Understanding depreciation

Depreciation is a simple word, and a difficult concept.

It simply means wear and tear. If the car you’re driving is about five years old, or maybe more, it isn’t going to be functioning as well as when you first bought it. Maybe the fender is a little bent, and maybe the engine is making noises it really shouldn’t be making. The specifics will be known only to you, the owner, but anybody will be able to predict that things aren’t as great as they were when she was first driven out of the showroom.

That is depreciation.

Now, the reason it is a difficult concept is because of what it implies for an economy, and how to go about accounting for it. Since we’ve been talking about masterclasses by Sachin, let’s continue to use the same example.

Who do you think knows more about the art of batsmanship – you or Sachin? That isn’t an entirely ridiculous question, because the reason behind asking it was this – who is more likely to forget stuff about the art of batsmanship – you or Sachin? Since the Little Master knows more than you ever will about batting, he is more likely to forget some things about it. That is why the very best batsman spend so much time in the nets – not necessarily to learn new things, but to polish stuff they are already very good at.

In other words, what they’re trying to do is reduce the depreciation of their skill sets.And the more you know, the more you have to protect.

It’s the same with countries! The more roads, dams, power plants and airports you have, the more money you have to spend on repairing them. And so, as you increase your capital stock, you have to spend an increasing amount of money every year in keeping that capital stock up and running. And what that means is, you therefore have lesser money to throw at building up new stock.

Put another way, here is what it means: the more you have grown, the more difficult it is for you to grow.

And so, we come to the crux of the Solow model.

Countries that have a low stock of capital, along with a mix of good institutions, are the countries that will grow the most rapidly. But, they can’t grow rapidly forever. As they accumulate more capital, the need to repair it will eat increasingly into the country’s ability to invest more, and growth will slow down. And eventually, all countries settle down into a rate of growth that is just about right for that country.

Economists call this the steady state growth rate – faster than this is unsustainable, and slower than this is not optimal.

Figuring out your long run steady state growth rate, figuring out the best set of institutions for your country, and figuring out how to get there – that’s what long run growth theory is all about.