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inflation and Public Policy
. . . D iscipline is the greatest need in today's inflation
ridden financial markets, says Reserve Bank President.
Investment Ratios and Economic Growth Rates
. . . Three m ajor factors help account fo r the noticeable
difference between U.S. and European grow th rates.
PUBLICATION NOTE
The Business Review henceforth w ill be published on a quarterly basis.
It is edited by W illia m Burke, w ith the assistance of Karen Rusk
(editorial) and Janis W ilson (graphics).
Subscribers to the Business Review may also be interested in receiving this
Bank's Publications List or weekly Business and Financial Letter. For copies
of these and other Federal Reserve publications, contact the Research
Inform ation Center, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco, C alifornia 94120. Phone (415) 397-1137.
By John J. Balles, President
Federal Reserve Bank of San Francisco
Remarks to Oregon Bankers Assn. Convention
Sunriver, Oregon, June 14, 1974
I'm glad to have the opportunity to
visit with so many old friends and
new acquaintances here in the
beautiful and productive state of
Oregon. And as a speaker, I'll try to
keep in mind your unofficial state
motto, "Come visit us, but don't
stay too long." However, quite a
few Californians apparently ignore
that injunction, because I understand that 18,000 of them cross the
border to settle in Oregon every
year.
I
f
A useful perspective on the nation's
problems and promises can be
obtained from overseas, and I
obtained just such a view recently
when I undertook a five-week tour
of nine Pacific area countries. The
immediate purpose of the trip was
to discuss the regulation of foreign
banks, both abroad and in the U.S.
In addition, I wished to establish
on-going contacts with the central
banks of the Pacific region, for the
purpose of future cooperation on
problems of mutual interest, and
also for the purpose of making the
Federal Reserve Bank of San Francisco a major nerve center in U.S.
banking and financial relations with
this rapidly growing region.
As I toured around the Pacific area,
however, I could not help but be
impressed-indeed dismayedwith the problem of rampant inflation in every country that I visited.
Of course, we in this country are
also suffering from this problem of
world-wide inflation, characterized
by double-digit interest rates and
double-digit price increases. Yet I
found that in most of the Far East
countries the rate of inflation over
the past year has been even more
serious than in the United States.
This has led to some highly destabilizing effects. For example, in Japan
the major wage contracts negotiated
this spring contained provisions for
25-percent annual wage increases,
adding a strong cost-push factor to
the inflationary trend already experienced there. In Australia, as
another example, the urgent need to
combat inflation has led to an extremely tight monetary policy, and
short-term business borrowing
costs were as high as 20-25 percent
when I was there last month.
Desperate Problem of Inflation
All of the officials that I contacted
overseas expressed sympathy for the
efforts we've been making in this
country to overcome our many
economic problems. At the same
time, they were worried about the
damage that could be done in their
area by continued price rises in the
United States, the cornerstone of
the Pacific and world economies.
But, for our own sake, we should be
concerned about the severe and
protracted problem of inflationone of the most difficult economic
problems in the nation's history.
This inflation threatens to destroy
all the hopes we have of regaining
the prosperity levels of recent years.
And in the words of Federal Reserve
Chairman Arthur Burns, /lif long
continued, inflation at anything like
the present rate would threaten the
very foundations of our society./I
You're already familiar with some of
the unique factors that helped cause
our present inflation, so I'll review
them only briefly. During 1973, a
business-cycle boom occurred
simultaneously in this and every
other major industrial country, and
because of this synchronized
upsurge in production, the prices of
labor, materials and finished goods
were bid up everywhere. In addition, disappointing crop harvests
the previous year forced a sharp
run-up in food prices through most
of 1973, while the price and production policies of the oil-exporting
countries brought about a dramatic
rise in energy prices last winter and
fall. More recently, a price bulge
has developed with the removal of
wage and price controls.
Worse still, these special factors
only magnified an underlying bias
toward inflation found in this and
every other ind ustrial nation. People
want the good things of life and
they want them now, generally turning to government when they
cannot obtain those things through
their own efforts. The public nowadays expects the government to
maintain a prosperous economy, to
ease the burden of job loss or
illness or retirement, and to sustain
b
the incomes of farmers, homebuilders and other segments of the
economy. But in the rush to realize
these goals-again I'm quoting
Chairman Burns-/lgovernmental
budgets have gotten out of control,
wages and prices have become less
responsive to the discipline of
market forces, and inflation has
emerged as the most dangerous
economic ailment of our time./I
To show the pernicious effects of
inflation, consider the havoc created
in the world's financial markets by
the increase in price of a single
major commodity, petroleum. This
development has placed more
severe strains on the world's monetary system than at any time since
World War II. For the U.S., Europe
and Japan, the oil-import bill will
be roughly $50 billion higher than
in 1973, contributing to a $100billion investable surplus for the oilexporting countries by the end of
the year.
tain obvious defects under present
circumstances. Funds placed in the
Eurocurrency market tend to be on
short-term deposit, while the debts
required to ease the payments
strains of oil imports will need to
be relatively long-term. Moreover,
serious financial instability may
result from sudden and massive
shifts of funds out of particular
money markets and across
lines.
l
Outlook for Prices and Production
The GNP price index rose at an
11% -percent annual rate-an unprecedented peacetime increaseduring the first quarter of this year,
and the rate was even higher after
adjustment for the soaring price of l
imports. The increase, of course,
was concentrated in the food and
fuels categories. Consumer food
prices rose at a 15-percent annual
rate-somewhat below last summer's peak increase-and energy
prices jumped at a 67-percent rate
-several times any earlier inr'rp;~<:p
Recent improvements in the supply
It could be said that a decision by
the OPEC countries to export oil at situation for food and fuels suggest
that these sectors will be less rritir,,1
today's high prices is equivalent to
a decision to invest huge sums of
during the rest of the year. Even so, 1
any improvement in these areas may'
money abroad, especially in view
of their very small domestic markets be offset by the drive on the part
for imported goods and services.
of basic materials-producing indusThe oil exporters apparently have
tries to cover sharply rising labor
demonstrated a preference for incosts and to enlarge long-depressed
vesting in the Eurocurrency market, profit m a r g i n s . ,
which is a highly efficient mechanism for financial intermediation.
Nevertheless, that market has cer-
Basic wage increases have not been
as high as might have been expected for such an inflationary era.
;2,( During the first quarter, wages and
fringe benefits increased at a 6.9percent annual rate in major contract negotiations-not much higher
than the 1973 average. But labor's
increasing emphasis on escalator
provisions for both wages and pensions-and "uncapped" escalators
at that-creates the danger of a
vicious circle of rising prices and
wages. And even with the total wage
bill kept under control, any decline
in productivity (such as we encountered last fall and winter) could send
unit labor costs soaring. Under the
impact of bottlenecks and market
ill distortions, unit costs increased at
an 11-percent annual rate over that
period-twice as fast as in most of
1973-and that type of inflationary
pressure is continuing.
!f
According to a forecast prepared by
my economics staff, prices are likely
to rise by 81/2 percent for the year.
Bad as that is, it still represents a
significant deceleration in the price
trend in contrast to the first quarter's
111/2 -percent rate of increase. As
for production, real output may
show no increase at all for 1974 as
a whole. However, that suggests a
noticeable improvement in the second half, following the 6-percent
rate of decline in the first quarter
and the generally sideways movement of the present period.
There is a crucial need to build up
capacity in petroleum, steel and
other basic materials-producing industries, which have been operating
close to the theoretical limits of
capacity for over a year.
The neglect of these basic industries
dates back to the period of excess
capacity of the 1960's, but investment continued to lag thereafter
because of the inhospitable atmossphere created by a recession, price
controls and environmentalist pressures. The need for new capacity
then became obvious when the
The major areas of strength in the
double devaluation of the dollar
outlook are business spending for
limited the sales prospects for fornew plant and equipment, as well
eign goods in this country while
as inventories. Government spendcreating a vast demand for American
ing should rise considerably-in
goods overseas. The stage thus has
Washington, and also at the statebeen set for a massive businesshouses and city halls. However, the
investment boom, although the
expansion will be held in check by
financing for this boom will remain
weakness in several consumerquestionable until business firms
Wholesale prices of industrial com- oriented sectors, especially autos
raise their profit margins above the
modities rose at a 36-percent annual and other durable goods and (in
low levels of the late 1960's and
particular) new residential construc- early 1970's.
rate in the several months prior to
tion.
the lifting of controls, and the increases since then in steel, alumiThe strong prospects for business
num and other basic industries have Business spending for new capacity spending are not likely to be
will be the driving force behind the
been equally large. We can hope
matched anytime soon by the conthat the initial bulge of post-control national economy this year and for
sumption sector. Consumers were
several years to come. New plant
increases will soon disappear, and
in a recession during the final
and equipment should increase at
that the spiral of price increases
quarter of 1973 and the first quarter
least 13 percent this year, despite
will begin to contract rather
of 1974, with a 4-percent rate of
than expand further. But to do this,
the continuation of shortages of
decline in real spending, and the
certain parts and materials. As eviwe must curb speculative excesses
recovery from that slump may be
wherever they appear.
dence, new orders for capital goods moderate and somewhat prolonged.
have jumped 50 percent over the
The consumer has seen his rising
past two years-the sharpest intake-home pay completely eaten
rr"'''C<> {"\f th", n"d c<>\/",r::ll rl",r"rl<>c
away by inflation over the past year;
he has seen his real wealth decline
because of rising prices and a sliding
stock market over the past halfdecade; and on top of that, he has
been confronted with a huge overhang of debt resulting from the
spending spree of the past several
years. He is thus likely to remain in
a cautious mood for quite a while,
especially when considering purchases of big-ticket items such as
autos and household furnishings.
The other weak spot in the outlook
is housing, an industry of considerable interest to Oregonians. In
dollar terms, spending in this sector
could decline 14 percent this year,
compared with last year's T'I2percent increase. But in real terms,
the slump should be somewhat
steeper. Real spending declined at
a 33-percent rate in late 1973 and
early '1974, and the upturn originally
projected for the second half of the
year has now been endangered by
sharply rising mortgage rates and
the withdrawal of savings funds
from mortgage-financing institutions. Some help will come from the
Administration's plan to subsidize a
potential 300,000 new and existing units, through below-market
interest rates. Even so, a sustained
recovery in housing is not likely
until the inflation menace is somehow overcome. As things stand,
many builders fear that the soaring
prices of land, labor and materials
In
could relegate the single-family
home to the status of a museum
piece.
Outlook for Oregon
The outlook for Oregon is mixed,
just as is the national outlook, with
weakness in those industries which
supply consumer-oriented sectors,
and strength in those industries
which support the nationwide
business-investment boom. The
lumber industry is likely to suffer
a moderate decline in production
and employment, reflecting the
slump in the housing industry and
the partially offsetting boom in nonresidential construction. Also, residential permit activity in the state
has been running about one-third
below year-ago levels, although
basic demand appears strong, as
evidenced by continued population
growth and a decline in Portland's
vacancy rates.
a more favorable position than its
neighbor to the south, which is
heavily dependent upon external
sources of natural gas and fuel oil r~
to meet industry's energy demands.
Agriculture should have a reasonably good year, although nothing
approaching the halcyon days of
1973. Gross cash receipts of Oregon's farmers and ranchers should
increase about 7 percent-far
last year's record-while net farm
income may even decline slightly
because of soaring production
Gross crop receipts should be up,
despite a recent decline in wheat
prices, because of a sharp increase
in the harvest of that major crop.
A gain in livestock receipts is less ~
certain, because of a softening of
prices and a one-third decline in
number of cattle placed on feed.
Policy Problems
The outlook for the state and the
In contrast, demand for pulp and
nation is dominated by the need to
paper has remained high, and prices expand basic industrial capacity, so
rose to 21 percent above year-ago
as to reduce the severe inflationary
levels after controls were lifted from pressures which now confront us.
the industry this spring. The rising
The choice of policy weapons thus
return on invested capital, together depends upon how well they supwith the prospect of continued
port the necessary expansion of
shortages, is spurring this and other supply, and how well they curb
basic industries-such as the
excessive demand. By this standard,
machinery industry-to plan for
direct wage and price controls
substantial additions to capacity.
clearly fail, because of the distorWith respect to energy supplies,
tions and bottlenecks they have
IY
Oregon's abundant rainfall (if you'll created over the past several years.!
pardon the reference) and its large
Controls were a noble experiment,;!
supplies of hydro-power place it in
but like that other noble experimenJI
,~,I
,I
of a generation ago, they will be
remembered only for the terrible
hangover they generated.
several months, after a bulge late
last fall and again in February and
in March. Over the past twelve
months, the money supply has increased about 61/2 percent altogether.
On the fiscal side, we must keep the
Federal budget under control so
that it doesn't aggravate our serious
inflation problem. Congress should
Yet monetary policy has had to
contend with a fantastic rise in
strongly resist pressures for a tax
cut, which would stimulate demand business demand for short-term
at a time when the correct pol.icy
credit. Commercial-bank business
prescription calls for a strong expan- loans increased at more than a 25percent annual rate in the first four
sion in supply. Restraint is doubly
necessary because a substantial
months of this year, and the presamount of fiscal stimulus is already
sure was eased only slightly by a
slowdown in mortgage and conincluded in the fiscal 1975 budget,
with a projected deficit of at least
sumer loans. Business-loan demand
$11V2 billion. This follows a $31/2was stimulated by increased financbillion deficit in the fiscal year now
ing for new plant, equipment and
ending-a period of unprecedented inventories, and also in recent
peace-time inflation. More broadly
months by a shift away from the
speaking, it is very discouraging to
commercial-paper market and into
look at the record of fiscal policy of
the banks. Loan increases incurred
the last fifteen years in terms of its
because of capacity-expansion recontribution to economic stabilizaquirements were to be welcomed.
tion. In the entire period 1961-1975, Increases incurred because of the
a surplus appears in only one year
higher costs of doing business in an
(1969). All other years show deficits. inflationary atmosphere were understandable, although not welcomeMonetary policy has a difficult role
but those loans made because of
to play because of the distortions
speculative inventory purchasing
created by inflationary pressures in
and other purposes should have
the real economy and in the credit
been rejected. At any rate, thanks to
markets. The Federal Reserve inrising prices and soaring loan detends to encourage sufficient growth mand-along with the market's
in supplies of money and credit to
expectation of a sharp monetaryfinance an orderly economic expan- policy response-we have witsion, but it does not intend to
nessed a sharp and surprising upaccommodate accelerating inflation. surge in interest rates. Within three
To this end, the growth of the money months' time, the prime businesssupply has decelerated in thelast
loan rate rose almost three percentage poi nts to an unparalleled 111/2
percent.
The capital markets have also been
under heavy pressure, even though
many corporate and government
treasurers have scaled down or
postponed scheduled bond issues.
The situation has not been helped
by the very large financing needs of
the housing agencies, and in particular, by the concern aroused by
the Can Ed and Franklin National
episodes. Thrift institutions meanwhile have suffered substantial
outflows of funds, reflected in the
rates of various market instruments
-witness the sharp increase in noncompetitive tenders at Treasury bill
auctions and at the May refunding
of longer issues.
Many market participants have
feared a further upsurge in interest
rates as a consequence of the recent
reduction in money-supply growth.
But their fears may be largely unfounded. Many borrowers this
spring saw the earlier rise in the
money supply as presaging both
increased inflationary pressures and
a tightened policy response, so they
borrowed as much as they could,
creating excess demand for funds
and pushing rates even farther
upward. These exceptional factors
could just as well change in the
other direction, causing short-term
rates to fall because of the bel ief
~
Concluding Remarks
To conclude, there's no blinking the
fact that the nation is going through
a very difficult period. Economic
activity seems to be slowly improv- IJl
ing, but at a somewhat fitful pace
If you follow the business press at
because of serious supply conall, you'll realize that I am not alone straints. The price trend seems to be
in making this plea for sanity. One
decelerating, helped along by the
At present, we have a difficult role
publication recently editorialized,
prospect of bumper crops as well
to play, but so do you. There's a
"The nation's commercial banks are as new productive capacity in indusnew word to describe your taskheading down a dangerous road. In try, but again, the improvement
"de-marketing", which means
their eagerness to accommodate
occurs at a maddeningly slow pace.
cutting back the demand for your
old customers and build new busiProductivity continues to stagnate
product during a period of shortbecause of the problem of bottleness, they are pushing out loans at
ages. You must make sure that your
an unsustainable rate and trying
stock in trade is used only for the
necks, and profits gains thus remain
most essential purposes, concentrat- desperately to attract deposits to
limited, at least after adjustment for
inflation.
ing on those sectors that will expand cover them." Here is another comment, "In the push to expand, banks
the nation's productive capacity.
This approach may make funds both have taken more and more risks
Nonetheless, we are moving in the ~
and devise more and more ways to
scarce and expensive for many of
right direction, especially since new
stretch the regulations"-followed
capacity is being built that will
your good customers, but at this
by the ominous note, "No bank
juncture, it seems essential that you
permit the economy to return to its
officer under 45 years old today can historical growth trend. Monetary
rein in the demand for loans.
even remember 1933." And here is
policy has been formulated to assist
a welcome note of caution from
The greatest need in financial marthat movement back to trend, and
Arthur Snyder, President of the Bank meanwhile to squeeze out the inkets today is discipline, and you are
of the Commonwealth of Detroit:
flationary excesses developed in
the people who must instill that
"As a matter of public policy, the
recent years. At the same time, in its
sadly lacking quality into current
role as lender of last resort, the
business activity. Admittedly, part of banker is expected to be different
from the ordinary business man.
Federal Reserve has shown that it
the problem has been caused by
He is affected with the public
will not permit disorderly conditions
corporations turning to banks for
interest; he is the guardian of
to develop in the credit markets.
the money they would ordinarily
the liquid assets of millions of famOver time, with the cooperation of
raise through the sale of stocks,
ilies and businesses. The essence of the banking and business communibonds and commercial paper. And
being a banker is to stand apart
as I've already said, some of these
ties, the return to a period of healthy
growth should be assured.
demands must be met, to help meet from the excitement and to serve
the nation's future needs. But those business and the community without joining in business activity."
that inflation was coming under
control. In addition, any slowdown
in inflation should reduce the massive increase in the replacement
cost of inventories, and thereby
reduce the need for borrowing to
carry larger stocks.
who come to you with other proposals, no matter how attractive,
must be forced to lower their sights
or even to withdraw completely
from the market.
-----------------------.
By Hang-Sheng Cheng
It is a well-known fact that the
United States generally invests a
smaller fraction of its current
national output in business plant
and equipment than other
industrial countries. This fact is
often cited as an explanation for,
first, a slower rate of capital
accumulation and, second, a
slower rate of economic growth,
than what is experienced by other
industrial countries. Both
inferences are a non sequitur.
The former is faulty, because it
implicitly assumes internationally
equal capital intensity of
production and identical relativeprice structures, whereas neither
could be taken for granted in
international comparisons. For
instance, when proper
adjustments are made to take
account of international price
differences, the U.s. investment
ratios for the 1950's and the early
1960's-the latest period for
which complete data are
available-turn out to be no
lower than those of other
industrial countries, contrary to
what unadjusted investment
ratios would show. As to the
relationship between investment
and growth rates, a singlevariable approach obviously
leaves much to be desired.
This paper presents a more
general analytical framework,
which includes capital
accumulation as one variable
accounting for growth, but also
permits empirical estimation of
the contribution to growth made
by several other individual
variables. Using this approach,
the author shows that the
difference between U.S. growth
rates and those of the European
countries in the 1950-62 period
can be traced to the relative
strength of three sources of
growth-technology
enhancement, economies of
scale, and improved allocation
of resources-all of which were
perhaps more closely related to
stages of economic growth than
to rates of capital formation.
*
*
*
*
*
Economists and policymakers
have long been concerned about
the role of capital formation in
the economic-growth proce6S. In
the United States, in particular,
several questions have often
been raised about the nation's
growth policy: Are we lagging
behind other industrial nations in
new business investment, thereby
accounting for our slower rate
of economic growth? If so, should
we not adopt effective policy
measures for encouraging
business investment in plant and
equipment?
The point has often been raised
in relation to the question of
lagging industrial productivity.
For example, former Secretary
of Commerce Peter G. Peterson
said,
"This whole issue of productivity
must become the central issue
for the country. For, in the final
analysis, the only way you are
going to avoid serious inflation
and the only way you are going
to avoid persistent devaluation is
to be managing the productivity
side of your economy as well as
other countries do. And this leads
to the matter of investment. At
the present time, for example, the
Japanese are investing about 20
percent of their gross national
product in new plant and
equipment. The Germans are
investing about 17 percent or 18
percent. We are investing 10
percent.... We should never
let ourselves believe that we can
maintain competitive productivity
and can continue to ignore the
fact that other countries regularly
put this much more into new
plant and equipment. For by
every study I have ever seen,
capital investment makes an
enormous contribution to
productivity./ll
This concern over the adequacy
of the U.S. investment rate has
been frequently expressed during
the last fifteen years. In 1958, the
b
Rockefeller Brothers Fund issued
a report calling for a higher rate
of investment-hence, a higher
rate of growth-as the most
practicable way to provide the
public services needed for solving
America's socio-economic
problems. 2 The call was picked
up in John F. Kennedy's 1960
election campaign and received
widespread attention in the
slogan: "Get the U.S. moving
again!/I Since then, a large
number of academic and
government studies have been
made, various policy measures
adopted, and government
agencies set up, for the express
purpose of encouraging
investment and promoting
productivity growth in the United
States. In the meantime, a
countervailing concern has arisen
over the costs of rapid economic
growth in terms of environmental
pollution, resource depletion,
and quality of life in general.
The issues arising from that
discussion are both broad and
complex. Instead of covering the
entire gamut of issues, this paper
concentrates on one narrow but
crucial question: the relationship
between investment ratios and
economic-growth rates.
"Investment ratio" is defined
here as the ratio of a nation's
investment in business plant and
equipment to its gross national
product, and "economic-growth
rate" is defined as the rate of
increase of real gross national
product.
It is often assumed that a direct
causal relationship exists between
the two, such that a low growth
rate can be directly attributed to
a low investment ratio. The policy
corollary of that assumption is
that a higher investment ratio is
needed for obtaining a higher
rate of economic growth.
However, this thesis stems from
an over-simplified view of the
economic-growth process. In
contrast, the main contention of
this paper is that investment
ratios are liable to provide a
distorted indication of the
relative capital-growth rates in
various nations, because of
international differences in
relative-price structures and
capital intensity of production.
Thus, on both economic and
purely statistical grounds,
investment ratios fail to explain
why economic-growth rates differ
among industrial nations.
Further, this paper proposes a
more general framework of
analysis for studying the
economic-growth process. A
simple model is suggested, in
which the investment ratio is
included as only one of several
factors affecting the economicgrowth rate. The model also
provides a convenient tool for
estimating the contributions to
t
economic growth made by
individual factors of growth. The
findings of a massive empirical
study by Edward F. Denison 3 on
t:l
the sources of economic growth
in the United States and eight
European countries are then cited
to show how this analytical
approach can provide a deeper
understanding of the economicgrowth process than is provided
by the naive investment-ratio
approach.
GNP Growth Rate (%)
Japa
10.0
Regression Lin
8.0
6.0
ii
Our analysis shows that the
higher European growth rates of
the 1950-62 period were
completely explainable in terms
of higher technology
enhancement, large economies
of scale, and improved allocation
of resources. All three factors
were related to the difference in
stages of econom ic growth
between the U.S. and European
economies, rather than to their
relative rates of capital formation.
!here is no doubt that capital
Investment stimulates growth,
and that within a reasonable
range a country can raise its
~conomic-growth rate by
~nvesting a larger proportion of
Its current output. However,
this paper attempts to look
beyond these simple
propositions, and to develop a
more useful way of
comprehending the economicgrowth process.
I
Germany
.Canada
·eden
4.0
.
u.s.
2.0
'--
10
--'-
.J....-
15
20
Part I presents statistical data on
investment ratios and economicgrowth rates of the United States
and other industrial nations for
the 1955-70 period. Part II
presents a critical appraisal of
the investment-ratio thesis of
comparative growth rates. Part
III suggests a more general
framework of analysis and
L-..
25
--L_ _
30
In vest men t
Ratio (%)
summarizes Denison's principal
findings in order to cast light
on the differential U.S. and
European growth rates in the
1950-62 period, the period
covered by Denison's study.
Part IV then explores the policy
implications and suggests
directions of further research.
..
Table 1
National Investment Ratios and Growth Rates
of Real Gross National Product, Annual Averages
1955-1970
Country Ranking
Investment
Ratio
japan
Germany
Canada
France
Sweden
Italy
United States
United Kingdom
30
24
23
22
22
21
17
17
GNP Growth
Rates
10.4
5.9
4.8
5.6
4.5
5.6
3.4
2.6
Investment
Ratio
1
2
3
4
4
5
6
6
GNP Growth
Rates
1
2
4
3
5
3
6
7
Sources: Based on data in United Nations, Statistical Office, Statistical Yearbook, 1971,
197~, Table 18, pp. 63-75; Organization of Economic Cooperation and Development
National Accounts of OECD Countries, various issues.
'
Table 1 presents data on the
average annual investment ratios
and average annual growth rates
of real gross national product for
the United States and seven other
industrial countries during the
period from 1955 to 1970.
;
;\
During that period, the United
States invested a far smaller
proportion of its current
national output in fixed capital
formation than did any of the
other industrial countries, with
the sole exception of the United
Kingdom. The investment ratio
for each of those two countries
was about 17 percent, in
striking contrast to japan, which
invested about 30 percent of
its current output. The other five
industrial nations' investment
ratios were all clustered within
a fairly narrow band between 21
and 24 percent.
Nearly the same pattern was
repeated with the growth rates of
real gross national product.
Again, the United States and the
United Kingdom ranked the
lowest on the list, with annual
growth rates of 3.4 percent and
2.6 percent, respectively. At the
other end was japan's output,
increasing at a whopping average
rate of 10.4 percent per year. In
between, the other countries'
growth rates ranged between 4.5
percent and 5.9 percent per year.
The table shows that the
countries with high rates of
growth were also the countries
with high investment ratios.
Figure 1 shows this even more
dramatically. The points all
scatter along a positive-sloped
straight line relating real growth
rates to investment ratios. The
goodness of the fit is no doubt
affected by the extreme case of
japan, but a close correlation
would result even if japan were
left out of the calculation.
The straight line shown in Figure
1 is based on the following
regression equation:
g=-6.42
0.53 IR,
(3.87)
(7.20)
r 2 = 0.90, SE = 0.81, OW = 2.09,
where g denotes the real-GNP
growth rate, IR the investment
ratio, r 2 the squared correlation
coefficient, SE the standard error
of the regression, DW the
Durbin-Watson statistics, and the
bracketed numbers below the
coefficients the t statistics.
+
It is tempting to conclude from
this evidence that high
investment ratios bring about
high growth rates, and that a
country can move up the
economic-growth scale by
investing a higher proportion of
its current output in business
plant and equipment. At first
blush, the argument appears
beyond dispute. Production
requires capital. Investment in
plant and equipment increases
tf
the nation's capital stock, thereby
expanding its productive
capacity. Cyclical fluctuations
aside, one can rightly argue that
the higher the long-term rate of
investment, the faster will be the
expansion in national output.
Hence, high investment ratios
provide a reasonable explanation
for high growth rates. 4
Nevertheless, the argument is
faulty in this context for two
major reasons.
First, capital is only one of the
factors, albeit an important one,
accounting for economic growth.
Other factors, such as labor,
technology, education, natural
resources and industrial
organization also affect the
nation's growth rate. Within an
individual nation, we could
assume constancy or steady
growth of those other factors,
and thus assert that a higher rate
of investment will bring about a
higher rate of economic growth.
In the international context,
however, this is not necessarily
so. Even among the so-called
advanced nations, conditions
differ significantly one from
If
another, such that it would be
injudicious to attribute a higher
growth rate to a higher
investment rate, or to imply that
a nation could possibly raise its
growth rate to anywhere near to
that of another nation by
investing a comparable
proportion of its national output. 5
Secondly, in analyzing the
contribution of capital investment
to economic growth, the point to
focus on is the growth rate of a
nation's capital stock, not its
investment ratio. Production
obviously requires plant and
equipment. Growth in output
requires expansion in plant and
equipment, and a high outputgrowth rate should call for a high
rate of expansion in such capital
stock. The investment ratio, on
the other hand, measures the
intensity of a nation's effort in
saving-investment activities.
Within the same nation, a high
investment ratio may well result
in a high capital-growth rate.
Between nations, however, the
nation with the higher investment
ratio will not necessarily have the
higher capital-growth rate.
There are two reasons why that is
so. First, a nation's capital-growth
rate is equal to its investment
ratio divided by its capital-output
ratio. 6 Hence, it is possible for a
country to have a lower rate of
capital growth, even though it
invests a higher proportion of its
national output than some other
nation, if its production is more
capital-intensive than the latter's.
Secondly, in computing investment ratios, both investment and
national output are expressed in
national prices. Where the prices
of capital goods relative to the
prices of other goods differ
internationally, a high investment
ratio could be consistent with a
relatively low rate of real capital
formation when adjustment is
made for such price differences'?
These are not mere theoretical
considerations. Empirical
evidence suggests that a simple
comparison of investment ratios
would indeed tend to give a
misleading impression of the
relative capital-growth rates in
different nations.
In testing the empirical importance of the above considerations, the most difficult problem
is that of data availability. In
particu lar, statistical data on
national capital stocks are
notoriously inadequate, making
it difficult to obtain a direct
comparison of national capitalgrowth rates or of national capital
intensities. However, the indirect
evidence presented later in this
paper indicates that production
in the United States was about 20
percent more capital-intensive
than in major European nations
during the 1950-62 period. On
this consideration alone, the
investment ratio would overstate
the U.s. capital-growth rate
relative to that of European
nations by about 20 percent.
In addition, the structure of
relative prices also appears to
have differed substantially from
one nation to another. In their
massive study of international
price comparisons for the 1950's,
Milton Gilbert and associates
found that the prices of capital
goods relative to general-output
prices were between 33 percent
and 73 percent higher in European countries than in the United
States during that period. 8 Using
these price data, Edward Denison
found that, when valued in
national prices, investment ratios
of seven European nations averaged about 16.6 percent in 1962,
considerably higher than the U.S.
investment ratio of 12.1 percent
for the same year; yet, when
valued in U.S. prices, that differential disappeared completely.9
With investment valued in
national prices, the U.S. investment ratio was much lower than
those of France, Germany and
Italy throughout the 1948-63
period, but with proper adjustment made for international price
differences, the cumulative in-
vestment during that period per
civilian employed was more than
twice as high in the United States
than in any of the other three
countries.l°
Thus, contrary to the usual impression, the U.S. investment
ratio during the 1950's and early
1960's was not any lower than
those of major European nations
-when adjustments are made to
take account of international
differences in relative prices.
Moreover, real investment per
worker was considerably larger
in the United States than in major
European nations. All this took
place over a twelve- to fifteenyear period-Le., 1950-62 or
1948-63, depending on the data
series used-for which an international comparison of investment ratios unadjusted for
international price differences
would show a much lower investment rate here than elsewhere.
It is true that economic growth
rates have been considerably
higher in other industrial countries than in the United States. If
higher investment ratios alone
are not a satisfactory explanation,
what other explanation or explanations can be offered?
This section presents a more
general framework of analysis,
including investment ratios as
one of the factors accounting for
growth, but extending beyond
that to include other factors as
well. The analytical framework is
stated in an explicit and systematic manner, so that all the
underlying assumptions are fully
revealed. The model is designed
to be empirically operational, in
the sense of having real-life counterparts capable of being
empirically tested.
The model presented here is
patterned after one developed by
Robert M. Solow. l l Very simply,
I
a nation's output is regarded as
dependent on its level of capital
input, labor input, and a catch-all
factor to be called "technology".
The latter includes such general
economic factors as education,
industrial organization, size of
market, factor mobility, etc., as
well as production technology in
the narrow sense. Technological
changes are considered II neutral"
with respect to both capital and
labor inputs, such that they
merely enhance or reduce the
volume of output obtainable from
given levels of capital and labor
inputs. Then, the production
function can be written as
------------------,-
-
s
(1 )
Yt = Tt f(K t I l),
t
Percent of Change
where:
Y designates national output,
T "tech nol ogy" ,
K capital stock
llabor force
f( ) a function,
and the subscript t time period.
By considering changes over
time and by assuming perfect
competition in commodity and
factor markets so that factors are
paid the value of their marginal
products,12 the nation's economic growth rate can be
expressed as
1-
y
t.Y
t.T
t.K
t.L
(2) g=y=--=r+ sKK+ sLL
where g designates the growth
rate , and sand
sL respectively
K
the shares of capital and labor in
national income, and a "t." sign
before a variable its change
over time.
If
Equation (2) states simply that the
growth rate can be decomposed
into three contributing factors:
(a) the rate of improvement in
"tech no logy", (b) the rate of
growth in the capital stock
weighted by capital's share of
national income, and (c) the rate
of growth in the labor force
weighted by labor's share of
national income.
100
0
J
:
~~~ ~~
Other
0
~ ~ ~ ~ ~ J--:
1-0
Economies of Scale
0
":'"0":'"0":'"0":'"0-,,1,
0
---I; ~ ~ ~ ~ ~ ~ ~ :
:JODDODOD
1
l'OO
DDOODDD
lODODDDOQ
80
60
~,-,. .- , .
-.-,-,,-,~,
" . , . , . " ..
...........
,
'
-
Improved Resource Allocation, ; ~ ~ ~ ~ ~ ~ ~
80
0
\1 0 0000000
60
- - Technology Enhancement _
Education
40
·C·.
40
-Growth in labor Employment _ .
20
20
- - Growth in Capital Stock - -
o
o
U.S.
What conclusions can be drawn
from this analysis? First, the
growth of capital stock resulting
from investment is one of the
contributing factors to economic
growth. Equation (2) thus restates
in a formal manner what has
already been stated previously.
But in analyzing the contribution
of capital investment to economic
growth, the point to focus on
should be the growth rate of
capital stock, not the investment
Northwest Europe
ratio. Nevertheless, insofar as the
investment ratio is related to the
capital-growth rate, the investment-ratio thesis can be considered as a special case for
explaining economic growth.
Secondly, other factors besides
the capital-growth rate also
account for differentials in
economic-growth rates among
nations. Equation (2) states that
one nation's growth rate may be
higher than another's because its
labor force is expanding faster,
because its capital stock is expanding faster, because its
relatively faster-growing factor
also commands a larger share of
the national income, or because
other factors lumped together as
"technology" make greater contributions to growth. Thus, the
equation shows clearly the logical
peril of attributing high growth
rates solely to high investment
ratios.
At the risk of oversimplification,
it may be said that equation (2)
lies at the core of the massive
study by Edward F. Denison,
Why Growth Rates Differ, which
contains far more refinement
than can be represented in our
equation. In his study, Denison
measures the sources of economic growth in the United
States and in each of eight European countries during the period
from 1950 to 1962. His findings
are summarized in Table 2.
Equation (2) provides a convenient analytical framework for
deriving quantitative estimates of
the contributions to economic
growth made by various individual factors. Given the growth
rates of the capital stock and the
labor force and their respective
shares of national income, their
contributions to economic
growth can be readily computed.
Other factors are grouped together under "technology" in this
equation only for convenience of
exposition. Empirically, "technology" may be decomposed
into any number of factors-such
as education, technology enhancement, economies of scale,
improved resource allocation,
etc.
Denison shows that real GNP increased by 3.32 percent annually
in the United States during the
1950-62 period, compared with
a 4.78-percent average rate of
growth in the Europeqn countries.
To account for the differential in
growth rates, he lists 23 different
sources of growth, which are
grouped here in 7 broader categories for ease of analysis. An
analysis based on these data suggests the following conclusions:
1. In both the United States and
the European nations, growth in
capital stock contributed only
about 13 percent of the economic
growth in the period discussed.
This finding lends support to the
earlier argument concerning the
inadequacy of the investment
ratio as the sole explanatory
variable.
2. In absolute magnitudes, capital contributed more to European
growth than to U.S. growth-0.64
vs. 0.43 percentage points, respectively. That difference was
due partly to the fact that the
annual growth rate of capital
stock was higher in Europe than
in the U.s.-4.55 vs. 3.75 percent,
respectively13-an d partly to the
fact that the capital share of
national income was higher in
Europe than in the United States
-18.4 vs. 15.0 percent, respectively.14 Assuming the validity of
our earlier findings that the
capital-growth rate is equal to the
real-investment ratio divided by
the capital-output ratio, and that
U.S. and European investment
ratios were about equal when
adjusted for international price
differences, then the evidence on
capital-growth rates indicates that
U.S. production was about 1.21
times as capital-intensive as
European production.
3. Growth in labor employment
and technology enhancement
together accounted for one-half
of the U.s. growth in real GNP
during the 1950-62 period. Technology enhancement, economies
of scale, labor employment, and
improved resource allocation
together accounted for threefourths of European growth during that period. I5
Table 2
Sources of Economic Growth in the
United States and Northwest Europe, * 1950·62
(percentages)
Shares in total contributions to growth in
Contributions to
growth rates in
U.S.
Northwest
Europe
U.S.
Northwest
Europe
Av erage annual rate of growth
3.32
4.78
100
100
Gr owth in capital stock
Growth in labor employment
Ed ucation
Te chnologyenhancement
1m proved resource allocation
Eco nomies of scale
Ot her**
0.43
0.90
0.49
0.76
0.29
0.36
0.09
0.64
0.71
0.23
1.30
0.68
0.93
0.29
13
27
15
23
9
11
3
13
15
5
27
14
19
6
So urces of Growth
--_.
-
Notes:
Source:
t
*Including Belgium, Denmark, France, Germany, the Netherlands, Norway, and the United Kingdom.
**Including hours of work, age-sex distribution of labor employment, capital stock other than business
plant and equipment (Le., dwellings, inventories, international assets), irregularities in demand pressure.
Denison, op. cit., pp. 281, 298, and 300.
4. The differential between U.S.
and European growth can be
attributed entirely to three factors: technology enhancement,
economies of scale, and improved allocation of resources.
Had the three contributed the
same amount of impetus to economic growth in Europe as in the
United States, European growth
would have been no higher than
U.S. growth du ring the 1950-62
period. These factors thus require
closer examination.
Technology enhancement contributed 1.30 points to European
growth but only 0.76 points to
U.S. growth, the difference of
0.54 percentage points being
attributed by Denison to a
"change in the lag in application
of knowledge."16 New technology once applied in one country
is quickly disseminated to the rest
of the world, but the actual
application of that new technology may lag considerably because
of institutional and human factors
-oligopolistic industrial structure, management attitudes towards innovation, availability of
a network of supporting services,
etc. The shortening of this time
lag provided a major impetus to
growth in Europe during the
1950-62 period, largely because
Europe acquired advanced U.S.
technology instead of being
forced to develop that technology
with its own resources.
Improved resource allocation
contributed 0.39 percentage
points of the difference between
U.S. and European growth rates.
Denison attributes slightly more
than one-half of the difference to
Europe's greater shift of resources
from agriculture to other industries, about one-quarter to shifts
out of non-agricultural selfemployment, and the rest to
removal of international trade
barriers,17 The first two were
clearly related to differences in
the pace of industrial adjustment
stemming from the difference in
stages of economic growth
between the United States and
Europe. The third source was
apparently the result of the formation of the European Common
Market in 1958.
Lastly, economies of scale contributed 0.57 percentage points
to the difference between U.S.
and European growth rates in the
1950-62 period. Part of that differential was due to the more
rapid growth of national markets
in Europe, but most was due to
the shift of European consumption to high income-elasticity
products. I8 As per capita incomes
rose in Europe, the consumption
of consumer durables and other
types of "luxury" goods expanded rapidly. Because of
Europe's relatively low per capita
incomes in the early 1950's, pro-
duction of such goods was
generally characterized by smallscale and high-cost operations.
As national markets for these
products expanded, European
producers were able to enlarge
their scale of operations and to
adopt many cost-saving devices
and techniques which had long
been in use in the continentalsized American market.
To summarize, all three factors
were strongly affected by special
conditions characteristic of
Europe's particular stage of economic growth and economic
integration during the 1950-62
period. In contrast, the difference
in investment ratios played only a
relatively minor part in accounting for the observed difference in
European and U.S. growth rates.
The fact that our data do not
extend beyond the early 1960's
does not diminish the significance
of these findings. The important
point is that technology enhancement, improved efficiency in
resource allocation, and economies of scale accounted for the
entire difference between U.S.
and European growth rates during
this particular period. We cannot
determine whether the same
factors would explain tre continued difference between U.S.
and European growth rates without a major updating of the
•
Denison study. Also needed is a
comparative study of Japanese
economic growth, which at first
glance might seem unique, although it could well turn out to
be reducible to the same factors
that accounted for the faster
European growth rates of the
1950-62 period.
This paper has focused on the
logic of certain commonly held
propositions regarding investment and growth, and on empirical data accounting for the
difference in U.s. and European
growth rates. The findings, however, are not devoid of policy
t( implications.
By refuting the meaningfulness of
the commonly-used international
comparison of investment ratios
and growth rates, we should be
able to lay to rest the illusion that
the United States could boost its
economic-growth rate to the
levels achieved elsewhere
through policy measures designed to raise the U.S. investment ratio. To the extent production is more capital-intensive
here than in Europe, the U.S.
investment ratio would have to
be much higher than the European ratio in order to achieve the
same capital-growth rate-and
even then, the U.S. growth rate
would still fall considerably short
because of other factors at play.
A fuller understanding of the
factors involved should help to
reduce the level of unrealistic expectations by growth enthusiasts.
However, policies for promoting
higher levels of saving and investment may still be justified for
other reasons. With the manifold
socio-economic problems confronting the nation, are-ordering
of national priorities is called for,
and a likely outcome of that reordering may well be a decision
to allocate more funds to overcome basic materials shortages
and other problems.
Considerable opposition to an
active growth policy has arisen in
recent years because of its alleged
costs to society.19 The arguments
for and against such a policy
extend far beyond the scope of
this paper. Suffice it to say that
questions on desired growth rates
and investment rates involve
some of the most fundamental
issues of social choice. Ultimately,
in a democracy, the public must
decide how much it is willing to
sacrifice its current standard of
living, how much environmental
pollution it is willing to tolerate,
how rapidly it can afford to deplete limited natural resources,
and how much compromise it can
accept on tax equity, in order to
stimulate investment and promote faster economic growth.
There are obviously no simple
answers.
Rational decisions on the nation's
economic-growth policy are
predicated on a sound understanding of the growth process.
Much has been learned on that
subject in the past several decades, thanks to a strong upsurge
of interest in growth problems
that brought forth a large crop of
scholarly studies on the topic. In
recent years, however, an antigrowth mood has set in. The
intellectual excitement generated
by the works of Kuznets, Solow,
Phelps, Denison, Mansfield and
others 20 has subsided considerably. But although intellectual
interest rises and falls, the problem of social choice persists, and
it can be expected to be with us
for many years to come. We can
only hope that the momentum
generated by the studies of the
1960's will be picked up again,
and that sustained effort will be
made in exploring the mysteries
of the economic-growth process.
To begin With, an updating and
expansion of Denison's classic
work should be among the research topics of first priority.
FOOTNOTES:
1. Floyd G. lawrence, "let's end deci-
sions without direction: an interview with
Peter G. Peterson," Industry Week,June
25,1973, pp. 34-39.
2. Rockefeller Brothers Fund, The Challenge to America: Its Economic and Sodal
Aspects (Doubleday, 1958).
3. Edward F. Denison, Why Growth
Rates Differ (Washington, D. c.: Brookings, 1967).
4. More precisely, it may be shown that,
under certain assumptions, the growth
rate will be directly proportional to the
investment ratio. let Y = kK, where Y is
national output, K capital stock, and k the
inverse of capital-output ratio. Then t:. Y =
kt:.K. (Note that ilK is also the rate of investment in real terms.) Now, define i =
DoK/Y as the investment ratio in real terms,
in contrast to IR, which is the investment
ratio when both investment and national
output are in current prices. Then, ilK =
iY. Substituting, we then obtain the
growth rate g = Do YIY = ik.
The expression appears identical to that
which results from the Harrod-Domar
model, yet is fundamentally different from
the latter in that the demand side-a crucial factor in the Harrod-Damar model-is
ignored in the present discussion. Bringing in the demand side would make no
difference to the result here, but would
greatly complicate the subsequent discussion with little gain to the substance of
this paper's conclusions. For the HarrodDomar model, see Evsey D. Damar, Essays
in the Theory of Economic Growth (New
York: Oxford, 1957), pp. 83-128, and Roy
F. Harrod, Towards a Dynamic Economics
(london: Macmillan, 1949), pp. 63-100.
5. Even as astute a scholar as Robert M.
Solow cited such data as evidence for the
alleged relation between investment and
growth, although he was not unaware of
the logical pitfalls thereof. See his "Fixed
Investment and Economic Growth," in Edmund S. Phelps, ed., The Goal of Economic Growth (New York: Norton, 1969),
pp. 90-105.
6. Symbolically, let c = ilK/K and i =
ilK/Y, where c designates capital-growth
rate, i the investment ratio in real terms,
K the capital stock, ilK growth in capital
stock, and Y national output. Then, by
simple substitution, c = iY IK.
7. Symbolically, let IR = I/Y = (Pi 1')1
(PyY') = pi, where IR designates the investment ratio when both investment and
output are in current prices, I and Y investment and output in national prices
respectively, Pi and Py the prices of capital goods and of general output respectively, I' and Y' real investment and real
output respectively, p the relative-price
ratio PilPy, and i as previously defined is
the real investment-output ratio, I'/Y'.
Then i = IR/p. Now let subscripts 1 and
2 denote countries 1 and 2. ObViously,
i1 <;', if IR 1 >IR2 but I Rr/IR 2 <pr/p2.
8. See Milton Gilbert, et ai, Comparative
National Products and Price levels: A
Study of Western Europe and the United
States, (Paris: Organization for European
Economic Cooperation, 1958).
9. Denison, op. cit., p. 161. The European nations studied were Belgium, Denmark, France, Germany, the Netherlands,
Norway and the United Kingdom.
10. Denison, op. cit., pp. 167-170.
11. Robert M. Solow, "Technical change
and the aggregate production function,"
Review of Economics and Statistics, August 1957, pp. 312-320.
12. Differentiate (1) with respect to t and
then divide through by Y to obtain
Do YilT
ilK
ill
(a) - = - + Tf - + TfY
T
K Y
l Y
where fK and flare the partial derivatives
of f with respect to K and l respectively.
Assume perfect competition, so that factors are paid the value of their marginal
products, which means, from (1), capital
income will be YKK = TfkK and labor income Yll = Tfll, where Y and Y are
K
l
partial derivatives of Y with respect to K
and l. Now, define s Kand s l respectively
as shares of capital and labor in national
income. Then
YKK
K
s = - = T f - and
K
Y
Ky
\l
l
s =-=Tf
l
Y
ly
Substitute into (a) above to obtain
ilY
ilT
ilK
ill
-=-+s-+sY
T
KK
II
which is (2) in the text.
13. Denison, op. cit., p. 137. The
averages of growth rates of a) gross
and b) net stocks, of business p
equipment.
14. Denison, op. cit., p. 42.
capital-growth rates are multiplle
capital shares in national income
tain capital's contribution to eco
growth rates, in accordance with e
(2) above" our data would yield O.
centage-points contribution to Eu
growth and 0.56 percentage-point
tribution to U.S. growth-rather th
0.64 and 0.43 figures presented by
son. Yet despite the difference in f
tion, the two sets of estimates are i
proportion to each other: 0.84/0.
0.64/0.43 = 1.49.
15. The contribution of "tech nolo
hancement" to economic growth
rived as a residual after the contrib
of all the other factors have been a
ed for. As such, it is possibly su
a wide margin of error.
16. Denison, op. cit., pp. 280-81.
17. Denison, op. cit., pp. 298 and
18. Ibid.
19. For a persuasive and econo
sound analysis, see Edward Mishan,
nology and Growth, the Price
(New York: Praeger, 1970).
20. Simon Kuznets, Economic Gro
Structure (Norton, 1965); Robert
low, op. cit.; Edmund S. Phelps,
Rules of Economic Growth (Norton,
Edward F. Denison, op. cit.; Edw'
field, The Economics of Techo
Change (Norton, 1968).
"
@FedFRASER