According to this year Nobel Prize winner in economics, Paul Romer, the technical knowledge that spills over into the creation of new products is the key to sustained economic growth.
Is it however true that technical knowledge is the heart of economic growth? If this would have been the case, why do economies in the developing world continue to experience poverty? After all individuals in these economies have access to the technical knowledge of the developed world.
Furthermore, Romer is of the view that free market economies, left to their own devices, tend to produce little new knowledge. In a fully competitive environment, firms will be concerned that other firms will quickly copy any innovations they introduce, so they will be reluctant to make costly investments in research and development, argues Romer.
To deal with this problem, Romer is of the view that it is necessary to introduce policies like subsidies for research and development. Hence on this way of thinking government policies play a critical role in fostering technological innovation.1
Contrary to Romer, the most important ideas actually emerge because of the initiative taken by various individuals in the private sector without any support from the government. To name a few such innovations includes computer technology in the late 20th century or the development of electricity, radio and television in the early 20th century, or the automobile industry and the airline industry also in the early 20th century.
Furthermore, the policy of providing subsidies by the government would bypass the market mechanism thereby stifling the usage of scarce capital thus undermining economic growth.
It seems to us that Romer ignores the key factor of economic growth — funding. Individuals that are engaged in the various stages of production require access to final consumer goods in order to support their lives and wellbeing.
At any point in time, there is a finite pool of final consumer goods. To fund a greater number of activities requires an increase in the pool of consumer goods i.e. an increase in the pool of real wealth.
The essence of the pool of real wealth
We have seen that to fund a greater number of economic activities requires an expansion in the pool of consumer goods i.e. the pool of real wealth. The key for the increase in this pool is the improvement in the productive structure i.e. tools and machinery. With the help of better tools and machinery one can secure a larger quantity of better quality consumer goods.
What is required is to allocate some of the consumer goods towards individuals that are going to be engaged in the improvement of tools and machinery i.e. the improvement of the infrastructure.
We label the part of the pool of real wealth allocated towards the maintenance and the expansion of the infrastructure as real savings.
Note that the improved infrastructure permits not only the increase in consumer goods but also the introduction of various services that were not available before.
The size of the pool of real wealth determines the quality and the quantity of various tools and machinery. If the pool of real wealth is only sufficient to support one month of work, then the making of a sophisticated tool that requires two months of work cannot be undertaken.
Thus, even if we had the best technical knowledge, if the pool of real wealth is not large enough then nothing is going to happen.
Note that the enhanced infrastructure permits the expansion of the pool of consumer goods i.e. the pool of real wealth. All other things being equal this permits a greater allocation of real wealth towards a further improvement of the infrastructure and consequently permits a higher living standard.
New ideas without the expanding pool of real wealth cannot generate economic growth
Whilst new ideas can result in a better use of scarce resources, they can however, do very little for real economic growth without an expanding pool of real wealth.
In Man, Economy, and State Rothbard says that technology, whilst important, must always work through the investment of capital in order to generate economic growth. On this issue Rothbard quotes Mises who says,2
“What is lacking in (underdeveloped counties) is not knowledge of Western technological methods (“know how”); that is learned easily enough. The service of imparting knowledge, in person or in book form, can be paid for readily. What is lacking is the supply of saved capital needed to put the advanced methods into effect.”
So regardless of how knowledgeable we are and regardless of various technological ideas, without an expanding pool of real wealth — which in turn permits an increase in real savings — no expansion in economic growth is going to emerge.
It is through the expansion in the pool of real wealth that an increase in the stock of capital goods is possible. The increase in capital goods — correctly allocated — permits the increase in economic growth to emerge.
Note again that we do not say that technical knowledge is not important. This knowledge however must be embedded in the infrastructure. For instance, to make a particular tool the toolmaker must have an idea of how to make this tool.
The idea alone however will not be sufficient to produce the tool. Various elements to make the tool must be produced before it could be assembled.
In the various stages of production i.e. intermediate and final stages, individuals that are employed in these stages must be supported by providing them with final consumer goods, which will sustain them.
As we have seen, the allocation of final consumer goods towards various individuals that are engaged in the various stages of production is what real savings is all about.
Observe that without the allocation of consumer goods towards the individuals in the various stages of production the tool will not be made notwithstanding that the toolmaker has the technical knowledge of how to make the tool.