Solow Residual

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. It is a measure of productivity growth that is usually referred to as total factor productivity (TFP).

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 1909-49 could be attributed to increased capital. America, in other words, became great because of American know-how.

Total factor productivity 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 TFP. Conversely, underdeveloped financial markets that fail to allocate capital efficiently, restrictive labor practices, environmental regulations or anything else that affects the aggregate productivity of the economy, reduce it. Thus, TFP has become a proxy for technological progress. Differences in economic development are primarily explained by differences in countries’ TFP levels.

Right now, China is running out of steam because it has a major productivity problem. Its growth ‘miracle’ has been the result of rapid capital accumulation and shifting underutilized labor into a modern capitalist economy, rather than a rise in productivity. Its TFP has actually been shrinking 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.

As China’s labor force contracts, due to its decades-long “one-child” policy, China’s economic growth rate looks unsustainable. Given that the fate of the global economy depends on whether China can increase TFP, investors should expect to hear this term used a lot more in the coming years. Unless China implements free-market reforms and truly opens its markets, it may become cheaper to manufacture in the United States. Any trade war with China has to be seen in this context.