2. To Grow or Not to Grow: That is the Question Thorvaldur Gylfason

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

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

5. 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

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

7. Growing apart Years Output per capita Case B: 2% a year Case A: 0.4% a year Efficiency Efficiency Economic system Economic system Economic policy Economic policy Threefold difference after 60 years 0 60

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

9. ++ + Adam Smith knew this, and more, as did Arthur Lewis Sources of growth: Investment and education Solow raised doubts on long- run linkages

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

11. 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

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

13. Botswana and Nigeria: GNP per capita 1964-99 Case 1 Current US$, Atlas method

14. Burma and Thailand: GNP per capita 1960-97 Case 2 Local currency, 1988 prices, 1960 = 100

15. Argentina and Spain: GNP per capita 1964-99 Case 3 Current US$, Atlas method

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

17. Ireland and Greece: Ireland and Greece: GNP per capita 1964-99 Case 5 Why? Current US$, Atlas method

18. Investment is good for growth, but hardly explains the growth differential between Ireland and Greece Ireland and Greece: Ireland and Greece: Investment 1960-99 (% of GDP)

19. Education is good for growth Ireland and Greece: Ireland and Greece: Expenditure on education 1960-96 (% of GNP)

20. Foreign trade is good for growth Ireland and Greece: Ireland and Greece: Exports 1960-99 (% of GNP)

21. Country A Country B A Tale of Two Countries

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

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

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

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

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

27. Country A Country B 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 3%-2% A Tale of Two Countries

28. And the countries are: MauritiusMadagascar Girls at primary school 100%72% Investment ratio 25%11% Export ratio 58%23% Primary export ratio 33%80% Inflation 10%18% Growth 3%-2% A Tale of Two Countries

29. Madagascar and Mauritius: GNP per capita 1964-99 Case 4 Current US$, Atlas method

30. 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 spectacular growth performance of Asia since the 1960s The new view that long-run growth depends on saving, efficiency, and depreciation is more illuminating Besides, it’s not really new, because Adam Smith knew this (1776)

31. 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

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

33. Absolute convergence? Do poor countries catch up? r = -0.09 Botswana China Korea Nicaragua Thailand Indonesia No sign that poor countries grow faster than rich 85 countries r = rank correlation Conditional convergence does not entail absolute convergence

34. Sources of endogenous growth I Saving Fits real world experience quite well No coincidence that, in East Asia, saving rates of 30- 40% 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

35. Sources of endogenous growth I 100 400 300 200 1965 1990 East Asia OECD Africa High saving rates Medium saving rates Low saving rates Income per capita

36. Investment and economic growth r = 0.65 Jordan Botswana Nicaragua 85 countries An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year 4% 1% Thailand

37. 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 out of given inputs And that is exactly what increased efficiency is all about! Thus, technology is best viewed as an aspect of general economic efficiency Important implication for economic policy: Everything that increases economic efficiency, no matter what, is also good for growth

38. Sources of endogenous growth II Five sources of increased efficiency Five 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!

39. 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

40. What to do to encourage economic growth Recap Maintain strong incentives to save Keep inflation low and real interest rates positive Maintain financial system in good health 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. Reasonable equality

41. 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 Compare former Soviet Union with the US and Europe Compare 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 North Korea and Cuba vs. Hong Kong and Singapore North Korea and Cuba vs. Hong Kong and Singapore Applies to trade in goods, services, capital 1

42. Openness to trade and growth 1965-98 87 countries An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year r = 0.40

43. Openness to FDI and growth 1965-98 Botswana An increase in openness to FDI by 2% of GDP is associated with an increase in per capita growth by more than 1% per year r = 0.62 85 countries

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

45. 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 3

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

47. 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

48. Same story time and again Can describe this by simple arithmetic The efficiency gain from eliminating an economic distortion (trade restrictions, inflation, unnecessary state intervention, insufficient education) is directly proportional to the square of the distortion: E = mc 2 E stands for efficiency gain, m is a multiplicative constant, and c is the distortion

49. E = mc 2 If the distortion is substantial (severe trade restrictions, high inflation, big SOE sector, poor education), then reducing or eliminating the distortion can increase efficiency and growth a great deal We can see this by plugging appropriate numbers into the formula and also by econometric research, where the theory is compared with experience (i.e., economic statistics)

50. Growth and education, 1965-98 Positive but decreasing returns to education An increase in secondary-school enrolment by 25% of each cohort goes along with an increase in per capita growth by 1% per year r = 0.72 87 countries

51. Natural resources and economic growth Natural resources, if not well managed, may turn out to be, at best, a mixed blessing Four possible channels Dutch disease Dutch disease Rent seeking Rent seeking Education Education Investment Investment What is the evidence? 5

52. Recent literature Four main linkages: 1.Dutch disease Hurts level or composition of exports 2.Rent seeking Protectionism, corruption 3.Education 4.False sense of security Poor quality of policies and institutions 5. Investment But Norway is, so far at least, an exception Foreign capital Social capital Human capital Real capital Natural capital tends to crowd out

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

54. Natural capital and economic growth What is the empirical evidence? r = rank correlation An increase in the natural capital share by 8% goes along with a decrease in per capita growth by 1% per year r = -0.64 8 African countries S/Y = 0.05 8 Asian countries S/Y = 0.32 Notice two clusters A new measure of natural resource abundance A new measure of natural resource abundance Confirms results based on other measures Confirms results based on other measures Venezuela Australia 85 countries

55. Secondary-school enrolment and natural capital r = -0.66 Finnland Niger Vietnam Uruguay An increase in natural capital by 5% of national wealth goes along with a reduction in secondary-school enrolment by almost 10% of each cohort 91 countries Congo Increased natural resource abundance hurts education and growth

56. Natural capital and investment An increase in the natural capital share by 10% is associated with a decrease in investment by 2% of GDP r = -0.38 Congo Sierra Leone Mali 85 countries

57. Natural resources and corruption Abundant natural resources appear to go along with corruption 45 countries

58. 6 Inequality and economic growth Two views: 1.Inequality is good for growth Too much equality weakens incentives to work, save, and acquire an education Too much equality weakens incentives to work, save, and acquire an education 2.Inequality is bad for growth Too much inequality reduces social cohesion and creates conflict Too much inequality reduces social cohesion and creates conflict What is the empirical evidence?

59. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Gini coefficient: An index of inequality

60. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Gini coefficient and the 20/20 ratio Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio

61. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio Gini coefficient and the 20/20 ratio

62. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio Gini coefficient and the 20/20 ratio

63. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio Gini coefficient and the 20/20 ratio

64. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio Gini coefficient and the 20/20 ratio

65. An increase in Gini index by 12 points goes along with a decrease in per capita growth by almost 1% per year r = -0.50 Growth and inequality, 1965-98 What do the data say? Sweden Thailand Central African Republic South Africa France Brazil No discernible sign that equality stands in the way of economic growth Korea 75 countries Lesotho

66. Inequality and natural resource abundance An increase in natural capital by 3% of national wealth goes along with an increase in Gini index by 1 point 7 African countries where saving is 5% of GDP and per capita growth is -1% per year Notice cluster Increased natural resource abundance increases inequality and reduces growth Rwanda Mauritania Norway Bangladesh r = 0.41 75 countries

67. What is the upshot? Economic growth responds to public policy In particular, by encouraging saving and investment of high quality saving and investment of high quality foreign trade and investment foreign trade and investment education education economic diversification economic diversification and perhaps also equality and perhaps also equality... the government can help foster rapid economic growth

68. 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 (1968)

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

70. 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 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: To grow or not to grow is in large measure a matter of choice To grow or not to grow is in large measure a matter of choice Many of the constraints on growth are man- made, and can be removed Many of the constraints on growth are man- made, and can be removed

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