To drive economic growth, Governments all across the globe, notably in less developed countries as they pursue debt-based development programs, seek strategy and policy advice from economists. In response, economists look into a set of theories of producing economic outputs. Consequentially, their advices are based on insights derived from those theories. However, are economic theories for development policies strong enough to offer a sustained growth path to reach and sustain high-income status? Or, do economic theories suffer from voidness in guiding less developed countries with policy decisions?
The use of economic theories for development policies began with the famous Cobb–Douglas production function, which produces economic outputs as a function of capital (K), labor (L) and total factor productivity (TFP, A). Subsequently, over the last 100 years, they have developed the Solow Growth Model, human capital theory, and endogenous growth models like the theory of ideas and objects.
Recently, they recognized the role of institutions empowering ideas for creating value instead of extracting in economic development by offering the Nobel Prize in 2024 to Daron Acemoglu, Simon Johnson, and James Robinson. Their theory is based on the learning of the last 2000 years that institutions in democratically government countries facilitate the growth of ideas from new entrants, causing prosperity through Creative Destruction, as outlined in a book—Why Nations Fail. Nobel Committee also offered several prizes for previous theories of economic output production.
Despite recognizing intellectual merits, have those theories matured enough to guide naturally resource-poor and highly populated countries to sustain economic growth and reach high-income status?
Historical perspectives
Most of the less developed countries suffered from European colonization. Before colonization, those countries had tinkering-based Innovation and craftmanship-centric manufacturing facilities like the rest of the world. During the preindustrial stage, prior to colonization, a few of these countries had a significant footprint in the global industrial economy.
For example, just before 1750, India was the most critical manufacturer in world trade. It produced about 25 percent of the world’s industrial output at that time. However, just after 1750, India’s share of global manufacturing output started rapid depletion. It happened due to two primary reasons. First, British-led Europe started advancing and adopting science, technology, and engineering to generate and scale up ideas, notably in energy production and mechanization of the production of primary products like textiles.
On the other hand, the British started treating India as the supplier of raw materials and consumers of European products through East India Company and other tools. Consequentially, colonies could not develop their capacity to scale up their production techniques and design of products.
Post-colonization period—seeking help from economic theories for development policies
Cobb-Douglas production function
Right after the end of colonization, former colonies started to focus on developing an industrial economy. Hence, they sought advice from the economists. Consequentially, economists referred to the Cobb-Douglas production function and advised them to import capital machinery and train the agricultural labor force to be machine operators to make copies of imported products—giving rise to the import substitution strategy. As Cobb-Douglas production function also recognizes the importance of the role of science, technology, and ideas as total factor productivity, economists advised them to offer education, following the curricula of advanced or former colonial powers. Hence, for diving economic growth, less developed countries focus on training, education, and importing capital machinery.
Initially, economic policy advice derived from the Cobb-Douglas production function offered economic progress, as value addition from labor, knowledge and ideas in replication was high. However, due to the import dependence on increasingly imported capital machinery, local knowledge and ideas started losing the scope of value addition, as they were being implemented in capital machinery by advanced exporting countries.
However, due to the advancement of capital machinery, low-skilled labor with little or no training started getting qualified for factory jobs. Consequentially, they witnessed export-oriented manufacturing jobs. Unfortunately, further progression of capital machinery has begun eating up those jobs. As a result, driving economic growth through production or replication or manufacturing by importing capital machinery has been suffering from decreasing value addition scope out of labor, knowledge, and ideas. Therefore, investment in training for how to operate and maintain imported capital machinery and expanding education for knowledge and ideas are suffering from eroding returns. Besides, due to growing maturity of capital machinery, there has been increasing trend of monopolization, creating barriers to new entrants.
Solow growth model
From 1950 to 1970, the US economy experienced high growth. In the 1960s, real GDP grew on an average 5% per year. Along with the US payroll growth of 32 percent during the 1960s, Government tax revenues grew by 65% from 1965 to 1970.
To decipher such high economic growth, Robert Solow observed a high difference between the summation of the marginal contribution from labor and capital and the economic development, terming it as Solow Residual, which underpins the Nobel Prize-winning Solow Growth model. Despite attributing to the role of investment and progress in science, technology, and innovation (STI) during WWII and the Cold War, he could not clearly explain explicit relations between STI and R&D indicators to Solow residual. Hence, he termed it an exogenous factor contributing to economic growth.
However, Robert Solow’s Nobel prize-winning growth model further underscored the importance of STI indicators for economic development. Consequentially, the economists were encouraged to suggest to less developed countries that they would favor expanding STEM education and research. Unfortunately, less developed countries could not leverage such investment like the USA and a few others did, as they focused on replication by importing capital machinery and design ideas.
Human capital theory
From 1970 to 2000, economists made progress in showing quantitative relations between high-income jobs, economic growth, and human capital indicators like quality of education, degrees, and health. Upon processing data from a few high-performing countries, they promoted that economic output as a function of physical capital, labor, and human capital (Y=F(L,K,H)). Subsequently, several Nobel prizes were awarded. Consequentially, economists got further theories to offer strong policy advice to less developed countries to increase the depth and breadth of education, notably higher education in STEM. As a result, less developed countries started experiencing accelerated growth in investment in education, the number of academic institutions, and graduate production. Ironically, they also started experiencing growing graduate unemployment, surfacing a phenomenon of higher the education greater the possibility of remaining unemployed.
Endogenous growth model or Romer’s theory of ideas and objects
In 2018, the Nobel Committee awarded Paul Romer’s idea and object theory, which articulated ideas as a non-rivalry endogenous factor. He reasoned that by increasing the Flow of Ideas, an economy could grow as better ideas extract more economic value from the same objects, like raw materials, labor, and energy. Besides, better ideas can potentially reduce negative implications like waste and pollution. Hence, the economy will be far more scalable. Thus, economists got another theory to support advice for less developed countries to increase investment in R&D to improve human capital, increase R&D investment and produce more ideas.
Unfortunately, more than 94 percent of patents are never used. Seventy-five percent of innovative products retire without generating profit—furthermore, more than a percent of Startups die within three years. Hence, with the promotion of ideas and offering funding for startups, there have been no significant success stories in creating new Wealth in less developed countries. Therefore, investment favoring idea production, as suggested by Paul Romer’s idea and object theory, runs the risk of making less developed countries poorer.
Unlike before, a single idea can no longer offer better substitutes and support a profitable business. Due to globalization and maturity of incumbent means in getting Jobs to be done, innovators must win the global competition to create wealth from the ideas they produce. Hence, the suggestion of idea production for driving economic growth runs the risk of wasting the wealth of less developed countries.
Institutions shape economic development
In 2024, Daron Acemoglu, Simon Johnson, and James Robinson received the Nobel Prize for their theory that a democratic and fair institutional framework empowers individuals and firms to pursue waves of ideas, unleashing creative destruction. As a result, better substitutes, destroying the demand for existing matured products, for getting jobs to be done will create higher consumer and producer surpluses, thereby driving economic growth.
In support of their thesis, they refer to the history of the last 2000 years, as summarized in the book, Why Nations Fail. They observed that due to democratic and fair policy decisions, special interest groups will face the challenge of pursuing an extraction economy due to the rise of the next wave of ideas.
Are fair and democratic institutions good enough to guide policies for development?
Unlike in the past, a single idea like spinning jenny, created by James Hargreaves, which revolutionized the textile industry by making fabric production much more efficient, is no longer sufficient for creative destruction. Hence, fair institutions offering the freedom to pursue new ideas are not good enough to drive sustained prosperity. For example, although a few countries like Canada and Australia have fair institutions for making development policy decisions based on democratic norms, their economies are mostly through natural resources. Furthermore, despite having sound education and national R&D systems, the success of these countries in driving economic growth through global-level leadership of large-scale creative destruction is basically absent.
On the other hand, Japan, South Korea, and Taiwan, likely having poorer institutional capacity, have shown far greater success in leveraging knowledge and ideas to drive their economic growth, making them global innovation powerhouses. Besides, despite having stronger institutional strength, the USA has lost epicenters of a few critical inventions to these countries, making it an importer.
Beyond Economic Theories for Development Policies—what could be the source of guidance for less developed countries?
Instead of competing in Western-style education, R&D, and developing an innovation ecosystem to pursue a linear model of innovation like the way the USA created success, less developed countries should focus on participating in the evolution race of existing products. By the way, due to non-scalability, grassroots innovations and micro crafts-based enterprises do not offer scalable paths of wealth creation to less developed countries. Hence, instead of being inspired by human capital and Romer’s idea and object theory for developing generic capacities, they should be very focus.
Hence, instead of competing in improving infrastructure by borrowing and recruiting foreign firms with the hope that those facilities will form the physical and intangible capital to drive efficiency, they should focus on how to open the path of outperforming global competition in a few selected products.
Therefore, they should focus their limited resources on winning the global innovation race in a few selected products instead of believing in Solow residual distilling from exogenous factors–like the way Japan did. However, to harness support from society to pursue such policies, basic education for all should include the dynamics of wealth creation out of technological possibilities. Once a critical mass understands it and feels the importance of necessary policies to pursue it, the democratic process will compel the adoption of appropriate policies, which may not be in line with economic theories for development Policies.
The policy decision to import capital machinery and product ideas to create economic value through local labor and knowledge does not offer a scalable path. Instead of scalability, such policies face the reality that imported capital machinery has been reducing the relevance of labor, knowledge, and ideas in production. Besides, investing in knowledge and ideas has been facing high risk. On the other hand, democratic and fair institutions are insufficient for empowering individuals to pursue creative destruction. Notably, for creating economic value from education and research, the challenge is to win global competition for profitably trading ideas. Hence, there should be a synchronized response among multiple actors, including the Government, to drive the next wave and win the global race. Leaving to market and running fair institutions are not good enough to address such a challenge.
Therefore, all the economic theories developed to date fall short of offering policy decisions that enable less developed countries to sustain economic growth and reach high-income status. Thus, is it time to look beyond existing economic theories for development policies to create scalable growth paths that empower less developed countries to achieve high-income status?
Seven specific steps to be followed for sustained prosperity in less developed countries
- Offer basic education to all about wealth creation dynamics out of technology possibilities, rational decision-making amid uncertainty, and idea management to create a cumulative effect. It will create broad-based democratic support for institutions and policies to open the window of creating wealth from idea flow distilling from technology possibilities.
- Promote ideas and technology management at the grassroots production level so that millions of idea streams form from systematic idea production, creating a new capacity for wealth creation.
- Promote systematic Process innovation to create a snowball effect in industrial sectors so that the competitiveness of local production keeps improving, institutions for idea-based wealth creation start forming, and managerial capacity starts growing.
- Set up a research center to understand and predict global dynamics of wealth creation by leveraging technology possibilities so that early signals are detected, trends are predicted, and opportunity windows are identified.
- Start investing in global technology stocks with the potential of scaling up to improve understanding of global dynamics and grow capital.
- Select a few products in suitable industries for winning the global race in evolving them through incremental advancement and creative destruction.
- Make synchronized responses to win the global race of advancing the candidate products to migrate the epicenters of innovation of target products. As a result, a new cluster of wealth creation through idea trade will start forming–opening a scalable path of growth for reaching high-income status.