What Makes Economies Grow?

Start Here: Two Countries, One Starting Line

In 1960, South Korea and Ghana were about equally poor. Output per person, adjusted for inflation, was about $1,000 a year in each. Then their paths split:

Both countries grew. But a gap of about 4.6 percentage points a year, kept up for 65 years, left the average South Korean about 16 times richer than the average Ghanaian. Small differences in growth rates, repeated year after year, become enormous differences in how people live. The Rule of 70 shows why. Divide 70 by a growth rate, and the answer is roughly how many years it takes for income to double:

WATCH Growth Rates Are Crucial (Marginal Revolution University)

The Base: Rules of the Game

1 Institutions come first

The reading “How Did the World Get Rich?” tells the long story: for most of history almost everyone was poor, and sustained growth began only about two centuries ago. Economists disagree about why, but many of their explanations start with institutions, the rules that shape what people can do and keep. Secure property rights, contracts that courts will enforce, and limits on those in power give people a reason to work, save, invent, and invest.

In 2024, the Nobel Prize in economics went to Daron Acemoglu, Simon Johnson, and James Robinson “for studies of how institutions are formed and affect prosperity.” In the words of the prize committee, “Societies with a poor rule of law and institutions that exploit the population do not generate growth or change for the better.” Institutions are the soil. The rest of this reading is about what grows in it.

The Engine: Productivity

2 Output per hour

Over the long run, a country’s standard of living depends on how much its people can produce in an hour of work. Economists call this labor productivity. OpenStax’s Principles of Economics puts it plainly: “The rate of productivity growth is the primary determinant of an economy’s rate of long-term economic growth and higher wages.” Productivity rises for three broad reasons:

• Physical capital. Machines, tools, buildings, roads, and software. A worker with a backhoe moves more dirt than one with a shovel.
• Human capital. The skills, education, experience, and health that workers bring to the job.
• Technology, in the broad sense. Better ideas about how to produce: new inventions, but also better management, better organization, and moving workers and money to where they produce the most.

3 Specialization: Smith’s pin factory

Adam Smith opened The Wealth of Nations in 1776 with a pin factory. A worker on his own, Smith wrote, “could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty.” In the small shop Smith saw, the work was “divided into about eighteen distinct operations” shared among ten men, who together made “upwards of forty-eight thousand pins in a day,” about 4,800 each. Each worker got faster at a few tasks, lost less time switching between them, and was more likely to spot a better tool or method. Smith also saw the limit: work can be divided only as finely as the market is large. That is one reason trade, in section 7, matters for growth.

4 What the U.S. numbers show

The Bureau of Labor Statistics (BLS) splits U.S. productivity growth into these three parts. The first row is the growth in output per hour. The rows below show how much of it came from each source:

The parts are in percentage points and may not add exactly because of rounding. The last row, total factor productivity, is what is left after counting more capital and more skill. BLS describes it as the joint influence of “technological change, efficiency improvements, returns to scale, reallocation of resources, and other factors.” In short, it is getting more out of the same inputs. Over almost 40 years, it accounts for nearly half of U.S. productivity growth, and it explains much of why growth sped up in the early 2000s and slowed after 2007. The same pattern shows up across countries. A Hamilton Project report from the Brookings Institution notes that “across developed and developing economies, the majority of per capita income differences are due to total factor productivity variation.”

5 Why capital alone runs out

The economist Robert Solow, who won the 1987 Nobel Prize, showed why ideas matter so much. Adding machines raises output, but each extra machine adds less than the one before. Giving a worker a first backhoe is a huge gain. A second backhoe for the same worker adds little. Economists call this diminishing returns. A country that grows only by piling up capital will slow down, however much it saves. New ideas are different. A better way of doing things can be used again and again, by anyone, without being used up. That is how rich countries keep growing even after they have plenty of machines.

WATCH The Solow Model (Brief, no math) and The Solow Model and Ideas (Marginal Revolution University)

6 How the parts work together

Capital, skills, ideas, and specialization don’t work alone. Each makes the others more valuable. A new machine is worth little without workers trained to run it, and training pays off only when there are machines and methods worth learning. A discovery adds to growth only when someone puts it to use. Fritz Haber found a way to make ammonia from nitrogen in the air in 1908, but in the words of one study, “it was Carl Bosch who subsequently developed it on an industrial scale.” The same study estimates that by 2008 fertilizer made this way was feeding 48 percent of the world’s population.

This is one reason diminishing returns need not end growth. Each machine adds less than the one before only if nothing else changes. Better ideas and better skills keep raising what the next machine can do, which makes saving, schooling, and invention worth more. Growth comes from these parts feeding one another, and it tends to slow when one of them is held back.

The Multiplier: Trade

7 Bigger markets, more ideas

The reading “Why Do We Trade?” explains how trade lets people and countries specialize in what they do best. Trade can also speed growth. It gives firms bigger markets, which reward new ideas, and it lets poorer countries buy machines and borrow methods invented elsewhere. Measuring that effect is hard, because countries that trade more may differ in other ways. Jeffrey Frankel and David Romer used geography, such as distance from other countries, to get around that problem. They found that trade “has a quantitatively large and robust, though only moderately statistically significant, positive effect on income.”

Not every economist finds the evidence so clear. Francisco Rodríguez and Dani Rodrik reviewed the major studies and found “little evidence that open trade policies… are significantly associated with economic growth.” They were careful about what that meant. They added: “We know of no credible evidence—at least for the post-1945 period—that suggests that trade restrictions are systematically associated with higher growth rates.” The debate is less about whether trade helps than about how much, and whether opening up matters more than the institutions and investment that go with it.

Can Poor Countries Catch Up?

8 The case for catching up

Solow’s idea of diminishing returns predicts that poor countries should grow faster than rich ones. Where machines and schooling are scarce, each new one adds a lot. A poor country can also copy methods that rich countries took decades to invent. Economists call this pattern convergence. South Korea is a clear example of catch-up growth, and so are China in recent decades and Botswana, whose output per person rose from about $400 in 1960 to about $6,800 in 2025.

9 The record: divergence, big time

For most of modern history, it didn’t happen. The economist Lant Pritchett, in an article called “Divergence, Big Time,” found that “between 1870 and 1990, the ratio of richest to poorest countries’ income increased from roughly 9 to 1 to 45 to 1.” Rich countries kept growing, and many poor countries did not. Ghana’s output per person was lower in 1990 than in 1960. Studies in the 1990s found little sign that poor countries in general were catching up.

10 A new era?

More recent work tells a different story. Dev Patel, Justin Sandefur, and Arvind Subramanian found that “poorer countries have in fact been catching up with richer ones, albeit slowly, since the mid-1990s.” They also found that “middle-income countries have exhibited higher growth rates than all others since the mid-1980s,” which they called “more trampoline than trap.” The Nobel laureate Michael Kremer and his coauthors Jack Willis and Yang You reached a similar finding. They report “a trend towards unconditional convergence since 1990,” driven by both faster growth in poor countries and slower growth in rich ones. They also found that many things linked to growth, including education, policies, and institutions, improved in poorer countries.

Even the optimists say the pace is slow. Patel and his coauthors estimate that “the average developing country will close half the gap between its current and steady state income in only about 170 years.”

11 Catching up to what?

Not everyone agrees that the rules have changed. Daron Acemoglu and Carlos Molina reworked the Kremer data. They argued that comparing countries without accounting for their lasting differences biases the results. Their reanalysis “finds no evidence of major changes in patterns of convergence and, more importantly, no flattening of the relationship between institutional variables and economic growth.” In their view, institutions still matter as much as ever.

Both sides accept an idea economists call conditional convergence: poor countries tend to catch up with countries that have similar institutions, schooling, and saving, not with every rich country. The disagreement is over how much the recent catch-up reflects poorer countries improving those conditions, and how much it reflects something new.

The Power of Small Differences

12 Compounding works for people, too

The same arithmetic that separated South Korea from Ghana works in a family budget. The St. Louis Fed’s Page One Economics explains: “Compounding is the process by which earnings generate additional earnings.” Its example assumes an 8 percent return every year. One saver puts away $5,000 a year from age 25 to 34 and then stops. A friend starts at 35 and saves $5,000 a year until 64, three times as many payments. At 65, the early saver has about $787,000, and the friend about $612,000. The early saver’s ten payments earn more because they had more years to grow. Real returns go up and down, but the lesson holds: “even modest amounts of money can transform into substantial sums in the long run.” The same article warns that compounding “can also amplify your debt!”

Countries get rich the way families build wealth: slowly, and in ways that are boring to watch. A country that adds one percentage point to its growth rate won’t notice much in a year. Over a 40-year working life, growing at 3 percent instead of 2 percent is the difference between living standards that double and living standards that more than triple.

What Economics Adds

LISTEN The Ever-Present Challenge of Escaping Poverty (with Noah Smith) and Can a Phone Be a Cow? (with Philip Auerswald) on EconTalk, hosted by Russ Roberts; and Why Is the U.S. Outpacing European Countries in AI Adoption? on the Brookings Podcast on Economic Activity, all with transcripts

Key Terms in Plain Words

Economic growth

A lasting rise in real output per person.

Rule of 70

Divide 70 by a growth rate to estimate how many years it takes to double.

Labor productivity

Output per hour of work.

Physical capital

Machines, tools, buildings, and software used to produce.

Human capital

The skills, education, experience, and health workers bring to the job.

Total factor productivity

Growth left over after counting more capital and skill: better ideas and better use of resources.

Diminishing returns

Each added unit of an input adds less output than the one before.

Institutions

The rules, formal and informal, that shape what people can do and keep.

Convergence

Poorer countries growing faster than richer ones, closing the gap.

Conditional convergence

Catching up with countries that have similar institutions, schooling, and saving.

Compounding

Earnings that generate more earnings, so growth builds on itself.

Catch-up growth

Fast growth from adopting machines and methods already used elsewhere.

Specialization

Dividing work so each person or firm focuses on a narrow set of tasks.

Complements in production

Inputs that make each other more productive, such as machines and trained workers.