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The transformation of the Spanish economy:
a success story of economic transition
Marta Santamaria Monturiol
February 4, 2015
Abstract
In a period of 15 years (from 1960 to 1975) Spain’s GDP per capita more than tripled. While the previous
decade had been marked by sluggish growth, high and very volatile inflation rates and economic isolation,
Spain transitioned to an increasingly open and competitive economy while catching up with respect to Europe.
Whereas the main explanation for the high growth in this period is related to the integration of Spain in the
world’s economy, the degree of openness was very moderate until 1975. Thus, I propose a complementary
explanation for the take-off of Spain: the transition from a centrally-planned autarkic system to a liberalized,
market-based economy where the role of the Public Sector changed from main economic agent to regulator.
I use the model of economic transformation proposed by Song, Storesletten and Zilibotti to explain China’s
economic growth (AER, 2012) to explore whether the same composition-effect story ( shrinking public sector
vs growing private sector) is able to explain Spain’s high economic growth in this period. The purpose of the
exercise is twofold: Firstly I write a modified version of the model by Song, Storesletten and Zilibotti and show
that it can be applied to the Spanish transition. Secondly I develop an extension with endogenous entrepreneurs
where inflation is the underlying mechanism used by the government to keep the private sector constrained and
be able to accumulate economic resources.
In the year 1950, more than ten years after the end of the Spanish Civil War, Spain’s GDP per capita was
3800 $USD. Twenty five years later, in 1975, it was four times higher, over 15000 $ USD. The most important
part of this recovery took place after 1960, when several economic reforms were undertaken to liberalize the
Spanish economy and make it more competitive. While between 1950 and 1959, and despite a massive effort
of public investment, the GDP per capita less than doubled, between 1960 and 1975 it almost tripled. Spain
also did catch up relative to other advanced economies. The Spanish GDP per capita was 30% of US GDP
per capita in 1950 and by 1970 it was already 50% of the US GDP per capita (see Figures 1 and 2). This is
surprising for two reasons. Firstly, the traditional literature on Economic Growth and convergence cannot fully
explain the performance of the Spanish Economy in this period. Rather than growing at a lower rate every
period as the country became richer, Spain grew even faster after 1960, avoiding the well-known law of decreasing
1
(a) Spain’s GDP p/c relative to the US GDP p/c
(b) Spain’s GDP PPP adjusted
Figure 1: The Spanish Growth
returns to capital accumulation. Some Spanish economists describe this fact as a change in the GDP trend
after 1960. It was, to put it simply, the beginning of modernity in Spain. Secondly, and what is even more
surprising, this convergence happened while Spain was mainly a closed economy and still deeply in-merged in a
political dictatorship. Explanations for high constant growth rates sustained for decades like the one proposed
by Ventura (1997) are based on an open economy framework and the market size effect. These models cannot
explain sustained economic growth in autarky. Nevertheless, Spain is not the only country that has gone through
a transition between economic systems while a) having a non-democratic political regime and b) keeping the
economy relatively closed. In this paper I propose an additional channel that could have increased the Spanish
growth rate based on some evidence from the period. The paper develops a stylized growth model hat captures
the main features of the Spanish economy before and after the transition to understand how was this catch-up
episode possible.
1
Introduction
1.1
Features of the Spanish Economy before 1960
Historians have divided the second half the XXth century in two relevant phases for Spain, one from 1950 to
1975 and another one from 1975 to 2000s, the democratic period. The growth rate of the Spanish economy started
to recover a decade after the end of the Spanish civil war (1939). During the 40s the Spanish economy grew mainly
thanks to the real state sector that was booming due to some favorable legislation. The process of industrialization
in Spain started in the 50s. The impulse came from the Government of General Franco that was deeply worried
2
about the low level of investment in the economy and the need to carry out a national industrialization plan. The
National Institute of Industry (INI) was created in 1941 with the purpose of industrializing the country. During
almost 10 years public investment was the main engine of (productive) investment in Spain. This investment was
directed towards some strategic sectors, chosen by the Government, and was following political goals rather than
economic efficiency principles. The huge investment effort made by the Government of Spain, still with a very
weak taxing capacity, forced the government to issue government bonds every period. This way of financing the
public investments through debt issuing and money-printing resulted in a very high level of inflation.
(a) Spain’s GDP
(b) Spain’s GDP per capita
Figure 2: The Spanish Growth II
The most remarkable features of this Pre-transition Spanish economy between 1940-1958 were:
• Strong intervention of the State in the economy: The interest rates ( and other lending rates) were set
by law, the access to credit and inputs was conditional on political connections, there was a very tight
connection between the Government and the central Bank of Spain so there was no autonomous monetary
policy and the State imposed a particular vision about the economic structure desirable ( all are common
features of authoritarian regimes).
• Public investment was financed through inflationary methods ( monetarization of government debt). Average inflation was above 10% from 1939-1957, reaching levels of 20%; and 7 % from 1951-1972. See figure
3.
• Financial repression: The Government set the interest rates below the market level in order to finance
public investments cheaply and benefit from debt liquidation. Figure 4.
• Lack of openness that limited growing possibilities, meaning that the difference between domestic savings
and investment was financed through credit and public debt. The Openness degree of the Spanish economy
3
was below 15% during the 50s and by 1970 it had only reached 20 % ( computed as (X+M)/GPD) Figure
5.
Figure 3: Inflation rate
Figure 4: Interest rates
In the last years of the 50s, there was a change in the Government and new Ministries accessed power. The new
Government, composed mainly of technocrats, set new objectives. Spain formalized the first trade agreements
(very limited, with US and the Vatican) and some economic sectors, that had been of minor importance until
then, flourished (Banking, Manufacturing, Electricity and other energies, Infrastructure). The new Government
realized that the big, inefficient public investments could not be maintained forever. They where the cause of
the high inflation, the depressed private initiative and the slow growth in productivity. The reforms in 1957 and
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1959 were directed to introduce financial discipline in the national budget, to stabilize inflation and to reduce the
distortions that were holding the Spanish economy from taking-off1 .
Note: Openness is computed as (X+M)/GDP*100.
Figure 5: Openness of the Spanish Economy as a percentage of GDP
1.2
Related literature
This paper contributes to the existent literature on Economies in Transition. The main sources of this
paper are Song, Storesletten and Zilibotti (AER, 2011)[15] and Buera and Shin (JEP, 2013)[3]. We follow Song,
Storesletten and Zilibotti (AER, 2011) in the structure of the model even though the framework developed here is
a closed-economy set-up, that is more coherent with the Spanish historical context ( and more generally, with the
majority of Economic Transitions). Besides that, the model is simplified in both the consumption and production
side, but the main mechanism survives in the same spirit of the original paper. The contribution of the closedeconomy framework is to introduce financial repression as a political choice of the government making possible
to explore the effects of such policy in macroeconomic outcomes.
The paper of Buera and Shin takes an alternative approach to explain different processes of transition in
world history. They model an economy initially affected by with a series of random distortions bore in a different
degree by the economic agents and that drives down economic efficiency. The transition is modeled as the joint
elimination of all of there distortions that allows the period of expansionary growth. The main difference with
this paper is that we simplify the assumption about the distortions by assuming that there are only two sectors
and the distortions affect only the most productive sector ( private sector). This makes the model very tractable
1 This
reforms, referred to as “ Plan de Estabilización” were carried out under the supervision of the FMI and the WB, applying
some of their recommendations.
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while keeping the main mechanism at work (sectoral reallocation) intact. The improvement of this model vis-a-vis
Buera and Shin is that it is focused on a particular economy and it can give more precise answer to the question
of the kind of distortions in place and the effects of these.
The paper also contributes to the Economic History literature on the Spanish modern growth. It builds on two
empirical papers by Leandro Prados de la Enclosura and Joan Rosés: Prados de la Enclosura, Rosés y Villaroya
(2012) and Prados de la Enclosura (2011)).
The two papers try to find the explanatory cause for the high growth attained by Spain in the second half
of the XXth century. In the first of these works they construct an Index of Macroeconomic Distortions (IMD)
and estimate the effect of a reduction of this index ( namely, the 1959 reform) in the economy. The variables
they include are: inflation rate, black-premium in the exchange rate market and government consumption. They
analyze different counterfactual scenarios to estimate the relative contribution of each of the variables to the GDP
growth rate. The contribution of my paper to their findings is to emphasize the importance of public investment,
rather than public consumption, to explain the high growth rate after 1960. In their approach they exclude
public productive investments from their measure of public consumption and focus on government expenditure.
It seems that the literature that has analyzed this period of the Spanish history has not paid enough attention
to the composition effect described in this paper (the existence in the economy of two different sectors and the
relative allocation of factors across them). As we will explain in the following section, there is some evidence to
believe that the shrinking size of the public sector versus the increasing importance of the private initiative could
have had an important effect on the increase in total factor productivity and the high growth of the decade of
the 60s.
Finally, in relation to the literature about the reconstruction of the European Economies after WWII, this
work also builds on the excellent estimation exercise of Catalán (2003) in which he compares the growth rate of
Spain after the Spanish Civil War with the registered growth rate of the West and Central Europe. He finds that
there lacks some explanation as to why Spain exhibited such stagnated growth during the 40s and 50s compared to
its European neighbors. This finding provides evidence for the need of finding other complementary explanations
to account for the “missing” growth.
The paper is organized as follows. Section I provides the historical evidence of the stylized facts about Spain
that serve as motivation for the paper. Section II describes the Benchmark Model and the Economic Transition.
Section III describes an extension of the model that endogenizes the measure of entrepreneurs in the economy.
The last section concludes
1.3
Spain’s Transformation: Empirical Evidence
The characteristics of the transition that started in 1960 are common to other economic transitions: An
important economic reform triggers an increase in the participation of the private sector in the economy and
6
creates an better environment of economic competition. The transition is slow due to imperfect and generally
underdeveloped credit markets. The private sector is more productive but due to financial constraints it specializes
in labor-intensive industries. In Spain the private sector specialized in the service sector, which was, by far, the
most productive and also, after agriculture, the most labour intensive sector (30% of total employment). The
transition takes place as a sectoral reallocation. Due to the economic reforms the State is no long able to make
us of public debt to keep the previous level of investment so it starts downsizing. This helps inflation go down
and stabilize. During the transition the investment rate decreases because the Public sector releases capital faster
than the rate at which the Private sector absorbs it ( because the Public sector is capital intensive). There is
also the correspondent increase in the interest rate, due to the fall in capital stock. Later on the Investment rate
stabilizes as the private sector accumulates labour and gets a higher share of the resources of the economy. Figure
7 b) shows that in Spain the investment rate fell after the reforms stabilize around 20 % later on. Notice that
this level had already been reached during the 1950s so the increase in growth must be caused by the sectoral
reallocation. Also, if we look at the composition of investment, it remains fairly constant during this period.
This provide additional support for the hypothesis that there was some composition effect of reallocation effect
in place: it was not that a higher share of Investment was devoted to productive investment but that the sector
investing was a different, more productive, sector.
In the aggregate economy there was an increase in the Total Factor Productivity due to the change in the
composition of the economy ( bigger private sector, with a higher productivity).
Notice that in the case of open economies, like China, the capital released after the reform flows outside in
form of net foreign assets. In the case of Spain, the released capital was absorbed by the constrained private
sector. This increase in private investment allowed the public sector to shrink and achieve financial balance.
This was crucial to stabilize inflation, one of the important factors in Spain’s successful catch-up. These are the
stylized facts of the transition mechanism that we observe from the Spanish economy and that we will try to
reproduce in a simple model.
1.4
The role of the Government and the beginning of the Economic transition
The key factor in the model will be a public sector that, through public firms, plays the main role in the
economy. The transition happens when the Public sector decides to scale down releasing capital that the private
sector is able to absorb. The motivation to model the State as the main actor comes from the fact that the
Government was choosing the interest rates setting them by law (see Figure 4), and controlling inflation by
issuing debt and printing money. This two tools allowed the Government to influence the amount of private
investment in the economy. Notice that with very low interest rates government bonds could compete for funds
with other investment options like keeping the money in bank deposits. This made it possible for the government
to capture a big share of the savings. Moreover, the high inflation made the economic environment uncertain for
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those who wanted to invest.
(a)
(b)
Figure 6: Total Investment and Investment over GDP
This also made the economy less dynamic, as investment opportunities would not be undertaken unless profit
was sure. The high level of inflation benefited the government, that was the main borrower in the economy, while
entrepreneurs could not get advantage of the effect on inflation on the liquidation of debts due to the low level of
financial intermediation and financial development.
The way the government could access funds was by issuing debt. This debt was always bought as refusing to
buy Public debt was seen as a very anti-patriotic behavior2 . After the 1957-1959 reform there was an important
change in the composition of public debt. In 1957 some autonomous public institutions were no longer allowed
to issue their own debt. Besides that, the State and the Treasury stopped issuing debt and the institution in
charge of debt issuing was the Ministry of Finance. The value of public debt and its composition can be seen in
Figure 7. It is very noticeable how the composition of debt change before and after the reforms. After 1960 debt
is issued for specific targets ( especial uses), to carry out Government consumption ( debt issued by the Ministry
of Finance) and some debt comes from foreign lenders.
Some of the most important academics that has studied this period, Francisco Comı́n and Manuel Jesús
González3 , both point out at the change in mid-set about debt issuing. With the arrival of the technocrats to the
Government an economic criterium of efficiency and profitability, even of necessity, was slowly introduced in the
decision-making process to determine public debt issuing ( linked to public investment). Is has been documented
that the Ministry of Finance had a less political approach to determining the funding needs of the Government
and imposed rigorous standards to determine the level of public debt that should be issued. This lasted until
1964 when the Government launched the first development plan ( public investment boomed again).
2 F.
3 F.
Comı́n, “La Hacienda Pública en el franquismo. La guerra y la autarquı́a (1936-1959)”
Comı́n, .... M J G, ....
8
Figure 7: Public Debt
Also, if we look at the composition of the capital stock it remains constant during the period we are studying. This provides further evidence for the sectoral reallocation explanation of the transition (Figure 22 in the
appendix).
1.5
Empirical evidence on the different hypothesis of growth.
Let us now discuss the evidence that points in favor of the sectoral reallocation story that this paper aims to
put forward. Besides the data on economic performance and on the behavior of the Public sectors we have to
make sure that no other factor can explain Spain’s economic take off.
Figure 8 compares the different growth rates between European Countries. Notice that the growth rate in
Spain between 1960 and 1970 was of 6.3 %, only surpassed by Greece. For the countries of the European ”Core”
the growth rate stays below 4%. Therefore, this provides some evidence about the importance of the “domestic”
factors. However, a part of the Spanish growth must have been affected by a positive trend that was present in
other countries too. We can see that in most of the European countries the growth rate of GDP was higher in
the second period.
It is known that the 60s were a period of caching-up both in Europe and in many other countries in the world,
so a change in the economic environment could have had some positive effect on the Spanish outcomes. One
of the explanations proposed is the technological catch-up that the middle-lower income countries made closing
the gap with the richest country ( US). This channel of the technological catch up was important for Spain as
well and adds to the strength of the sectoral reallocation story. In this sense, Figure 9 shows the contribution
to growth of the different components of the GDP. It should be noticed how imports increase with the reform.
In this moment the government is still controlling imports so normal consumption goods were not imported but
9
Figure 8
machinery and equipment imports were allowed more freely after the reform. This is inline with the story of the
increase in productivity after the reform as the importers were private firms ( the government invested in national
technology to push domestic R&D).
With a different estimation of the sources of growth, Prados de la Enclosura (2011) extracts the contribution
of different factors to GDP growth rate; see Figure 5. In the period from 1958-1974 half of the GDP growth rate
is explained by TFP increases and 1.2% points (out of 4.7 %) due to increases in the capital stock. This is also
clear when we look at the estimated TFP by Prados de la Enclosura (2011)( See Figures 21, in the Appendix).
Another possible factor explaining the higher growth is structural transformation. Spain was a rural country
in the late 1940 and it transitioned to a more industrialized society with a high importance of the service sector.
Almost since the end of the Spanish civil war there where two trends in the economy: rural to urban migration was
high and the services sector was increasing in importance. However, Figure10 shows that the structural change (
rural to urban transformation) was already happening before the reform and took place slowly. We don’t observe
any breaks or spikes in the process that could make us think that both factors ( sectoral reallocation between
private and public sectors and the structural transformation) were correlated or casually related.
Additionally I have estimated the employment in each sector as a fraction of total employment, the productivity
of labour in the sector and the contribution of the sector to the GDP for Agriculture, Construction and Public
works, Industry and Services. The plots are included in the Appendix (Figures 22-25). The main conclusion that
emerges from this analysis is that, even if there was structural transformation going on across sectors, the trend
does not show any break in the surroundings of 1960 (vertical red line).
10
Note: Data from Penn World Tables.
Figure 9: GDP growth rates for European Countries
.
(b)
(a)
Figure 10: Structural Transformation
The assumption that private entrepreneurs were credit constrained and thus specialized in labour intensive
activities is also based on the historical information we have about the period. For example, the National
Institute of Industry, a holding of public firms, employed around 3 % of all industrial workers while its enterprises
accumulated from 20-24 % of the industrial capital (Comı́n y Martı́n-Aceña (1991)).
On the evidence about the existence of credit frictions in the Spanish economy it is enough to read some of
the analysis of González (1980) to understand the level of underdevelopment of the Spanish financial sector.
There is also evidence about obstacles in firm creation. According to González (1980) when an individual
entrepreneur wanted to start a firm it was necessary to get an authorization from the Government. This authorization was only given to people well connected with politicians or close to Franco’s regime and it was easier to
be given one if the amount of the capital you wanted to invest was not too big. It seemed that the government
11
wanted to have under control the activity of the private initiative.
The level of credit in Spain was also small, as well as the value of the Stock Market Exchange, finance started
booming only towards the second half of 1960.
(a) Credit level
(b) Value of new Issued Stocks and bonds
Figure 11: Credit and Stock Market evolution
2
The baseline Model
2.1
Preferences and savings
We model an OLG economy where each generation is of size 1 and agents live for two periods. All agents
work in the first period and consume in both. Agents are heterogeneous in their ability to set up firms in the
second period. These agents have log-utility preferences and face the following problem:
M axct ,ct+1 Ut = log(ct,1 ) + βlog(ct+1,2 )
s.t. ct,1 +
ct+1,2
rt+1
(1)
= wt
The Euler equation that defines the optimal pattern of consumption is:
ct,1
ct+1,2
=
1
βrt+1
Thus, when young, agents work, earn wage wt , save a fraction ζt =
(2)
1
1+β
and consume
β
1+β wt
. The savings are
invested in period one and returns are yield in period two. In period 2, agents use the capital they own to produce
( using a unique Cobb-Douglas technology) and consume the capital share. Thus, while consumption in the first
period is homogeneous across agents, consumption in the second period will depend on the individual’s ability to
12
invest and in the role that the agent plays in the credit market.
We will describe first the basic version of the model where we will take as exogenous the different productivities
of agents to produce and therefore, the share of entrepreneurs in the economy. We start with a simplified version
of the model where there are two kinds of agents, savers and entrepreneurs, that differ in their ability to invest.
A fraction of the population , that we will call entrepreneurs, can start their own firm and earn the returns
from capital while the rest of the population, 1 − , don’t have the ability to create a firm.Therefore, the saving
mechanisms available in the economy are to invest in your own firm or keep the savings in form of deposits in a
bank. Savers will never start an investment project but will save by holding deposits in a bank. Banks collect
the savings and invest in domestic firms ( run by entrepreneur or by the government) and pay back the deposit
rate (rd )t = rt in the next period.
The particularity of the model is the role of the government and the State owned firms in the economy. The
government is able to invest and produce through State owned companies (SOEs). This firms will differ in some
important aspects from the privately stablished firms, from now on POEs. We now describe the two kinds of
firms in the production side.
2.2
Production and Technology across Sectors
There are two kinds of firms in the Economy. They have different production technologies given by Fi (K, L) =
α 1−α
Ai ∗ Ki,t
Li,t where i denotes the type of firm. The firms also differ in their ability to borrow resources from the
credit markets. The Privately Owned Enterprises ( POEs) are the companies set up by individual entrepreneurs
and are, therefore, credit constrained. Besides, for POEs Ai = Ap > 1. The State Owned Enterprises (SOEs)
are publicly owned firms that produce with the an inferior technology, Ai = As = 1 but are not financially
constrained, as they are backed by the government when borrowing. As we are in a closed-economy set-up, total
savings has to equal total investment.
Formally, the production functions are:
α
FP (K, L) = AP ∗ KP,t
L1−α
P,t
α
FS (K, L) = KS,t
L1−α
S,t
The market returns to capital and labour are given by the following equations:
ρi,t+1 = f 0 (κi,t ) = αAi κiα−1
wi,t+1 = f (κi,t ) − κi,t f 0 (κi,t )
Where κi,t = (Ki,t /Li,t ).
13
As we assume that the labour market is competitive, full employment means that the wage will be the same
for all of the workers, independent of the firms they work for and the proportion of workers in each firm.
This means that
−α
α
α
wp,t = (1 − α)Ap Kp,t
L−α
p,t = (1 − α)KS,t LS,t = ws,t
Solving for the capital per labour ratio we find the following relation:
1
κs = Apα κp
(3)
This ratio will hold in every period. In period t, both entrepreneurs and state owned firms will decide their
capital investment (and borrowing). In the next period, for any possible interest rate, both sectors will demand
labour so that the MPL equates across sectors so the relative K/L ratio will remain constant. Therefore, private
firms have a lower capital labour ratio as they use capital more efficiently and the relative capital-labour ratio
between firms will only depend on the relative productivities.
Replacing the K/L ratio in the equations for the MPK we can find another important relation in the model:
ρs = ακα−1
= αA(
s
α−1
α )
κpα−1 < ρp,t+1 = αAκpα−1
(4)
This equation implies that capital invested in POEs will always earn a higher return than in SOEs, because
both sectors have to keep the relation between the K/L ratio constant to make wages equalize.
If there were no frictions in the credit market, SOE would not survive as their productivity is always lower
than POEs. However, as we will see later, in this economy there is a credit friction that will shape the equilibrium
allocation in a different way, allowing for SOEs to exist.
Denote bjt , j{P, S}, the borrowings of each type of firm and sjt , j{P, S} the savings. The j indicates whether
it is a private or a public firm. The entrepreneurs will always invest all of their savings in their own firms, as
they can get the highest return in the economy. As we will see in the next section we assume the State is unable
to save4 . As we are in a closed- economy set-up, savings must equal investment:
S
S
ζwt (kt ) = spt + bP
t + st + bt
S
(1 − t )ζwt (kt ) = bP
t + bt
(5)
4 We assume that the State has no means of income and thus, has no savings. We could, however, let sS = (1 − τ )ζw . The reason
t
t
why this way is not pursued will be explained in the section about the Public Sector.
14
The fist equation tells us that entrepreneurs always invest in their own firms all their savings and may borrow
as well. The more they borrow, the more output they produce, the higher will be the wage and the following
generations will be less constrained as well. The second equation imposes spt = t ζwt ; sst = 0. The savings of the
non-entrepreneurs are distributed across POEs and SOEs.
Each firm will be willing to borrow according to a participation constraint and a borrowing constraint that
we describe in a following section. Given the empirical evidence described earlier we will assume that the SOEs
will be the main investor, as they are the unconstrained one.
2.3
2.3.1
Funding of the State Owned Enterprises: Financial repression
Public Investment decision
The most innovative part of this paper is trying to understand how the public investment decision was taken.
Along history, investment by the public sector has been a tool to industrialize, to develop, to push strategic
sectors and many other goals and purposes. Governments, mainly authoritarian ones but not only these, try to
take control over the economy in order to carry out their political roadmap. The multiple examples given by
history can help us understand how to model public investment as the result of a maximization problem.
How is KS,t determined in the model? The investment of State Owned Enterprises is not determined by
market competition. SOEs follow some political goals that explain why they may be investing while making loses
as the Government is able to roll on debt by borrowing more every period. Besides, as they can also set the
nominal interest rate there will be no first order condition that pins down the optimal level of capital. In the
model the SOEs invest a higher than efficient amount of capital for political reasons.
From the documents of the time we know that Government expenditure on public investment was independent
from the interest rate and from the return to capital.
In the first decade after the Spanish Civil war there was almost no state intervention in the economy. The
poor economic conditions and the underdevelopment of the financial sector depressed private investment and this
resulted in a very low growth rate ( virtually zero or even negative). The low population growth and the lack
of investment caused the GDP to stagnate during the first years after the Civil War. In the beginning of the
40s the Government decides to take a stake in the economy and start a “production policy” strategy directed to
increase investment and economic activity to escape the stagnation and poverty that had taken over the economy.
Franco’s Government founded the National Institute of Industry (INI) in 1941. The justification for the creating
of the INI was that the private initiative was too weak to realize the major infrastructure investments that the
Spanish recovery needed and was not willing to invest in some strategic sectors with very high fixed costs and low
15
profitability. Spain was inspired by Mussolini’s Industrialization policy in Italy. 5 . During the decade before 1950
the government imported machinery to increase production instead of assessing other problems like the scarcity
of food in order to reach the production target.
These policies, even if radical, finally resulted in a growth rate of 10% in 1951 and of 8,2 % in 1952. We can
learn from the behavior of the Government that the decision on where and how much to invest was based on the
industrialization goals of the regime rather than on an efficiency criterium or on the interest rate of the time.
Thus, the public investment in year t + 1 can be written as:
Kts = γt ζ(1 − )wt
(6)
Where we set γt = γ = 12 . With this equation we are modeling the Public Sector as if it accumulated half of
the savings stock in the economy6 .
In this model public investment is exogenous and private investment will be given by the savings left after the
investment of the government.
2.3.2
Public borrowing and financial repression
The Government in Spain financed the public investment with the emission of public debt. The particularity
of this debt was that it could be bought by private banks or private investors and immediately deposited in the
Spanish Central Bank ( Banco de España) in exchange for its value. Effectively, the Central bank was giving
the money in advance, and multiplying the monetary base in the economy. This created a constant inflationary
pressure that effectively reduced the savings of citizens. We will follow two different approaches to try to capture
this phenomenon. In this first simplified version of the model the Government will issue debt to finance the
desired level of public investment. On top of that we can introduce a tax on savings ( for both entrepreneurs
and non entrepreneurs) to capture the effects of inflation. A tax on savings has the same effect as a constant
inflation on savings, as the real interest rate decreases in inflation and could even be negative. This is, in fact,
what happened in Spain as explained in the first section. In the extension of the model presented in Section 3, we
examine not only the level effect of a high inflation on savings but also the effect of inflation volatility in saving
/ investment decisions.
bst = γ(1 − )ζwt
(7)
In addition to this we define a tax τ , that Government sets on savings. We assume that the Government uses
5 The
Italian industrialization plan is mentioned like a model in the Consititutional Law of INI
reality this share was a bit lower than half. In Spain there was a big private sector but it was affected by multiple constraints,
i.e. 37 % of the authorizations for the establishment of a firm were denied, on average in the 1940s. Most of these denials had a
political reason or where taken to adjust the economic activity to the planified production by the State.
6 In
16
this money for political/ strategic purposes ( like defense, propaganda, etc) and that it provides zero utility to
the citizens ( we could also assume that this money is burnt or thrown to the sea as it is not uncommon in macro
models). The point is to capture the fact that with a very high inflation rate, a part of next period savings is
gone.
The savings available after tax are:
(1 − τt )ζwt = bpt + spt + bst
The disposable savings for citizens are (1 − τt )ζwt and available savings from savers that will be deposited in
banks will be (1 − )ζ̃wt where we denote the tax-adjusted savings rate with ζ̃ = (1 − τ )ζ. After-tax savings of
non-entrepreneurs (1 − )ζ̃wt will be allocated between lending to the SOEs or to the POEs. As this is made
through bank deposits, the agent is indifferent between both types of investments as they both will pay the
deposit rate. As the interest rate was already artificially low we assume that banks pay back a deposit rate equal
to interest rate:
rtd = rt
(8)
It should be noticed that for both types of debt to exist, it must be that, in equilibrium, both types of actives
pay the same return. If the POEs would pay a higher lending rate than the SOEs, no bank would lend to the
Government. This explains the choice of financial repression by the Spanish Government.
Remember that in a free-market economy set up with no financial frictions the SOE firms would disappear as
no investor would lend money to the SOEs, that paid a lower interest rate.
How was the interest rate set in this set up? The interest rates where set equal to the return paid by the
public debt (see figure 4). The Government of Spain was carrying out financial repression (setting the interest
rates lower than the market level to give the Government access to cheap funding) to be able to compete for
funds with the public sector. In fact set the market interest rate equal to the return paid by public debt.
In the model, interest rate will be set equal to the MPK of the SOEs:
ρs,t = αA
α−1
α
α−1
κp,t−1
= rt
This means that the private sector will be able to reap some rents from the fact that
1
ρp,t = αA- α κα−1
s,t−1 > rt
So the relation between both return is
17
(9)
1
1
ρp,t = A α ρs,t = A α rt
2.4
Credit Market equilibrium
2.4.1
Credit allocation
Every worker, at the end of period 1, has to decide whether to participate in the credit market as a borrower
or a lender. Savers are always lenders so the credit supply from non entrepreneurs in the economy will be
(1 − )ζ̃wt (kt ). Entrepreneurs, have the following participation constraint that helps them decide whether to
invest in their own POE or to keep their savings in the bank. The participation constraint for the POEs has the
following form:
ρpt ∗ it − rt (it − ζ̃wt ) ≥ rt ζ̃wt
(10)
where it = bpt +ζwt is the investment that the entrepreneur wants to make. The above equation has a straight
forward interpretation: the profit from investing (return form investment minus repayments) has to be bigger
than the gains from keeping the savings in a bank. This condition can be rewritten simply as:
ρpt ≥ rt
(11)
According to this equation the participation in the credit market depends only on the relative ability to invest
of the agent. Entrepreneurs will be willing to ask for a loan in the first period and invest the savings plus the
loan to earn a return in period 2 only if the previous condition holds. As we have already shown, this condition
will hold in every period so the return to private investment is always higher than the Government-set interest
rate.
In addition, POEs are affected by a financial constraint: The low level of development of the Economy and
the difficult access to credit will restrict the amount of money that POEs can borrow. We model the constraint
as a limited pleadgeability constraint:
bpt (1 + rt ) ≤ η(st + bpt )
(12)
In the absence of a credit constraint, η ≥ 1, the entrepreneurs can pledge all their funds to borrow and can
leverage on their savings (i.e. when η >
7
Notice that
bP
t
p
st
=
η
(1+rt )−η
(1+rt )
2
⇒
bp
t
sp
t
> 1)7 When η < 1 the entrepreneurs cannot pledge all their
is the leverage ratio and that this leverage ratio depends on the financial constraint and the interest
18
funds so the conditions to get credit are tighter.
Rewriting the constraint and replacing the expression for savings of entrepreneurs we get an expression for
private borrowing:
bpt <
η
(1+rt )−η ζ̃wt
As the participation constraint holds entrepreneurs always want to borrow more so that the constraint is
binding. Thus, the borrowing of entrepreneurs is given by:
bpt =
η
ζ̃wt
(1 + rt ) − η
(13)
For each period in time, the borrowing constraint of POEs determines the optimal capital they demand.
However, it can be that POEs cannot get the desired amount of investment. Remember that SOEs are not
financially constrained. This implies that SOEs will choose the capital they want to invest and only the remaining
savings will be absorbed by the private sector. So, there is an additional constraint on the borrowings private
sector:
bpt = (1 − )ζ̃wt − bst = (1 − γ)(1 − )ζ̃wt
(14)
Where we have replaced bst = γ(1 − )ζ̃wt .
As the amount of savings in Spain was not very high, it seems reasonable to assume that bpt > (1−γ)(1−)ζ̃wt ;
this is to say, that the private sector absorbed all the remaining savings in the economy as their desired level of
investment is higher.
Proposition 1: The credit demand will be higher of equal to the credit supply if :
η
(1 − )
>
(1 − γ)
(1 + rt ) − η
(15)
A plot showing the restriction on parameter values so that the condition holds can be found in the appendix,
Figure 29.
Thus, in equilibrium we will have that
rate.
19
bst = γ(1 − )ζ̃wt
bpt = (1 − γ)(1 − )ζ̃wt
2.5
Labour market clearing and General Equilibrium
The labor market clearing conditions are
Ls,t + Lp,t = 1
M P Ks = M P Kl = wt
From this two conditions we find the labour demand of the Public sector:
Ls,t =
Ks,t
(16)
1
α
A Kp,t + Ks,t
Wage is determined from plugging the aggregate labour level in the formula for the marginal productivity of
labour
Kα
wt = (1 − α)( Lαs,t )
s,t
With the wage determination we know the next period savings and the investment levels, that will determine
Kt+1 = Ks,t+1 + Kp,t+1 .
The aggregate low of motion of the economy is
α α λp,t
λs,t
(1 − α) α
Kt
Kt+1 = ζ̃t wt = A
+
ζ̃
Lp,t
Ls,t
2
Where λi,t =
Ki,t
Kt ,
(17)
the sector specific capital shares.
As we can see, the low of motion is concave so, under constant capital shares in both sectors, the economy
will reach a steady state, that is non-linear in the relative capital stocks. We can also see that the relative shares
of the public and private sectors are premultiplied by their respective TFPs.
Aggregate TFP can be computed as the weighted averages of both sectors:
AggT F P = [Aλp,t + λs,t ]
h
Y
AggT F P = A Yp,t
+
t
20
Ys,t
Yt
i
(18)
2.6
Transition to a new equilibrium
We denote period T as the beginning of the transition. There were two major political reforms that took
place in 1957 and 1959 respectively. These two reforms resulted in a period of increased growth, high TFP and a
decreasing relative importance of the public sector. The target of the reforms was to reduce the macroeconomic
instability in the country by decreasing the booming inflation, unifying the exchange rates and imposing some
discipline in the debt issuance process of the public debt (giving monopoly to debt issuing to a few public
institutions).
Even thought the reforms were broad, history shows that the main effects of the changes were an improvement
in the general conditions for business (as we can will see from the increase in the firm entry and capitalization)
and a relative decrease/stagnation of the importance of public investment (coming from changes in the types of
debt that were issued). Besides, all debt from 1960 onwards was issued by the Ministry of Finance, attending
efficiency and economic criteria as much as possible. We have to keep in mind that, even if the 60s were a decade of
increasing openness and modernization of the Spanish society, Spain remained a dictatorship until 1975. The key
parameters that capture these combined shocks in the model are the percentage of entrepreneurs in the population
(represented by) and the share of public sector in the economyγ. In 1957 a very important fiscal reform was
implemented. The goal was to bring financial discipline to the Government budget. An upper bound was set to
public borrowing and the public entities that had been borrowing at a zero lending rate were no longer able to do
so anymore. All this changes are captured in the model by an exogenous ( politically driven) downward change in
the share of public investment γ in the economy. In 1959 the reform was completed with the “Stabilization Plan”.
It’s aim was to control inflation, increase openness and decrease the distortions and interventions in the economy.
With a series of economic changes a more favorable environment for business and investment was accomplished.
We capture this change with a shock to; as an increase in the amount of entrepreneurs in the economy. In next
section I introduce an extension of the model where the parameter is endogenously generated by the model due
to a reduction in the economic uncertainty, caused by a fall in inflation.
Finally the tax on savings disappears, liberating even more savings in the economy, τ = 0. This final change
captures the effect of the fall in inflation.
2.6.1
The result of the transition and the composition effect.
The transition will take place slowly due to the financial constraint on entrepreneurs. Spain was still a country
with an underdeveloped financial system and there was still some State intervention in the allocation of credit
across sectors/ entrepreneurs.
This makes possible a slow transition in which the public investment slowly shrinks while the private sectors
starts to grow in importance. It is important to notice that during the transition the wages will grow. Opposite
21
to other models of transition between economic systems, as in Chadha, Coricelli (1997), the model predicts
an increase in wages as the transition takes place. The reason for this is simple and follows from the different
capital/labour ratios across sectors. As the Public sector is a very capital intensive sector, it releases proportionally
more capital than labour. On the contrary, the POEs are labour intensive sectors that absorbe labour faster than
it is released. The abundance of capital and the large demand for labour from the POEs cause an upward pressure
on wages. This feature is introduced in the model in the spirit of Song, Storesletten and Ziliboti (2011).
Another effect of the transition will be an increase in the aggregate TFP through a composition effect, as the
share of the POEs in the economy is larger, the average TFP will increase with the transition until the relative
sizes of sectors stabilise again.
In the model the transition phase implies an important change in the allocation of credit. From T period on
the SOEs are not able to unilaterally determine the amount of funds they want to demand from the economy.
Instead, the POEs will be able to demand funds in the market, at the interest rate set by the government. Then,
the Government absorbs the remaining savings.
Thus,
bpt =
bst
η
0 ζwt
(1 + rt ) − η
= (1 − )ζwt − 1 +
0
η
0
ζwt
(1 + rt ) − η
(19)
(20)
The rest of the equations are unchanged although there is no tax on savings and is now replaced by 0 .
Labour demand is determined by the same equation and wage will be such that the labour market clears.
The following two figures show the evolution of an economy based on the analytical model just exposed. In
figure 12 a) we present some of the macroeconomic aggregates in the economy. As we can see, a period after
the transition starts wages, output and TFP start growing until a new, higher, steady state. The transition ends
when almost 100% of the labour is allocated in the private sector. The return to capital, calculated as a weighted
average to MPKs of both sectors, decreases slowly as the Private Sector accumulates capital. Towards the end of
the transition the capital shares have stabilized and the changes are smoother. We also observe a high increase
in savings over GDP.
In Figure 12 b) we plot the sectoral reallocation in more detail. Panel A shows how the borrowing stock
of each sector evolves. After the transition a lot of savings are released but as the financial constraint is high,
entrepreneurs cannot absorbe all this capital and the borrowing of the State increases after the initial fall. As
savings grow, entrepreneurs are less and less constrained and at some point start borrowing a larger share of the
savings in the economy. In Panels C and D we see a similar thing happening with the relative output and capital.
22
(a) Evolution of Aggregate magnitudes
(b) Evolution of variables across the two sectors.
Figure 12: Simulation
Notes: The blue vertical line marks the beginning of the transition. The transition ends when almost all labour is
employed in the Private sector.
23
3
Extension: Endogenous share of entrepreneurs
We now extend the model to take into account the effect of a reduction in inflation (both in the average and
volatility) right after the reform. This change deeply affected the entrepreneurial conditions of the economy. A
high inflation is painful for savers that see their savings reduced in the following period. However, it can harm
more strongly investors. When there are fixed costs to pay, a high volatility in inflation can make an entrepreneur
evaluate whether or not start the project as she could end up with negative profits. As it is common in economies
under dictatorial or authoritarian regimes, the barriers to start a firm were very high in Spain during this period
(and they are still quite high). Not only because of the permits that you should get from the Government
but taxes and heterogeneous access to credit as well sum up to the common fixed costs that entrepreneurs face
normally (i.e. establishment cost). We model the effect of inflation volatility as a source of uncertainty for the
entrepreneurs when, after taking the investment decision and starting the firm, they are required to pay a fixed
cost (i.e. Cost for accessing the market, for getting license to commercialize the product, patent registration). As
it has already been explained the government was able to control both the interest rate and the inflation rate to
access cheap funding. In this version of the model the SOEs set the level/ volatility of inflation to keep the private
borrowing very low and access the remaining savings. Instead of modeling the level of government borrowing bs,t ,
the government now sets the inflation rate ( of more specifically the mean and variance of the process generating
the inflation rate) to affect the investment decision of the agents.
To keep the model very simple we introduce the effect of inflation as an “ inflation shock” that can be thought
of as a negative shock to the productivity of the firm. The reference model here is a highly simplified version
of the Aghion, Angeletos, Banerjee, Manova (2005) [1] model. It should be clarified that inflation will affect the
return from investment negatively because, as the interest rate is not set by the market, the nominal interest will
not adjust to changes in inflation.
3.1
3.1.1
The investment decision of POEs
The fixed cost and the probability of a successful investment.
The part the model that we will change is the decision-making process of the entrepreneurs. The introduction
of a fixed cost and the creating of a high and volatile inflation by the government will shape the decision taken
by the different agents, with different idiosyncratic productivities. The share of agents that decide to invest will
be denoted by t , as before. The motivation for this extension is to target one of the features of the firm creation
trend in Spain in those years. Figure 15 shows a graph of the number of registrations of corporations each year
and the total capital they paid-in. The black line shows the total number of registered societies and the red line
shows the total number of registered corporations that were listed in the stock exchange.
24
(a)
(b)
Figure 13: Number of Registered corporations in Spain and capital
What is interesting about this graph is that we can see the different effects of a change in regulation and the
decrease of macroeconomic uncertainty ( decrease in inflation volatility). In 1951 a Law was dictated to better
regulate the characteristics and the status of the Stock-exchange listed corporations. A spike can be seen clearly
in this year. In 1953 a Law was dictated to better regulate the other main type of corporation in Spain, the
limited liability Corporation. We can also see a positive trend starting one period after 1953 on. But the number
of corporations remains constant until 1959. The trend is positive and much steeper just after the two economic
reforms. This seems to point out that a lot of entrepreneurs did not start a company until the uncertainty in the
economy was reduced, even if the improvement of the legal framework was done much earlier.
Besides, if we compare the newly created firms with the existing firms we get another piece of interesting
evidence. In figure 16 we see the number of new firms relative to the total number of firms and the average
capital per firm for both groups.
Firstly notice that the newly created firms are about 1/5 of the total population of firms in the economy
in 1959 but they represent almost one third, implying that the rate of firm registration accelerated. In the
second plot we can see the average capital per firm in the economy. We see that while the average capital for a
established firm in the market is around 15 millions and increases a lot ( showing a higher level of capitalization
of the economy through share offers) the average capital per newly created firm stays constant and at around 2
millions of pesetas. This suggests that a lot of very small firms were being created while at the same time the
larger firms were absorbing more capital. This is the support for looking at the share of investors and how it can
endogenously change with the model.
25
(a)
(b)
Figure 14: Number of Registered corporations in Spain and capital
We introduce the “inflation shock” as a negative sign shock that reduces the firm marginal productivity of
capital. The “inflation adjusted” gross return to capital for POEs will be:
(1 + ρpt − πt+1 )
(21)
Now the model will have two stages: in every period the young agents, after being paid their salary will first
decide whether they want to be entrepreneurs depending on the probability of success of the investment, that we
will describe later. Afterwards, oncet has been determined the model works almost in the same way as before.
However the public investment will now be, from the beginning, the residual of private investment. However,
recall that the Government is the one deciding the level and volatility of inflation.
The maximization problem is the following: In period t the agent will have to choose whether to allocate her
savings ζwt in a bank deposit that will pay a gross return of (1 + rt − πt+1 ) or investing in her own firm. One of
the options will dominate the other, as the returns will not equalize. We will now introduce the probability that
the creation of a firm is successful. This probability will depend on the probability that the entrepreneur will be
able to pay a fixed cost after production ( the cost of entering the market, getting a license, etc). The fixed cost
ct is a random variable from a uniform distribution in the interval [c, c]. The expected probability of paying the
fixed cost is



 

η
 

p
p
Et P r  ρt+1 − rt − πt+1
+ 1 + ρt+1 − πt+1 st > ct+1 
1 + rt − η
 

|
{z
}
(22)
ExpectedP rof its
We care about the expected probability because the agent will decide based on this predicted probability of
success, with the information at hand in period t. This is also why uncertainty is very important in this set up.
26
The left hand side of the inequality is the profit function for the entrepreneur owner of the company. It is
composed of the return from the borrowing and the return from the invested savings. This profits should be
higher than the fixed cost to pay. If the cost is not paid the entrepreneur will not be able to access the market
and sell her production. The profits, in that case, would be zero.
We can rearrange the left hand side to show how the profits depend on the parameters:
Et
(1 + rt )
η
p
p
Pr −
πt+1 +
(ρ
− rt ) + (1 + ρt+1 ) st > ct+1
1 + rt − η
1 + rt − η t+1
(23)
We can rewrite the equation as:
(1 + rt )
η
P r Et
−
Et (πt+1 ) +
(Et ρpt+1 − rt ) + (1 + Et ρpt+1 ) st > Et (ct+1 )
1 + rt − η
1 + rt − η
(24)
As we can see, the left hand side can be written as a function on the inflation shock, the parameter of the
financial friction and the interest rate and private return to capital, δ(Et (πt+1 ), η, rt , Et ρpt+1 ) ∗ st . It is easy to
show that
∂δ(Et (πt+1 ), η, rt , Et ρpt+1 )
<0
∂Et (πt+1 )
∂δ(Et (πt+1 ),η,rt ,Et ρp
)
t+1
∂η
<0
∂δ(Et (πt+1 ), η, rt , Et ρpt+1 )
>0
∂Et ρpt+1
The effect of the interest rate is more ambiguous. For values of η that are consistent with the model and when
the difference between the interest rate rt and Et ρpt+1 is big the effect of the interest rate on profits is negative
∂δ(Et (πt+1 ),η,rt ,Et ρp
)
t+1
∂rt
<0
From now on we denote the probability of profits being higher than the fixed cost with δ(t, t + 1).
We will make some assumptions relative to the agents’ expectations. For the expected return to private
capital, we know from the previous section that the following relation holds:
1
ρp,t+1 = aiα rt+1
1
(25)
1
So we can set Et ρpt+1 = A α Et (rt+1 ) = A α rt . This is a reasonable assumption because in this period of the history
of Spain interest rates were very stable and jumps where unlikely. As the market rate is effectively a rate set by
the Government, they remained constant for many periods. For some empirical support for this assumption, as
can be see in Figure 4.
We will also assume that all agents know the distribution of c, so that they can compute the expectation of c
as E(ct+1 ) =
c−c
2
= E(c). This knowledge could come from the old entrepreneurs and their experiences in setting
27
up businesses. This kind of information flows are very common in economies with a rather big informal sector, as
the Spanish economy at this stage. The most crucial assumption is about inflation. We choose to model agents
as myopic so that Et (πt+1 ) = πt , that can be observed in period t. This assumption makes sense given the high
variance of inflation. It is unlikely that people knew the mean of the process. Even assuming that they know
inflation in the period is maybe too optimistic but is a reasonable assumption8 .
9
As the fixed cost is distributed uniformly, the probability of being able to pay the fixed is given by:
δ(ai,t ) =
n
(1+rt )
πt +
− 1+r
t −η
1
η
α
1+rt −η (ai rt+1
o
1
− rt ) + (1 + aiα rt+1 ) st − c
c−c
(26)
Notice, that the probability of paying the fixed cost will differ across agents because of differences in productivities ai,t .
For one period, we can plot the probability of success of the investment (paying the fixed cost) as a function
of Et (πt+1 ) = πt to see the effect of the variance of inflation for given values of interest rate, rate of return, the
idiosyncratic productivity and the financial constraint:
Figure 15: Probability of Paying the fixed cost over inflation levels
Note: The blue vertical line is the value of inflation for which the fixed cost can be always paid. In this example
we assume that if inflation was constant πt = π̄t , then the probability of paying the fixed cost would be always
one. However, if inflation fluctuates around the mean π̄t with some variance ( in the example between [0, 2.4917]
whereπ̄t+1 = 1.4, then taking an average between both values, the red line, the probability of paying the fixed cost
is δ(πt+1 ) < 1. The larger the variance, the lower the probability that the fixed cost will be covered.
For different levels of expected inflation, all else equal, the expected probability of paying the fixed cost is
different.
8 The real interest rates in Spain were negative for most of the years in which this research is focused ( see Figure 4). Still people
would buy public debt and believed the “financial fiction” so we can infer that people knew little about the level of inflation.
9 This formulation of the model is inspired by an example in Aghion, Howit (2009) [2]
28
3.1.2
The decision to invest: an endogenous measure of the mass of entrepreneurs in the economy.
Now that we have computed the probability of success of the investment we can solve the maximization
problem of the agent to get the optimal allocation for savings. An agent will want to start a firm if the expected
profits from opening the firm are higher than the expected return of saving the money in the bank:
δ(ai,t ) ∗
Where st = ζt wt , λt =
δ(ai,t ) ∗
|
nh
i
o
1
1
(1 + aiα rt+1 − πt ) + λt (aiα rt+1 − rt ) − E(c) st > (1 + rt − πt )st
η
1+rt −η .
(27)
We can rearrange the previous expression as:
i
o
nh
1
1
(1 + aiα rt+1 − πt ) + λt (aiα rt+1 − rt ) − E(c) st > (1 + rt − πt )st
{z
}
{z
} |
(28)
CC
RR
As we can see, the LHS of the inequality ( RR curve) depends positively on δ(ai,t ). For the expected values
of the return to POEs and SOEs, and a given value for parameters, we can see that the decision will depend on
the probability of being able to pay the fixed cost, which is the uncertainty that the agent faces.
As all agents have the same information, with homogeneous productivity across agents all agents will take the
same decision: either to invest or to save.
We now introduce idiosyncratic differences in productivities across entrepreneurs so that the decision will
change depending on the individual productivity parameter. It can be shown that there will be a cutoff value for
productivity a∗i,t such that only entrepreneurs with ai,t ≥a∗i,t will invest. The graph below shows the intersection
1
of the RR and CC curves as a function of values of the expected return ρ(ai,t ) =aiα rt
Figure 16: RR-CC
Note: The cutoff productivity is defined by the point where the line (RR-CC) crosses zero. The agents with a
productivity higher than the cutoff will become entrepreneurs.
29
The idiosyncratic productivities are introduced as individual draws from a Pareto distribution10 . Each agent,
when born, is given a draw αi from the Pareto distribution, M (am , σ). We assume, for simplicity, that the agent
knows her type and can compute her expected return to capital:
α−1
ρpt = ai ακp,t
= ai rt
(29)
Given this, the productivity cutoff ρp,t ∗ is a function of the idiosyncratic productivity ai and we can solve for
the productivity threshold:
ρ∗t
=a∗
α−1
ακp,t
= (a∗) rt → a∗ =
rt
ρ∗
−1
(30)
The fraction of entrepreneurs in the economy is given by the opposite of the cumulative density function of
h
2 i
m
the Pareto distribution(a∗) = 1 − 1 − aa∗
. For each period, the productivity cutoff will change depending
on the parameters and the share of entrepreneurs will come endogenously as the mass of the Pareto distribution
above a∗ Now the model goes back to the same form and the investment and production decisions will be taken.
All the formulas of the Baseline model hold as before though the share of entrepreneurs now is given by(a∗).
3.1.3
Discussion on the borrowing decisions
The dynamics of the model are similar to the baseline model but it is necessary to discuss about how are the
investment decisions taken in both sectors. There are two possible channels through which inflation affected the
allocation of savings across the two sectors. The first one has already been described in the previous section, and
it is related to the effect of inflation on the nominal interest rates. In a market economy, the interest rate is set
to clear the credit market. Inflation will have an effect on the nominal interest rate but the real interest rate will
remain unaffected. Recall that we can write the real interest rate as
it = rt + πt .
In a model with financial repression, the nominal interest rate is not set by the market but is fixed so it will
not adjust to inflation keeping the real interest rate constant. Thus, the real interest rate will be affected by
inflation shocks. This is what was happening in Spain for almost two decades: the nominal interest rate was
set equal to the return paid by the government debt and the high inflation contributed to the liquidation of
the government debt. The following figure shows again the evidence of the financial repression undertaken by
Franco’s government and of the interest rate setting by the Government:
Following this evidence it is clear that inflation had also an effect on the incentives to borrow. The higher
10 In
the calibration the Pareto distribution has scale parameter, am = 1.2 and shape parameter σ = 4.
30
(a) Financial repression
(b) Interest Rates in Spain
Figure 17: Nominal and real interest rate
inflation is, the lower is the cost of borrowing. Therefore, a high inflation would allow the unconstrained sector (
the government) to borrow more and accumulate most of the resources in the economy. On the contrary, once the
transition is decided, the cut back on public investment and issuing, a decrease in inflation and a lower interest
rate made the Government unwilling to borrow as much, releasing capital in the economy.
If we take the view that the Government was the principal investor in the economy, then a higher inflation
gave the government incentives to borrow more and invest more.
If, on the contrary, we take the view that the Government was the principal investor only in the pre-Transition
period, then we should investigate the effect of a reduction in inflation for entrepreneurs ( there will be a trade-off
between lower uncertainty but higher cost of capital). The final affect could be that entrepreneurs decide to
borrow less once inflation is low. We have already said that the effect of inflation on the probability of investing
successfully is negative, so it seems that the channel of the decrease in the real return dominated the incentives
to borrow more created by the high inflation. In the end both formulations are practically identical in the model.
3.1.4
Simulation
The following figures show the evolution of the economy before and after the transition in the extended model.
Figure 18 a) displays the evolution of the aggregate magnitudes after the transition. Panel E shows the inflation
level during the transition. Both the mean and volatility are higher before the transition, represented by the blue
vertical line. As in the baseline model the labour share of POEs, the wages and the aggregate output rise slowly
to a higher steady state. The aggregate return to capital increases as the released capital by SOEs is higher than
the capital absorbed by POEs. This causes a fall in investment one period after the transition and boosts the
marginal productivity of capital in SOEs. Finally aggregate TFP rises as well and then stabilizes. Figure 19 a)
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plots the sector specific magnitudes. As in the baseline model there is an increase in private borrowing, even
though public borrowing remains high. Output of SOEs shrinks while POEs’ output increases rapidly, due to
the high productivity of capital. The relative capital stocks are shown in panel D. Initially the capital stock of
the private sector is almost zero. After the reform POEs start absorbing capital and SOEs scale down. For a
moment aggregate capital decreases to recover later on and reach a higher level than before the transition. The
return to private capital, panel E, also decreases as more capital is allocated to this sector.
Figure 18: Simulation: Aggregate Magnitudes
Note: The blue vertical line marks the beginning of the Transition.
Finally, figure 19 b) shows the evolution of private capital and borrowing next to the share of entrepreneurs
in the economy and the productivity cutoff. In the pre-transition period the productivity cutoff is very high (
panel B), well above the mean of the productivity distribution. Therefore, the share of entrepreneurs is close to
zero. After the transition the lower inflation makes the productivity cutoff decrease and jumps to 0,4 ( 40%
of the agents). As the transition formalizes the equilibrium level of this share dreases to around 30%. The low
volatility of private capital stock and private borrowing before the transtion is given by the low level of , almost
zero.
32
(a) Relative magnitudes
(b) Other relevant variables
Figure 19: Relative Magnitudes and the effect of inflation
Note: The blue vertical line marks the beginning of the Transition.
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4
Conclusion
This paper describes a model of Economic transition in a closed-economy framework with the following features.
Before the transition takes place the economy has an over-dimensioned public sector, very low interest rates (
due to financial repression), a high inflation and high government debt. The transition from a centrally-planned
autarkic system to a more liberalized, market-based economy takes place when the Public Sector changes from
main economic agent to regulator. This happens through an economic transformation
where the public sector is gradually replaced by a growing private sector. In Spain, a series of economic
reforms undertaken between 1957 and 1959 set the Spanish economy in the path of high growth. The model tries
to capture the mechanism at work.
Explaining an economic transition entails many challenges. The period that this paper studies was a very
important period in the history of Spain. Even if the arrival of democracy and the integration of Spain in the
EU arrived around 10 and 20 years later, respectively, a change was already taking place. The opinion of the
government members about of a well-functioning economic system shows up in the character of the reforms. The
key points were to achieve macroeconomic stability and public financial discipline. The aim of this paper is to
underline the link between the high directed government investment, the booming debt issuing and the high
inflation.
The reform in Spain was successful because it targeted the three goals at once. It would have not been possible
in other way. Spain before the sixties was a country with a strong government with a high control of the economy,
very limited access to financing and a low taxation capacity, and the ambition to improve the country’s situation.
All of these features are common in low income and middle income countries, specially after the end of a war
or revolutions. The country is in a bad initial state and the government makes use of financial repression and
inflation to push production and growth. In the beginning the returns to these centrally-planned and politicallydriven programs is high, and the economy starts growing. After the first push, however, the law of decreasing
returns kicks in bringing stagnated productivity and growth. The classic theory of growth says that you can
only attain sustained growth through increases in productivity. And the best way to incentivize productivity is
through economic incentives. Be it the possibility of registering ownership rights through a patent or being able
to keep the fruits of the investment instead of loosing most of them due to high inflation, the importance is in
the incentives.
The plan of 1959 and the previous fiscal reform of 1957 targeted the instability of the macroeconomy and the
unsustainability of the public debt. The consequence of these two problems was a depressed private initiative with
barriers to access credit and low incentives to invest. The model captures the connection between debt, inflation
and incentives. The public sector, by scaling down the amount of debt, allows agents to save more and investors
to start more firms and investment projects. It also explains in a simple way the important interdependence
34
between financial repression, high inflation and over-dimensioned public sector that has been already described
in several empirical works ( i.e. Reinhart & Sbrancia[14]).
The approach to studying the Spanish transition has been mainly empirical, with very few theoretical contributions. This paper builds on all the previous empirical contributions to tell a simplified version of the facts. The
framework is simple enough to support further improvements like a more flexible savings rate, the inclusion of
different sectors with different K/L ratios and productivities or the possibility of opening up to trade. All of these
are possible ways to further expand the paper. In the future, we would like to extend the model calibrate it to the
Spanish economy. In this way the model would be able to compare the contribution of the different changes that
took place during these years. There is a need to understand better how to make a successful transition between
economic systems as there are still many countries in the world that exhibit some, if not all, of the features of the
Spanish economy before the reform. There is need to do further research on understanding economic transitions
both for scientific interest and for the positive consequences that some policy recommendations could bring to
other nations looking of a change.
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5
Appendix
Figure 20: Investment composition
Figure 21: Contribution of growth, Leandro Prados de la Enclosura.
36
Figure 22: Agriculture
Figure 23: Construction sector
37
Figure 24: Industry
Figure 25: Services
38
Figure 26: Values forη for which private borrowing is higher than available savings
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