The most dynamic economies rely on creative destruction to grow

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As the world continues to recover from the Great Recession, governments and businesses are focused on how to spur economic growth. But if they really want to create jobs, raise incomes, and lift living standards, they should devote more energy to figuring out how to generate economic dynamism over the long term.

At times like this, governments tend to champion particular sectors such as manufacturing or industries such as green technology. But true dynamism flows from continuous innovation, experimentation, adaptation, and change, all of which raise productivity over time. Those productivity gains, in turn, lift incomes and drive consumption. This fuels more innovation—and a dynamic economy thus expands in a healthy, sustainable way.

Unfortunately, economic dynamism can also cause dislocation and turmoil as workers lose jobs in failing companies or in fading industries. Change in the ranking of companies has accelerated in many countries, including the United States, over the past century. The 90 names listed on Standard & Poor's index of major US companies in the 1920s remained there for an average of 65 years. By 1998 a company listed on the S&P 500 could expect to stay there for an average of only 10 years.

The distress caused by such turnover causes many people to resist change. But this process, famously labeled "creative destruction" by economist Joseph Schumpeter, frees resources for new uses that can vastly improve life over time. We may have fewer farmers, coachmen, and switchboard operators today than in Schumpeter's time, but we have software engineers, EKG technicians, Google mapmakers, and a host of other occupations people couldn't have imagined back then. The "productivity paradox" is that while we may need fewer workers in certain occupations in the short term, improved productivity leads to a stronger economy as a whole. Over the past half century, in fact, three out of every four dollars of new US GDP per capita have come from gains in labor productivity. So policies to spur economic dynamism are essential elements of any strategy to create jobs.

How exactly do we foster economic dynamism? Twenty years of McKinsey Global Institute research shows that the mix of sectors within an economy explains very little of the difference in a country's GDP growth rate. In other words, dynamism doesn't turn on whether an economy has a large financial sector or big manufacturers or a semiconductor industry but instead depends on whether the sectors are competitive or not. Instead of picking winners and funneling subsidies to them, countries must get the basics right. These include a solid rule of law, with patents and protections for intellectual property, enforceable contracts, and courts to resolve disputes; access to finance, particularly for start-ups; and an efficient physical and communications infrastructure.

Once the basics are in place, the key is ensuring strong competition within sectors. Governments can encourage this by minimizing the barriers to entry and exit in an industry, opening their markets to trade, repealing subsidies and regulations that favor incumbents, and breaking up monopolies. They can create greater transparency in heavily regulated sectors such as health care and power generation. They can also nurture human talent by providing workers with the ongoing education and skills needed to adapt to 21st-century jobs.

Ireland is a good example of how to do this. Beginning in the 1980s the Irish government invested in developing the skills of its citizens and facilitated collaboration between industry and academia. Global tech companies set up subsidiaries in Ireland, tripling its software revenues between 1995 and 2008. The takeaway is that economic dynamism is built from the ground up. It can be tempting, in the short term, to prop up old industries and preserve obsolete jobs. But as Schumpeter said, "With capitalism, we are dealing with an evolutionary process." Nations that want to move up the list should be prepared to evolve.

James Manyika is a director of McKinsey and of the McKinsey Global Institute, where Susan Lund is the director of research. Byron Auguste is the director of McKinsey’s social sector office.

This article originally ran in Newsweek.