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NS4540 Winter Term 2017 Sources of Growth in Latin America Overview • Central problem in Latin America – slow rate of GDP growth throughout the region • For much of the post-war era, economic growth has been positive • However growth of economies in Latin America has been slow relative to some other regions at a similar stage of economic development • Modern growth theory stems from the 1950s and work of Robert Solow at MIT • Growth is seen in terms of changes in the labor force the stock of capital and productivity of resources • More recent “new” growth theory focuses more on human capital and technology • Empirically want to develop growth accounting or contribution of labor, capital and productivity to growth 2 Growth Preconditions I • In many areas of economics an implicit assumption concerning some preconditions that need to be in place • If these preconditions not met, the usual theories we use in economics may not work as well. • While there are a number of factors that can interfere with workings of the market – two that are absolutely critical: • Property rights, and • Rule of law • Many very poor countries and failed states are the result of the complete lack of either of these preconditions • Extreme lack of either precondition is not the case in modern Latin America (usually Haiti is left out of these discussions). 3 Growth Preconditions II • Property rights • Essential – for markets to work must be clear who owns what • Lack of enforcement of property rights makes market participants reluctant to engage in many economic transitions • Any reduction in the enforcement of property rights increases the risk of engaging in transactions • Effectively increases the cost of normal economic activity • Fewer transactions most often translate into a lower level of overall economic activity and GDP 4 Growth Preconditions III • Currently, Latin America something of a middle ground with respect to property rights • Region did not start out well in this regard particularly in colonial period • Protection of property often difficult in post-colonial times due to political instability • In more recent times • Prevention of outright theft of property made difficult due to ineffective enforcement of laws protecting property, or • The the settlement of property disputes may be slow due to legal system and courts • Corruption also makes the rule of law less effective. 5 Property Rights in Latin America • Scale 0 none to 7 complete South America Argentina Bolivia Brazil Chile Colombia Ecuador Mexico Paraguay Peru Uruguay Venezuela Average • 3.2 3.0 4.1 5.1 4.1 3.6 4.1 3.8 4.0 5.2 1.6 3.8 North America Costa Rica Dominican Republic El Salvador Guatemala Honduras Jamaica Nicaragua Panama Average 4.6 4.0 3.8 4.3 4.0 4.7 3.2 4.9 4.2 Source World Economic Forum 2016 Derived from surveys of business executives 6 Growth Preconditions IV • Scores for Uruguay, Chile and Panama in the range of Portugal and Spain • Latin America scores than scores for Canada (5.9) and U.S. (5.6) • Still there is sufficient enforcement of property rights to be able to use conventional models of economic growth with some degree of confidence. • The protection of Intellectual Property Rights • Covers areas such as copyrights and patents • In general intellectual property is more protected in developed countries than developing countries • Latin America clearly falls into this pattern • Best scores are Uruguay and Panama • Worst scores Venezuela and Bolivia 7 Intellectual Property Protection in Latin America • Scale 0 none to 7 complete South America Argentina Bolivia Brazil Chile Colombia Ecuador Mexico Paraguay Peru Uruguay Venezuela Average • 3.6 2.7 4.1 4.3 4.2 3.7 4.2 3.4 3.6 4.8 2.0 3.7 North America Costa Rica Dominican Republic El Salvador Guatemala Honduras Jamaica Nicaragua Panama Average 4.5 4.0 3.4 3.9 4.1 4.4 3.0 4.8 4.0 Source World Economic Forum 2016 Derived from surveys of business executives 8 Growth Preconditions V • Rule of Law • Normal economic transactions involve legally binding contracts • If there is no effective referee to enforce business contracts, far fewer business contracts will occur. • Rule of law difficult to define in an extremely precise way • World Bank components in Rule of Law Index • Enforcement of Contracts • Judicial independence • Favoritism in decisions of government officials • Efficiency of legal framework 9 Rule of Law Ranking 10 Rule of Law: Latin America Large Countries 60 Rule of Law (Percentile) 55 50 45 40 35 30 25 20 15 1996 2000 2003 2005 2007 2009 2011 2013 2015 Legend ARG BRA MEX 11 Rule of Law: South America East 80 Rule of Law (Percentile) 70 60 50 40 30 20 10 0 1996 2000 2003 2005 2007 2009 2011 2013 Legend ARGENTINA BRAZIL Uruguay VENEZUELA 12 Judicial Independence 13 Growth Preconditions VI • Summing up • Latin America has a sufficient level of property rights and rule of law to foster positive economic growth. • Improving for most countries in Latin America, although some back-sliding occurring 14 Neo-Classical Growth Model I • Stresses increases in Labor, capital and technology • Technology anything that causes resources to be used in a more efficient way • Total factor productivity and technology often used interchangeably – output beyond what would be expected from increases in labor or capital stock alone • Holding capital stock (K) and technology (TFP) constant and increasing labor will produce increased output at a declining rate 15 Neo-Classical Growth Model II • Changes in the capital stock and technology • If the economy accumulates more capital, the production function will shift upwards • L1 workers can now produce Y2 rather than Y1 16 Neo-Classical Growth Model III • With capital formation the capital-to-labor ratio (K/L) can increase • A worker with more capital can produce more goods and services than one with less • As the average capital-to-labor ratio rises, real GDP rises • Because increases in the K/L ratio increase labor productivity it also is associated with increased wages • A similar situation occurs when the level of technology or total factor productivity increases • An improvement in technology should allow the economy to produce more goods and services with the same level of capital and labor • Graphically the same as the increase in capital 17 Neo-Classical Growth Model IV • This basic model explains a substantial part of the progress of economic growth for virtually any country. • A good place to start to understand economic growth in Latin America • As a developing region of the world, the population and labor force are growing faster than most developed countries • To see this growth potential, need to examine the Latin American labor market and scope for capital accumulation 18 Latin American Labor Markets I • The labor market in any country is usually far from perfectly competitive • Labor markets are special in two ways • First, labor markets work, but they work slowly • Equilibrate much slower than commodity markets • Second, and more importantly, labor markets are among the most regulated markets in any county • This is especially true in the case of Latin America • Result of these factors – cannot simply infer the supply of labor from data on the population and the available labor force • Imperfections in labor markets influence the quantity of labor supplied and where it is employed. 19 Latin American Labor Markets II • The Latin American labor force • In 2008 around 250 million workers • Nearly half the population is in the workforce • Brazil and Mexico alone account for almost 150 million workers • Argentina, Colombia, Peru and Venezuela have labor forces between 10 and 20 million. • Often statistics fail to capture the millions in the informal sector • Also missing from the labor force are individuals working in North America or Europe. 20 Labor Force (millions) 21 Latin American Labor Markets III • Increases in the labor force mean movement along the production function • Can potentially lead to faster economic growth • If labor force growing rapidly the economy needs to grow at a fast pace to absorb the large numbers of workers entering labor force • If GDP is slow, then problems of unemployment and underemployment become common • If employment a problem in face of a rapidly expanding labor force then production function not shifting upwards at a fast enough pace • Could be consequence of either slow rate of growth of capital or slow productivity increases • In many countries slow rates of capital formation. 22 Latin American Labor Markets IV • Labor Market Distortions • In every country a variety of rules and regulations designed to protect workers from effects of labor markets • Large variation throughout the region • Job security regulations • Attempt to enhance job stability by employing labor codes that make it more difficult for firms to adjust the level of their workforces – Measures • Minimum advanced notice dismissal • Mandated severance payments • Limitations on temporary labor contracts • Consultations with the government prior to large-scale layoffs. 23 Latin American Labor Markets V • While such regulations enhance security of existing workforce they may hinder creation of jobs in formal sector. • Latin America has the most comprehensive set of job security provisions in the world • Even if a worker can be dismissed, employer must pay such workers • In Latin America this “firing tax” is often equal to 64 weeks of salary • Practices hinder development of more jobs in the formal sector • Despite more than two decades of economic reforms, these regulations have proven to be very difficult to alter. 24 Latin American Labor Markets VI • Conditions of Employment • Cover various limitations on what employers may ask workers to do in terms of number of hours worked and other conditions of employment • Relative to the rest of the world Latin America has some of the more restrictive conditions of employment • The cost of these restrictions seen in the existence of a large informal labor market. • Minimum wage • Nearly every country has a minimum wage • One of the most contentious issues in economics 25 Latin American Labor Markets VII • Important considerations – minimum wage in Latin America • First, minimum wage has to be effective. • In an inflationary environment has to be indexed or regularly adjusted or it is irrelevant – often this does not happen • Second, need to consider the existence of the informal labor market • Recent estimates indicate 30 to 70 % of Latin American workers in informal market and 1 to 45% earn less than minimum wage • Effects of minimum wage have to consider the effects on the informal as well as formal labor markets 26 Latin American Labor Markets VIII • Generally minimum wage has two conflicting effects • Can raise wages of whose who are covered • However if minimum wage if above the wage equilibrium can depress the level of employment • Empirical literature scant in Latin America, but much as one would expect. • Increase in minimum wage tends to decrease employment for low-skilled workers in formal sector • It does increase the income of those that maintain employment • As a result, effects on the overall incomes of the poor are uncertain. 27 Latin American Labor Markets IX • For the informal sector – workers that lose their jobs in the formal sector may not become unemployed, but rather find employment in the informal market • However this may increase the supply of workers in this market and depress wages • The result is that income losses to low-skilled workers may not be as drastic as in developed countries where there are fewer employment opportunities outside formal sector • It is possible therefore that an increase in the minimum wage may have positive impacts on the distribution of income in Latin America 28 Latin American Labor Markets X • Unions • Conventional wisdom is that labor unions constitute a significant labor market distortion in Latin America • Not wrong, but needs to be qualified • Labor unions are a much smaller percentage of the labor force in the area than was once the case • In every county of Latin America the percentage of unionized has declined over the last several decades • Only Brazil and Mexico have over 30% unionized and • Argentina and Nicaragua with 20% • For Latin America as a whole only 14% of the labor force is unionized • No longer the case where labor unions dominate the labor markets 29 Latin American Labor Markets XI • Summing up, labor markets in Latin America are large, diverse and subject to substantial distortions • World Bank has developed an index to capture different labor market conditions. It is composed of: • The difficulty of hiring workers • The rigidity of hours worked • The difficulty of firing workers • The rigidity of employment and • The cost of firing workers • Result allows countries to be ranked based on the relative flexibility of their labor markets • Latin America has relatively inflexible markets with respect to the rest of the world 30 Labor Market Flexibility Index 31 Latin American Labor Markets XII • Index provides a partial explanation of the relatively poor economic growth performance of the region. • Hard to explain how a region full of hard-working relatively well educated workers can produce relatively low economic growth. • Explanations: • First, mere possession of a quality labor force not enough • If significant barriers to the effective utilization of these workers then potential productivity is diminished • Second, the size of the informal labor market becomes more understandable • If employment in formal labor market involves a large amount of inflexible rules tendency for employers to evade rules in the underground economy 32 Capital Formation I • Capital in Latin America • As capital stock increases, the production function increases and GDP rises • Raid economic growth normally requires rapid increases in the stock of capital • As the K/L ratio rises the productivity of the labor force increases • Important because in the long run increases in productivity lead to increases in real wages. • K/L ratio for Latin America in 2013 was nearly $3,000 • Varies from $5,638 in Chile to a low of $560 in Bolivia 33 K/L and Per Capita Income 34 Capital Formation II • Growth Patterns • From 1990 to 2013 the K/L ratio in Latin America increased by nearly 60% • For the middle income countries the ratio tripled • For Latin America GDP per capita increased from $4,130 to $6,092 or 48% • For middle income countries GDP per capita increased by 133% • How can Latin America increase the capital stock? • Increased savings by business and government could be funneled through the banking system to produce higher rates of investment 35 Capital Formation III • Problems with the savings – banking system – investment model • Savings itself may be a function of economic growth and growth has been slow • Further exacerbated by the regions somewhat inefficient capital markets – results in savings not flowing to best areas • Data show the sum of FDI and savings for the region in 1990 was less than 20% • Under most circumstances his percentage is unlikely to lead to a large increase in the production function or rapid economic growth • Saving ratio in 2013 was 2% higher, so some reason for optimism 36 Savings in Latin America 37 New Growth Theory I • Neo-Classical theory of economic growth described before is correct as far as it goes • However an incomplete explanation of the process of economic growth • Problem is the theory not explain technology (or TFP) which is assumed to be determined by factors outside he model or exogenous • Empirically meant that TFP was being computed as a residual. • Once one had accounted for the amount of economic growth caused by changes and labor and the stock of capital, TFP assumed to be the residual or “unexplained growth”. 38 New Growth Theory II • In the new growth theory models technology is endogenous – explicitly included in the model with other variables determining the level of technology • Key assumption is that the level of technology and thus economic growth can be enhanced by the accumulation of knowledge. • More knowledge can increase the level of technology and become a driver of economic growth • Knowledge has another important characteristic. It can be accumulated without the constraint of diminishing returns. • Furthermore, it is usually subject to increasing returns. 39 New Growth Theory III • What determines or enhances the accumulation of knowledge? Two factors thought to be important • First, level of education in a society matters – the accumulation of human capital matters • Human capital is the education, training, and job skills embodied in labor that increases its productivity • Second, along with human capital investments in research and development (R&D) can also enhance the level of knowledge • In Latin America human capital more critical than R&D. Most of the world’s R&D occurs in the developed countries where conditions are favorable for this activity • Gives Latin America the opportunity to acquire knowledge inexpensively through trade or FDI 40 New Growth Theory IV • Patterns of education in Latin America • One of success stories in Latin America is the low level of illiteracy • Literacy rates in the region now approaching those in the highincome countries • Past primary education the data for the region is less promising • There has been some improvement in the number of students finishing secondary education and moving to tertiary education. • However even for those students who remain in school the average quality or actual educational attainment is low by international standards • Problem not money spent on education, but its utilization 41 Educational Attainment in Latin America 42 New Growth Theory V • For a middle-income country, R&D is a less important factor in economic growth • With so many pressing investment needs in Latin Amrica, in both the pubic andprivate sector, not surprising that the level of R&D low. • Only Mexico and Brazil have R&D spending approaching 1% of GDP • For the poorer countries of the region this percentage is far less • For Latin America FDI inflows are biggest source of R&D • Still some key areas such as Embraer jet made in Brazil embody indigenous R&D 43 New Growth Theory VI • Summing up • Neo-Classical theory of growth posits growth a function of increase in labor force, capital and technology (TFP) • New theory of economic growth adds two factors: • Increases in the amount of human capital and • Investment in R&D. • Empirical testing critical and this leads to growth accounting. 44 Growth Accounting I • Growth models we have discussed ultimately can be estimated with the relative importance of various inputs identified – called growth accounting. • Each factor has part to play in explaining why the growth of a country has been what it was in the past. • By explaining past periods of economic growth it is possible to see what went right or wrong over time • Using growth accounting possible to narrow the scope of the problem of growth in Latin America • Bad news is that there is no magic bullet that will suddenly transform Latin America into East Asia • Good news is that these exercises indicate where the bulk of the problems are, and that in theory these problems can be remedied over time 45 Growth Accounting II • • • • • • • • • Basic equation: Y = f(K,L, H,A) where Y = real GDP K = the stock of capital L = the labor force H = human capital A = TFP Collect historical data on all variables except TFP Use regression equation to determine the strength of independent variables affecting real GDP • One study found: 46 Growth Accounting III • Growth accounting in Latin America, 1960-99 • Growth at 1.25 positive but low by international standards. Labor force accounted for 0.43% of total growth, with capital 0.55% and human capital 0.52% • Productivity was negative during this period 47 Growth Accounting IV • Most studies find low productivity growth for the region. • Not the whole story of the relatively low growth of the region, but it is a substantial part of it. • Looking at the differences between Latin America and the rest of the world are also instructive 48 Growth Accounting V • Shows that growth in Latin America has not kept up with the rest of the world • Much stems from the very low productivity in Latin America – the last column • Normally TFP is positive, contributing to growth, not the case in Latin America 49 TFP Growth in Latin America I • Researchers have asked question – What would happen to growth in Latin America if TFP were the same as in the U.S. Answer – it would double. • Given empirical evidence on the importance of TFP for increasing growth in Latin America one might assume it would be easy to design policies to increase it. • Problem is TFP can be influenced by a multitude of general factors that are hard to quantify • However literature on TFP in Latin America can be used to produce a list of general factors that could be negatively influencing TFP in the regions. These include: • Informal sector, • Infrastructure, • Structural reforms and • Institutional quality 50 TFP Growth in Latin America II • Informal sector extremely large in Latin America • International Labor Organization (ILO) estimates that nearly 50% of workers in low income countries are in the informal sector • For middle income countries not Latin America, informal employment is about 35% • Latin America is unusual in that the figure is 55% • Another measure is the % of GDP in the informal sector • Regional average is nearly 43% with Mexico the lowest at 28% 51 TFP Growth in Latin America III • Informality has been shown to be an important determinant of low TFP in Latin America • One link is the micro data • The general pattern is that • firm size is correlated with informality, and • smaller firms in the informal sector are less productive than larger firms in the formal sector • one study found firms with more than 250 workers more than 150% more productive than firms with fewer than 20 workers. • In general formal firms 84% more productive than informal firms. • Policy implication: reducing the amount of informality would have a positive impact on TFP and GDP per capita 52 TFP Growth in Latin America IV • Little research on the causes of informality in general or for Latin America in particular • Main work done by Hernando de Soto who found • Root cause of informality firms attempting to escape burden of taxation and/or regulation • Process seems to be an entrepreneur starts a small business and never registers it with the government • World Bank data show the cost of becoming formal in terms of procedures and taxes – a rough correlation with the degree of informality in Latin America • Most small firms in Latin America do not have the resources to devote to the time or resources to comply with the tax laws 53 Starting a Business in Latin America 54 Business Taxes in Latin America 55 TFP Growth in Latin America V • Summing up • Causes of low TFP and hence economic growth can be traced in part to informality • Causes of informality are complex, but part of the problem can be traced to the difficulty of starting a business in the region • This is compounded by • tax rates that are higher than the global average and • A cost of complying with the tax regulations that is considerably higher than the global average • The social cost of reducing these impediments is low • However reducing labor market inflexibility is more difficult – many genuinely designed to protect workers 56 TFP Growth in Latin America VI • Old truism that much of the problems in Latin America can be boiled down to two things: education and infrastructure • Poor infrastructure makes it difficult for businesses to operate efficiently – thus reduces TFP • Term infrastructure does not have a precise definition, but some of its more important dimensions are easy to define. • World Economic Forum published surveys of business perception of infrastructure • Countries are rated on a scale of 1 (low) to 7 (high) • Latin America overall rated 3.7 versus a global mean of 4.2. In every category the story is the same. • Best category is electricity and by far the worst is railroads 57 Infrastructure Quality in Latin America 58 TFP Growth in Latin America VII • Great scope for increasing infrastructure • One study found infrastructure investment in region currently around 2.0-2.5% of GDP • If infrastructure investment doubled, GDP could increase by as much as 2% • If investment at these levels could be maintained for 20 years, infrastructure in the region would catch up with the more successful Asian economies • Problems with expansion in infrastructure • Money scarce • Private savings low, and • Public sector budgets tight with a bias toward current expenditures 59 TFP Growth in Latin America VIII • Other factors affecting TFP include institutional quality • Have already looked at property rights and rule of law as essential preconditions to economic growth • Economic historians have emphasized • the role of institutional factors that tended to encourage economic growth or • The absence of institutions as retarding growth • “New Institutional Economics” argues that economic growth is critically dependent on the quality of institutions in a country • Point: major differences in the level of economic development among countries that cannot be explained purely in terms of growth of the labor force, the capital stock, or human capital 60 TFP Growth in Latin America IX • It is assumed that institutional quality affects economic growth through TFP • Unfortunately the link between the two is difficult to quantity due to our inability to define precisely what institutional quality is. • Best to look at a number of different indexes of institutional quality then look for a common story. • Common dimensions of institutional quality include • Corruption – Latin America fairly average by international standards • Ease of Doing Business – Latin America worse than international standards • Government Effectiveness – Latin American Governments relatively ineffective • Competitiveness – tends to be better than other parts of the developing world 61 Measures of Institutional Quality in Latin America 62 TFP Growth in Latin America X • While none of these indexes is definitive, overall picture is of a region with moderate problems with • Corruption • A poor business environment, and • Relative ineffective governments • Not surprising that increasing TFP in this kind of environment would not be easy • Despite the bleak data on institutional quality –must be something beyond these numbers • Figures on competitiveness derived from surveys of business executives • Executives usually thinking not just about the present but also future • If the data is expressing expectations then future of Latin 63 America looks brighter