Let’s face it, economic growth models are outdated. We’ve continuously tried to explain how countries achieve growth using our current models but have failed to identify how, in the 21st century, China and other I-6 countries were able to achieve exponential growth while the U.S. and G7 countries began to stagnate in their economic output. The fact of the matter is that it can be attributed to something quite simple: human capital.
Our current economic models fail to incorporate human capital effectively since they assume it as exogenously given (meaning a variable obtained outside the model) which significantly under-represents the value of human capital within the economy. Subsequently, economic models assume perfect competition, and, in such models, it is difficult to incorporate the profit-maximizing behavior of firms through a lens of competitive advantages. In particular, current measures of growth fail to correctly encompass the imbalance developed economies face over industries that value intangibles and human capital in order to gain a competitive advantage and increase their value-added.
The truth is that human capital formation is what drives the economy to sustain a consistent level of economic growth. And economists have noticed, because in recent years many have tried to incorporate human capital endogenously. However, they have faced significant criticism because it is difficult to truly quantify such metrics. Accountants have met similar challenges valuing the intangible capital of firms. It is hard to put a number on the brands of Coca-Cola or Apple when their company names themselves hold immense value.
As a result, economists, specifically Nobel laureate Paul Romer, have devised ways to incorporate human capital in growth models by explaining economic output through measures such as savings and investment. Paul Romer’s endogenous growth model holds that investment in knowledge capital generates enough output per person and savings per person to always maintain the investment required, and the savings which is generated is in excess of the amount of investment required. Thus, Romer’s model intuitively identifies how companies investing in human capital continuously realize excess returns from their initial investment.
Yet, since intangibles, know-how, and human capital are not easily transferable from one firm to another, or in other words the carry-over of skills in one industry to another is quite limiting, an investment in human capital makes sense only if firms see a value-added return from their investment. Therefore, Romer’s theory identifies that such investment will ultimately lead to a single firm dominating the entire market within its respective sector, something that economists argue is not present in our society.
However, this exact phenomenon has been exemplified by Amazon. With greater demand for its goods, the company gained experience and became more efficient, eventually achieving the monopolistic characteristics it exhibits today. This reiterates Kenneth Arrow’s claim of a learning curve and affirms Wright’s Law on production capabilities. So is the case with China, as there was and continues to be a considerable emphasis on skill development and specialization to promote human capital formation.
As David Sainsbury identified in his new book Windows of Opportunity,
“the capabilities of firms that enable them to take advantage of the opportunities they face are undoubtedly a critical factor in explaining the growth rates of sectors of an economy. In particular, whether firms have the dynamic capabilities which enable them to link their technological and organizational capabilities to a product or service demand is central to the theory of economic growth.”
To make this point clear, we can look at the consolidation of companies and banking institutions over the past decade, as the SEC approved questionable M&A transactions in order for U.S. companies to be “competitive” on the global economic landscape. The logic was that larger firms would be more efficient and drive innovation if they allocated their resources and profits accordingly. As a result, there is less competition among domestic companies which would have been used to drive innovation.
However, the majority of corporations in the U.S. are not taking advantage of their organizational capabilities and reinvesting a majority of their profits to R&D and other human capital-intensive initiatives. Many are more concerned with short-term profitability and executive remuneration through dividends and stock buybacks, rather than focusing on reinvestment in workers and the processes that will benefit the company’s stakeholders in the long-term.
As of January 2019, of all the companies in the S&P 500 that were publicly listed between 2009 and 2018, 465 of them spent, over that decade, $4.3 trillion on buybacks, equal to 52% of net income, and another $3.3 trillion on dividends, an additional 39% of net income.
The main purpose of these buybacks was to inflate short-term profits but by doing so limited the firm’s ability to expand their innovation businesses because of the risks associated with realizing a return on investment in unknown sectors.
With fewer companies managing greater amounts of assets to be more efficient and profitable in the short-term, there is little room for innovation as those companies are focusing on cutting costs and are able to dictate what they charge for their products. As with monopolies, this is subsequently reducing the competitive advantage driven motivations that are fostered by having a multitude of firms competing with one another.
Yet at its heart, innovation is at the core of economic growth and it is what drives the economy. And since total factor productivity is the key variable in determining economic growth, innovation ensures that productivity always increases. We can see that innovation is a direct result of human beings interacting with each other as they build on their ideas in hopes of creating something new that will benefit society, or rather allow them to achieve a competitive advantage over other firms in their respective industries.
That’s why certain industries actually have a higher value-added than other industries. So, when innovations, products and processes mature within certain industries, or in other words reach a technological dead-end, such as in the mass production of clothes and golf balls, the global market will assign those industries to low-wage countries. This is because every country goes through a ladder of economic development in a ‘race to the top’. Thus, high-wage countries outsource low value-added industries so they can continuously retain their competitive advantage in high value-added sectors that subsequently spur innovation and thus economic growth.
For example, potato chip manufacturing has a low value-added to society since there is not much innovation that can result from making a better potato chip. So, the sector is easily exported to other countries to take advantage of cheaper labor. On the other hand, semiconductor manufacturing is a high value-added industry in which initiating R&D to improve production results in a significant positive externality.
We can see this very theme occurring in finance and more specifically in the S&P 500. Let’s take a step back and look at what history has to show us, empirically.
As we can see, although the S&P 500 has increased at an exponential rate, the economic output among the top 500 U.S. companies has remained relatively the same as evidenced by the constant level the Value Line Geometric Index ($XVG) has been at since 1998.
In other words, since a greater weight of the S&P 500 has shifted to more innovative sectors such as information technology, healthcare, communication services and financials, and tech accounts for roughly 28%, the stock market has increased exponentially while less innovative sectors, such as the production of baseball gloves, have been more easily outsourced.
However, economic output has been stagnant due to the corporate governance of those companies being focused on short-term profits rather than long-term reinvestment. This may be a significant reason why U.S. GDP has increased at a relatively low rate over the past 20 years.
Additionally, while small businesses account for a major portion of the U.S. economy through employment and other means, they do not account for a major portion of economic output. The Office of Advocacy of the U.S. Small Business Administration identified that while small-business contribution has grown at a slower rate than that of large businesses, small businesses continue to be at the forefront of driving innovation, jobs and economic growth.
Such strategic initiatives pursued with competitive intent is what ultimately can, and will, drive growth within a certain sector. This often results in positive externalities in other sectors due to its role as a pure public, and abundant, good. For instance, cheaper and cleaner energy will have lasting effects on the transportation sector which will impact the auto and home manufacturing sectors which will impact the real estate sector and so forth. In other words, innovations utilizing a generic technology platform that provide positive externalities will provide a higher value-added to society as they become more abundant. Though once innovation halts, meaning research and funding into such programs begins to stagnate, a country will begin to lose its competitive advantage.
Since we attribute private-sector free-market capitalism as the only option, we fail to see that with proper co-operative policies which promote education and research, we can undoubtedly drive innovation. In fact, innovation failures are more prone to occur if the government does not play an active role in our free-market economy. The “rational” firm will fail to invest in innovative next-generation technologies, no matter the rewards, if high levels of risk and excessive R&D time frames would impede profits. So, the government must take the first step to lay the groundwork for firms to expand upon, as was the case with the initial development of the Internet (aka ARPANET). This is precisely the case in markets where multiple firms need to co-operate and make use of pure public goods to build new technology platforms since “governments can play a useful role by facilitating the development of systems and funding infrastructure, so that once the platform is deployed the private sector can innovate on top of it” (Sainsbury).
Yet, while the US has failed to heed these principles for political reasons over the past 20 years, other governments around the world have actively developed national innovation strategies since they acknowledge the fact that innovation drives economic growth. For instance, Sainsbury emphasizes that, “China has made clear it wants to win the race for global innovation advantage…[as] it launched a fifteen-year ‘Medium to Long-term Plan for the Development of Science and Technology’. Thus, with governmental guidance by investment in certain industries that have a significant value-added to society, we can, in fact, enable abundance as more innovations will lead to further automation and technological advances which reciprocate to different industries.
Though to ensure industries have a significant value-added to society we must emphasize the importance of human capital, especially among small and medium sized enterprises. To reiterate the importance of education and research in promoting economic growth, Milton Friedman even proposed a voucher program to incentivize students and workers to be educated so that they can be more skilled when they enter the workforce and in turn become more productive members of society while also earning a higher income. In other words, greater education produces more positive externalities that may cost more in the short term but with benefits that will repay society at a greater rate in the future.
As the Department for International Development of the OECD put it, strong economic growth therefore advances human development, which, in turn, promotes economic growth.
We can see the development of human capital in small and medium sized enterprises today. For instance, Dutch Bros., the largest privately held drive-thru coffee chain in the U.S., limits the expansion of new franchises from within. That is, it sells franchises only to people who have worked for the company and sucked up the culture for a minimum of three years. This model allows employees to stay dedicated and incentivizes them to continue to excel and reflect the company culture while developing their own business skills.
The financial markets have been aware of something that politicians are just starting to incorporate with President Biden’s American Jobs Plan, and what more economists are starting to see despite a lingering belief in frictionless “perfect-markets”. That is, in the World in 2030 report by the Capital Group, one of the 10 predictions for long-term investors as noted by Anne-Marie Peterson is that innovative companies will make the world better. And not only innovative companies, but also research and development in science and technology, education spending, domestic infrastructure, sustainability, and ensuring manufacturing in innovative sectors are all at the forefront of economic policy. All this in turn, with the help of strong political institutions, will improve the well-being of those in society and make sure that humans, and not the lure of profits, are at the center of capitalism.
In macroeconomics, every model is only as good as its assumptions. So, by ignoring the role of human capital, we may be severely distorting our view of economic growth. If this new model can accurately incorporate the necessity of human capital, it provides us with a roadmap for achieving constant and productive growth not only now but in the long-term as well.