population and economic growth. This, as I noted above, was also at the heart of Malthus' fear in the sense that he envisioned a world where population growth would outstrip production growth.

As such Lucas summarizes ...

The model predicts that the living standards of working people are maintained at a roughly constant, “subsistence” level, but with realistic shares of income going to landowners, the theory is consistent as well with high civilization based on large concentrations of wealth.

The second theoretical response is represented by the neo-classical growth model as it is famously formulated by Solow in 1958. As Lucas notes, this model is constructed for (i.e. responds to) a world where economies have moved through the demographic transition and most importantly a world where fertility rates stabilized at replacement level (2.1) as envisioned by the original theory of the DT. In short, the population factor is neutralized as a fixed exogenous stimulant to growth. In this way, we also have the key to the main characterstics of the Solow model (exogenous growth) where we have decreasing returns to capital formulation (i.e. saving and investment dynamics) and where growth in income per capita consequently can only be stimulated by advances in technology, knowledge, and human capital; the last component famously added by the Mankiw, Romer, and Weil study linked above.       

In conclusion on these two theorie Lucas notes ...

The modern theory, based on fixed fertility, and the classical theory, based on fertility that increases with increases in income, are obviously not mutually consistent. Nor can we simply say that the modern theory fits the modern world and the classical theory the ancient world, because we can see traditional societies exhibiting Malthusian behavior in the world today.

However, Lucas also notes the crucial point that we need to look at theories which explain the reduction in fertility in the industrialized and indeed service based economy. We can say, following Lucas, that if Malthusian dynamics explain us why fertility increased in the agricultural society which factors do then explain why fertility declines today. Conceptually, the drivers of declining fertility is well beyond the scope of this notesheet but very briefly we are operating with two overall components; the quantum effect (quantity/quality tradeoff, see Lucas' references) and the tempo effect (birth postponement). In his essay, Lucas only notes the former as he explains  ...

Gary Becker proposed long ago that this second factor be identified with the quality of children: As family income rises, spending on children increases, as assumed in Malthusian theory, but these increases can take the form of a greater number of children or of a larger allocation of parental time and other resources to each child. Parents are assumed to value increases both in the quantity of children and in the quality of each child’s life

Ok ... I will stop now since what really interests me here is the conceptualization of the transition dynamics here. So in short, what are the important lessons to take away from this:

•  The transistion dynamics as explained by Lucas represent the real important points here and what I immediately want to get across the table is the following. Lucas talks about the transition from the agricultural society (Malthus) to industrial/modern society (Solow) and more specifically how we can reconcile this transition in terms of a theoretical response/explation of the change in population and growth dynamics which essentially changed during the course this period. This is in iteself very interesting but has these transition dynamics ended? By linking the transition from the agricultural society to the industrial/modern society itself with the demographic transition Lucas (more or less deliberately) opens up the flank for a simple yet crucial ... what happens if in fact the demographic transition is not over?    
  

• Another question which we need to ask at this is simply how the Solow growth model or indeed its derivatives treat the transition mechanism from demographics to economic growth. An intial important is whether we are we speaking of ageing or population decline? For laymen this might seem as the same thing but this is very far from the truth. As such it is safe to say I think that by holding population dynamics as an exogenous increasing factor any model based on Solow's framework is incapable of reacting to the dynamics of an ageing population which after all is a long term process. Regarding the question of population decline it is pretty obvious that if growth is constant due to a process of capital deepening and technological progress (productivity gains) the GDP per capita would increase as a function of a constant rate of GDP growth relative to fewer people. This might in itself be unlikely but in a theoretical sense this is an important point once we get into the idea of a 'balanced growth path' and international capital flows. Moreover, this is essentially a theoretical cheapshot since how we might potentially (!) get to such a situation (i.e. the process of ageing) is much more important since this at some point very well could entail decreasing GDP per capita not to mention a heavy domestic debt/finance burden operationalized as a function of dis-favorable depedancy ratio. This brings us to another important point about the process of ageing and indeed the demographic transition, namely the concept of path dependancy which essential means (from Wikipedia):

This dynamic vision of economic evolution is very different from the neo-classical economics tradition, which in its simplest form assumed that only a single outcome could possibly be reached, regardless of initial conditions or transitory events. With path dependence, both the starting point and 'accidental' events (noise) can have significant effects on the ultimate outcome.

One of the best way to conceptualize is incidentally the idea of a changing dependancy ratio as country ventures through the DT. Consequently, one of the first phases in the DT where mortality declines relative to a stable fertility rate is traditionally called the demographic dividend and signifies a period where the dependancy ratio in a country declines as the labour force grows relative the 'dependant' part of the population. India is a prime example here. However, as a country ages and thereby moves through the DT this changes and indeed at some point the dependancy ratio increases to such an extent that we might speak of another demographic dividend which is the mirror of the first; a penalty if you will. Now the point here is that the decisions and actions taken during the initial DD have implications for how you get to the second DD and ultimately how you are able to deal with the challenges associated with an ageing population. The idea of path dependancy suggests two potential considerations towards traditional growth theory: 1) It fundamentally questions the idea of a steady state, and 2) it suggests that demographics should be included as an endogenous variable to growth in the long run

• Lastly, I will like to mention the idea of international capital flows and how they might illunimate further the issues at hand here. Let us revert back to the idea of a balanced growth path operationalized as a growth path along the steady state where output and capital per worker is constant; that is to say that the relationship between capital deepening and capital widening is equal in the long run. However, this idea of a steady becomes very difficult to sustain in the long run if we factor in demographics and crucially the idea of how demographics affect the international capital flows by acting as an anchor to gauge whether a country is running an external surplus or deficit. As such, ageing societies such as Japan will be biased towards a growth path characterized by high capex (investment) and thus also highly dependant on exports which then translates into an external surplus. This also means that the saving/investment dynamics in such a society only will lead to growth depending on whether the excess supply in the domestic market (i.e. the current account surplus) can be offloaded.
  

PS ...

Please do not see the above as a thrashing of Solow as an economist. I am not out to disfavor anyone or anyone's thoughts. I am merely trying to point to the issue of how demographic trends can change the way we look at economic growth in the long run.  

Comments

[cheap percocet]

very interesting article. on most issues I agree with the author:)