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Seventh International Conference on “Enterprise in Transition”
ROLE OF CAPITAL IN GROWTH THEORIES: LESSONS FOR
CROATIAN ECONOMY
Saša Drezgić
University of Rijeka, Faculty of Economics
I. Filipovića 4, 51 000 Rijeka
Phone: ++ <+385 51/ 355129 >; Fax: ++ <+385 51/ 355129 >
E-mail: <[email protected] >
Brian A. Mikelbank
Maxine Goodman Levin College of Urban Affairs, Cleveland State University
2121 Euclid Ave, UR350
Cleveland, OH 44115
Phone: ++ <1-216-875-9980 >; Fax: ++ <216-687-9277 >
E-mail: < [email protected] >
Key words:
Capital investment, Growth theories, Regional economic growth, Economic
development, Croatia,
1. INTRODUCTION
From the beginning of 17-th century, when classical economists imposed the question of
economic growth, many theories arose. They all had a same goal – by determining the crucial
factors within the production function, proper economic policy can be established and longterm growth will be assured. Classical economists failed in their attempt to capture the
essence of the economic growth and same destiny occurred in the research of their
predecessors: Marginalists, Keynesians, neoclassical economists and finally different
variations of endogenous models of economic growth. However, the results of their
productive research have not been in vain. Although these theories that used structural models
have not been able to capture the complexity of the growth process, each theory added a
significant contribution to understanding of that complex phenomenon. It is hardly fair to
expect that any theory is able to do that – but even a rough approximation of macroeconomic
reality would be beneficial for the guidelines of government economic policy and
development planning.
Regional growth theories arose on the basis of theories of economic growth but diverge from
them because “spaceless” growth theories failed to predict trends in regional and local
development. They add significant importance to spatial effects on economic growth and
location theory in explaining growth patterns of particular areas1.
Another mainstream of theories belong to so called “Development theories”. These theories are deeply
involved in issues of economic development and their focus is not in revealing the theoretical secrets of
economic growth but more in practical problems of persistent inequalities in division of national income
worldwide. Expression applied on case of developed and underdeveloped countries, regions and localities is
often called as “North and South” problem. However, since these theories are more policy oriented and based on
theoretical foundations of growth theory, this issue is not included within this text.
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Voluminous empirical literature on role of capital accumulation in economic growth gives
proof of the complexity of economic growth. The focus of empirical research diverges not
only on geographical coverage, but also in using different variables as explanatory variables
in the growth equation. These variables influence the production function directly in the form
of relations between inputs (like labor, capital, technology, trade etc.) but also indirectly, in
the form of conditions in which the process of capital accumulation and formation occurs
(rule of law, corruption, effects on aggregate demand, financing of investments, spatial
effects, openness, small vs. large countries, etc.)
Theoretical and empirical findings provide help in understanding the crucial elements that are
the foundation for positive effects of investments on economic growth. This knowledge
should be incorporated in policy recommendations. In the first part of the paper theoretical
contributions from the classical theories to recent theoretical findings will be examined. In the
second part, significant empirical research will be summarized. At the end, some important
lessons are drawn for Croatian economic policy.
2. ROLE OF CAPITAL WITHIN THEORIES OF ECONOMIC GROWTH
2.1. Theories of economic growth
Adam Smith’s (1776) book “An Inquiry into the Nature and causes of the Wealth of
Nations” had a profound impact on the development of economic theory. Important in
Smith’s view for the modeling of the growth equation is that the production function is not
subject to the law of diminishing returns. On the contrary, Smith thought that the real costs of
production will tend to diminish due to the existence of external and internal economies as a
consequence of increasing market size. Economies of scale will be realized in production and
in marketing because of the greater degree of division of labor and general improvements in
machinery. Smith denotes crucial meaning of capital accumulation for division and
specialization of labor.
From Smith’s theoretical concepts it can be concluded that capital accumulation is the most
important endogenous factor of production. Only in the case when capital accumulation is
increasing, is the output of the economy also expanding. Several other important of notions of
Smith theory can be stated: greater capital stock leads to greater division of labor and,
therefore, higher productivity of labor; output is connected with institutional variable (that
observation is in line with contemporary economic thought – there are numerous measures on
the institutional bases that can be conducted for the growth incentives – free trade,
deregulation, decentralization of government and other); Smith connects technological
progress with the amount of capital invested (that is in line with endogenous theory of
growth); defines the rate of investment to be determined by rate of saving, and saving is
motivated by acquiring profits; states that marginal product of capital is falling with more and
more capital employed, and as profit is decreasing, more and more capital is employed (in
order to keep the previous income level) – therefore, finally, economy comes to the high-level
development equilibrium where additional units of capital would not provide any benefits.
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It is worthwhile to mention Thomas Malthus – who first noted the importance of aggregate
demand – according to his view – effective demand has to grow together with the productive
potential in order to sustain desired level of profit (as stimulus for investments).
Ricardo’s model differs from Adam Smith’s in the important assumption that the production
function is subject to diminishing marginal productivity because of the fact of fixed supply
and quality of land. That constraint imposes that the only source of output growth has to be
relation of profit, population growth and wage. Rise of wages and population growth decrease
profits, and therefore capital accumulation. That dynamic process occurs until the steady state
is reached with no profits and capital accumulation and equal demand and supply for labor.
Then technological progress increases the productivity of production factors so tendency
towards new, higher equilibrium starts.
Karl Marx stated that improvements in production techniques are regulated by the gross rate
of capital formation in the economy, since any piece of capital equipment actually in
operation requires fixed amounts of labor to work on it. The rate of innovation is
consequently governed by the gross rate of addition to the capital stock of the economy. Like
Smith, he relates technological progress with the amount of investments employed. The
difference is that he defines technical progress differently than mainstream economists of that
time – as the measure of the interaction between techniques of production and the social and
economic organization of society. Marx postulated that, generally speaking, technological
progress is labor-displacing2. In addition, he stated “lows of acceleration” and “centralization”
of capital which go together as self-sustaining process. “Every individual capital is a larger or
smaller concentration of means of production, with a corresponding command over a larger or
smaller labor army. Every accumulation becomes the means of new accumulation. With the
increasing mass of wealth which functions as capital, accumulation increases the
concentration of that wealth in the hands of individual capitalists, and thereby widens the
basis of production on a large scale and of the specific methods of capitalist production”
(Marx, 1867, p. 309). However, according to his theory such accumulation of capital will not
be beneficial, on contrary; it will lead to the collapse of capitalistic society.
Marginalism denotes a period where more attention was devoted to microeconomic
phenomena of the economic theory. As far as growth was concerned, attention is devoted to
analysis of structural change and equilibrium growth rate. The most distinctive author whose
insights significantly marked the path of economic growth theory was Schumpeter.
Schumpeter’s central insight that a significant number of innovations are large, endogenous,
discontinuous, and have their initial impact on particular sectors caused a problem for growth
theorists. That assertion meant that these innovations affect not only the structure of the
economy as a whole but virtually all of its major variables (the rate of growth of output, the
demand for credit, the price level, real wages and the profit rate). The Schumpeter problem
was bypassed by the following major devices (Rostow, W.W., 1990, p. 336-337):
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That is, he assumed that the techniques of production become more capital-intensive with the passage of time.
As an index of this effect Marx used the ratio of constant (plants and raw materials) to variable capital (wage
bill) which he called the “organic composition of capital”. The rate of change of this ratio (which determines the
rate of pace at which the relative displacement of labor in production occurs) depending solely upon the rate of
change of technology, which, in turn, depends upon the rate of gross capital formation. So, therefore, organic
composition of capital is an increasing function of gross capital formation. The greater the rate of gross
investment, the more rapid the increase of the constant capital stock compared with the variable.
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
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Assume no technical progress and treat growth as a product of an expanding
working force and capital stock.
Assume technical progress is incremental, exogenous, and a function of the
passage of time (disembodied).
Assume technical progress is embodied in investment and a function of the rate of
investment – a kind of return to Smithian incremental technical change in response
to the expansion of market.
Assume all technical change is endogenous but incremental, induced by factor
prices, cumulative experience in production, education and other improvement of
human capital, and/or by R&D investment.
Keynes caused a dramatic turning point in the economic theory with his book “General
Theory of Employment, Interest and Money”. It was not just that he reshaped the traditional
view on economic theory, but that his theory came as a cure for the crises of economies
during the period before the Second World War.
It is worth mentioning that all classical economists had not questioned Say’s law – that
aggregate supply is automatically matched with aggregate demand. Therefore, they were
completely devoted to exploring supply side factors as only sources of economic growth.
Keynes focused on the short-run economic equilibrium. For that orientation, equilibrium of
the aggregate supply and aggregate demand becomes a matter of issue. He was interested in
questioning what way government can raise macroeconomic indicators and employment
especially, in the short term. Of course, his efforts were product of economic conditions of
that time with high unemployment and worsening macroeconomic indicators. There was a
constant shortage of aggregate demand, so he had to introduce some measures to raise it – the
only subject able to do that – was government. Keynes ascribes to the government spending
the characteristic of multiplicative effects – that are highest for investment. So, in short term,
investments raise aggregate demand but in long-term have their effects through the process of
multiplication (his conclusions are based on Kahn’s work).
In perspective of the Keynesian economy, long-run growth rate will depend on the dynamic
interaction of aggregate supply and demand. Later authors showed the specific details of the
growth rate of the Keynesian economy. His major argument is that government has to conduct
systematic intervention both to promote investment, and at the same time, to promote
consumption, beyond the level generated from to a higher level still (see Keynes, p.325).
Long-run dynamics between investments and output growth of the Keynesian economy is
determined by the dynamic relationship of aggregate demand and aggregate supply.
Latter work of post-Keynesian economists was focused on improving the basic model to
fixing some of its flaws that were especially connected with questions of long-term growth
rate. The most significant contributors were Harrod (1948) and Domar (1946). HarrodDomar3 model introduces the explanation of the long-term growth relationship within the
Keynesian economic model. This model can be described as dynamic model of Keynesian
static equilibrium. Criticism of Harrod-Domar model stem from the restrictive assumptions
(Solow, 2000). Steady-state growth will occur only in the case when the saving rate is the
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The model was called Harrod-Domar because both economists came to the same conclusion on causes of
economic growth. However, they used different approach: Harrod tried to resolve a question of income rate
necessary for desired growth rate under the condition that investments are equal to savings. Domar asked what
rate of growth of investment has to be in order to match aggregate supply and demand growth (at full
employment).
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product of capital/output ratio and the rate of growth of the labor force (s = kn) 4. However,
numbers s, k and n are independently given facts of nature. The rate of growth of labor supply
depends primarily on those demographic factors that influence birth rates and death rates, and
on those sociological factors that in the long run influence the choice between participation in
the labor force or non-participation. The capital/output ratio is intended to be a technological
fact only slightly, if at all, capable of variation in response to economic forces. The saving
rate is supposed to describe still another set of facts, attitudes towards consumption and the
ownership of wealth. This poses a problem. If s, k, and n are independent constants, then there
is no reason at all why it should happen that s=kn.
The basic neoclassical growth model was developed in 1956 by Robert Solow and Trevor
Swan. The basic model consists of four variables: output (Y), capital (K), labor (L) and
“knowledge” or the “effectiveness of labor” (A). The production function takes the form:
Y (t )  F ( K (t ), A(t ) L(t ))
where t denotes time.
The stated function denotes that output increases over time by increases of quantities of
capital and labor. This increase of factors is induced by technical progress. Inputs A and L
enter multiplicatively into the equation. The way of entering of factor A will have profound
effect on production function. It will determine the function of capital-output ratio. Three
possible positions of technological progress (A) create different outcomes:
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if A is multiplied by L, or Y (t )  F ( K (t ), A(t ) L(t )) , technological progress is laboraugmenting (capital-saving) or Harrod-neutral5
if A is multiplied by K, or Y (t )  F ( A(t ) K (t ), L(t )) , technological progress is capitalaugmenting (labor-saving)
if A is multiplied by K and L, or Y (t )  AF ( K (t ), L(t )) , technological progress is
Hicks-neutral
It is assumed that capital-output ratios are constant, so A(t) multiplies L(t) which simplifies
the model.
Solow model is extremely simplified – there is only a single good, government is absent,
fluctuations in employment are ignored, production is described by an aggregate production
function with just three inputs, and the rate of savings, depreciation, population growth, and
technological progress are constant (Romer, 1986, p.13). The critical assumption of Solow’s
model is that there are constant returns to scale with regard to capital and effective labor.
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If the saving rate exceeds product kn - then if the unemployment rate is somehow held constant, so that
employment grows as fast as the labor force, each year’s saving and investment must be more than enough to
provide capital for the annual increment for employment, so the economy must be adding to its excess capacity
every year, over and above the normal excess capacity already included in v. alternatively, if the economy insists
on using all capacity it creates by investment, it can do so only by increasing employment faster than the labor
force grows, so eventually the economy will run out of labor, and revert to the first state of affairs.
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Technological progress is said to be Harrod neutral if the marginal product of capital remains undisturbed at a
constant capital-output ratio. Hicks neutrality refers to the ratio of the marginal product of capital to the marginal
product of labor that remains unchanged at a constant-capital labor ratio. These definitions impose different
restrictions that change production function. Hicks idea was that technological progress is neutral if it does not
change the relative prices of factors. Harrod’s notion was that given the interest rate, the capital-labor and
capital-output ratio is determined (see Arrow and Kurz, 1970, p.18).
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Apparently, capital investments play one of the crucial roles under the Solow model as well.
Within this model certain amounts of investments are always necessary.
Sollow-Swan model implied that capital investments are not important for the long-term
growth rate (they only raise a level of output because they are necessary for supporting the
growth rate of labor6). Therefore, the only mechanism that enables long-term growth of the
economy would be then growth rate of technological progress.
What should government do in order to increase national output? The Solow model points to
the saving rate that can be increased by beneficial tax treatment for savings and also
borrowing (in case that internal accumulation is not sufficient). But, according to the model,
permanent increase in saving rate would produce only temporary rise in output. This is
because the additional investments would raise output per unit only to the point where they
are sufficient to maintain the higher level of capital per labor unit. That is due to the fact that
under the assumptions of the model only the rate of technological progress has growth effects,
all other changes have level7 effects. If the assumption is added that additional capital
investment influences the rate of the technological progress, the situation changes. With that
possibility, a new chapter of theories is opened – this possibility is examined under various
“endogenous growth models”.
The goal of the new theories of economic growth was to explain the reasons for increase of
productivity per worker that was not revealed by the Solow model. He defined growth of
effectiveness of labor as exogenous. Even the meaning of the effectiveness of labor was not
explained. There are many possible interpretations of Solow residual (A): the education and
skills of the labor force, the strength of the property rights, the quality of infrastructure,
cultural attitudes toward the entrepreneurship and work, and others (Romer, 2006, p. 28). The
major inspiration of the “new” growth theory, which relaxes the assumption of diminishing
returns to capital and shows that, with constant or increasing returns, there can be no
presumption of the convergence of per capita incomes across the world, or of individual
countries reaching a long-run steady state growth equilibrium at the natural rate. If there are
not diminishing returns to capital, investment is important for long-run growth and growth is
endogenous in this sense. In these “new” models of endogenous growth, pioneered by Arrow
(1962), Uzawa (1965), Lucas (1988) and Romer (1986,1990), positive externalities are
assumed to be related with human capital8 formation (for example, education and training)
and research and development that prevent the marginal product of capital from falling and
the capital-output ratio from rising.
An important motivation for new growth models was to understand variations in long-term
growth. As a result, early endogenous growth models orientated on constant or increasing
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And neutralize effects of capital depreciation.
As Lucas (2002) pointed out, even granted its limitations, the simple neoclassical model has made basic
contributions to the theory of economic growth. Qualitatively, it emphasizes a distinction between “growth
effects” – changes in parameters that alter growth rates along balanced paths – and “level effects” – changes that
raise or lower balanced paths without affecting their slope – that is fundamental in thinking about policy
changes. However, Lucas argues that even sophisticated discussions of economic growth can often be confusing
as to what are thought to be level effects and what growth effects. Under classical model one would not expect
the removal of inefficient trade barriers to induce sustained increases in growth rates. Removal of trade barriers
is, on this theory, a level effect, analogous to the one-time shifting upward in production possibilities, and not a
growth effect. Of course, level effects can be drawn out through time through adjustment costs of various kinds,
but not so as to produce increases in growth rates that are both large and sustained.
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Shultz (1963) introduced importance of the human capital variable.
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returns ascribed to the production function factors, where changes in saving rates and
investment on R&D permanently change growth. Jones (1995) points out that in the second
half of last century, the fraction of resources devoted to R&D increased tremendously.
Therefore, new growth models with constant and increasing returns would imply that growth
rates should also increase proportionally. But that was not the case. The explanation for such
circumstances would be in decreasing returns on the production function factors (Jones,
2002). With that assumption, empirical findings on the rate of growth would not be
surprising. Result of repeated rises in R&D investment would lead to temporary periods of
above-normal growth. However, investments in R&D cannot rise indefinitely – if their share
in output is low – substantial period of rapid growth can be expected by their increase.
Another explanation of differences in levels of national income was provided by “social
infrastructure9” effect (see Hall and Jones, 1997). That term, according to them, denotes
institutions and policies that align private and social returns to activities. There is a
tremendous range of activities where private and social returns may differ. They fall into two
main categories. The first consist of various types of investment. If an individual decides to
engage in conventional saving, to acquire education, or to devote resources to R&D, his or her
private returns are likely to fall short of the social returns because of taxation, expropriation,
crime, externalities and so on. The second category consists of activities intended for
individual’s current benefit. An individual can attempt to increase his or her current income
through either production or diversion. Production refers to activities that increase the
economy’s total output at a point of time. Diversion, (rent-seeking – crime, lobbying for tax
benefits) refers to activities that merely reallocate that output. The social return to rentseeking activities is zero by definition, and the social return to productive activities is the
amount they contribute to output. As with investment, there are many reasons the private
returns to rent-seeking and to production may differ from their social returns. Hall and Jones
(1997) conclude that differences in levels of economic success across countries are driven
primarily by the institutions and government policies (or infrastructure) that frame the
economic environment in which people produce and transact. Societies with secure physical
and intellectual property rights that encourage production are successful. Societies in which
the economic environment encourages the diversion of output instead of its production
produce much less output per worker. Diversion encompasses a wide range of activities,
including theft, corruption, litigation, and expropriation10.
Inability of general growth theories to provide basis for prediction of economic development
of countries and regions proved ground for evolution of different regional theories and
models. Regional approach to growth issue is shortly described in text below.
2.2. Regional growth theories
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There are many types of social infrastructure. One group consist of government fiscal policy (tax treatment of
investments and marginal tax rates on labor income directly affect relationship between private and social
returns); second refers to institutions and policies that make up social infrastructure consist of factors that
determine the environment that private decisions are made in (laws, enforcement of laws – influence the
attractiveness of investment); the final group of institutions and policies that constitute social infrastructure are
ones that affect the extent of rent seeking activities by the government itself (corruption within the government)
(Romer, 2006, 145-147).
10
For example, the kind of diversion of resources can have important dynamic concequences for the allocation
of talent. Individuals who might otherwise become entrepreneurs will instead devote their energies to rentseeking or other forms of diversion. The types of skills that an individual accumulates may be those that
maximize an individual’s chance of securing a position in the government bureaucracy instead of skills that
would increase the productive capacity of the economy.
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Until the late 1950s there was little direct analysis of the regional growth phenomenon.
Myrdal’s “cumulative causation” theory (1957), though loosely formulated, has had a
persuasive influence on subsequent developments in regional growth theory. After that, a
voluminous literature emerged.
The main point of divergence between regional growth theories and neoclassical theory that
gained a foothold in the 1960s was the question of convergence of economic development of
regions and countries. According to neoclassical theory, based on abstract assumptions (such
as perfect competition, Cobb-Douglas production functions, and constant returns to scale),
differences in the level of development between regions should disappear in time. However,
despite intervention in most advanced economies the economic problem of lagging regions
has persisted. Areas suffering from low incomes, high unemployment, low growth rates and
productivity performance and high out-migration rates continue to create difficulties for
governments committed to full employment, equal opportunities for all citizens and other
worthwhile social goals. In descending from national to the regional level it can be expected
to find a range of regional values for economic indicators around the national mean. There
must always be some regions that are above average and others that are below average (see
Richardson, 1973). The problem is twofold: that the coefficients of variation has in many
countries been unacceptably high, with per capita income gaps between the poorest and
richest region much too wide for social cohesion and stability; second, that the areas at the
bottom of the league have remained the same, and at least in the bottom half of regional
growth tables rankings have scarcely altered at all over decades.
Few important issues related with capital accumulation in the context of economic
development of regions have to be mentioned. These are specific regional features of
infrastructure investments, spatial component, impact of decentralization process and location
theory.
There is no argument that infrastructure is a very important (though not the exclusive)
potentiality factor for regional development. The following features distinguish infrastructure
from other potentiality factors (investment subsidies, tax subsidies, for example) (Nijkamp,
1986, p.4):
 a high degree of publicness (in contrast with the frequent private goods properties
of other resources)
 a high degree of immobility (meaning that the costs of a spatial mobility of
infrastructure facilities are very high)
 a high degree of indivisibility (implying that the separation costs of such public
capital are very high, so that usually problems of over – and undercapacity arise)
 a high degree of non-substitutability (implying high costs for transforming
infrastructure capital into alternative or complementary uses);
 a high degree of monovalence (so that the costs of employing infrastructure in a
less specialized way are very high).
Therefore, it is apparent that these features of infrastructure make difference in risk between
developed and underdeveloped regions, and from that point it is to be expected that capital
will naturally be installed in areas with lower risk. Without intervention of government it is
likely that differences in growth will diverge.
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The spatial component of investment is related to the fact that regions do not have firm
boundaries and there is much more mobility of production factors than in case of countries.
Because of that, some extent of spill over effects is expected in the case of investment.
However, the problem is that these effects are country and region specific, and cannot be
incorporated in a general model of regional growth.
Important for development of investment policy is the decentralization process that emerged
worldwide and especially in developing and transition economies from 1990s. That process
presents an attempt of these countries to catch up with level of development of advanced
Western economies. The traditional standpoint of fiscal policy that there is no room for subnational governments in stabilization policy was abandoned. It is believed that sub-national
level investment activity (either in increasing the quantity of investments or structural shift
from current to capital expenditures) can have significant multiplicative effects and raise the
growth rate and employment of a particular region11.
Traditional location theory was focused on rates of return to capital, transport cost
advantages, cheap labor costs and other key elements. To the extent that the macro-economic
growth rates of regions reflect the influence of thousands of micro-locational decisions,
understanding how location decisions are reached is essential to explanations of regional
growth. Similarly, this understanding is also necessary in order to devise more effective
policy measures. Policy is, in effect, one of the major links between the actions of the
individual decision takers and their net impact on inter-regional growth differentials that are
the very objects of policy. As far as location theory is concerned, evidence is mounting that
such factors as access to metropolitan living, social amenities, environmental preferences, and
economies of urban agglomeration are more important determinants of location. If these
arguments have substance the appropriate policy implication is not monetary subsidies but
more interventionist planning to influence the spatial distribution of resources, population and
economic activities within regions, particularly the intra-regional urban pattern. This further
implies that regional economic policy and physical planning are not independent but are
highly inter-connected (see Richardson, 1973).
3. EMPIRICAL FINDINGS
Research on the relationship of capital and economic growth has been intensified by
development of neoclassical theory and growth accounting. For the first time it was possible
to distinguish the contributions of individual factors of production on economic growth.
Previously, relations between inputs in production function were examined by use of inputoutput techniques, capital-output ratios and short-run multipliers and laid much of the
emphasis on the demand side of the economy. The new approach offered possibility of
exploring the long-term effects of factors of economic growth and it was supply-side oriented.
Evolution of empirical contributions to the relevant issue begins by papers of Abramowitz
(1956) and Solow (1957). Empirical findings of Abramowitz (1956) and Solow (1957)
disturbed the mainstream of economic thought in this period. There was a deep belief in the
importance of capital investments in economic growth. Almost all theories of economic
growth supported that opinion. In addition, neoclassical theory had many opponents
especially because of the neoclassical concept that capital does not play major role in the
11
for example, see Terr-Minnassian (1997).
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long-term growth of the economies. Abramowitz and Solow showed that 80-90 per cent of
growth of output per head in the US economy in the first half of the twentieth century could
not be accounted for by increases in capital per head. Even allowing for the statistical
difficulties of computing a series of capital stock, and the limitations of the function applied
to the data (for example, the assumption of constant returns and neutral technical progress,
plus the high degree of aggregation), it was difficult to escape from the conclusion that the
growth of capital stock was of relatively minor importance in accounting for the growth of
total output.
After that research, there was a certain period of shortcoming in volume of literature on
growth and investments12. That period lasted until the year 1989 when Ashauer’s paper “Is
Public Infrastructure Productive?” was published. On the bases of aggregate production
function with Hicks-neutral technical change (data in levels) Ashauer estimated that elasticity
of output on public capital is 0.39. That finding disturbed the economists because it offered
explanation for recent productivity decline of U.S. economy13.
However, his paper raised many criticisms. They were especially pronounced because of
incredibly high rates of returns of public infrastructure increases. Issues of the validity of
econometric techniques are raised as well. That was especially because of use of time series
data in levels that are considered to be useful only as a preliminary data analysis. This is due
to fact that time series are dominated by trend and therefore do not contain much information
about inflection points that denote interdependency between variables. Due to the influence of
trend, time-series data that are not processed through various methods such as detrending,
differencing and others give good fits and give bias to coefficients. They increase estimators
if there is a correlation between variables. Furthermore, critics had pointed out that direction
of causality is ambiguous – more private output could lead to an increase in the demand for
public capital. Possibility of spurious correlation was also accented (see Gramlich, 1994).
Ashauer’s (1990) later paper finds smaller coefficients for public capital, 0.11, but
nevertheless criticism of his methods remained.
During the 1990s research in this area has risen exponentially. There are several reasons for
such developments. First of all, Ashauer’s paper was launched at the time when economists
were trying to explain the reasons for productivity decline in the US, and shortcoming of
investments was a plausible and possible reason. In addition, datasets on capital stocks and
investments due to improvements of methodology in collecting and processing of data
provided much better basis for conducting econometrical examinations. Furthermore, there
was a tremendous improvement and development in various econometric techniques. Within
the time series analysis techniques many new concepts emerged and that was especially
applicable in the area of macroeconomics. Finally, it is not irrelevant that longer time spans of
the data helped in better estimation by benefit of larger sample sizes. Of course, it has to be
pointed out that the majority of research was conducted for U.S. economy with rare
exceptions – Netherlands and Spain. European countries still do not have appropriate data sets
12
Few studies published in that field had regional scope. For example, Mera (1973) examined effects of public
capital on the regional productivity of Japanese regions and found significant positive effects. Looney and
Frederiksen (1981) studied the link between income, productivity and public capital for the Mexican states.
Although these papers denoted that public infrastructure has significantly positive impact on economic growth,
there was not much attention focused on that findings.
13
Shortly after his paper, Munell (1990) finds more moderate results for the elasticity of public capital, but still
significantly positive.
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Seventh International Conference on “Enterprise in Transition”
on capital stocks so therefore it is expected to see a rise of research in that area in EU from the
year 2000.
Criticisms of the traditional production function approach motivated empirical research to
make use of the cost production function approach and the profit function approach. The basic
idea of cost function approach is that private firms are assumed to produce a given level of
output at minimum cost. In this approach factor prices are exogenous variables while labor
input and private capital are endogenous variables to be derived from the firm’s optimization
problem. The cost function model has the advantage over the single-equation production
function model in that it uses information about total cost and individual input shares to
determine the parameter estimates. This constitutes a major difference to the production
function approach where the factors of production are taken as exogenously given. A major
difference is that the cost function approach takes output as exogenously given while the
profit function approach takes the price of output as given. The profit function model uses
information on profit as well as profit ratios to determine parameter estimates and therefore,
like the cost function model, should provide more efficient estimates. The profit function
model has no a priori advantage over the cost function model (see Vijverberg, 1997, p. 269).
Development of Multivariate time-series and introduction of VAR (vector-autoregression)
into microeconomics by Sims (1980) opened a new chapter in examination of public-private
investment on economic growth. Important contribution was endogeneity of variables that is
inherent in the VAR method and the possibility of examination of causality directions
between variables. From the 1990s many authors use VAR methodology. The idea of making
public capital an endogenous variable in a macro growth system has been pursued by Flores
de Frutos and Pereira (1993). They find very high rates of return on public capital, almost as
high as those found by Aschauer.
Economic models that incorporate spatial effects have gained a foothold in mainstream
economic literature. The estimation of these models is commonly carried out using spatial
econometric techniques. One of the harshest criticisms of the spatial econometric models is
the use of ad hoc spatial weighting matrices. The criticism stems from the lack of empirical
justification for any type of weight matrix in particular and that small changes in the spatial
weight matrix often result in changes to the model results. It has been suggested that
flexibility needs to be incorporated into the specification of the spatial weight matrix.
However, flexibility introduces further estimation issues.
Over the past ten years a large body of literature has emerged developing methods for the
analysis of nonstationary panel models. An extensive treatment of methods for panel data
analysis in general can be found in Baltagi (2001) and Hsiao (2003). An interesting result
from the panel literature is that in contrast to pure time-series analysis with nonstationary
panels many test statistics and estimators have normal limiting distributions. But so far there
was little use of nonstationary panel models in the analysis of effects of public capital.
However, in spite of these mentioned developments, effects of public investments on output
growth are still empirically ambiguous. Extensive reviews of the literature and the different
methodological approaches are presented by Kamps (2004) and Sturm (1998).
Within the theoretical part of this research, complexity of effects of public and private
investments was distinguished. It is clear that simple increase of investment in some sector of
economy does not mean that output will increase accordingly. That is not certain even in the
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Session Name (Please DO NOT CHANGE THIS TEXT)
case of evident high influence on productivity growth. The reason is in fact that this positive
influence can be offset by numerous direct or indirect phenomena’s that occur in the process
of financing, operating an implementing investment projects. Understanding of these channels
is crucial for determining the policy recommendations in particular economy. Therefore, it is
useful to isolate specifically topics that were considered important to cover in empirical
examinations in field of investment effects. Some major strands of literature can be isolated:
1. Effects of financing public investment – these effects are related to the fact that costs
of capital in regions and countries diverge (especially between small and large ones, or
developed or underdeveloped economies), existence of crowding-out effects (in case
of extensive public borrowing and limited capital market it is likely that crowding-out
of private investments will occur).
2. Spatial effects of public investments – there is growing literature on impact of regional
investments on regional inequality. Existence of spillovers during the investment
process makes regional planning of investment an important tool of regional policy
(optimal location of investments)14.
3. Question of optimal provision of public investments – it is obvious that economies and
regions on different level of development demand different levels of capital
investments. Keynesian theory advocates strong government intervention in raising
investment levels in case of excess capacity of production factors in economy.
Structure of investments also changes in transition to more developed economy (see
Thirlwall, 2003).
4. Efficiency of public investments – more and more attention is devoted to questions of
efficiency of investments. That issue is usually connected with existence of
corruption. Extensive review of relation of capital accumulation and corruption can be
found in Tanzi (1998) and Mauro (1996).
Previously mentioned issues that make just some of important factors for positive or negative
sign of contribution of capital accumulation to economic development have to be incorporated
in government policy. Therefore, effects of capital accumulation are country (and region)
specific. In following part, Croatian investment policy is examined.
4. ROLE OF CAPITAL IN CROATIAN ECONOMY
Understanding of role of capital in Croatian economy is complex. This is due to many
reasons. First of all, Croatia belongs to a group of “transition economies” that turned to
capitalism and at the same time gained sovereignty. In addition, war that ended in year 1998
made substantial direct and indirect damages. From the beginning, privatization of public
enterprises started and it is hard to capture public and private ownership on assets in such
circumstances. Data on capital accumulation are also doubtful and official capital stock
estimates still do not exist. Due to these reasons lack of empirical studies on capital
accumulation effects in Croatia is not surprising. The only exception is the study of
Lovrinčević et al. (2004) that dealt with efficiency of investments based on incremental
capital-output ratio. That study showed substantial differences between efficiency of private
and public investments. According to that research public investments in Croatia are much
more inefficient in comparison with private investments (however, that is not surprising).
14
see Mikelbank and Jackson (2000)
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Seventh International Conference on “Enterprise in Transition”
As a candidate for EU membership it is interesting to see what trend is present in the ratio of
gross fixed capital formation in GDP in Croatia. Figure 1 shows data in period from 1996 to
2004. Apparently, Croatian investment policy did not have same patterns as the
majority of EU countries. It is important to mention that impact of EU fiscal rules on shortage
in capital accumulation in EU countries is recently heavily criticized as a cause of low growth
rates of EU economies (see Blanchard, 2004). However, it is not surprising that the level of
investment in Croatia remained on high level. Croatian public debt increased tremendously
and privatization revenues were enormous. Sever (2005) estimated that growth rates of
economy in case that revenues gained from borrowing and privatization were utilized on
investments (and efficiently) much more than actual ones (several times higher).
It has to be mentioned that macroeconomic indicators of Croatian economy in period from
year 1996 to year 2006 are stabile – growth rate moves around 4% on average, low inflation
rate around 3% and there is a persistent rate of unemployment (around 20%)15. According to
these data it can be stated that Croatian economy is characterized by low-level equilibrium
state (or utilization of resources). These features imply that some kind of Keynesian policy
could be successful – in terms of efforts toward higher utilization of capacities.
35.00
30.00
25.00
31.07
30.92
2003
2004
28.15
24.02
22.14
23.04
20.23
22.33
24.34
20.00
15.00
10.00
5.00
0.00
1996
1997
1998
1999
2000
2001
2002
Figure 1: Ratio of gross fixed capital formation in GDP in Croatia
Source: Croatian Central Bureau of Statistics
However, closer focus on the institutional aspect of capital accumulation issues reveals much
inefficiency. Figure 2 shows interest rates on long-term loans for corporate sector in Croatia
in the period from 1996 to 2006. Figure can be good approximation of monetary
circumstances in which capital accumulation occurred. It is evident that the cost of capital was
extremely high. In addition, Croatia entered into international capital markets in year 1998
with a low credit rating (although, much lower interest rates than in domestic market).
However, liquidity problems during 1990s definitely prove the existence of significant
crowding out of private sector investments.
15
Review of Croatian macroeconomic indicators is given at Annual reports of Croatian Ministry of Finance,
available at http://www.mfin.hr/
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Session Name (Please DO NOT CHANGE THIS TEXT)
20.00
18.00
16.00
14.00
12.00
10.00
8.00
6.00
19
96
4.00
2.00
0.00
Figure 2: Interest rates on long-term loans for corporative sector in Croatia in period of January, 1996 to
September of 2006
 based on Kuna (without currency clausule)
 monthly weighted ponders, in annual percentage
Source: Croatian National Bank, http://www.hnb.hr/ (December, 01, 2006.)
Uncertainty and risk of investment undertakings was certainly accented by weak
enforcements of laws and judiciary system. That institutional weakness and strong
government bureaucracy certainly contributed to occurrence of corruption. According to the
corruption index estimated by Transparency International 16, Croatia did not make large
improvements in that matter (69th rank among 163 countries).
In addition, Croatia does not have consistent development policy. Investment policy is
subjected to short-sited political horizons and these decisions are usually discretionary.
Therefore, misallocation of investments, either sectorally and/or regionally is to be expected.
However, according to theoretical and empirical findings, circumstances of Croatian economy
demand high investment levels. Long period of low-level equilibrium growth of Croatian
economy (especially high level of unemployment) demands proactive investment policy. It is
irrelevant whether that will be made by government directly or private sector (supported by
government interventions in loans or subsidies). Contemporary economic doctrine suggests
coordination of activities – additional investments have to be supported by appropriate
institutional surroundings.
5. CONCLUSION
Theoretical and empirical research of the effects of capital accumulation on economic growth
has not yet arrived to final conclusion. However, voluminous evidence accumulated since 17th
century, made clear some general principles. Capital accumulation cannot be beneficial only
by itself. It has to be supported with numerous economic and non-economic factors specific to
a certain economy or region. In a globalized world, more and more important factors that
determine effectiveness of capital investment is “social infrastructure”. Social infrastructure
presents catalyst for and capital accumulation fuel for economic growth.
16
Ranking list for the year 2006 is available at http://www.infoplease.com/ipa/A0781359.html
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Seventh International Conference on “Enterprise in Transition”
Development and investment policy has to incorporate specificity of particular economic
entity. Therefore, Croatian investment policy needs to have in mind that Croatia is on the lowlevel equilibrium of economic development and large infrastructure needs. In the same time,
constraints are imposed due to unfavorable social infrastructure that could eliminate the
positive effect of capital accumulation. However, at present moment, capital investments are
employed in much better circumstances, and therefore it is likely that effects of these
investments will be much more beneficial than those undertaken in recent past.
Lack of necessary data presents obstacle to empirical investigation of role of capital in
Croatian economy. However, improvement of statistical database on capital investments and
stocks in Croatia, and progress of methodology and econometric theory and practice will
enable estimation. That should be goal of future papers.
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