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Thorvaldur Gylfason Joint Vienna Institute/ Institute for Capacity Development Distance Learning Course on Financial Programming and Policies Vienna, Austria NOVEMBER 26–DECEMBER 7, 2012 I. Determinants of growth 1) 2) Saving and investment Efficiency a) b) c) d) e) f) g) Liberalization Stabilization Privatization Education Finance Diversification Institutions II. Pictures of growth III. Empirical evidence National economic output Economic growth in the long run Potential output Actual output Upswing Business cycles in the short run Downswing Time To analyze changes in actual output from year to year – in the short run Need short-run macroeconomic theory Keynesian or neoclassical To analyze the path of potential output over long periods Need modern theory of economic growth Neoclassical or endogenous National economic output West-Germany : East-Germany Austria : Czech Republic Finland : Estonia Taiwan : China South Korea : North Korea Botswana : Nigeria Kenya : Tanzania Thailand : Burma Tunisia : Morocco Spain : Argentina Mauritius : Madagascar Economic system Rapid growth Economic policy? Slow growth Time Case B: 2% a year Output per capita Aspects of efficiency Economic system Economic policy Threefold difference after 60 years Case A: 0.4% a year 0 60 Years Investment Education + + Growth + denotes a positive effect in the direction shown Adam Smith knew all this, and more, as did Arthur Lewis Investment + Education + Growth Robert Solow raised doubts about long-run linkages Investment + Education + Growth + Arthur Lewis: X can be trade, stable politics, good weather + + But Solow carried the day: long-run growth is exogenous! + Suppose X is openness to trade; then … Trade + Investment + Education + Growth Traces the rate of growth of output per capita to a single source: • Technological progress Hence, long-run growth is immune to economic policy, good or bad “To change the rate of growth of real output per head you have to change the rate of technical progress.” ROBERT M. SOLOW Traces the rate of growth of output per capita to three main sources: • Saving • Efficiency • Depreciation “The proximate causes of economic growth are the effort to economize, the accumulation of knowledge, and the accumulation of capital.” W. ARTHUR LEWIS You may recognize the endogenous growth model as a reinterpretation of the Harrod-Domar model where growth depends on • The saving rate • The capital/output ratio • The depreciation rate Four building blocks S=I Saving equals investment in equilibrium S = sY Saving is proportional to income I = K + K Investment involves addition to capital stock Y = EK Output depends on quality and quantity of capital Let’s do the arithmetic: S = sY = I = K + K = Y/E + Y/E Rearranging terms we find Y/E = sY - Y/E Multiplying by E and dividing by Y gives Y/Y = sE - Bottom line g = sE - Rate of economic growth equals Saving rate times Efficiency (i.e., the output/capital ratio) minus Depreciation Three implications for growth dg 0 ds dg 0 dE dg 0 d Our standard of living today depends solely, by definition, on economic growth Rich countries are rich because they grew rapidly over long periods Poor countries are poor because they did not grow rapidly enough So why do some countries grow more rapidly than others? Why, e.g., did Thailand leave Zambia so far behind in one generation? Hard to think of anything else (Lucas) Thailand and Zambia started out in a similar position and grew apart Thailand pursued growth-friendly policies, stressing liberal trade, stability, private enterprise, and education GDP per capita 1965-2004 (US$ at 2000 prices) 2,400 THAILAND ZAMBIA 2,000 1,600 1,200 800 400 0 65 70 75 80 85 90 95 00 Thailand 4.7% per year Zambia -1.5% per year 1.06239 = 10.4 Argentina and Sweden went hand in hand 1900-1930, and then grew apart Sweden pursued free trade, liberal democracy, and income equality, and avoided high inflation Argentina did not GDP per capita 1900-2003 (US$ at 1990 prices) 24,000 20,000 ARGENTINA SWEDEN 16,000 12,000 8,000 4,000 0 1900 1925 1950 1975 2000 Sweden 2.1% per year Argentina 1.0% per year 1.011103 = 3.1 Argentina and Spain went hand in hand 1965-1970, and then grew apart Spain pursued free trade and price stability through EU membership and adopted democracy Argentina lacked stability GDP per capita 1965-2004 (US$ at 2000 prices) 16,000 SPAIN ARGENTINA 14,000 12,000 10,000 8,000 6,000 4,000 65 70 75 80 85 90 95 00 Spain 2.7% per year Argentina 0.6% per year 1.02139 = 2.2 Botswana and Nigeria went hand in hand 1965-1970, and then grew apart Botswana stressed education and resisted corruption Nenadi Usman, Nigeria’s finance minister: “Oil has made us lazy” GDP per capita 1965-2004 (US$ at 2000 prices) 4,000 BOTSWANA NIGERIA 3,500 3,000 2,500 2,000 1,500 1,000 500 0 65 70 75 80 85 90 95 00 Botswana 7.1% per year Nigeria 0.6% per year 1.06539 = 11.7 Mauritius did many things right and reaped rapid growth Madagascar’s economy has remained at a standstill all this time for many reasons, as we will see shortly GDP per capita 1965-2004 (US$ at 1990 prices) 5,000 MAURITIUS MADAGASCAR 4,000 3,000 2,000 1,000 0 65 70 75 80 85 90 95 00 Mauritius 4.3% per year Madagascar -1.2% per year 1.05539 = 8.1 Country A Country B In % Girls at primary school Country A Country B 100 72 In % Country A Country B Girls at primary school 100 72 Investment ratio 25 11 In % Country A Country B Girls at primary school 100 72 Investment ratio 25 11 Export ratio 58 23 In % Country A Country B Girls at primary school 100 72 Investment ratio 25 11 Export ratio 58 33 23 80 Primary export ratio In % Country A Country B Girls at primary school 100 72 Investment ratio 25 11 Export ratio 58 33 23 80 10 18 Primary export ratio Inflation In % Country A Country B Girls at primary school 100 72 Investment ratio 25 11 Export ratio 58 33 23 80 Inflation 10 18 Growth per capita 1960-2002 4.3 -1.2 Primary export ratio And the countries are: Country A Country B Girls at primary school 100 72 Investment ratio 25 11 Export ratio 58 33 23 80 Inflation 10 18 Growth per capita 1960-2002 4.3 -1.2 Primary export ratio And the countries are: Mauritius Madagascar Girls at primary school 100 72 Investment ratio 25 11 Export ratio 58 33 23 80 Inflation 10 18 Growth per capita 1960-2002 4.3 -1.2 Primary export ratio Mauritius did many things right and reaped rapid growth Madagascar has been at a standstill all this time for many reasons, including too little investment, trade, and education, as we will see shortly GDP per capita 1965-2004 (US$ at 1990 prices) 5,000 MAURITIUS MADAGASCAR 4,000 3,000 2,000 1,000 0 65 70 75 80 85 90 95 00 Mauritius 4.3% per year Madagascar -1.2% per year 1.05539 = 8.1 The neoclassical view that economic growth in the long run is merely a matter of technology does not throw much light on the impressive growth performance of Asia since the 1960s, or on growth differentials The new view that long-run growth depends on saving and efficiency is more illuminating Besides, it’s not really new, because Adam Smith knew this (1776) The neoclassical view If two countries are identical (same saving rate, same population growth, same technology), then their income per head will ultimately be the same This means that poor countries must grow faster than – catch up with! – rich countries: “conditional convergence” Endogenous growth theory does not have this implication Conditional convergence Initial income Trade – – + Investment + + – Natural capital Growth + Education denotes a positive effect in the direction shown denotes a negative effect in the direction shown Once the main determinants of growth have been taken into account, initial income will have a negative effect on growth Conditional convergence does not entail absolute convergence 164 countries from 1960 to 2000 Growth of GNP per capita 1960-2000 (%) 8 6 4 2 0 -2 -4 -6 -8 5 6 7 8 9 10 11 GNP per capita 1965 (log) 12 Poor countries grow faster than rich ones if Growth is inversely related to initial income, or if Regression of current income on initial income produces a slope coefficient that is smaller than one GNP per capita 2000 (log) 12 11 10 9 8 7 6 45o 5 5 6 7 8 9 10 11 GNP per capita 1965 (log) 12 Fits real world experience quite well In East Asia, saving rates of 30-40% of GDP went along with rapid economic growth In several African economies, saving rates of around 10% of GDP went for a long time hand in hand with economic stagnation In OECD countries, saving rates of about 20% of GDP went along with respectable growth Important implication for policy Economic stability with low inflation and positive real interest rates spurs saving, which is good for growth An r = rank correlation Per capita growth adjusted for initial income (%) increase in investment by 8% of GDP is associated with an increase in per capita growth by one percentage point per year Quantity and quality Cause and effect World Bank data for 164 countries and 40 years, 1960-2000 r = 0.42 6 4 2 0 -2 -4 -6 -8 5 10 15 20 25 30 35 40 45 Investment (% of GDP) Also fits experience quite well Technical progress is good for growth because it allows us to squeeze more output out of given inputs And that is exactly what increased efficiency is all about! Thus, technology is best viewed as an aspect of general economic efficiency Important Everything implication for policy that increases efficiency, no matter what, is also good for growth First things first: Output is produced by labor, capital, and other inputs Output per capita can grow through accumulation of capital through saving and investment, as we have seen Output per capita, however, cannot grow through population growth, as we will see But, output per capita can grow through improvements in labor, via investments in human capital: Education and health care Investment and education: Key drivers of growth Education and health care make labor force more efficient Technological progress enhances efficiency Liberalization of prices and trade increases efficiency: good for growth Stabilization reduces the inefficiency associated with inflation: good for growth Privatization reduces the inefficiency of state-owned enterprises: good for growth The possibilities are virtually endless! Why do education and health care matter? Because they increase labor productivity This is also why technological progress is good for growth Technological progress enables firms to squeeze more output from given inputs But so does increased efficiency! Latin American story about air fares Increased efficiency is tantamount to technological progress, which helps growth If growth were merely a matter of technology, we could not do much about it Except follow technology-friendly policies by supporting R&D and such But if growth depends on saving and efficiency, there are things that we can do, in the private sector as well as through the public sector, to foster rapid growth Because everything that is good for saving and efficiency is also good for growth In sum, output per capita depends on the quantity and quality of inputs Quantity of inputs can be increased through accumulation, esp. capital accumulation Quality of inputs – their productivity! – can be increased through increased efficiency Education and health Liberalization Stabilization Privatization Aspects of institutions Education and health care make the work force more efficient o Need to provide primary and secondary education to all, especially females o Need to provide tertiary education to a greatly increased number of people o Need increased public commitment to education as well as health care o Need both increased public expenditure on education and probably also increased scope for private sector involvement in education and health care lifts labor productivity, thereby increasing overall economic efficiency and growth of output From unskilled to skilled labor Data for 131 countries, 1960-2000 Per capita growth adjusted for initial income (%) Education r = 0.50 6 4 2 0 -2 -4 -6 0 20 40 60 80 100 Secondary school-enrolment rate (%) of regression line: An increase in secondary-school enrolment by 25% of each cohort goes along with an increase in per capita growth by one percentage point per year Per capita growth adjusted for initial income (%) Interpretation r = 0.50 6 4 2 0 -2 -4 -6 0 20 40 60 80 100 Secondary school-enrolment rate (%) is another way to provide more and better education to children Produce fewer children to increase their average “quality” 163 countries, 1960-2000 Pefr capita growth adjusted for initial income (%) There r = -0.54 6 4 2 0 -2 -4 -6 -8 1 2 3 4 5 6 7 Fertility (number of children) 8 public health, reflected in longevity, is also conducive to increased labor productivity and economic growth 156 countries, 1960-2000 Per capita growth adjusted for initial income (%) Good r = 0.54 6 4 2 0 -2 -4 -6 -8 30 40 50 60 70 Life expectancy 1960 (years) 80 spending on health care also spurs economic growth Close connection between public health and health care, i.e., between output and input 162 countries, 1960-2000 Per capita growth adjusted for initial income (%) Increased r = 0.40 6 4 2 0 -2 -4 -6 -8 0 2 4 6 8 10 12 Health expenditure (% of GDP) 14 Liberalization of prices o Markets, not bureaucrats, set prices o Mixed market economy is more efficient than central planning o Former Soviet Union vs. the US and Europe Liberalization of trade o Specialization according to comparative advantage o Free trade is more efficient than selfsufficiency o North Korea vs. South Korea and Singapore of prices increases efficiency in resource allocation Liberalization of trade increases efficiency in division of labor 163 countries, 1960-2000 Per capita growth adjusted for initial income (%) Liberalization r = 0.26 6 4 2 0 -2 -4 -6 -8 0 40 80 120 160 Exports (% of GDP) 200 are not a good indicator of openness because size matters So look at import duties as well Higher duties hurt growth, but connection is weak 147 countries, 1960-2000 Per capita growth adjusted for initial income (%) Exports r =r-0.23 = 6 0.20 4 2 0 -2 -4 -6 -8 0 10 20 30 40 50 60 70 Share of import duties in tax revenues (%) Economic theory is clear, from Adam Smith (1776) on: external as well as internal trade is good for growth Good external governance is good for growth Autarky spells disaster, always and everywhere Darkness in North-Korea Stabilization of prices Reduces distortions due to inflation o Inflation distorts the choice between real and financial capital by punishing money holdings, and thus creates inefficiency in production o Implicit inflation tax is an inefficient tax o Inflation creates uncertainly that tends to discourage trade and investment o Inflation tends to result in currency overvaluation, hurting exports and growth increases efficiency by reducing production distortions, uncertainty, inflation tax, and overvaluation 164 countries, 1960-2000 Per capita growth adjusted for initial income (%) Stabilization r = -0.46 r = -0.46 6 4 2 0 -2 -4 -6 -8 0.0 0.2 0.4 0.6 Inflation distortion 0.8 1.0 inflation is a sure sign of lax fiscal and monetary policies, so sound policies support rapid growth Sound financial institutions, incl. independent central banks, also support rapid growth Per capita growth adjusted for initial income (%) High r = -0.46 r = -0.46 6 4 2 0 -2 -4 -6 -8 0.0 0.2 0.4 0.6 Inflation distortion 0.8 1.0 Model 1 Inflation distortion -2.51 (2.07) Natural resources Initial income Investment Secondary education Population growth Adj. R2 0.04 Note: t-values are shown within parentheses. Inflation distortion Model 1 Model 2 -2.51 -2.46 (2.37) (2.07) -0.09 Natural resources (5.75) Initial income Investment Secondary education Population growth Adj. R2 0.04 0.30 Inflation distortion Model 1 Model 2 Model 3 -2.51 -2.46 (2.37) -2.26 (2.25) -0.09 -0.10 (6.52) (2.07) Natural resources (5.75) -0.45 Initial income (2.67) Investment Secondary education Population growth Adj. R2 0.04 0.30 Inflation distortion Model 1 Model 2 Model 3 Model 4 -2.51 -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) -0.09 -0.10 (6.52) -0.07 (5.01) -0.45 -0.45 (3.05) (2.07) Natural resources (5.75) Initial income (2.67) 0.15 Investment (5.41) Secondary education Population growth Adj. R2 0.04 0.30 0.35 0.51 Inflation distortion Model 1 Model 2 Model 3 Model 4 Model 5 -2.51 -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) -1.97 (2.49) -0.09 -0.10 (6.52) -0.07 (5.01) -0.04 (2.93) -0.45 -0.45 (3.05) -1.10 (5.39) 0.15 0.09 (3.36) (2.07) Natural resources (5.75) Initial income (2.67) Investment (5.41) 1.24 Secondary education (4.24) Population growth Adj. R2 0.04 0.30 0.35 0.51 0.60 Inflation distortion Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) -1.97 (2.49) -1.61 (2.14) -0.09 -0.10 (6.52) -0.07 (5.01) -0.04 (2.93) -0.04 (2.49) -0.45 -0.45 (3.05) -1.10 (5.39) -1.27 (6.42) 0.15 0.09 (3.36) 0.10 (3.74) 1.24 1.07 (3.82) Natural resources (5.75) Initial income (2.67) Investment (5.41) Secondary education* (4.24) Population growth Adj. R2 -0.56 (3.42) 0.04 0.30 0.35 0.51 0.60 0.64 Note: An increase in secondary-school enrolment by a third increases growth by 1%. Privatization o Profit-oriented owners and able managers are allowed to direct enterprises o Profit motive replaces political considerations as the guiding principle of business operations o Profit-maximizing owners generally appoint managers and staff on merit rather than on the basis of political connections o Private enterprise is generally more efficient than state-owned enterprises Privatization Per capita growth (% per year) replaces political motives by profit motive in business Private enterprise is usually more efficient than stateowned enterprises 38 countries, 1978-92 r = -0.35 8 6 4 2 0 -2 -4 -6 .0 .1 .2 .3 .4 Share of SOEs in employment (%) Free trade is good for growth o Reduces the inefficiency that results from restrictions on trade Price stability is good for growth o Reduces inefficiency resulting from inflation Privatization is good for growth o Reduces inefficiency resulting from SOEs Education is good for growth o Reduces the inefficiency that results from inadequate education, and health care Natural resources, if not well managed, may turn out to be, at best, a mixed blessing Four possible channels o o o o Dutch disease (foreign capital) Rent seeking (social capital) Education (human capital) Investment (real capital) Dutch disease through overvaluation Hurts level or composition of exports and FDI Rent seeking takes many forms Protectionism, corruption, oppression Education falters False sense of security Poor quality of policies and institutions Investment: Same story One more thing: Resource drag Nonrenewable natural resources are a fixed factor of production Decreasing returns to scale Initial income Trade Resource curse Natural capital – – + + – – Investment + + – Growth + Education denotes a positive effect in the direction shown denotes a negative effect in the direction shown is an important source of technological innovation and progress and thereby also of economic growth 156 countries, 1960-2000 Per capita growth adjusted for initial income (%) Manufacturing r = 0.48 8 6 4 2 0 -2 -4 -6 0 20 40 60 80 100 Share of manufactures in exports (%) and mining are low-skill labor intensive and offer few spillover benefits to other industries Natural resources: Mixed blessing if not well managed 156 countries, 1960-2000 Per capita growth adjusted for initial income (%) Agriculture r =r-0.59 = 6 0.48 4 2 0 -2 -4 -6 -8 0 10 20 30 40 50 60 Primary production (% of GDP) 70 increase in primary production by 11% of GDP goes along with a decrease in per capita growth by one percentage point per year Per capita growth adjusted for initial income (%) An r =r-0.59 = 6 0.48 4 2 0 -2 -4 -6 -8 0 10 20 30 40 50 60 Primary production (% of GDP) 70 aid has sometimes been compared to natural resource discoveries Aid and growth are inversely related across countries Cause and effect 156 countries, 1960-2000 Per capita growth adjusted for initial income (%) Foreign r = -0.36 6 4 2 0 -2 -4 -6 -8 -20 0 20 40 60 Foreign aid (% of GDP) 80 Three aspects of social capital What do the data tell us? Equality Honesty Democracy views Inequality sharpens incentives and thus helps growth Inequality endangers social cohesion and hurts growth 117 countries, 1960-2000 Per capita growth adjusted for intial income (%) Two r = -0.27 6 4 2 0 -2 -4 -6 -8 10 20 30 40 50 60 Gini index of inequality 70 is good for growth No visible sign here that equality stands in the way of economic growth An increase in Gini index by 16 points goes along with a decrease in per capita growth by one percentage point per year Per capita growth adjusted for intial income (%) Equality r = -0.27 6 4 2 0 -2 -4 -6 -8 10 20 30 40 50 60 Gini index of inequality 70 views Political oppression restrains special interest groups and thus helps growth Political oppression breeds inefficiency and hurts growth 117 countries, 1960-2000 Per capita growth adjusted for initial income (%) Two r = -0.64 6 4 2 0 -2 -4 -6 0 1 2 3 4 5 6 Political oppression 7 8 two views Democracy plays into hands of special interest groups that hurt growth Democracy facilitates change of government and helps growth 143 countries, 1960-2000 Per capita growth adjusted for initial income (%) Again, r =r0.50 = 6 0.48 4 2 0 -2 -4 -6 -8 -12 -8 -4 0 4 Democracy 8 12 is good for growth No visible sign here that democracy stands in the way of economic growth A rise in democracy index by 7 points goes along with an increase in per capita growth by one percentage point per year Per capita growth adjusted for initial income (%) Democracy r =r0.50 = 6 0.48 4 2 0 -2 -4 -6 -8 -12 -8 -4 0 4 Democracy 8 12 Per capita growth adjusted for initial income (%) Once more, two views Corruption greases wheels of production and exchange and thus helps growth Corruption breeds inefficiency and hurts growth 88 countries, 1960-2000 r = 0.69 6 4 2 0 -2 -4 -6 0 2 4 6 8 10 12 Corruption perceptions index More corruption good business governance is good for growth Argument can be extended to other aspects, such as secure property rights and effective bankruptcy laws Same story Per capita growth adjusted for initial income (%) So, r = 0.69 6 4 2 0 -2 -4 -6 0 2 4 6 8 10 12 Corruption perceptions index More corruption Economic growth responds to public policy In particular, by encouraging osaving and investment of high quality oforeign trade and investment oeducation and health care oeconomic diversification osound institutions ... the government can help foster rapid economic growth Since the second world war it has become quite clear that rapid economic growth is available to those countries with adequate natural resources which make the effort to achieve it. W. ARTHUR LEWIS (Accra, 1968) These lessons are borne out by experience from around the world Additional lessons: Too much SOE activity hurts the quality of investment and education — and growth Too much agriculture and, more generally, natural resource dependence, if not well managed, hurts education, investment, and trade — and thereby also growth Too rapid population growth also tends to impede economic growth Even so, the question of rapid growth is, of course, a bit more complicated We also need to address a host of political, social, and cultural questions as well as questions of natural conditions, climate, and public health But the main point remains: To grow or not to grow is in large measure a matter of choice Many of the constraints on growth are man-made, and can be removed These slides – and more! – can be viewed on my website: www.hi.is/~gylfason