Robert Solow is no mean economist. He is a former winner of the Nobel Memorial prize for economics. His big idea was the Swan-Solow growth model. A neat theory that explains something quite profound.

Solow argued that in a mature economy, investment has no impact on growth. He said that in such an economy, growth can only occur via innovation. Investment is required to replace old capital, or is required if the population is rising and capital density is therefore falling, but that is it.

To understand why, imagine a farmer with a set amount of land. He would benefit from one combine harvester. If his farm is especially large, maybe he would benefit from two. But would he need three? There comes a time when there is simply no point in further investment. If an innovation occurs, say someone comes up with a smarter design for a combine harvester, than maybe investment is called for; that is the only occasion when investment leads to more productivity per person.

Now consider Europe, and to a lesser extent the US, in 1945. Two world wars and the Great Depression had decimated industry. Innovations had occurred over the previous half a century, but we were not close to realising them. It is not difficult to see why, during the 25 years or so after the Second World War, investment led to growth.

This slowed down by the mid 1970s, probably because we had more or less closed the gap between actual and potential output, and had become reliant on innovation.

 This is always a difficult time. The transition from an economy growing because it needs more capital, and an economy that needs innovation to fund growth, can be quite painful. In the 1970s Europe suffered inflation during this transition period. Fifteen years later, Japan entered a lost decade.

Some say China is set to go the way of Japan. That like Japan in the 1980s an asset bubble has been created. As it bursts the result will be a decade or more of anaemic economic performance.

This is surely wrong. Japan had closed the gap between potential and actual output. She had become reliant on innovation. Growth stalled. Imagine a fast-growth company. Say it doubles profits every year. You would expect that company to have a high p/e ratio. But there will come a time when the growth will stop. If its p/e ratio is still high when this happens, expect the share price to crash.

In Japan, markets had got used to high growth, and when this period ended, assets were overvalued. So they crashed in price. The result was very painful.

China is not in that position. The potential to increase output is still huge. There is plenty of scope for productivity to rise. It is true that investment may have grown too fast, and that she may need a catch up period. But this will be nothing like as serious as the Japanese lost decade or the mid 1970s in the UK.

For the next China piece see Will the emergence of China mean more unemployment in the West?