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The Myth of Economic Miracles

Paul Krugman back in 1994 wrote an excellent article called The Myth of Asia's Miracle (Foreign Affairs, Nov/Dec 1994, V73, N6).

He compares the rise of the Asian economies to the rise of the Russian economy in the 50's and 60's. In both cases economic growth was achieved by an increase in economic inputs. This means increasing the level of employment, education, investment in physical capital and in general just shoveling more resources into the economy.

This kind of growth is great as far as it goes, but as Krugman states so well: "Economic growth that is based on expansion of inputs, rather than on growth in output per unit of input, is inevitably subject to diminishing returns." Long term sustainable growth must be based more on increases in productivity. At some point you have to figure out how to get more output per unit of input. Productivity has to be increased. The Economy must become more efficient.

An analogy is useful. Lets say you are trying to heat a house that is not well insulated i.e. there are cracks around the doors and windows where heat can escape. You can increase the temperature in the house by increasing the amount of energy input, burning more wood, gas, oil or using more electricity. You can also increase it by improving the insulation, filling the cracks around windows, doors, etc. This latter method is the more efficient way to go and is the most sustainable in the long run.

The Asian economies achieve their growth by simply putting more logs on the fire not by increasing efficiency and productivity. This is probably due to the fact that Asian businesses have access to an abundant supply of cheap labor and are more focused on short term gain (the Chinese get rich quick obsession) than long term profitability and growth.

Another way to create short term unsustainable economic growth is to have a central bank with a loose money policy. When credit is easy to come by then every half baked idea has a good chance of getting funded. This leads to a misallocation of resources and overcapacity in many areas of the economy. In the short run the effect is the appearance of a vigorous economic expansion. To keep the expansion going however requires an ever greater increase in the amount of credit. At some point the debt can simply no longer be serviced and there is a collapse in economic activity.

This is what has been happening in the United States since the twin maestros, Greenspan and Bernanke, have been running the Federal Reserve. The latest collapse in the housing market has prompted Bernanke to print more money than the world has ever seen. This has seemingly produced a rebound in the economy, another economic miracle. It is all an illusion and it will end with another economic collapse from which there will be no painless escape. Losses will eventually have to be realized. Destruction has to occur for new growth to be possible.

The massive pumping of money into the financial system by the Federal Reserve is very analogous to the unsustainable increase in economic inputs that Krugman talked about in his article. The funny thing is that Krugman is one of the strongest advocates of this policy. His blind faith in Keynesian ideology makes it impossible for him to see the connections.

There is no such thing as an economic miracle. Improvements in the standard of living for the general population (not just the bankers) must ultimately be based on an increase in knowledge and improvements in technology and these take time to develop. The best thing a society can do is to encourage research and technological development. They are ultimately the only way to keep the economy growing. We will have an economic utopia only when scientists and engineers are valued more than bankers. The United States is a long way from this goal.

© 2010-2012 Stefan Hollos and Richard Hollos

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