In 1950 Argentina and Venezuela were richer per person than Japan, Singapore, or South Korea. By 2018 Singapore's per capita income was more than seven times Venezuela's. Nothing dramatic happened in any single year; a few percentage points of annual growth compounded for seven decades did all the work.
Equity prices capitalize expected future earnings, and earnings in aggregate cannot outrun the economy forever. Potential GDP, the maximum output an economy can sustainably produce without pushing inflation up, sets that ceiling. Actual output above potential means labor and capital are being worked beyond optimum levels, which is temporary by construction. So over long horizons, actual real GDP growth converges to potential GDP growth, and potential GDP growth is the economy's sustainable growth rate.
For earnings growth to exceed GDP growth permanently, the corporate profit share of GDP would have to rise without limit. It cannot. Stagnant labor income eventually breaks both the willingness to work and aggregate demand.
Cross-country comparisons of GDP should convert using purchasing power parity (PPP) exchange rates, not current market exchange rates.
Common mistakes
- Extrapolating past equity returns as a growth forecast. Equity returns are far more volatile than potential GDP growth. Long-run real growth and inflation forecasts deserve higher confidence than an average of historical index returns.
- Converting GDP at market exchange rates. Market rates are volatile and ignore cheaper non-traded goods in developing countries, understating their living standards. Use PPP for any cross-country comparison.
- Swapping the factor shares. With , a 1% capital increase adds 0.3%, not 0.7%. Using 0.7 for capital roughly doubles the capital contribution and corrupts the TFP residual.
Bottom line
- Potential GDP growth caps long-run real earnings growth and the long-run rate of stock market appreciation, because the profit share of GDP cannot rise forever
- Grinold-Kroner: E(Re) = dy + Δ(P/E) + i + g − ΔS, where ΔS = net buybacks + relative dynamism; dilution is why fast-growing economies can deliver poor equity returns
- Growth accounting: ΔY/Y = ΔA/A + αΔK/K + (1−α)ΔL/L; TFP growth is the Solow residual, and α is capital's income share (about 0.3 in the US)
- Capital deepening moves along the production function and faces diminishing returns; technological progress shifts the function up and does not
Exam shortcut
Growth accounting vignettes give you three of four terms and want the fourth. Write the equation, multiply, subtract. If the stem says "capital's share of income is 0.3," that number is α and it multiplies capital growth; the trap answer swaps it onto labor.
The full lesson (about 3,931 words, 26 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- economic growth
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