Letter:New school of economic growth
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Your support makes all the difference.Sir: I infer from Gavyn Davies' column (3 June) that he has understood neither my analysis of the impact of higher physical investment on trend growth in the UK nor the weight of academic evidence regarding the presence of diminishing returns to physical capital. Mr Davies and the Labour Party clearly believe that a rise in the rate of physical investment could exert a marked and lasting effect on the pace of economic growth over the long term. Both seem to have fallen under the spell of a revisionist school of the theory of economic growth - the "post-neo-classical endogenous growth theory" to which the Shadow Chancellor, Gordon Brown, famously referred in his speech in 1994.
New growth theory is undoubtedly an exciting area of academic enterprise which deserves a wider audience. However, pioneers in the field - like Paul Romer and Larry Summers, whom Davies cites in support of his view - produced results about the importance of physical investment which have been pretty decisively rejected by later studies. The most recent in a long line comes from Nicholas Oulton and Garry Young at the National Institute who find that "... contrary to DeLong-Summers, there seems to be no special magic to equipment investment as an engine of growth".
On this basis, I concluded in my analysis that the contribution of physical investment to the UK's trend growth was likely to be close to that suggested by traditional theory - that is, small and ultimately transient. For example, a one percentage point rise in the share of physical investment in the gross domestic product might at most raise trend growth by 0.1 percentage point.
My study acknowledged Davies' point that the level of national output would be (in principle) permanently higher but whether this was achievable and a good thing was open to question. In the 1960s Harold Wilson's new Labour government introduced all manner of investment schemes which created distortions and a re-entry problem as the stimulus wore off.
After its first false move, the new school of economic growth now emphasises the importance of technological diffusion and human capital. On this we can all agree. The problem remains how to raise the UK's capabilities in these respects in the face of a still-inadequate rate of return on capital.
BILL MARTIN
Chief Economist, UBS Limited
London EC2
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