The Solow Model Unleashed:

Understanding Economic Growth

BY NICOLAS VINCENT® AND PIERRE YARED
Background
DURABUILD: SEEKING NEW INSIGHTS
The peeling Durabuild Inc. sign, desperately in need of a touch up, caused Lisa Stone to
cringe slightly as she entered the company's St. Louis headquarters. She had mixed feelings
about the meeting she had scheduled with the company's president —her father, Frank
Stone Jr.
Lisa's agenda was a tough one: to try to get a better sense of what she viewed as her father's
(and her grandfather's) less-than-perfect business acumen. In the weeks since Lisa had left
her analyst position in New York to join the family's firm as vice president for business
development, she had become concerned about the company's future and had also grown
curious about details of its early growth.
Durabuild Inc. was a diversified, family-held business in the construction industry, with
significant interests in France as well as in the United States. The president's spacious corner
office looked out over the faded glory of an industrial brick skyline. Lisa's father, finishing up
what appeared to be a customer call, silently motioned for his daughter to settle into the
most comfortable spot in the room-an overstuffed, butter-soft, leather armchair. A large-
scale aerial photo of Durabuild's operations in France circa 1962 hung on the wall.
As soon as her father hung up the phone, Lisa cut right to the chase. "I've been studying our
books, Dad, trying to make sense of where Durabuild has been and where we are headed.
From what I can see, the company's best growth period was in the middle of the last
century, right after we opened operations in France. I want to work with you to understand
that growth in a larger context so we can try and recapture it. Maybe, as we discussed last
week, in China." DURABUILD: THE EARLY YEARS
Frank Jr. loved to tell stories, and especially liked to sprinkle them with facts about US
history, his passion. He poured himself a glass of chilled water from the carafe before he
began. "Lisa, i think you wow how this story started. Tirst, some history... Ai the end of
World Wat il your grandfather saw a great opportunity in the GI. Bill of Rights. Right after the
war, the G.I. Bill provided free college tuition to the millions of soldiers who came home
from the war. That bill gave veterans the opportunity to go to college, but it also gave them"
—here he ticked the benefits off on his fingers- "housing subsidies, business loans, and other
help in getting their lives back on track."
"When Grandpa Frank came back from France, he took out a business loan and established
Durabuild in 1947 with offices in the United States and France. The construction industry
was a good choice. After 15 years of the Depression and five years of war, housing in
America was in bad shape, or at least in need of renewal. Mortgage loan guarantees
provided by the G.I.
Bill were helping the war veterans buy homes, which started a big housing boom. Those
were some of our best years."
"But why expand into France? I never quite understood that choice."
Frank Ir. gazed out the window. "As you know, during the war, your grandfather fought on
the front lines in Normandy. He saw firsthand the destruction of factories, the ashes of
villages, the wreckage of schools and bridges. As the US housing market shot up after the
war, he saw that once the recovery got underway in Europe, France would have an even
greater need to rebuild than we did here in America. And he was right. For nearly two
decades, France's economy soared."
"I remember once when I was about 10 years old, your grandfather told me about the
miracle of postwar Europe. 'Out of the ashes of destruction have risen the wings of
opportunity, he said. We, Durabuild, were helping to make that happen."
"But Dad, did Grandpa Frank think the growth was going to continue forever?"
"Well, there's the catch. The housing market in France that had boomed so impressively in
the 1950s and 1960s leveled off in the 1970s, and my father didn't understand what was
happening. He fully expected the French market to get back on track any minute. He kept
thinking opportunity was just around the corner, because there was still so much room left
for France to grow." He shook his head.
"Expecting the building industry to come roaring back, Grandpa invested Durabuild's capital
year after year in factories and warehouses from Calais to Cannes. While the US part of the
business held steady, Durabuild's French affiliates suffered. The demand for new
construction in France was drying up, but Grandpa Frank refused to see it. I was a young
apprentice at your grandfather's side at that time, and I admit I was taken in by his view of
the world. Or maybe blind to the same things."
Lisa felt herself growing impatient. "What's frustrating to me is that you guys waited around
for more than 30 years, just hoping that Europe would retur to the high growth rates of the
postwar times. Thirty years in the twentieth century and beyond! Didn't you even try to
understand what was going on? It seems like the best tool in your whole analytical toolkit
was hope!"

"Hindsight is always 20/20, Lisa. Why doil't you bring your MBA tooikit in here ard show me
how we should have done it."
LESSONS FROM THE PAST
A few days later, when Lisa had calmed down, she opened her laptop in the company
conference room and dug into the kinds of source material she had not looked at since her
days at Columbia Business School, nearly a decade before. The growth of the construction
and building materials industry was closely tied to the overall economy, so she spent many
hours looking at macroeconomic trends in France and the United States since the end of
World War II. She also tried to recall the precise modeling tool that would help her to
understand how Grandpa Frank had so inaccurately forecast the longer-term potential of
Durabuild's operations in France. Drawing on her experience as an analyst, she prepared a
report for her father.
Lisa's report highlighted a number of important macroeconomic trends in the United States
and France. "In the decades following World War II," she wrote, "France grew at a much
faster rate than the United States. GDP per capita growth in France from 1950 to 1980
averaged 3.8%, compared to 2.2% in the United States. Between 1980 and 2000, however,
GDP per capita growth in France averaged 1.6%, compared to 2.3% in the United States. In
other words, economic activity expanded at a much more rapid pace in France during the
early years after the war, but the growth rate of the economy eventually tapered off." (See
Exhibit 1.)
Lisa's report continued, "Part of the reason why France grew so quickly at first was that it
started at a much lower level relative to the United States. As a consequence of the
destruction of the war, in 1950 France's GDP per capita was 54% that of the United States',
and its capital-to-labor ratio was less than 10% of the United States'. France and the United
States had similar investment rates during this period, and because France started from such
a low capital base, its capital stock grew very rapidly, achieving the same capital-to-labor
ratio as the United States by 2000. Nonetheless, France never caught up. In 2000 its GDP per
capita was 75% that of the United States'." (See Exhibit 2.)
Lisa's report then went on to try to analyze some of the problems with the French economy
and to describe some of the differences between the French and the American labor market,
which may have been behind the slowdown. "In the decades following World War II,
unemployment in France was so low, around 3%, that US economists wondered how the
United States could replicate the labor miracle of France and the rest of Europe. By the end
of the century, however, France's unemployment rate had risen to over 11%, more than
twice that of the United States'. Moreover, total labor hours per capita in France were 72%
that of the United States'" (See Exhibits 2 and 3.)
"The French live very differently than Americans," the report went on. "At the end of the
century, in France, the work week could not legally be longer than 35 hours, with a
mandatory five-week vacation. The average French worker put in 40 weeks per year, while
the average US worker put in 46.2 weeks." The report then explained some of the possible
reasons behind these differences: "The French unemployment insurance program, which
replaces 60% of prior pay for up to two years, may discourage individuals from seeking work,
while high marginal tax rates make working additional hours less interesting. Furthermore,
firms have little
incenüve to hire new workers, given the high minimum wage regulation as well as the legal
restrictions which make it difficult to fire workers."1
LESSONS FOR THE FUTURE
Lisa was now walking along the Mississippi River, lost in her thoughts, envisioning
Durabuild's future plans. Did China present the best long-term potential, or would its current
high-growth phase peter out as it had in France? China's rate of investment was
extraordinarily high; it had never been replicated by either the United States or France and
was driving very rapid economic growth. Nonetheless, doing business in China was difficult,
given the difference between its regulatory environment and the United States' or France's.
How easy would it be to apply new technologies in China? How does China's one-child policy
affect its economic growth? When Lisa had gotten about a mile down the river, the tool she
was searching for finally dawned on her: the Solow model.