The secret to growth may be how your economy deals with downside risk

Andrew Haldane’s work is always worth reading and a recent speech he made titled “Ideas and Institutions – A Growth Story” is no exception.

Haldane’s revised story of growth

Haldane starts with the observation that GDP growth matters and not just for narrow materialistic reasons.

“It is now pretty well-established that growth is a vital ingredient, indeed pre-requisite, for meeting many of the broader societal objectives many would view as important to our longer-term health, wealth and happiness. While not an end in itself, economic growth appears to be a vitally important means of achieving those societal ends.”

If you accept this premise then understanding how to foster growth matters. One of the clues has been to look at what drove the step change in the pattern of cumulative long term GDP growth that started around 1750. Haldane notes that the traditional explanation was that there had been a happy confluence of ideas and innovation starting with the Industrial Revolution that resulted in growth taking off.

Haldane recounts that he subscribed to this story of growth but two facts prompted him to reconsider.

“I thought I understood the story of economic growth, its drivers and determinants. But recently I have changed my mind. I have a new story of growth.”

Fact number one is that innovation did not just start in 1750 …

”… waves of innovation, big and small, have been lapping the shores of society for the entirety of human civilisation… while ideas and innovation may well be a necessary condition for economic growth, the historical record suggests they may not themselves have been sufficient. Other forces appear to have been at play, translating these ideas into sustained growth in living standards.”

Fact number two was analysis of long term growth provided by economic historians, Steve Broadberry and John Wallis.

Indeed, Haldane states it was probably this new perspective, above all others, that led him to change his own story about growth. This “fact” must be treated with caution given the challenge of seeking to collate a picture of GDP growth over the past 1000 years. However, it does offer an intriguing and plausible (to me at least) new perspective on one of the keys to sustaining the kinds of growth that underpin modern standards of living.

Broadberry and Wallis found that, even prior to the Industrial Revolution, economies experienced notable periods of strongly positive growth. This has continued post the Industrial Revolution (albeit a bit less than growth during expansion periods prior to the Industrial Revolution). What changed post the Industrial Revolution was a dramatic fall in both the probability and cost of GDP contractions.

“Since 1750, recessions have become far less frequent and less painful. It is the avoidance of deep recessions that differentiates the Golden Era from its Malthusian predecessor.”

The alternative story Haldane finds persuasive is that the real game changer altering the long term cumulative growth trajectory was just as much an “Institutional Revolution” as an Industrial Revolution. Innovation in the institutional structures of the economy reduced the incidence and severity of recessions but also helped to mitigate the social impact of the disruption associated with the technological change that was driving increases in productivity.

“… the story that better fits the facts appears to be one in which the conveyor belt of ideas and innovation has been continuous over the centuries, causing lengthy if lumpy ideas-fuelled expansions. But whereas prior to the Industrial Revolution this conveyor belt was regularly halted by recessions, more recently these interruptions have been far fewer and less costly.

Put differently, the real revolution in living standards after 1750 came about not exclusively, or perhaps even mainly, from the surge in ideas and technologies. Rather, it resulted from societies having found some means of avoiding the subsequent recessionary bullets. Prior to the Industrial Revolution, these killed expansions dead. After it, societies appear to have found some effective means of dodging them.”

What exactly is the Institutional Revolution that Haldane sees playing a key role in having facilitating sustainable growth

Haldane offers a definition by Douglass North as a good starting point:

Institutions are “…. humanly devised constraints that structure political, economic and social interactions”. So defined, institutions are social infrastructure. They include formal or legal institutions, like Parliaments, judiciaries, central banks, social safety nets and schools. But they also include less formal associations and groups, such as universities, trade unions, guilds and charities.”

The Industrial Revolution resulted in new forms of physical capital but the Institutional Revolution is reflected in a broader set of “capitals” not just physical capital (plant and machines) but human (skills and expertise), intellectual (ideas and technologies), infrastructural (transport and legal systems), social (co-operation and trust) and institutional (national and civic, private and public) capital.

History suggests each of these capitals may have played an important supporting role in the story of growth. Ideas alone, without the support of one or more of these broader capitals, have historically run aground. For example, in the UK many of the foundations for growth after the Industrial Revolution were laid in the centuries preceding it. It was on this platform of “capitals”, plural, that ideas and innovation then built.

What flows from this revised story of growth

Haldane identified a number of institutions but this speech is addressed to a group of university students so he naturally focuses on the role universities can play in managing the downside associated with the current wave of technological innovation.

“The story of growth is a story with two “i”s – ideas and institutions. The Fourth Industrial Revolution will expand the range of ideas, perhaps more than any of its predecessors. It may also expand the range of workers who suffer its side-effects, perhaps more so than any of its predecessors. In the past, new institutions have emerged to cushion this painful transition, limiting the recessionary hit to societies.

Historically, doing so appears to have held the key to sustainable growth. If this time’s technological transition is as great as any previously, securing sustainable growth will need new institutions to manage this transition and mitigate its societal side-effects. I have speculated on one area where that next institutional wave might usefully break – universities like this one, as new centres of lifelong learning and technological diffusion. In future, institutional innovation will be every bit as important as technological innovation if that gift of growth is to keep on giving.”

“What experience since the Industrial Revolution has taught us is that this risk can be mitigated by an appropriate institutional response. To be effective in curbing recession risk, that response should have as its objectives, first, speeding-up the process of reskilling by workers (“enabling”) and, second, cushioning the impact of new technologies on displaced companies and their workers (“insuring”).

If true, this alternative explanation for why the growth trajectory changed carries important implications for understanding the future challenges of technology and for devising the future policies and institutions necessary to meet them”

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

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