Mankiw Principles of Macroeconomics (3rd ed)
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PART FIVE THE REAL ECONOMY IN THE LONG RUN |
The next chapter examines in more detail how the economy’s financial markets coordinate saving and investment. It also examines how government policies influence the amount of saving and investment that takes place. At this point it is important to note that encouraging saving and investment is one way that a government can encourage growth and, in the long run, raise the economy’s standard of living.
To see the importance of investment for economic growth, consider Figure 12-1, which displays data on 15 countries. Panel (a) shows each country’s growth rate over a 31-year period. The countries are ordered by their growth rates, from most to least rapid. Panel (b) shows the percentage of GDP that each country devotes to investment. The correlation between growth and investment, although not perfect, is strong. Countries that devote a large share of GDP to investment, such as Singapore and Japan, tend to have high growth rates. Countries that devote a small share of GDP to investment, such as Rwanda and Bangladesh, tend to have low growth rates. Studies that examine a more comprehensive list of countries confirm this strong correlation between investment and growth.
There is, however, a problem in interpreting these data. As the appendix to Chapter 2 discussed, a correlation between two variables does not establish which variable is the cause and which is the effect. It is possible that high investment causes high growth, but it is also possible that high growth causes high
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(a) Growth Rate 1960–1991 |
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(b) Investment 1960–1991 |
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South Korea |
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South Korea |
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Singapore |
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Singapore |
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Japan |
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Japan |
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Israel |
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Israel |
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Canada |
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Canada |
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Brazil |
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Brazil |
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West Germany |
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West Germany |
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Mexico |
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Mexico |
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United Kingdom |
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United Kingdom |
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Nigeria |
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Nigeria |
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United States |
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United States |
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India |
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India |
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Bangladesh |
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Bangladesh |
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Chile |
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Chile |
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Rwanda |
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Rwanda |
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Growth Rate (percent) |
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Investment (percent of GDP) |
Figur e 12-1 |
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GROWTH AND INVESTMENT. Panel (a) shows the growth rate of GDP per person for |
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15 countries over the period from 1960 to 1991. Panel (b) shows the percentage of GDP |
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that each country devoted to investment over this period. The figure shows that |
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investment and growth are positively correlated. |
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252 |
PART FIVE THE REAL ECONOMY IN THE LONG RUN |
This catch-up effect shows up in other aspects of life. When a school gives an end-of-year award to the “Most Improved” student, that student is usually one who began the year with relatively poor performance. Students who began the year not studying find improvement easier than students who always worked hard. Note that it is good to be “Most Improved,” given the starting point, but it is even better to be “Best Student.” Similarly, economic growth over the last several decades has been much more rapid in South Korea than in the United States, but GDP per person is still higher in the United States.
INVESTMENT FROM ABROAD
So far we have discussed how policies aimed at increasing a country’s saving rate can increase investment and, thereby, long-term economic growth. Yet saving by domestic residents is not the only way for a country to invest in new capital. The other way is investment by foreigners.
Investment from abroad takes several forms. Ford Motor Company might build a car factory in Mexico. A capital investment that is owned and operated by a foreign entity is called foreign direct investment. Alternatively, an American might buy stock in a Mexican corporation (that is, buy a share in the ownership of the corporation); the Mexican corporation can use the proceeds from the stock sale to build a new factory. An investment that is financed with foreign money but operated by domestic residents is called foreign portfolio investment. In both cases, Americans provide the resources necessary to increase the stock of capital in Mexico. That is, American saving is being used to finance Mexican investment.
When foreigners invest in a country, they do so because they expect to earn a return on their investment. Ford’s car factory increases the Mexican capital stock and, therefore, increases Mexican productivity and Mexican GDP. Yet Ford takes some of this additional income back to the United States in the form of profit. Similarly, when an American investor buys Mexican stock, the investor has a right to a portion of the profit that the Mexican corporation earns.
Investment from abroad, therefore, does not have the same effect on all measures of economic prosperity. Recall that gross domestic product (GDP) is the income earned within a country by both residents and nonresidents, whereas gross national product (GNP) is the income earned by residents of a country both at home and abroad. When Ford opens its car factory in Mexico, some of the income the factory generates accrues to people who do not live in Mexico. As a result, foreign investment in Mexico raises the income of Mexicans (measured by GNP) by less than it raises the production in Mexico (measured by GDP).
Nonetheless, investment from abroad is one way for a country to grow. Even though some of the benefits from this investment flow back to the foreign owners, this investment does increase the economy’s stock of capital, leading to higher productivity and higher wages. Moreover, investment from abroad is one way for poor countries to learn the state-of-the-art technologies developed and used in richer countries. For these reasons, many economists who advise governments in less developed economies advocate policies that encourage investment from abroad. Often this means removing restrictions that governments have imposed on foreign ownership of domestic capital.
An organization that tries to encourage the flow of investment to poor countries is the World Bank. This international organization obtains funds from the
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PART FIVE THE REAL ECONOMY IN THE LONG RUN |
discussed economic interdependence in Chapter 3, production in market economies arises from the interactions of millions of individuals and firms. When you buy a car, for instance, you are buying the output of a car dealer, a car manufacturer, a steel company, an iron ore mining company, and so on. This division of production among many firms allows the economy’s factors of production to be used as effectively as possible. To achieve this outcome, the economy has to coordinate transactions among these firms, as well as between firms and consumers. Market economies achieve this coordination through market prices. That is, market prices are the instrument with which the invisible hand of the marketplace brings supply and demand into balance.
An important prerequisite for the price system to work is an economy-wide respect for property rights. Property rights refer to the ability of people to exercise authority over the resources they own. A mining company will not make the effort to mine iron ore if it expects the ore to be stolen. The company mines the ore only if it is confident that it will benefit from the ore’s subsequent sale. For this reason, courts serve an important role in a market economy: They enforce property rights. Through the criminal justice system, the courts discourage direct theft. In addition, through the civil justice system, the courts ensure that buyers and sellers live up to their contracts.
Although those of us in developed countries tend to take property rights for granted, those living in less developed countries understand that lack of property rights can be a major problem. In many countries, the system of justice does not work well. Contracts are hard to enforce, and fraud often goes unpunished. In more extreme cases, the government not only fails to enforce property rights but actually infringes upon them. To do business in some countries, firms are expected to bribe powerful government officials. Such corruption impedes the coordinating power of markets. It also discourages domestic saving and investment from abroad.
One threat to property rights is political instability. When revolutions and coups are common, there is doubt about whether property rights will be respected in the future. If a revolutionary government might confiscate the capital of some businesses, as was often true after communist revolutions, domestic residents have less incentive to save, invest, and start new businesses. At the same time, foreigners have less incentive to invest in the country. Even the threat of revolution can act to depress a nation’s standard of living.
Thus, economic prosperity depends in part on political prosperity. A country with an efficient court system, honest government officials, and a stable constitution will enjoy a higher economic standard of living than a country with a poor court system, corrupt officials, and frequent revolutions and coups.
FREE TRADE
Some of the world’s poorest countries have tried to achieve more rapid economic growth by pursuing inward-oriented policies. These policies are aimed at raising productivity and living standards within the country by avoiding interaction with the rest of the world. As we discussed in Chapter 9, domestic firms sometimes claim they need protection from foreign competition in order to compete and grow. This infant-industry argument, together with a general distrust of foreigners, has at
CHAPTER 12 PRODUCTION AND GROWTH |
255 |
times led policymakers in less developed countries to impose tariffs and other trade restrictions.
Most economists today believe that poor countries are better off pursuing outward-oriented policies that integrate these countries into the world economy. Chapters 3 and 9 showed how international trade can improve the economic wellbeing of a country’s citizens. Trade is, in some ways, a type of technology. When a country exports wheat and imports steel, the country benefits in the same way as if it had invented a technology for turning wheat into steel. A country that eliminates trade restrictions will, therefore, experience the same kind of economic growth that would occur after a major technological advance.
The adverse impact of inward orientation becomes clear when one considers the small size of many less developed economies. The total GDP of Argentina, for instance, is about that of Philadelphia. Imagine what would happen if the Philadelphia City Council were to prohibit city residents from trading with people living outside the city limits. Without being able to take advantage of the gains from trade, Philadelphia would need to produce all the goods it consumes. It would also have to produce all its own capital goods, rather than importing state-of-the-art equipment from other cities. Living standards in Philadelphia would fall immediately, and the problem would likely only get worse over time. This is precisely what happened when Argentina pursued inward-oriented policies throughout much of the twentieth century. By contrast, countries pursuing outward-oriented policies, such as South Korea, Singapore, and Taiwan, have enjoyed high rates of economic growth.
The amount that a nation trades with others is determined not only by government policy but also by geography. Countries with good natural seaports find trade easier than countries without this resource. It is not a coincidence that many of the world’s major cities, such as New York, San Francisco, and Hong Kong, are located next to oceans. Similarly, because landlocked countries find international trade more difficult, they tend to have lower levels of income than countries with easy access to the world’s waterways.
THE CONTROL OF POPULATION GROWTH
A country’s productivity and living standard are determined in part by its population growth. Obviously, population is a key determinant of a country’s labor force. It is no surprise, therefore, that countries with large populations (such as the United States and Japan) tend to produce greater GDP than countries with small populations (such as Luxembourg and the Netherlands). But total GDP is not a good measure of economic well-being. For policymakers concerned about living standards, GDP per person is more important, for it tells us the quantity of goods and services available for the typical individual in the economy.
How does growth in the number of people affect the amount of GDP per person? Standard theories of economic growth predict that high population growth reduces GDP per person. The reason is that rapid growth in the number of workers forces the other factors of production to be spread more thinly. In particular, when population growth is rapid, equipping each worker with a large quantity of capital is more difficult. A smaller quantity of capital per worker leads to lower productivity and lower GDP per worker.
THE REAL ECONOMY IN THE LONG RUN
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You may have heard economics |
the world are on average much |
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called |
“the |
dismal |
science.” |
higher. As a result of economic |
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The field was pinned with this |
growth, chronic hunger and malnu- |
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label many years ago be- |
trition are less common now than |
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cause of a theory proposed |
they were in Malthus’s day. |
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by |
Thomas |
Robert |
Malthus |
Famines occur from time to time, |
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(1766–1834), an English min- |
but they are more often the result |
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early |
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of an unequal income distribution |
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thinker. In a famous book |
or political instability than an inad- |
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called An Essay on the Princi- |
equate production of food. |
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ple of Population as It Affects |
Where did Malthus go wrong? |
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the |
Future |
Improvement of |
He failed to appreciate that growth |
THOMAS MALTHUS |
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Society, Malthus offered what |
in mankind’s ingenuity would |
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may be history’s most chilling forecast. Malthus argued that |
exceed growth in population. New |
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an ever increasing population would continually strain soci- |
ideas about how to produce and even the kinds of goods to |
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ety’s ability to provide for itself. As a result, mankind was |
produce have led to greater prosperity than Malthus—or |
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doomed to forever live in poverty. |
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anyone else of his era—ever imagined. Pesticides, fertiliz- |
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Malthus’s logic was very simple. He began by noting |
ers, mechanized farm equipment, and new crop varieties |
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that “food is necessary to the existence of man” and that |
have allowed each farmer to feed ever greater numbers of |
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“the passion between the sexes is necessary and will |
people. The wealth-enhancing effects of technological |
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remain nearly in its present state.” He concluded that “the |
progress have exceeded whatever wealth-diminishing |
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power of population is infinitely greater than the power in the |
effects might be attributed to population growth. |
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earth to produce subsistence for man.” According to |
Indeed, some economists now go so far as to suggest |
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Malthus, the only check on population growth was “misery |
that population growth may even have helped mankind |
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and vice.” Attempts by charities or governments to alleviate |
achieve higher standards of living. If there are more people, |
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poverty were counterproductive, he argued, because they |
then there are more scientists, inventors, and engineers to |
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merely allowed the poor to have more children, placing even |
contribute to technological progress, which benefits every- |
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greater strains on society’s productive capabilities. |
one. Perhaps world population growth, rather than being a |
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Fortunately, Malthus’s dire forecast was far off the |
source of economic deprivation as Malthus predicted, has |
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mark. Although the world population has increased about |
actually been an engine of technological progress and eco- |
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sixfold over the past two centuries, living standards around |
nomic prosperity. |
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This problem is most apparent in the case of human capital. Countries with high population growth have large numbers of school-age children. This places a larger burden on the educational system. It is not surprising, therefore, that educational attainment tends to be low in countries with high population growth.
The differences in population growth around the world are large. In developed countries, such as the United States and western Europe, the population has risen about 1 percent per year in recent decades, and it is expected to rise even more slowly in the future. By contrast, in many poor African countries, population growth is about 3 percent per year. At this rate, the population doubles every 23 years.
Reducing the rate of population growth is widely thought to be one way less developed countries can try to raise their standards of living. In some countries, this goal is accomplished directly with laws regulating the number of children families may have. China, for instance, allows only one child per family; couples who violate this rule are subject to substantial fines. In countries with greater
CHAPTER 12 PRODUCTION AND GROWTH |
257 |
freedom, the goal of reduced population growth is accomplished less directly by increasing awareness of birth control techniques.
The final way in which a country can influence population growth is to apply one of the Ten Principles of Economics: People respond to incentives. Bearing a child, like any decision, has an opportunity cost. When the opportunity cost rises, people will choose to have smaller families. In particular, women with the opportunity to receive good education and desirable employment tend to want fewer children than those with fewer opportunities outside the home. Hence, policies that foster equal treatment of women are one way for less developed economies to reduce the rate of population growth.
RESEARCH AND DEVELOPMENT
The primary reason that living standards are higher today than they were a century ago is that technological knowledge has advanced. The telephone, the transistor, the computer, and the internal combustion engine are among the thousands of innovations that have improved the ability to produce goods and services.
Although most technological advance comes from private research by firms and individual inventors, there is also a public interest in promoting these efforts. To a large extent, knowledge is a public good: Once one person discovers an idea, the idea enters society’s pool of knowledge, and other people can freely use it. Just as government has a role in providing a public good such as national defense, it also has a role in encouraging the research and development of new technologies.
The U.S. government has long played a role in the creation and dissemination of technological knowledge. A century ago, the government sponsored research about farming methods and advised farmers how best to use their land. More recently, the U.S. government has, through the Air Force and NASA, supported aerospace research; as a result, the United States is a leading maker of rockets and planes. The government continues to encourage advances in knowledge with research grants from the National Science Foundation and the National Institutes of Health and with tax breaks for firms engaging in research and development.
Yet another way in which government policy encourages research is through the patent system. When a person or firm invents a new product, such as a new drug, the inventor can apply for a patent. If the product is deemed truly original, the government awards the patent, which gives the inventor the exclusive right to make the product for a specified number of years. In essence, the patent gives the inventor a property right over his invention, turning his new idea from a public good into a private good. By allowing inventors to profit from their inventions— even if only temporarily—the patent system enhances the incentive for individuals and firms to engage in research.
CASE STUDY THE PRODUCTIVITY SLOWDOWN
From 1959 to 1973, productivity, as measured by output per hour worked in U.S. businesses, grew at a rate of 3.2 percent per year. From 1973 to 1998, productivity grew by only 1.3 percent per year. Not surprisingly, this slowdown in productivity growth has been reflected in reduced growth in real wages and family incomes. It is also reflected in a general sense of economic anxiety.
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PART FIVE THE REAL ECONOMY IN THE LONG RUN |
Because it has accumulated over so many years, this fall in productivity growth of 1.9 percentage points has had a large effect on incomes. If this slowdown had not occurred, the income of the average American would today be about 60 percent higher.
The slowdown in economic growth has been one of the most important problems facing economic policymakers. Economists are often asked what caused the slowdown and what can be done to reverse it. Unfortunately, despite much research on these questions, the answers remain elusive.
Two facts are well established. First, the slowdown in productivity growth is a worldwide phenomenon. Sometime in the mid-1970s, economic growth slowed not only in the United States but also in other industrial countries, including Canada, France, Germany, Italy, Japan, and the United Kingdom. Although some of these countries have had more rapid growth than the United States, all of them have had slow growth compared to their own past experience. To explain the slowdown in U.S. growth, therefore, it seems necessary to look beyond our borders.
Second, the slowdown cannot be traced to those factors of production that are most easily measured. Economists can measure directly the quantity of physical capital that workers have available. They can also measure human capital in the form of years of schooling. It appears that the slowdown in productivity is not primarily attributable to reduced growth in these inputs.
Technology appears to be one of the few remaining culprits. That is, having ruled out most other explanations, many economists attribute the slowdown in economic growth to a slowdown in the creation of new ideas about how to produce goods and services. Because the quantity of “ideas” is hard to measure, this explanation is difficult to confirm or refute.
In some ways, it is odd to say that the last 25 years have been a period of slow technological progress. This period has witnessed the spread of computers across the economy—an historic technological revolution that has affected almost every industry and almost every firm. Yet, for some reason, this change has not yet been reflected in more rapid economic growth. As economist Robert Solow put it, “You can see the computer age everywhere but in the productivity statistics.”
What does the future of economic growth hold? An optimistic scenario is that the computer revolution will rejuvenate economic growth once these new machines are integrated into the economy and their potential is fully understood. Economic historians note that the discovery of electricity took many decades to have a large impact on productivity and living standards because people had to figure out the best ways to use the new resource. Perhaps the computer revolution will have a similar delayed effect. Some observers believe this may be starting to happen already, for productivity growth did pick up a bit in the late 1990s. It is still too early to say, however, whether this change will persist.
A more pessimistic scenario is that, after a period of rapid scientific and technological advance, we have entered a new phase of slower growth in knowledge, productivity, and incomes. Data from a longer span of history seem to support this conclusion. Figure 12-2 shows the average growth of real GDP per person in the developed world going back to 1870. The productivity slowdown is apparent in the last two entries: Around 1970, the growth rate slowed from 3.7 to 2.2 percent. But compared to earlier periods of history, the anomaly