– Feature Address on Economic Growth and the Thinking of Sir Arthur Lewis Delivered at the Wreath Laying Ceremony, Nobel Laureate Week Morne Fortune, Saint Lucia, January 21, 2022.
By Dr Claudius Preville
As we remember and celebrate our own Nobel Laureates this week, I think it is fitting to revisit the work that they did and to ask ourselves, in the case of Sir Arthur – how would Lewis see our economic development challenges today? Have we learnt anything from him, or are we destined to continue making the same mistakes over and over again, whilst expecting a new and superior result?
Let us begin with the theory of economic growth in Sir Arthur’s day. Back in the 1940’s when Sir Arthur began his academic career at LSE and subsequently, Manchester, the Harrod-Domar model was being used extensively to analyze the relationship between growth and capital requirements in a one-sector economy. That model assumes that output of an economy depends primarily on the amount of capital invested. In its simplest form, the growth rate of an economy could be determined by knowledge of its savings rate (which is always equal to the investment rate) and the incremental capital-output ratio, or the marginal efficiency of capital.
Moreover, in the standard Harrod-Domar model, growth is directly proportional to the savings rate and inversely proportional to the marginal efficiency of capital. This model also assumes constant returns to scale and fixed or variable proportions of capital and labor in production. The model can be applied at the level of individual sectors of an economy and knowing the output of each sector, one can estimate the output of the economy.
Sir Arthur Lewis wrote his seminal piece at a time when there were issues concerning absorption of surplus labor – idle human capacity – in many developing countries that had just started their development journeys. It was believed among the neoclassical economists that labor supply was limited, hence unemployment never existed in a growing economy. The economy as a whole was susceptible to output in the two prevailing sectors, agriculture and manufacturing. In the neoclassical view, any movement of labor from agriculture to manufacturing would impact agriculture’s output.
However, Sir Arthur, receiving the inspiration one day whilst walking in the streets of Bangkok in 1952, decided to relax the neoclassical assumption of full employment, and this paved the way for a new economic theory, predicated on development with unlimited supplies of labor. This would subsequently be called the two-sector or Lewisian model of economic growth.
Many countries, primarily in Asia and Africa, have since adopted development strategies that can be well explained by this Lewisian theory of economic growth, or some derivative of it, for their successful development. Notably, economic growth of the so-called “Newly Industrializing Economies of East Asia – Singapore, Hong Kong, South Korea and Taiwan” (back in the 1980s), have been explained using the Lewisian model by many influential economists, including the like of Paul Krugman as the reasons for their rapid economic growth. Others in Africa, like Ghana applied Lewisian economic growth theory and met with some success.
However, the Lewisian economic model appears to have been least appreciated or applied in Caribbean countries, despite its dominance in academia at the major institutions of higher learning. Among Sir Arthur’s major works are the “Lewis model”, The Theory of Economic Growth (1955), Labour in the West Indies: The Birth of a Workers’ Movement (1939), and The Agony of the Eight (1965).
Whilst the Harrod-Domar model provides very useful analysis and good predictions of economic growth, it has the limitations of subsuming all growth into the capital input and does not adequately satisfy the full spectrum of the sources of growth, which in practice include inputs like technology, land, and recognition of the fact that human capital development has serious implications for economic growth. Sir Arthur Lewis and other economists like Robert Solow, were among the pioneers of the need to explain the sources of growth beyond the issue of the marginal efficiency of capital.
The production function used in these models allows for increases in output or GDP to be explained by partial contributions from capital, skilled labor, unskilled labor, technology, and other variables. Empirical analysis using growth models that decompose the sources of growth show that increases in productivity or efficiency account for a much higher proportion of growth than previously believed. In fact, increase in capital is now understood to account for less than half the increase in output or GDP, especially among rapidly growing economies.
Sir Arthur Lewis then pioneered what is called the two-sector model of an economy, drawing upon the framework developed by David Ricardo to explain trade based on comparative advantage of nations. The central reason for his award of the Nobel Prize in 1979 was that he had sought a solution to the question of what determines the relative prices of steel and coffee. The marginal utility approach made no sense to him neither did the Hechsher-Ohlin framework, which assumes that trading partners have the same production functions, yet coffee is not grown in the major countries that produce steel.
The other question that he grappled with was that during the first fifty years of the industrial revolution, real wages in Britain remained more or less constant while profits and savings soared. But the prevailing neoclassical framework predicted that a rise in investment would result in a rise in wages and depress the rate of return on capital.
According to Sir Arthur, the solution came to him like a “hunch” while walking down the street in Bangkok in 1952 “to throw away the neoclassical assumption that the quantity of labor is fixed”. An unlimited supply of labor will keep wages down, producing cheap coffee in the first case and high profits on steel in the second case. Hence the creation of a dual economy where one part is a reservoir of cheap labor for the other part. The unlimited supply of labor derives ultimately from population pressure, so it is a phase in the demographic cycle. It is important to note that the concept of unlimited supply of labor can be understood in relative terms, i.e., the labor supply is far greater than available demand for labor. It need not mean that the country must have an infinitely large population and labor force.
Accordingly, that concept is equally applicable in small economies where unemployment is large, as it might be applied to large economies where labor is more abundant in physical quantity.
In summary, Lewis published in 1954 what was to be his most influential development economics article, “Economic Development with Unlimited Supplies of Labor” (Manchester School). In this publication, he introduced what came to be called the dual sector model, or the “Lewis model”. He combined an analysis of the historical experience of developed countries with the central ideas of the classical economists, like David Ricardo, to produce a broad picture of the development process.
According to his theory, a “capitalist” sector develops by extracting labor from a non-capitalist, or backward “subsistence” sector. The subsistence sector tends to be governed by informal institutions and social norms. Thus, producers do not maximize profits and workers can be paid above their marginal product.
During the early stage of development, the “unlimited” supply of labor from the subsistence sector means that the capitalist sector can expand for some time without the need to raise wages. This results in higher returns to capital, which are reinvested in capital accumulation. In turn, the increase in the capital stock leads the “capitalists” to expand employment by drawing further labor from the subsistence sector. Given the assumptions of the model (for example, that the profits are reinvested, and that capital accumulation does not substitute for skilled labor in production), the process becomes self-sustaining and leads to modernization and economic development. The point at which the excess labor in the subsistence sector is fully absorbed into the capitalist sector, and where further capital accumulation begins to increase wages, is sometimes called the Lewisian turning point.
However, I would like this short lecture to go beyond pure economic theory, and instead to focus on the practical application of economics to solve the pressing challenges of Saint Lucia today. Knowledge, of course, is of little value, unless we organize it into targeted plans, to bring about a desired result. This seems to be the problem in our country today, basic knowledge exists everywhere, but its application using targeted plans is sorely lacking, so the people cannot escape poverty and successive governments seem more burdened than enlightened in their pursuit of the quests for the people. Lewis spoke quite a lot about industrialization by invitation, in which he saw the need for foreign investment to fuel the industrialization process. This idea is sound, since a target level of savings are needed for investment, given a known value for the marginal efficiency of capital.
The lack of adequate levels of national savings means we have to turn to foreign investment to fuel growth. Given Saint Lucia’s current economic circumstances of high debt, increasing unemployment and severe economic contraction since the onset of COVID-19, unless we have foreign investment flows into specific sectors to drive economic growth, our economy will sputter, at best. In order for you to really appreciate this predicament, I will start with an outline of the macroeconomic situation facing Saint Lucia today. I will draw upon primarily the Economic and Social Review of 2020, Department of Finance (2021) and other emerging sources from the IMF, the World Bank, the Caribbean Development Bank, and the Eastern Caribbean Central Bank for 2021 to present an image of our economy and its prospects in 2022. Where possible I will undertake deeper sectoral analysis to isolate the major constraints to growth facing Saint Lucia.
Let us begin with the Gross Domestic Product (GDP) and in particular, the sectoral contributions to GDP over time. Since economic growth is really the extent of overall expansion of the economy, it follows that those sectors that account for a larger share of GDP need expand only by a small percentage to result in a significant impact on overall growth and equally, their poor performance in any one period can result in overall economic contraction.
The sectors accounting for the GDP of Saint Lucia in decreasing importance of their shares (based on real averages for 2010 to 2019) are Accommodation and Food Services (19.41%); Real Estate Activities (10.80%); Wholesale & Retail Trade (10.42%); Financial Services (6.96%); Public Administration, Defence & Compulsory Social Security (5.25%); Transport and Storage (4.97%); Construction (4.21%); Communications (3.53%); Education (3.31%); Arts, Entertainment & Recreation (3.08%); Manufacturing (3.06%); Electricity (2.28%); Health and Social Work (2.24%); Agriculture, Livestock and Forestry (1.72%); Other Community, Social & Personal Services (0.84%); Water (0.79%); and Mining & Quarrying (0.15%).
These sectors together made up 83 percent of the real economy, on the average, for the period 2010 to 2019. Taxes accounted for approximately 13.5 percent of the GDP on the average. What is evident from this review of the sectoral contributions to GDP is that the Saint Lucian economy is primarily a services economy (95%) with a fringe of Agriculture and Manufacturing activities, jointly accounting for a little under 5 percent. Therefore, central to economic growth would be growth of the top ten sectors of the economy.
Now let us continue with the growth in Gross Domestic Product (GDP) over the last decade, excluding 2020. First, average real economic growth has been stagnant for the decade 2010 to 2019, at 1.1 percent. During that decade, growth reached its highest rate of 4.6 percent in 2011 relative to 2010 and its lowest rate of -2.0 percent in 2013 relative to 2012. The growth rates also follow very closely, the gross value added (GVA) at basic prices. In 2011 GVA was 2.1 percent and in 2013 GVA was -1.1 percent.
Let us briefly analyze the performance of some major sectors of the economy over that same decade. Average real growth rates of the leading sectors of the economy for the period 2010 to 2019 were as follows, Accommodation and Food Services (3.49%); Real Estate Activities (0.44%); Wholesale & Retail Trade (0.21%); Financial Services (-0.13%); Public Administration, Defence & Compulsory Social Security (1.41%); Transport and Storage (-0.2%); Construction (-1.22%); Communications and Information Services (6.53%); Education (1.19%); Arts, Entertainment & Recreation (7.94%); Manufacturing (3.19%); Electricity (1.62%); Health and Social Work (2.84%); Agriculture, Livestock and Forestry (0.55%); Other Community, Social & Personal Services (-3.35%); Water (0.07%); and Mining & Quarrying (24.83%).
Therefore, we see that growth has been sluggish even before the advent of COVID-19 pandemic in 2020, pointing to the fact that the macroeconomic fundamentals have been weak for quite some time and that the pandemic (as described below) has merely exacerbated the woes of a weak economy. Excluding accommodation and food services, which posted overall positive growth on the average, most of the large sectors among the top twelve have been performing rather weakly, on the average.
The economy seems to have found itself on an automatic steady state, with a high propensity to deteriorate even further, unless some comprehensive plans are developed and implemented without further delay. Also, with falling Agricultural output per capita, Saint Lucia could find itself in a food crisis in the near future as demand for food products is increasingly being met from imports, which require foreign exchange. Yet, there are no clear strategies to generate more foreign exchange beyond tourism.
To be continued, Part 2.
