The elusive search for growth

The mechanisms driving economic growth have not been well understood until the end  of the 20th century. Over most of the last century macroeconomists focused on the analysis of short run fluctuations of economic activity. The first successful attempt to model economic growth was the Solow model (Solow, 1956). The model was built around a production function concave in the inputs labor and capital. The model implied that countries could not grow indefinitely just by increasing investment because the marginal productivity of capital was decreasing (which implied a bleak future for the economy of the Soviet Union, by the way, as history has indeed shown). Capital accumulation would eventually reach a point where its contribution to the overall product would equal zero. Growth was only possible in the model if it was added as an assumption, in the form of exogenous technological change. As a result, growth theory remained in a sort of dead end in subsequent decades. This was the theoretical scenario till the late 1980s.

Paul Romer (2018 Nobel prize winner) induced a breakthrough with two key elements: the possibility of endogenous growth and the crucial importance of new ideas for this process (Romer 1986; 1990). According to Romer, the drive engine of growth is endogenous technological change associated with innovations. In turn, innovations are expressed in ideas or knowledge, which may be replicated at very small, trivial, costs; this property allows the presence of non-decreasing returns to scale in a broad concept of capital (the sum of technological capital and physical capital) which in turn makes sustained growth feasible.

This new approach has changed dramatically the way economists think about economic growth. According to this theoretical framework, countries may grow for long periods without the exhaustion of the drive engine of growth (as the Solow model had  predicted). Instead, the own development of the country or area brings about new technological change in the form of further innovations which enhance economic growth.

There is another important implication: growth is not limited by any external force, or by the performance of other countries. It may be triggered within each particular economy, if the appropriate mechanisms are in place. Hence economic growth worldwide is not a zero-sum game, as some economists – for example, the structuralists – had claimed in the past. In the 1960s the economists of the structuralist school had argued that countries could be classified in two main categories, center and periphery; countries in the center grew at the expense of the periphery, which was doomed to stagnation. This view is no longer prevalent among economists, partly because it was at odds with the fast growth of South Asian Economies, which belonged to the periphery.

Entrepreneurs and creative destruction

One of the factors which bring about growth is the activity of entrepreneurs. This process requires the active participation of an entrepreneur, somebody capable of understanding that an idea, a new combination of factors or a disruptive business model may produce something that adds value to prospective purchasers, because that something helps cover a particular need previously not resolved, or because it covers that need more efficiently that previous suppliers.

By means of their creativity, entrepreneurs design new ideas and business models which enable the efficient use of resources, enhance dynamism and favor knowledge spillovers and economic development. The recent economic literature has shown that the activity of entrepreneurs impacts economic development positively. This idea is not new: it was already discussed by Schumpeter (1939); however, it has experienced a revival in the last decades with new features, partly because of the own progress of economic analysis on this issue.

As economic history shows, technical progress comprises disruptive innovations which might generate short-run negative effects on existing firms. Schumpeter (1939) understood this phenomenon and named it creative destruction. Creative destruction comes about when a disruptive innovation enables an improvement of the good or service previously available. This, in turn, may allow a newcomer to compete with incumbent firms previously serving the market.

The innovative firm may take over the activity of other firms and eventually replace them totally or partially (think, for example, of electronic mail displacing fax machines). In the long run, though, the net effect of innovations on the economy is positive although they may entail the disappearance of obsolete companies in the short run. Creative destruction enables the reallocation of labor and other inputs over time to more technologically advanced and efficient industries.

This idea has been revisited and reintroduced in the economic debate by two of the scholars receving the Nobel Prize in Economics in 2025: Phillipe Aghion and Peter Howitt. In 1992 they published an important paper, A Model of Growth Through Creative Destruction, which showed how innovations entail an improvement in the quality of the goods already in the market, generating creative destruction and ultimately economic growth.

Subsequent theoretical and empirical contributions exploring these issues further have confirmed this process. They have also showed the crucial role of some factors in order to facilitate growth (human capital, investment, protection of property rights, sound economic institutions, fiscal and monetary stability, flexible markets, among others). Moreover, the literature has documented as well that more outward oriented countries have grown faster and experienced higher decreases in poverty rates, ceteris paribus (Dollar and Kraay, 2002; Dollar, Kleineberg and Kraay, 2006).

A virtuous circle in place

Entrepreneurship, thus, has the potential to foster economic growth and development in surrounding areas, improving material conditions and the living standards in the population. Development, in turn, enables the creation of a social environment where individuals can live with peace and stability and where non-material needs in the form of education, culture and health can be provided for. Abundant historical evidence shows that economic and social development are closely linked: sound economic performance facilitates the progressive consolidation of economic and social institutions (private property, financial intermediaries, rule of law, sound judicial system). There is indeed research available for different areas showing the positive effect of entrepreneurship on growth and development.