Sources of Economic Growth Thorvaldur Gylfason Tunis February

Sources of Economic Growth Thorvaldur Gylfason Tunis, February 2006

Outline I. II. Pictures of growth Determinants of growth 1. 2. Saving and investment Efficiency a) b) c) d) e) f) Liberalization Stabilization Privatization Education Diversification Institutions III. Empirical evidence of growth

National economic output Economic growth: The short run vs. the long run Economic growth in the long run Potential output Actual output Upswing Business cycles in the short run Downswing Time

Economic growth: The short run vs. the long run To analyze the movements of actual output from year to year, viz. , in the short run Need short-run macroeconomic theory Keynesian or neoclassical To analyze the path of potential output over long periods Need modern theory of economic growth Neoclassical or endogenous

National economic output Growing together, growing apart West-Germany : East-Germany Austria : Czech Republic Economic system Finland : Estonia Taiwan : China South Korea : North Korea Rapid growth Botswana : Nigeria Kenya : Tanzania Thailand : Burma Economic policy? Tunisia : Morocco Spain : Argentina Mauritius : Madagascar Slow growth Time

Growing apart China – Europe: 1: 1 in 1400 1: 20 in 1989 Case B: 2% a year Output per capita Aspects of efficiency ü Economic system ü Economic policy Threefold difference after 60 years Case A: 0. 4% a year 0 60 Years

Sources of growth: Investment and education + + denotes a positive effect in the direction shown +

Sources of growth: Investment and education Adam Smith knew this, and more, as did Arthur Lewis Solow raised doubts on longrun linkages + + denotes a positive effect in the direction shown +

More sources of growth Arthur Lewis: x is trade, stable politics, good weather But Solow carried the day: long-run growth is exogenous! + + + denotes a positive effect in the direction shown +

More sources of growth Suppose our x is openness to trade; then … + + + denotes a positive effect in the direction shown +

The Neoclassical Theory of Exogenous Economic Growth Traces the rate of growth of output per capita to a single source: Technological progress Hence, economic growth in the long run is immune to economic policy, good or bad “To change the rate of growth of real output per head you have to change the rate of technical progress. ” ROBERT M. SOLOW

The New Theory of Endogenous Economic Growth Traces the rate of growth of output per capita to three main sources: Saving Efficiency Depreciation “The proximate causes of economic growth are the effort to economize, the accumulation of knowledge, and the accumulation of capital. ” W. ARTHUR LEWIS

Endogenous Growth in the Harrod-Domar Model You may recognize the endogenous growth model as a reinterpretation of the Harrod-Domar model where growth depends on A. the saving rate B. the capital/output ratio C. the depreciation rate

A Simple Model of Endogenous Growth Four building blocks n S=I Saving equals investment in equilibrium n S = s. Y Saving is proportional to income n I = K + K Investment involves addition to capital stock n Y = EK Output depends on quality and quantity of capital

A Simple Model of Endogenous Growth Let’s do the arithmetic: S = s. Y = I = K + K = Y/E + Y/E Rearranging terms we find Y/E = s. Y - Y/E Multiplying by E and dividing by Y gives Y/Y = s. E -

A Simple Model of Endogenous Growth Bottom line n g = s. E - Rate of economic growth equals n Saving rate times n Efficiency (i. e. , the output/capital ratio) minus n Depreciation

What this means Three implications for growth Saving is good for gro Efficiency helps growth Depreciation hurts gro

Case 1 Botswana and Nigeria: GDP per capita 1960 -2002 (1995 USD) Botswana 6. 3% (1. 061)42 = 12. 0 Nedadi Usman, ister: Nigeria’s economy min Oil has made us lazy Nigeria 0. 2%

Case 2 Spain and Argentina: GDP per capita 1960 -2002 (1995 USD) Spain 3. 3% Argentina 0. 6% (1. 027)42 = 3. 1

Case 3 Madagascar and Mauritius: GDP per capita 1960 -2002 (1995 USD) Mauritius 4. 4% (1. 058)42 = 10. 7 Madagascar -1. 4%

A Tale of Two Countries Country A Country B

A Tale of Two Countries Girls at primary school Country A Country B 100% 72%

A Tale of Two Countries Girls at primary school Investment ratio Country A Country B 100% 72% 25% 11%

A Tale of Two Countries Country A Country B 100% 72% Investment ratio 25% 11% Export ratio 58% 23% Girls at primary school

A Tale of Two Countries Country A Country B 100% 72% Investment ratio 25% 11% Export ratio 58% 23% Primary export ratio 33% 80% Girls at primary school

A Tale of Two Countries Country A Country B 100% 72% Investment ratio 25% 11% Export ratio 58% 23% Primary export ratio 33% 80% Inflation 10% 18% Girls at primary school

A Tale of Two Countries Country A Country B 100% 72% Investment ratio 25% 11% Export ratio 58% 23% Primary export ratio 33% 80% Inflation 10% 18% Growth per capita 1960 -2002 4. 4% -1. 4% Girls at primary school

A Tale of Two Countries And the countries are: Mauritius Madagascar Girls at primary school 100% 72% Investment ratio 25% 11% Export ratio 58% 23% Primary export ratio 33% 80% Inflation 10% 18% Growth per capita 1960 -2002 4. 4% -1. 4%

Case 3 Madagascar and Mauritius: GDP per capita 1960 -2002 (1995 USD) Mauritius 4. 4% (1. 058)42 = 10. 7 Madagascar -1. 4%

Exogenous vs. endogenous growth The neoclassical view that economic growth in the long run is merely a matter of technology does not throw much light on the impressive growth performance of Asia since the 1960 s, or on growth differentials The new view that long-run growth depends on saving and efficiency is more illuminating Besides, it’s not really new, because Adam Smith knew this (1776)

One crucial implication of exogenous growth The neoclassical view If two countries are identical (same saving rate, same population growth, same technology), then their income per head will ultimately be the same This means that poor countries must grow faster than – catch up with! – rich countries: “conditional convergence” Endogenous growth theory does not have this implication

Enter initial income Conditional convergence + – + ? + + – denotes a positive effect in the direction shown denotes a negative effect in the direction shown

Do poor countries catch up? Absolute convergence? Botswana China Indonesia No sign that poor countries grow faster than rich 85 countries r = rank correlation r = -0. 09 Korea Thailand Nicaragua Conditional convergence does not entail absolute convergence

Absolute convergence: Growth rates 165 countries

Sources of endogenous growth I Saving Fits real world experience quite well No coincidence that, in East Asia, saving rates of 3040% of GDP went along with rapid economic growth No coincidence either that many African economies with saving rates around 10% of GDP have been stagnant OECD countries: saving rates of about 20% of GDP Important implication for economic policy: Economic stability with low inflation and positive real interest rates spurs saving, which is good for growth

What is the empirical evidence? Investment and economic growth r = 0. 65 Quantity and quality Botswana China Thailand 4% Niger 85 countries Nicaragua 1% Jordan An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year

Sources of endogenous growth II Efficiency Also fits real world experience quite well Technical progress is good for growth because it allows us to squeeze more output of given inputs And that is exactly what increased efficiency is all about! Thus, technology is best viewed as an aspect of general economic efficiency Important implication for economic policy: Everything that increases economic efficiency, no matter what, is also good for growth

Sources of endogenous growth II Sources of increased efficiency 1. Liberalization of prices and trade increases efficiency, which is good for growth 2. Stabilization reduces the inefficiency associated with inflation, which is good for growth 3. Privatization reduces the inefficiency associated with state-owned enterprises, which … 4. Education makes the labor force more efficient 5. Technological progress also enhances efficiency The possibilities are virtually endless!

Sources of endogenous growth II This is good news If growth were merely a matter of technology, we would not be able to do much about it … … except to follow technology-friendly policies by supporting R&D and such But if growth depends on saving and efficiency, there are things that we can do, in the private sector as well as through the public sector, to foster rapid economic growth Because everything that is good for saving and efficiency is also good for growth

What to do to encourage economic growth Maintain strong incentives to save Keep inflation low and real interest rates positive Maintain financial system in good health p a c e R so as to channel saving into high-quality investment Foster efficiency 1. Liberal price and trade regimes 2. Low inflation 3. Strong private sector 4. More and better education 5. Limited, or well managed, natural resources 6. Social justice: equality 7. Sound institutions: democracy

1 Liberalization and economic growth Liberalization of prices means that markets, not bureaucrats, are allowed to set prices Mixed market economy is more efficient than central planning üCompare former Soviet Union with the US and Europe Liberalization of trade allows specialization according to comparative advantage Free trade is more efficient than self-sufficiency üNorth Korea and Cuba vs. South Korea and Singapore Applies to trade in goods, services, capital

Darkness in North-Korea China Japan

What is the empirical evidence? Exports and growth 1965 -98 r = 0. 33 87 countries by An increase in exports ted 20% of GDP is associa r with an increase in pe er capita growth by 1% p year

2 Stabilization and economic growth Stabilization of prices means that distortions associated with inflation are reduced ü Inflation distorts the choice between real and financial capital by punishing money holdings, and thus creates inefficiency in production ü Inflation thus involves a tax, the inflation tax üAn inefficient tax compared with most other taxes ü Inflation also creates uncertainly which tends to discourage trade and investment ü Inflation also tends to result in overvaluation of currency, thus hurting exports and growth

What is the empirical evidence? Stabilization and economic growth: Regression results Inflation distortion = Model 1 Inflation distortion -2. 51 Natural resources Initial income Investment Secondary education Population growth Adj. R 2 (2. 07) + ) /(1+ th Inflation impedes grow 0. 04 Note: 87 countries, method is OLS, t-statistics are shown in parentheses.

Stabilization and economic growth: Regression results Model 1 Model 2 Inflation distortion -2. 51 (2. 07) -2. 46 (2. 37) Natural resources -0. 09 Initial income Investment Secondary education Population growth 0. 04 0. 30 Adj. R 2 (5. 75) Natural resource curse

Stabilization and economic growth: Regression results Model 1 Model 2 Model 3 Inflation distortion -2. 51 (2. 07) -2. 46 (2. 37) -2. 26 (2. 25) Natural resources -0. 09 (5. 75) -0. 10 (6. 52) Initial income -0. 45 Investment Secondary education Population growth 0. 04 0. 30 0. 35 Adj. R 2 (2. 67) Convergence

Stabilization and economic growth: Regression results Model 1 Model 2 Model 3 Model 4 Inflation distortion -2. 51 (2. 07) -2. 46 (2. 37) -2. 26 (2. 25) -1. 95 (2. 25) Natural resources -0. 09 (5. 75) -0. 10 (6. 52) -0. 07 (5. 01) Initial income -0. 45 (2. 67) -0. 45 (3. 05) Investment 0. 15 (5. 41) d for growth o o g is t n e Investm Secondary education Population growth 0. 04 0. 30 0. 35 0. 51 Adj. R 2

Stabilization and economic growth: Regression results Model 1 Model 2 Model 3 Model 4 Model 5 Inflation distortion -2. 51 (2. 07) -2. 46 (2. 37) -2. 26 (2. 25) -1. 95 (2. 25) -1. 97 (2. 49) Natural resources -0. 09 (5. 75) -0. 10 (6. 52) -0. 07 (5. 01) -0. 04 (2. 93) Initial income -0. 45 (2. 67) -0. 45 (3. 05) -1. 10 (5. 39) Investment 0. 15 (5. 41) 0. 09 (3. 36) Secondary education 1. 24 Population growth Adj. R 2 th Education boosts grow (4. 24) 0. 04 0. 30 0. 35 0. 51 0. 60

Stabilization and economic growth: Regression results Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Inflation distortion -2. 51 (2. 07) -2. 46 (2. 37) -2. 26 (2. 25) -1. 95 (2. 25) -1. 97 (2. 49) -1. 61 (2. 14) Natural resources -0. 09 (5. 75) -0. 10 (6. 52) -0. 07 (5. 01) -0. 04 (2. 93) -0. 04 (2. 49) Initial income -0. 45 (2. 67) -0. 45 (3. 05) -1. 10 (5. 39) -1. 27 (6. 42) Investment 0. 15 (5. 41) 0. 09 (3. 36) 0. 10 (3. 74) Secondary education* 1. 24 (4. 24) 1. 07 (3. 82) Population growth -0. 56 Adj. R 2 0. 04 0. 30 Population drag 0. 35 0. 51 0. 60 (3. 42) 0. 64 * An increase in secondary-school enrolment by a third increases growth by 1%.

3 Privatization and economic growth Privatization means that profit-oriented owners and able managers are allowed to direct enterprises Profit motive replaces political considerations as the guiding principle of business operations Profit-maximizing owners generally want to appoint managers and staff on merit rather than on the basis of political connections, for example Private enterprise is generally more efficient than state-owned enterprises

State-owned enterprises and economic growth r = -0. 35 38 countries

4 Education, health, and economic growth Education means a better trained and hence more efficient work force ü Need to provide primary and secondary education to all, especially females ü Need to provide tertiary education to a greatly increased number of people ü Need increased public commitment to education ü This requires both increased public expenditure on education and probably also increased scope for private sector involvement in education

Same story time and again Free trade is good for growth Reduces the inefficiency that results from restrictions on trade Price stability is good for growth Reduces inefficiency resulting from inflation Privatization is good for growth Reduces inefficiency resulting from SOEs Education is good for growth Reduces the inefficiency that results from inadequate education

What is the empirical evidence? Growth and education, 1965 -98 r = 0. 72 Thailand g Positive but decreasin returns to education Finland New Zealand Jamaica ary-school An increase in second each cohort enrolment by 25% of ease in per goes along with an incr er year capita growth by 1% p 87 countries

Birth care and growth Medical care is good for growth, even if the effects of education as well as ial income on it in r = 0. 50 growth are also taken into account Medical care is good for growth and vice versa 157 countries

Life expectancy Medical care is good and growth for growth r = 0. 60 Long lives are good for growth and vice versa Here, causation runs from life expectancy to growth 147 countries

Health expenditure and economic growth in r = 0. 42 An increase in health expenditure by 2. 5% of GDP goes along with an increase in growth per capita by 1% per year Health expenditure is good for growth and vice versa: Same story 163 countries

5 Natural resources and economic growth Natural resources, if not well managed, may turn out to be, at best, a mixed blessing Four possible channels ü ü Dutch disease (foreign capital) Rent seeking (social capital) Education (human capital) Investment (real capital)

Recent literature Four main linkages, again 1. Dutch disease q Hurts level or composition of exports and FDI 2. Rent seeking q Protectionism, corruption, oppression 3. Education q False sense of security q Poor quality of policies and institutions 4. Investment

Enter natural resources Dutch disease Rent seeking + – ? – – + + – Natural resource abundance hurts investment and education, and hence also growth

What is the empirical evidence? Natural capital and economic growth Australia Venezuela r = -0. 64 85 countries ral An increase in the natu oes capital share by 8% g in along with a decrease % per capita growth by 1 per year

6 Inequality and economic growth One more thing Two views: 1. Inequality is good for growth ü Too much equality weakens incentives to work, save, and acquire an education 2. Inequality is bad for growth ü Too much inequality reduces social cohesion and creates conflict What is the empirical evidence?

Growth and inequality, 1965 -98 x by 12 e d in i in G in se a e cr in An a points goes along with growth decrease in per capita r Korea by almost 1% per yea China France Norway Thailand Lesotho Brazil Sweden r = -0. 50 75 countries South Africa Central African Republic Sierra Leone Equality is good for growth: No visible sign that equality stands in the way of economic growth

7 Democracy and economic growth Institutions Two views: 1. Democracy is good for growth ü ü Facilitates change of government Makes it easier to replace bad governments with better ones 2. Democracy is bad for growth ü Too much democracy interferes with farsighted policy making by playing into the hands of pressure groups and such What is the empirical evidence?

1990: When the world changed Democracy Oligocracy Dictatorship

Growth and political liberties, 1965 -98 UK = 1 India = 2 Botswana = 2 Brazil Botswana Korea China An increase in the political liberties index by 2 points goes along with an increase in per capita growth by over 1% per year Venezuela r = -0. 62 85 countries Central African Niger. Republic Democracy is good for growth: No visible sign that democracy stands in the way of economic growth

What is the upshot? Economic growth responds to public policy In particular, by encouraging üsaving and investment of high quality üforeign trade and investment üeducation üeconomic diversification üsound institutions . . . the government can help foster rapid economic growth

Sir Arthur Lewis got it right Since the second world war it has become quite clear that rapid economic growth is available to those countries with adequate natural resources which make the effort to achieve it. W. ARTHUR LEWIS (Accra, 1968)

What else? These lessons are borne out by experience from around the world Additional lessons: Too much SOE activity hurts the quality of investment and education — and growth Too much agriculture and, more generally, natural resource dependence, if not well managed, hurts education, investment, and trade — and thereby also growth Too rapid population growth also tends to impede economic growth

Reservations Even so, the question of rapid growth is, of course, a bit more complicated We also need to address a host of political, social, and cultural questions as well as questions of natural conditions, climate, and public health — which would take us too far afield But the main point remains: ü To grow or not to grow is in large measure a matter of choice ü Many of the constraints on growth are manmade, and can be removed

Conclusion: It can be done These slides – and more! – can be viewed on my website: www. hi. is/~gylfason To grow or not to grow is in large measure a matter of choice d n E The