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Friday, June 22, 2012

Economic Growth

So, I read the news about India's GDP growth other day. Headlines about how it has slowed in recent years from 8-9% two years back to 5-6% in 2011-12. I wondered what difference does it make if growth reduces by few digits. Why do we care so much about this number?. The politicians talk about it, the bankers talk about it. What is the fuss about?
To find out let's look at two cases. One is the case of low growth rate of 2% and another with high growth rate of 6%. Let's assume people in both the countries make 1000 rupees initially.

If we use the simple high school compound interest formula we'll end up with something like this :-

YEAR                 2%                  6%
   0                  1000                1000
   1                  1020                1060
   10                1219                1791
   35                2000                7686
   100              7245              339,302

After first year, the difference between the per capita income is not much. 40 dollar per person that is not a huge difference. If we go ahead 10 years from now, the people in the second country are almost 50% better off than the first one. Similarly during 35 years period, the people in the second country are almost 4 times better off  than the first one. This means the growth is exponential.  And to simplify things we'll use a new formula called "rule of 72". It explains what we can actually deduct from these numbers.

Rule of 72  - "Divide 72 by the growth rate and it tells you (approximate) time for GDP to DOUBLE"

Let's suppose our growth rate is 2%. We get 72/2 = 36. Which means it'll take about 36 years for everybody's income to double. 
What if I had 6% growth rate. 72/6 =  12. Which means it'll take 12 years to double. Both the arguments are also clear from the table above.
The overall conclusion is, if we go from 2% to just 6% growth rate. The country's GDP will be 8 times to that of initial value during the same period in which the country with 2% growth rate doubles itself. That is a HUGE difference!.
And that is why people focus so much on growth rates. Since the growth is exponential a slight difference turns out to be huge in the long run.

Why Do Some Countries Not Grow?

I'm reading fascinating new book called "Why Nations Fail" written by the economist Daron Acemoglu and the Harvard political scientist James A. Robinso. It argues that the key differentiator between countries is “institutions.” Nations thrive when they develop “inclusive” political and economic institutions, and they fail when those institutions concentrate power and opportunity in the hands of only a few. Growth requires a strong central government to protect capital and investment but that government cannot be controlled by a select few. Too few people will extract money from the economy thereby lowering investments in innovation and capital.

                        "Growth requires creative destruction"

 It is true that when one market gets wiped out another emerges. The advent of Tractor replaced horses in  agriculture. Cd's replaced cassette tapes. In more recent times, the internet has acted as a catalyst for creative destruction. The internet has allowed businesses to compete in markets outside of their geographic location, reach more consumers, create efficiencies and cut costs in manual processes as well as pioneer new techniques for doing business.
                         Sustained economic growth requires innovation and innovation cannot be decoupled from creative destruction, which replaces the old with the new in the economic realm and also destabilizes established power relations in politics.
                    "Unless a country makes the transition to an economy based on creative destruction, its growth will not last," argues the author.
                     Once I finish the book, I'll look into what it means for India. Why growth rate has fallen in recent times and how it'll affect our future.