The Growth Model of New Supply Economics

By Teng Tai (Director of the Wanb Institute)

In the short term, economic growth is affected by investment, consumption and export. In the long term, actual growth is caused by changes in the Five Sources of Wealth: labor, land, capital, institution and technology. The potential economic growth rate is determined by the expansion of new supply.

I. The different functions of the Five Sources of Wealth seen through conditions, factors and driving forces

A. The neoclassical growth theory and the endogenous growth theory

In the neoclassical growth theory, Robert Solow argued that technology is an exogenous variable, independent of the values of other variables, and the marginal rate of return of investment decreases progressively.

Output (Y) is the function of labor (L) and capital (K), i.e. Y=f (L, K)

The theory stresses the important impact of population growth and savings rates on economic growth.

Different from the neoclassical growth theory, the endogenous growth theory argues that technology is the endogenous power of economic growth. In the Cobb–Douglas production function, Y=A*K. A is technological level and K is capital stock. Paul Romer, an economist and Nobel Prize winner, further developed the endogenous growth theory and placed more importance on the function of human capital and technological level.

B. The Five Sources of Wealth of economic growth

Neosupply economics believes that output is affected by factors such as labor, capital, land, technology and institution.

Y=S*A*F (L, W, K)

L is labor, W is land, K is capital, A is technology and S is institution.

In other words, the Five Sources of Wealth are labor, capital, land investment, technological progress and institutional improvement.

C. Different functions of the Five Sources of Wealth: conditions, factors and driving forces

Each of the Five Sources of Wealth plays a different role in promoting economic growth. Generally speaking, land, capital and labor are production factors, while technology is a driving force and a reasonable institutional plan is the condition for growth.

If we see economic growth from a short-term perspective (one year), technology and institution are exogenous factors that hardly change and are independent of the variables of land, capital and labor.

If we see economic growth from a long-term perspective (10 years),technology becomes a variable. But the total amount of a country's production factors does not change too much. In some European countries, population, land and people's savings basically stay stable for a decade, but their economy still grows due to technological progress. Under these conditions, technological development is not just endogenous, but also a driving force for sustained growth.

Institution is a condition for growth, thus, without proper institutions, an economy can barely achieve sustainable growth. Looking back at China's 40 years of reform and opening up, production factors and technology couldn't have worked without dividends from institutional and market-oriented reforms.

As a result, in the short term, land, capital and labor are variable production factors; while in the long term, institution and technology are also variables and important conditions and driving forces for economic growth.

D. Conditions for economic growth

Institution determines the efficiency of a country's social division of labor at the macro level and enterprises' productivity at the micro level. At the end of the 1970s, with factors such as population, land, agricultural technology and others remaining unchanged in the short term, China implemented a system of household contract responsibility with remuneration linked to output to replace the rural people's commune system, leading to a surge in grain output.

In fact, in the over 40 years of reform and opening up, China's institutional reform has constantly created conditions for economic growth, including gradual price reform, the establishment of a market system, the encouragement of the development of private enterprise, the introduction of reforms in the corporate and shareholding systems in stateowned enterprises (SOEs), reform in mixed-ownership enterprises, and the improvement of infrastructure and the business environment which created domestic conditions for growth, as well as furthering opening up and integration into the global market, which created external growth conditions.

However, after over four decades of rapid growth, China has encountered a slowdown since 2007. Quarterly GDP growth decreased from nearly 12 percent in the first quarter of 2007 to 6.4 percent in the fourth quarter of 2018. This means a new round of market-oriented reform is urgently needed in order to create more conditions for growth.

E. Turning potential sources of wealth into production factors

Population, land and savings are potential sources of wealth, but sometimes they don't turn into production factors. Thus, turning population into labor or human capital, ensuring better use of land and natural resources and turning savings into capital are important tasks for economic growth.

(1) From population to labor or human capital

Population is an important source of wealth. Education, training and immigration can turn population into production factors such as labor or human capital. In addition, a flow of labor from low to high efficiency sectors can also improve productivity. Once a country sees a shortage of labor or a continuous rise in wage costs, its economic growth will slow down. China is not an exception. If the household registration system impedes the free flow of labor, it will also exert a negative impact on economic growth.

(2) Turning land into a production factor

Land is a source of wealth, however, before humans grasped how to use it, it could not be turned into a production factor. The essence of the agricultural revolution was the understanding and application of the reproductive laws of animals and plants, which enabled land to become a factor in agricultural production. In the agricultural age, in areas with fertile soil and a rich variety of animals and plants, people gradually accumulated and produced diversified agricultural products.

The first industrial revolution enabled more natural resources to turn into production factors. In the 1760s, with the invention of the steam engine, coal was transformed from an unusable resource into a new production factor. In the middle of the 20th century, the petrochemical revolution turned petroleum and natural gas into production factors. Consequently, production factors were no longer limited to land or the application of laws for breeding animals and growing plants. Furthermore, with the progress made in physics and through several energy revolutions, people became more competent in understanding and using resources. More and more sources of wealth were turned into production factors.

Currently, a clear property rights system is required for improving land use efficiency. The deepening of reform of the land property rights system has huge potential for improving China's land use efficiency. In the past, fertile land was the basis for agricultural production, while resources and raw materials were vital to the manufacturing industry. In the future, new production factors will not be limited to natural resources needed for agriculture and industry;more will come from the soft resources generated by people's creative thinking. Their formation and value will be closely related to the protection of intellectual property (IP) rights.

(3) Turning personal savings into capital

Personal savings are not a production factor, but capital is. It is an important task of the financial system to turn personal savings into capital.

In China, large savings are a result of traditions and habits. Forced savings due to a lack of investment products have played a positive role in the country's economic growth. Commercial banks turn a large amount of savings into low-interest loans and rolling capital for companies, which directly brings high-speed growth of investment and strongly drives China's economic growth.

F. Technological progress: a driving force for economic growth

At the beginning of the 1990s, Deng Xiaoping, chief architect of China's reform and opening up, said that science and technology are the primary productive forces. In 2018, Romer put forward an endogenous growth theory, stressing that technology is the endogenous power of economic growth.

Zhang Weiying, an economics professor at Peking University, said he believes that the reason for China's remarkable achievement is the use of market-oriented reforms, entrepreneurship and technology developed in Western countries over the past three centuries, and not the so-called China Model.

Neosupply economics argues that in the long run, technology is an endogenous variable and technological progress is an important driving force for economic growth. Technology can not only improve the current total factor productivity (TFP) of supply, but also promote the expansion of new supply.

G. Summarizing China's economic growth: conditions, factors and driving forces

Since 1978, China's economy has enjoyed rapid development thanks to the sound conditions for growth, a large amount of factor input, technology promotion and independent innovation.

First, reform and opening up has provided an institutional condition for China's economic growth. It has enabled the market to play an increasingly important role in resource allocation, thus changing the social division of labor, greatly increasing TFP and pushing swift growth.

Second, substantial investment of capital and resources, and an increase in TFP have played a crucial role. For example, in terms of labor input, from 1978 to 1990, China's aggregate employment grew from 401.52 million to 647.49 million, with an annual average increase of 20.5 million. As labor has transferred from the lowefficiency agricultural sector to higher-efficiency areas, the productivity of labor has constantly improved, greatly driving China's economic growth.

Third, China's fast economic development is also a result of global popularization of industrial technology, which includes the European textile industrial revolution 200 years ago, the steel and railroad industrial revolution 150 years ago and the chemical, automobile, communications, high-end information technology (IT) and biotechnology industries that emerged later.

II. Economic growth models seen from the supply side

A. Growth models from the supply or production side

From the perspective of the production side, increasing input or improving efficiency of one or more sources of wealth can promote economic growth. This includes increasing labor input, improving the quality of labor supply or labor productivity, raising land input, raising the efficiency of land supply, increasing capital input, elevating the supply efficiency of capital, introducing technology or making independent innovation, and improving the division of labor and TFP through institutional reform, among others.

B. The Smith-North growth model

Smith believed that the greatest improvements in the productive power of labor lay in the division of labor. He stressed that the division of labor promotes specialization and further improves efficiency. He paid great attention to the relation between the division of labor and technological innovation in economic growth. He argued that economic development promotes the division of labor and that as the division of labor becomes complex, productivity increases. Specifically, he said, more specified division of labor promotes the development of new products and technology, which in turn leads to more specified division of labor, thus achieving economic growth.

For example, in the few years after 1978, China implemented a system of household contract responsibility with remuneration linked to output in rural areas, while the cities adopted contract, rental and shareholding systems. Because of the institutional reform and progress in the division of labor, TFP greatly improved. This is the main reason for the country's fast growth in the 1980s. It is a typical Smith-North growth model.

C. The Kuznets-Solow growth model

In the book Economic Growth of Nations, Kuznets discusses the quantitative characteristics of the economic growth of different countries. After a quantitative analysis and study of countries' national products and their components, he concluded that endogenous labor growth, zero-cost improvement in capital conditions, knowledge stock, technology stock and ideological systems are crucial components of economic growth.

Kuznets analyzed the driving force of long-term economic growth as follows: population growth, TFP improvement, economic structure upgrade and social structure transformation. He thought the interaction and mutual promotion of these elements are of utmost importance.

In neosupply economics, economic development driven by the increase of labor, land, capital and other factors, along with the improvement of production factors is called the Kuznets-Solow growth model.

D. The Schumpeter-Romer growth model

Schumpeter believed that the destructive creation of technology is a force in the economy that can break and restore balance, making innovation the long-term driving force of economic growth.

Schumpeter argued that innovation is a process of creative destruction. Once a company gains success in its innovative work, it will exclude its competitors and earn a monopoly of profit. For example, at the beginning of 2008, the smartphone market was just beginning to take shape. Subsequently, its production and market share expanded quickly, forcing traditional cellphone brands like Motorola and Nokia out of the market. In this process, the contribution of the smartphone to total market output exceeded traditional cellphones. It opened a new era of economic prosperity.

In the Romer growth model, there are two other production factors besides capital and labor, namely, human capital and technological level. Romer paid great attention to technological innovation and discussed how knowledge is the driving force of long-term economic growth and how economic policies and market conditions determine the creation of new technology.

In neosupply economics, economic growth driven by technological innovation is called the Schumpeter-Romer growth model.

E. China's economic growth model: summary and outlook

Since 1978, China has created over 40 golden years of highspeed economic growth and has become one of the largest economies with the longest continuous growth. This development is attributed to reform, a large population, land, large savings and technological progress. It is also a combination of the Smith-North, Kuznets-Solow and Schumpeter-Romer growth models.

The fast economic development in the first phase from 1978 to the mid-1990s benefited from the system of household contract responsibility with remuneration linked to output implemented in rural areas, and the contract, rental and shareholding systems in urban areas. Changes in the social division of labor and the organization of production also accelerated the development of productivity and further promoted economic growth. This is the typical Smith-North growth model.

From the mid-1990s to 2010, thanks to large savings, the introduction of foreign capital, hundreds of millions of laborers shifting from the agriculture sector in rural areas to the industrial sector in cities, the consumption of domestic and imported energy, and raw materials (iron ore, coal, petroleum, electricity and cement), China maintained an annual GDP growth rate of 10 percent for two decades. During this stage, growth was driven by a large amount of investment of labor, land and capital, as well as production factors. This is a typical Kuznets-Solow growth model.

Since 2010, China has entered a crucial period of economic restructuring. An aging supply structure is the principal contradiction at this time. Due to the distortion of the supply structure, the supply costs of labor, land and capital have surged, while the efficiency of factor supply has decreased. If China fails to implement supply-side reform, lower production factor costs and raise supply efficiency, the Kuznets-Solow growth model can hardly be sustained.

Meanwhile, in this later phase of industrialization, it has become increasingly hard to apply technology from Western countries because of IP restrictions. China should therefore create more endogenous power for economic growth through independent innovation.

The four decades of reform and opening up started from the ideological guideline of emancipating the mind and seeking truth from facts. Looking back, each reform measure seems to have been the right decision based on actual conditions. But in reality, they emerged and grew from intense discussion between reformers and conservatives. Currently, there is still a lot of room for improvement in striking a balance between the function of state-owned and private enterprises, the function of the market and government intervention, and administrative control and monopoly, as well as in the property rights system. If China can get rid of conservative ideas, a new growth cycle following the Smith-North growth model can be created. The future potential of the country's economy does not lie in the stimulation of the demand-side, but in the structural reform on the supply-side.

III. New supply drives growth

The Smith-North growth model driven by institutional reform, the Kuznets-Solow growth model driven by new factor input and the Schumpeter-Romer model driven by technological progress can all bring economic growth. However, growth potential is determined by the expansion of new supply, including the expansion brought about by wealth and technological revolutions and the constant upgrading of the supply structure.

A. New supply expansion in wealth revolutions

From the point of view of the sources and creation methods of wealth, the history of humanity's pursue of wealth can be divided into three eras: the agricultural, industrial and soft wealth eras. Each stage started from the wealth revolution created by the expansion of new supply.

The first wealth revolution was the agricultural revolution, which was also a process of new supply formation and expansion that changed people's lives and production methods. By discovering the laws of reproduction and growth of plants and animals, humans expanded the resources of wealth in agriculture, greatly improved the supply of food and clothing, and promoted the circulation of goods. However, for centuries, the economy didn't grow quickly due to limited wealth sources and the restriction of the agricultural production mode.

With the emergence of Isaac Newton's principles of physics and relevant technological progress, sources of wealth started to extend beyond the ecological resources on Earth's surface and toward the non-living world which included ore, petroleum, natural gas and coal. People's wealth creation methods also broke the limits of biological reproduction and growth cycles. The ability to drive economic growth reached a new historical level.

After the first industrial revolution, sources of wealth expanded to thermal energy, electricity and oil. Today, soft wealth brings more new supply, with the sources of wealth coming predominately from people's intellect. The design, spread and promotion of intellectual, cultural, informational and financial products, as well as other service products, are the main economic activities. World economic growth is entering into an era of the creation and expansion of soft wealth.

B. New supply expansion in technological revolutions

Technological revolutions also bring about the expansion of new supply and the rise of economic growth potential. For example, since the first industrial revolution, at least five technological innovations have led to new supply expansion.

The first technological revolution created a new supply expansion from 1787 to 1816, which is forged by the innovation of the textile industry and metallurgical technology and played a crucial role in rapid economic development. The new supply expansion brought about by the second technological revolution began in 1842 with the development of the steam engine, iron and steel smelting, and railway technology. In 1898, the new supply expansion created by the third technological revolution began, with the electrical, chemical and automobile industries as the main impetuses. Starting in 1946, new supply creation and expansion in the petrochemical, electronic and telecommunications industries became the main driving force of fast economic growth after World War II. The year 1990 ushered in the fifth technological revolution, with the formation and expansion of new supplies created by the Internet, new material, gene technology and new energy industries as the main economic growth drivers.

C. Constant emergence of new supply pushing the upgrading of the supply structure

The new supply expansion brought about by wealth revolutions elevated economic growth potential for hundreds of years and the new supply expansion created by technological revolutions led to a decadeslong growth cycle. Now, different new supplies are emerging in every industry and field and its formation and expansion are the sustained driving force of growth.

On the one hand, through the creation and expanding of new supply, the upgrading of the supply structure leads to the spiraling escalation of the consumption structure. On the other hand, the upgrading of the consumption structure can affect the supply structure through the creation of new demand. Actual economic growth is the result of the interaction of supply and demand.

The upgrading of the supply structure expands consumption options, leading to consumption upgrading. Each kind of new supply creates new demand. The upgrading of the supply structure brings about the upgrading of the consumption structure, making more room for economic growth.

How does the upgrading of the supply structure improve growth potential? In transportation, for example, before the invention of cars, animals were the main means of transportation. With the invention and application of the steam and internal combustion engines, cars, steamships and airplanes were able to meet people's need for the speed and passenger capacity of travel. When the supply of these powered vehicles reached the saturation point, people's attention shifted to the quality of traveling, which brought about consumption upgrading. Mercedes-Benz captured this psychological need. As a former chief designer for the company once said, the company did not sell cars, but a work of art that happened to run. Similarly, Tesla is not selling cars that can just run fast, it is selling the idea of environmental friendliness and fashion. This supply structure upgrading has made cars more environmentally-friendly and trendy, increasing the room for growth in the entire automobile industry.

The sustained upgrading of the supply structure leads to consumption upgrading. For example, the integration of Internet technology with other industries changes people's consumption patterns. People start to get information from search engines and web portals; communicate with each other via e-mail, instant messaging and online forums; buy things online and get customized services while completing transactions with e-commerce and e-payment systems. They also enjoy online games, music and other entertainment platforms.

In conclusion, the nature of growth is not only determined by the Five Sources of Wealth, but also the three growth models and all kinds of supply expansion. In the form of a new technology, product, business model and management pattern, new supply constantly creates new demand and markets. The upgrading of the supply structure leads to the upgrading of the consumption structure, thus injecting sustained power into economic growth.