Solow Residual

What Is the Solow Residual?

The Solow residual is based on the work of Nobel prize-winning economist Robert Solow, whose growth model defined productivity growth as rising output with constant capital and labor. It tells you whether an economy is growing because of increases in capital or labor, or because those inputs are being used more efficiently. Solow found that only one-eighth of the increase in labor productivity in the United States between 1909 and 1949 could be attributed to increased capital. America, in other words, became great because of American innovation and know-how.

The Solow residual is the portion of an economy’s output growth that cannot be attributed to the accumulation of capital and labor, the factors of production. The Solow residual represents output growth that happens beyond the simple growth of inputs. As such, the Solow residual is often described as a measure of productivity growth due to technological innovation. The Solow residual is also referred to as total factor productivity (TFP).

Understanding the Solow Residual

The Solow residual is affected by a huge variety of technological, economic, and cultural factors. Innovation, investment in more productive sectors, and economic policies aimed at liberalization and competition all boost total factor productivity. Conversely, the Solow residual can be lowered by restrictive labor practices, excessive regulations, underdeveloped financial markets that fail to allocate capital efficiently, or anything else that affects the aggregate productivity of the economy. However, total factor productivity is often used as a proxy for technological progress and innovation. Differences in countries’ TFP levels are sometimes used to explain differences in economic development.

It is important to note that Solow did not use the term total factor productivity and did not consider his growth model or the residual bearing his name as having any kind of predictive function. Solow merely pointed out that growth was unaccounted for in a standard model and that the growth was likely attributable to innovations that spurred extra productivity. The Solow residual spurred improvements to economic models and measures, resulting in a better understanding of the importance of innovation — and investment in innovation — in improving a nation's economic performance.

Real-World Uses for the Solow Residual

As mentioned, the Solow residual has often been used as an explanation for the changing economic fortunes of national economies. For example, slowing growth in China has often been explained as an underlying productivity problem. In this interpretation, China's growth 'miracle' was the result of rapid capital accumulation and shifting underutilized labor into a modern capitalist economy, rather than a rise in productivity. China's TFP has been consistently negative since 2015, according to the Conference Board, because it has wasted huge amounts of financial resources on inefficient state-owned enterprises in industries like steel, coal, and cement, and excess infrastructure.

Viewed through the lens of total factor productivity, China has managed to become an economic superpower through its sheer size rather than through gains in productivity. This lack of productivity is, however, becoming more of an issue as China has seemingly reached the limits of its appetite for market reforms. China may also see less access to potentially important technologies as the EU and U.S. have taken a firmer stance on sharing important intellectual property — something that can impact its Solow residual. As China’s labor force contracts, due to its decades-long “one-child” policy, China’s economic growth rate looks unsustainable.

Given the importance of China to the global economy, investors should expect to hear about Chinese total factor productivity a lot more in the coming years.