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Chapter V: Growth and Employment A. B. C. D. E. F. Accounting for Growth Efficiency of Labor Solow model and interpretation The labor market Real wages Population and migration Goethe Business School Production function again Key to our analysis of growth will be the production function: YS = F (L, K, ) Output produced Capital Buildings, machinery infrastructure Labor Number of workers Hours worked Factor productivity Technical knowledge Organization Efficiency 2 Goethe Business School Differences in per capita economic growth 3 Goethe Business School Index of industrial production 120 Developing economies (without China) 115 110 High income economies 105 100 95 90 Jan 00 Jul 00 Jan 01 Jul 01 Jan 02 Jul 02 Jan 03 Jul 03 Jan 04 Jul 04 Source: Worldbank 4 Goethe Business School Index of industrial production 170 160 China 150 140 130 120 Other LDCs 110 High income countries 100 90 Jan 00 Jul 00 Jan 01 Jul 01 Jan 02 Jul 02 Jan 03 Jul 03 Jan 04 Jul 04 Source: Worldbank 5 Goethe Business School Production and capacity utilization in the US 6 Source: Federal Reserve Goethe Business School Accounting for growth There are large differences in GDP per capita over time and across countries. Our first impulse is to interpret this data using the production function relating per capita output to the capital/labor ratio. If the exponent is 0.25, then this function is (Y/L) = (K/L)0.25 We are interested in the percentage difference in per capita GDP between two points in time, or between two countries 7 Goethe Business School Accounting for growth Mathematically, percentage differences behave like logarithms log(Y/L) = .25 log(K/L) It says that for every one percentage point difference in the capital-labor ratio, we get a .25 percentage point difference in output per worker If one country has 5 percent higher output per worker than another country, then we would expect the more productive country to have 20 percent more capital per worker 8 Goethe Business School Growth and capital accumulation 9 Goethe Business School The “growth residual” The capital-labor ratio is certainly important Countries increase this ratio via investment: Most countries with high rates of labor productivity have investment shares of more than 20% of output The majority of low-productivity countries have investment shares below 20% However, differences in the capital-labor ratio can explain not more than half of the differences in output per worker There is an unexplained growth residual: “labor efficiency” 10 Goethe Business School The decomposition of growth Coverage GDP growth rate Capital share Labor share Labor Efficiency share United States 1948-90 3.1 24 28 49 United Kingdom 1957-90 2.5 35 4 61 Germany 1960-90 3.2 36 -7 71 France 1957-90 3.7 33 -1 69 Japan 1957-90 6.7 49 6 46 South Korea 1960-90 8.6 67 19 14 Source: Kim, Jong-Il and Lawrence J. Lau, Journal of the Japanese and International Economies (Sept. 1994) 11 Goethe Business School Efficiency of labor We include the residual, “efficiency of labor”, into the production function log(Y/L) = .25 log(K/L) + .75 log(E) We are now obligated to produce some analysis of what determines E Some plausible factors include: education per worker knowledge economic, political, and social systems 12 Goethe Business School Growth and education 13 Goethe Business School Efficiency of labor Education is reasonably “measurable”, but does, again, not explain E in full Knowledge falls into two categories: Knowledge in the public domain Proprietary knowledge Monopolized proprietary knowledge Shared proprietary knowledge Because most knowledge is public, it does not explain variations in E across countries Monopolized proprietary knowledge is often shared, so again it cannot explain E in full 14 Goethe Business School Growth and institutional environment When we attempt to explain differences in the efficiency of labor in different countries, we are inevitably forced to focus on differences in economic, political, and social systems 15 Goethe Business School Example: Liberian kleptocracy in 1998 After the civil war, president Taylor installs what it typical for many African countries: “State” monopolies (diamonds, petroleum products, cement, rice imports) Price controls (caps on prices shift taxes and market risks solely onto the producer) Arbitrary “charges” with extortionist character (i.e. large scale and petty corruption) Regulatory measures impeding market activities (licensing of business activities, exporting, etc.) There is no rule of law, fiscal responsibility, protection of private property, etc. 16 Goethe Business School Institutional convergence? The differences in economic, political, and social systems are enormous explaining much of the differences in growth rates Many countries are still working on improving governance and management techniques as regards both institutions and processes Globalization generally supports this through Institutional and regulatory competition Dissemination of “good practices” Conditionality of international lenders 17 Goethe Business School Reading Reading 5-1 (Optional) “A global war against bribery” The Economist, January 14th 1999 18 Goethe Business School Growth models An influential growth model was proposed by Robert Solow The basic idea was to link per capita GDP to per capita capital, and labor efficiency: 0.25 GDP K K f , E A Pop Pop Pop (The third term, A(.), is just a specific formulation of f[.]) Robert M. Solow * 1924. Nobel prize 1987 19 Goethe Business School Capital accumulation and saving Solow would link the net accumulation of capital (= gross investment minus depreciation) to saving K = Inet = S, all on a per capita basis This renders the growth pace dependable, apart from the production function, on the accumulation of capital, and hence on saving This has a number of consequences: 20 Goethe Business School Solow model: interpretations 1. For countries with similar technology (production function) and similar capital stock per worker ratios, income levels per capita should be similar 2. Differences in labor efficiency might matter in the short run, but in the long run they should disappear due to the general availability of knowhow (convergence thesis) 21 Goethe Business School Do real wages converge? Table 5-4 Real Hourly Wage in Manufacturing in Leading Industrial Countries as a Percentage of the U.S. Wage Country 1959 1970 1983 1996 Japan Italy France United Kingdom Germany Canada 11 23 27 29 29 42 24 42 41 35 56 57 51 62 62 53 84 75 106 103 98 95 131 102 Unweighted Avg. 27 43 63 106 100 100 100 100 United States Source: Salvatore, International Economics, Prentice Hall 22 Goethe Business School Convergence in the EU? 23 Goethe Business School Solow model: more interpretations 4. Countries with a high savings rate might enjoy higher investment and economic growth 5. Countries with easier access to world savings may experience higher growth by “crowding out” others 6. Countries with high population growth may see incomes per capita falling 7. There may be other “asymmetries” in a globalizing world 24 Goethe Business School Population growth Source: Worldbank Globalization has a severe impact on population growth Global access to medical progress has led to uneven demographic developments Productivity growth could be “eaten up” by population growth 25 Goethe Business School Uneven population growth Source: Worldbank Population growth is also very unevenly distributed between industrialized and developing regions There are further important imbalances in the labor market 26 Goethe Business School Imbalances in the labor market Flagrant or pending civil wars, kleptocratic government, “warlords”, corruption, etc. Exclusions from the labor market (gender, social status, ethnicity, etc.) Disparity in human rights, social protection, and labor standards Differences in environmental protection Exclusion from education, professional training, and know how 27 Goethe Business School Savings In the United States, the growth of productive capacity roughly equals 2% to 2.5% a year In contrast, many of the Asian Tigers enjoy average annual increases in growth of double, triple, or even greater amounts than seen in the United States The partial answer could be saving 28 Goethe Business School Saving rates Economist 29 Goethe Business School Reading Reading 5-2 “The economics of saving The shift away from thrift” The Economist, April 7th 2005 30 Goethe Business School Reading: Recession in the US and household saving Reading 5-3 „The long hangover“, The Economist, April 10th 2008 31 Goethe Business School More on convergence According to the convergence thesis, incomes per capita would be similar over the longer run It results from the assumption that the marginal product of capital falls, so more “mature” economies would be constrained more heavily than emerging economies 32 Goethe Business School Static production function GDP/Pop f(K/Pop) Emerging Mature economies K/Pop 33 Goethe Business School Tendencies in world economic growth 6,0 Rate of increase of GDP 5,0 Developing countries 4,0 3,0 2002 2003 2004 20052006 OECD 1.4 2.0 3.1 2.6 2.5 Developing 3.4 4.8 5.4 5.2 5.0 East Asia 6.7 7.7 7.4 6.7 6.3 PECO 4.6 5.5 4.9 4.8 4.7 Latin America -0.6 1.3 3.8 3.7 3.5 Middle East & North Africa 3.3 5.1 3.7 3.9 4.0 South Asia 4.3 6.5 7.2 6.7 6.5 Subsaharan Africa 3.3 2.4 3.4 4.2 3.9 2,0 1,0 OECD 0,0 2002 2003 2004 2005 2006 Source: Worldbank 34 Goethe Business School Puzzles of the Solow model Puzzle 1: Income per capita varies too much across countries to be explained by neoclassical theory. Obviously, all countries do not have the same production function. Puzzle 2: Poor countries do not have a higher rate of return on capital. Again, poor countries do not operate on the same production function as rich countries. Puzzle 3: Convergence of income is not occurring among ‘rich’ versus ‘poor’ countries or even within regions in the same country. Convergence occurs among regions in the same ‘club’, but not among regions outside the ‘club’. 35 Goethe Business School Globalization: Is Solow nonetheless right? The puzzles that critics of the Solow model put forward appear to evaporate under the impact of globalization The situation of developing countries has remarkably improved over the last decade Market integration, trade, improved terms of trade, the spread of knowledge, and capital flows were the driving force of positive developments 36 Goethe Business School Per capita growth (percentages, 1998-2003) 1.800 1638 Population moyenne (millions) 1998-2003 1.600 1428 1.400 1.200 1.000 800 605 600 400 446 381 325 200 0 Number of countries Falling (16) 0 and 1% (8) 1% and 2% (16) 2% and 3% (16) Growth rate per capita (%), 1998-2003 3% and 4% (14) More than 4% (14) Source: Worldbank 37 Goethe Business School Reading Abel, Bernanke and Croushore, Chapter 6 38 Goethe Business School Globalization and development The World Bank’s Development Report illustrates the large improvements in developing countries over the course of the 1990’s About 3.5 billion people (70% of the population of developing countries) live in 44 countries (including China and India) that have seen incomes per capita rise 2% per year, or faster In the 19th century – a period of massive industrial transformation and advance in living standards -, per capita incomes in Europe are estimated to have risen at just 1% per year on average 39 Goethe Business School Catching up ! Therefore underdeveloped countries could eventually catch up to developed countries Chances are maximized when there is high domestic savings and the government promotes free-market policies open and competitive markets foreign trade liberalization investment in education (human capital) and infrastructure (physical capital) the maintenance of property rights a smaller public or government sector, and low taxes 40 Goethe Business School But there are “laggards” All of the 16 countries where incomes fell have suffered one or more severe adverse shocks, including civil war, political instability, financial crisis, droughts, terms of trade deterioration, or governance issues The “political environment” in these countries is typically hostile to market forces, openness, civil rights, citizens’ participation, education, etc Unfortunately some of these factors continue to haunt these countries and their citizens 41 Goethe Business School Strategic aspects of growth The Solow model does not include dynamic labor efficiency gains through Dynamic technology “leads” Capital embedded technical progress There is a continuous drive to “lead” sector developments through innovation Technical progress may also be embedded in capital and be proprietary for some time Such elements play an important role in prevailing “growth strategies” of some major industrialized countries 42 Goethe Business School R&D of industrialized countries Source: Worldbank 43 Goethe Business School Dynamic growth factors and cultural obstacles Mastering expertise requires education and professional training, which will take time Not only in developing countries, the content of education often clashes with traditional paradigms, social values, religion, ethics This, and other factors, could contribute to uneven developments of the globalizing economy, not so much the market itself 44 Goethe Business School