Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 18 Policies and Prospects for Global Economic Growth

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Introduction Some governments have sought to promote economic growth by providing funds to help entrepreneurs open new businesses. Many observers, however, question whether government officials are better able than private investors to identify entrepreneurial ideas worthy of funding. This chapter will help you understand the basis of this criticism.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Learning Objectives Explain why population growth can have uncertain effects on economic growth Understand why the existence of dead capital retards investment and economic growth in much of the developing world Describe how government inefficiencies have contributed to the creation of relatively large quantities of dead capital in the world’s developing nations

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Learning Objectives (cont'd) Discuss the sources of international investment funds for developing nations and identify obstacles to international investment in these nations Identify the key functions of the World Bank and the International Monetary Fund Explain the basis for recent criticisms of policymaking at the World Bank and the International Monetary Fund

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Chapter Outline Labor Resources and Economic Growth Capital Goods and Economic Growth Private International Financial Flows as a Source of Global Growth International Institutions and Policies for Global Growth

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Did You Know That... In Zimbabwe, the cost of registering business property to meet the legal requirements for operating a business is nearly 25 percent of the value of that property, as compared to 0.5 percent for the United States? These figures help economists understand the determinants of global economic growth—the topic of this chapter.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Labor Resources and Economic Growth Population growth does not necessarily translate into an increase in labor resources In poor areas, many people do not join the labor force, or they may remain unemployed for long periods

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Labor Resources and Economic Growth (cont'd) We can express the growth rate of per capita real GDP in a nation as the difference between the rate of growth in real GDP and the population growth rate: –Example: If real GDP grows at a rate of 4% per year and population growth increases from 2 to 3%, then per capita real GDP will decline, from 2% to 1% Ratio of growth of per capita real GDP rate of growth in real GDP rate of growth of population =–

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Labor Resources and Economic Growth (cont'd) The arithmetic of the relationship between economic growth and population growth can be misleading Population growth can affect the growth rate of real GDP (e.g., with higher labor force participation rate) Whether population growth hinders or contributes to economic growth depends on where you live

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Table 18-1 Population Growth and Growth in Per Capita Real GDP in Selected Nations Since 1970

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Labor Resources and Economic Growth (cont'd) The role of economic freedom –A crucial factor influencing economic growth is the relative freedom of a nation’s residents –Only 17 nations, with 17% of the world’s people, grant their residents high degrees of economic freedom

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Policy Example: Freedom of Information and Growth in Developing Nations The Indian government requires farmers to sell soybeans to middlemen who in turn resell the beans in wholesale markets. The middlemen used to have an advantage in price negotiations because they had up-to-the- minute data about wholesale soybean prices. Today, farmers can obtain current wholesale soybean prices through a wholesale buyer’s network of Internet kiosks. This information has enable farmers to bargain for better prices on their corps. The resulting higher farmer profits have led to increases in the supply and consumption of soybean in India.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Labor Resources and Economic Growth (cont'd) Economic Freedom –The rights to own private property and to exchange goods, services, and financial assets with minimal government interference

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Labor Resources and Economic Growth (cont'd) The role of political freedom –Political freedom: the right to openly support and democratically select national leaders –Economic freedom tends to stimulate economic growth, which then leads to more political freedom

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Labor Resources and Economic Growth (cont'd) Question –Why do you suppose that per capita real GDP appears to be related to the extent to which the rule of law prevails?

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Capital Goods and Economic Growth A fundamental problem developing countries face is that a significant portion of their capital goods, or manufactured resources that may be used to produce other items in the future, is what economists call dead capital

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Capital Goods and Economic Growth (cont'd) Dead Capital –Any capital resource that lacks clear title of ownership –A resource that people cannot readily allocate to its most efficient use –Is among the most significant impediments to growth in poor nations

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Capital Goods and Economic Growth (cont'd) Dead capital and inefficient production –Nontransferable physical structures are valued at more than $9 trillion in developing nations Dead capital and economic growth –Disincentives to invest in new capital goods can greatly hinder economic growth

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Capital Goods and Economic Growth (cont'd) Government inefficiencies, investment, and growth –Governments in many of the world’s poorest nations place tremendous obstacles in the way of entrepreneurs –These entrepreneurs are interested in owning capital goods and directing them to profitable opportunities

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Capital Goods and Economic Growth (cont'd) Government inefficiencies, investment, and growth –In a nation with a stifling government bureaucracy regulating the uses of capital goods, newly created capital will all too likely become dead capital –Thus, government inefficiency can be a major barrier to economic growth

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 18-1 Bureaucratic Inefficiency and Economic Growth

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Capital Goods and Economic Growth (cont’d) Access to credit matters –2006 Nobel Peace Prize winner Muhammad Yunus of Bangladesh contends that access to private credit is vital for promoting economic growth in poverty-stricken countries –Microlenders are banking institutions that specialize in making very small loans to entrepreneurs trying to lift themselves from poverty

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 18-2 The Ratio of Private Credit to GDP in Selected Nations

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth Question –Given the large volume of inefficiently employed capital goods in developing nations, what can be done to promote greater global growth?

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth (cont'd) Answers –One approach is to rely on private markets –Another is to entrust the world’s governments

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth (cont'd) Private investment in developing nations –Each year since 1995, at least $150 billion in private funds have flowed to developing nations in the form of purchases of bonds or stock –Nearly all funds that flow into developing countries due so to finance investment projects in those nations

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth (cont'd) Economists group international flows of investment funds into three categories 1.Loans from banks and other sources 2.Portfolio investment 3.Foreign direct investment

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth (cont'd) Portfolio Investment –The purchase of less than 10% of the shares of ownership in a company in another nation Foreign Direct Investment –The acquisition of more than 10% of the shares of ownership in a company in another nation

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 18-3 Sources of International Investment Funds

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth (cont'd) Obstacles to international investment –Markets for loans, bonds, and stocks in developing countries susceptible to problems relating to asymmetric information

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth (cont'd) Asymmetric information as a barrier to financing global growth –Adverse selection problems arise –Moral hazard problems also arise

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth (cont'd) Question –To what countries do most residents of developing nations allocate the majority of their own foreign direct investment?

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Why Not … direct more foreign aid to poor nations to help them grow faster? Government officials have fewer incentives than do private parties when they consider lending to firms in developing nations. Government officials use “other people’s money”—the funds of taxpayers. In contrast, private individuals and firms will earn lower returns or even incur losses if they fail to do their best to evaluate risks arising from asymmetric information problems.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Private International Financial Flows as a Source of Global Growth (cont'd) International Financial Crisis –The rapid withdrawal of foreign investments and loans from a nation

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth Since 1945, the world’s governments have taken an active role in supplementing private markets Two international institutions, the World Bank and the International Monetary Fund, have been at the center of government- directed efforts

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth (cont'd) The World Bank –A multinational agency that specializes in making loans to about 100 developing nations in an effort to promote their long-term development and growth –Loans are made to finance improved irrigation systems, roads, and better hospitals

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 18-4 Distribution of World Bank Lending Since 1990

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Example: How Cellphones Are Fueling Economic Development In many developing nations, firms have trouble communicating effectively with customers and employees because postal and telecommunications services are inefficient. World Bank economists have found that business communications flourish once cellular networks have been established. A recent World Bank study further found that adding an extra 10 cellphones per 100 people in a typical developing country raises the nation’s average annual rate of economic growth by 0.8 percentage point.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth (cont'd) The International Monetary Fund –A multinational organization that aims to promote world economic growth through more financial stability –The IMF assists developing countries primarily by making loans to their governments

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth (cont'd) When a country joins the IMF, it deposits funds into an account called a quota subscription –A nation’s account with the International Monetary Fund, denominated in special drawing rights

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth (cont'd) These funds are measured in terms of an international unit of accounting called special drawing rights (SDRs) SDRs have a value based on a weighted average of four key currencies –The euro, the pound sterling, the yen, and the dollar –At present, one SDR is equal to just under $1.50

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth (cont'd) The World Bank’s Mission –To make loans to developing nations that fund projects incapable of attracting private financing from investors at home or abroad –The World Bank makes many loans to countries that have no trouble attracting financing –Some observers contend that a number of countries that receive funds are inappropriate recipients of development assistance (i.e. China)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth (cont'd) Asymmetric information and the World Bank and the IMF –Conditions on loans exist to reduce adverse selection and moral hazard problems but are often imprecise –Have the World Bank and the IMF contributed to international financial crises?

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth (cont'd) Rethinking long-term development lending: a main theme of development economics has been market reforms –Markets work better when a developing nation has more effective institutions Basic property rights Well-run legal systems Uncorrupt government agencies

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Institutions and Policies for Global Growth (cont'd) Alternative institutional structures for limiting financial crises –Many proposals for change diverge sharply –Economists recommend improvements in standards

Copyright © 2012 Pearson Addison-Wesley. All rights reserved You Are There: Putting Meager Capital to Work in India In India, streets are becoming more crowded with street vendors who have lost their jobs during the worldwide economic downturn. Consequently, market clearing prices in the street market are declining fast, while police officers are soliciting higher bribes in exchange for not enforcing the laws limiting street selling.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Issues & Applications: Supporting Private Entrepreneurs with Public Funds Some governments try to promote entrepreneurship by providing public support to the entrepreneurs that their officials conclude are most likely to succeed. Their efforts, however, rarely succeed in promoting economic growth due to asymmetric information problems—the adverse selection problem in identifying entrepreneurs most likely to succeed; and the moral hazard problem with entrepreneurs receiving the funds.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Summary Discussion of Learning Objectives Effects of population growth and personal freedoms on economic growth –Increased population growth has contradictory effects on economic growth –There is evidence of a positive relationship between economic freedom and growth

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Why dead capital deters investment and slows economic growth –Few people in less developed countries establish legal ownership of capital –Unofficially owned resources are known as dead capital –In many developing nations, there is a disincentive to accumulate capital, which limits growth prospects

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Government inefficiencies and dead capital in developing nations –A negative relation between government inefficiency and economic growth

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Sources of international investment funds and obstacles to investing in developing nations –Sources include bank loans, portfolio investment, and foreign direct investment –Obstacles include problems relating to asymmetric information such as adverse selection and moral hazard

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The functions of the World Bank and the International Monetary Fund –The World Bank’s function is to finance capital investment –A fundamental duty of the IMF is to stabilize international financial flows

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The basis for recent criticisms of the World Bank and IMF policymaking –The World Bank has extended credit to companies and governments that could have obtained private funds –The World Bank and IMF have failed to effectively deal with adverse selection and moral hazard, suggesting more stringent conditions on credit access are needed