Sources of Economic Growth Thorvaldur Gylfason

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)Institutions III.Empirical evidence of growth

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

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

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?

Growing apart Years Output per capita Case B: 2% a year Case A: 0.4% a year Aspects of efficiency Economic system Economic system Economic policy Economic policy Threefold difference after 60 years 0 60 China Europe: China – Europe: 1:1 in :20 in 1989

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

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

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!

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

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: SavingEfficiencyDepreciation “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 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 Saving equals investment in equilibrium n S = sY Saving is proportional to income Saving is proportional to income n I =  K +  K Investment involves addition to capital stock Investment involves addition to capital stock n Y = EK Output depends on quality and quantity of capital Output depends on quality and quantity of capital

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

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

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

Botswana and Nigeria: GDP per capita (1995 USD) Case 1 Nedadi Usman, Nigeria’s economy minister: Oil has made us lazy Botswana 6.3% Nigeria 0.2% (1.061) 42 = 12.0

Spain and Argentina: GDP per capita (1995 USD) Case 2 Spain 3.3% Argentina 0.6% (1.027) 42 = 3.1

Madagascar and Mauritius: GDP per capita (1995 USD) Case 3 Mauritius 4.4% Madagascar -1.4% (1.058) 42 = 10.7

Country A Country B A Tale of Two Countries

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

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

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

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

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

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 %-1.4% A Tale of Two Countries

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 per capita %-1.4% A Tale of Two Countries

Madagascar and Mauritius: GDP per capita (1995 USD) Case 3 Mauritius 4.4% Madagascar -1.4% (1.058) 42 = 10.7

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 1960s, 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 – + denotes a positive effect in the direction shown – denotes a negative effect in the direction shown ? Conditional convergence

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

Absolute convergence: Growth rates 165 countries Equatorial Guinea

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

Investment and economic growth Jordan Botswana Thailand r = 0.65 An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year 85 countries 4% 1% Botswana China Nicaragua Niger Quantity and quality What is the empirical evidence?

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

Sources of endogenous growth II Sources of increased efficiency 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 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. Sound institutions

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. South Korea and Singapore North Korea and Cuba vs. South Korea and Singapore Applies to trade in goods, services, capital 1

Darkness in North-Korea China Japan

Exports and growth An increase in exports by 20% of GDP is associated with an increase in per capita growth by 1% per year r = 0.33 What is the empirical evidence? 87 countries

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

Model 1 Inflation distortion (2.07) Natural resources Initial income Investment Secondary education Population growth Adj. R Stabilization and economic growth: Regression results Note: 87 countries, method is OLS, t-statistics are shown in parentheses.  /(1+  ) Inflation distortion =  /(1+  ) Inflation impedes growth What is the empirical evidence?

Table 1. Regression results on economic growth Model 1 Model 2 Inflation distortion (2.07) (2.37) Natural resources -0.09(5.75) Initial income Investment Secondary education Population growth Adj. R Stabilization and economic growth: Regression results Natural resource curse

Table 1. Regression results on economic growth Model 1 Model 2 Model 3 Inflation distortion (2.07) (2.37) (2.25) Natural resources (5.75) (6.52) Initial income -0.45(2.67) Investment Secondary education Population growth Adj. R Stabilization and economic growth: Regression results Convergence

Table 1. Regression results on economic growth Model 1 Model 2 Model 3 Model 4 Inflation distortion (2.07) (2.37) (2.25) (2.25) Natural resources (5.75) (6.52) (5.01) Initial income (2.67) (3.05) Investment 0.15(5.41) Secondary education Population growth Adj. R Stabilization and economic growth: Regression results Investment is good for growth

Table 1. Regression results on economic growth Model 1 Model 2 Model 3 Model 4 Model 5 Inflation distortion (2.07) (2.37) (2.25) (2.25) (2.49) Natural resources (5.75) (6.52) (5.01) (2.93) Initial income (2.67) (3.05) (5.39) Investment 0.15 (5.41) 0.09 (3.36) Secondary education 1.24(4.24) Population growth Adj. R Stabilization and economic growth: Regression results Education boosts growth

Table 1. Regression results on economic growth Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Inflation distortion (2.07) (2.37) (2.25) (2.25) (2.49) (2.14) Natural resources (5.75) (6.52) (5.01) (2.93) (2.49) Initial income (2.67) (3.05) (5.39) (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(3.42) Adj. R Stabilization and economic growth: Regression results * An increase in secondary-school enrolment by a third increases growth by 1%. Population drag

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

State-owned enterprises and economic growth 38 countries r = -0.35

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

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

Growth and 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 decreasing returns Positive but decreasing returns to education r = countries Finland Thailand New Zealand Jamaica What is the empirical evidence?

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 (foreign capital) Dutch disease (foreign capital) Rent seeking (social capital) Rent seeking (social capital) Education (human capital) Education (human capital) Investment (real capital) Investment (real capital) 5

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

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

Natural capital and economic growth What is the empirical evidence? An increase in the natural capital share by 8% goes along with a decrease in per capita growth by 1% per year r = Venezuela Australia 85 countries

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

1990: When the world changed Democracy Oligocracy Dictatorship

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

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 sound institutions sound 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 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 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 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

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