Economic Growth and poverty reduction

1. Economic Growth and poverty reduction ThorvaldurGylfason Joint Vienna Institute/Institute for Capacity Development Distance Learning Course on Financial Programming and Policies Vienna, Austria November 26–December 7, 2012

2. outline • Determinants of growth • Saving and investment • Efficiency • Liberalization • Stabilization • Privatization • Education • Finance • Diversification • Institutions • Pictures of growth • Empirical evidence

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

4. Economic growth: Short run vs. long run To analyze changes in actualoutput from year to year – in the shortrun • Need short-run macroeconomic theory Keynesian or neoclassical To analyze the path of potentialoutput over longperiods • Need modern theory of economic growth Neoclassical or endogenous

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

6. Growing apart China – Europe: 1:1 in 1400 1:20 in 1989 Case B: 2% a year Aspects of efficiency • Economic system • Economic policy Threefold difference after 60 years Output per capita Case A: 0.4% a year 60 0 Years

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

8. Sources of growth: Investment and education Adam Smith knew all this, and more, as did Arthur Lewis + +

9. Sources of growth: Investment and education Robert Solow raised doubts about long-run linkages + +

10. More Sources of growth: Trade, stability, nature + + Arthur Lewis: X can be trade, stable politics, good weather

11. More Sources of growth: Trade, stability, nature + + But Solow carried the day: long-run growth is exogenous!

12. More Sources of growth: Trade, stability, nature Suppose X is openness to trade; then … + + +

13. The neoclassical theory of exogenous growth • Traces the rate of growth of output per capita to a single source: • Technological progress • Hence, long-run growth 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

14. The new theory of endogenous 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

15. 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 • The saving rate • The capital/output ratio • The depreciation rate

16. A simple model of endogenous growth Four building blocks • S = I Saving equals investment in equilibrium • S = sY Saving is proportional to income • I = K + K Investment involves addition to capital stock • Y = EK Output depends on quality and quantity of capital

17. A simple model of endogenous growth Let’s do the arithmetic: S = sY = I = K + K = Y/E + Y/E Rearranging terms we find Y/E = sY - Y/E Multiplying by E and dividing by Y gives Y/Y = sE - 

18. A simple model of endogenous growth Bottom line • g = sE -  Rate of economic growth equals • Saving rate times • Efficiency(i.e., the output/capital ratio) minus • Depreciation

19. What this means g = sE - d Three implications for growth Saving is good for growth Efficiency helps growth Depreciation hurts growth

20. Importance of growth • Our standard of living today depends solely, by definition, on economic growth • Rich countries are rich because they grew rapidlyover long periods • Poor countries are poor because they did not grow rapidly enough • So why do some countries grow more rapidly than others? • Why, e.g., did Thailand leave Zambia so far behind in one generation? • Hard to think of anything else (Lucas)

21. Growing apart:Thailand and Zambia • Thailand and Zambia started out in a similar position and grew apart • Thailand pursued growth-friendly policies, stressing liberal trade, stability, private enterprise, and education GDP per capita 1965-2004 (US$ at 2000 prices) Thailand 4.7% per year Zambia -1.5% per year 1.06239 = 10.4

22. Growing apart:Sweden and Argentina • Argentina and Sweden went hand in hand 1900-1930, and then grew apart • Sweden pursued free trade, liberal democracy, and income equality, and avoided high inflation • Argentina did not GDP per capita 1900-2003 (US$ at 1990 prices) Sweden 2.1% per year Argentina 1.0% per year 1.011103 = 3.1

23. Growing apart:Spain and Argentina • Argentina and Spain went hand in hand 1965-1970, and then grew apart • Spain pursued free trade and price stability through EU membership and adopted democracy • Argentina lacked stability GDP per capita 1965-2004 (US$ at 2000 prices) Spain 2.7% per year Argentina 0.6% per year 1.02139 = 2.2

24. Growing apart:Botswana and Nigeria • Botswana and Nigeria went hand in hand 1965-1970, and then grew apart • Botswana stressed education and resisted corruption • Nenadi Usman, Nigeria’s finance minister: “Oil has made us lazy” GDP per capita 1965-2004 (US$ at 2000 prices) Botswana 7.1% per year Nigeria 0.6% per year 1.06539 = 11.7

25. Growing apart:Mauritius and Madagascar • Mauritius did many things right and reaped rapid growth • Madagascar’s economy has remained at a standstill all this time for many reasons, as we will see shortly GDP per capita 1965-2004 (US$ at 1990 prices) Mauritius 4.3% per year Madagascar -1.2% per year 1.05539 = 8.1

26. A Tale of two countries

27. A Tale of two countries

28. A Tale of two countries

29. A Tale of two countries

30. A Tale of two countries

31. A Tale of two countries

32. A Tale of two countries

33. A Tale of two countries

34. A Tale of two countries

35. Growing apart:Mauritius and Madagascar • Mauritius did many things right and reaped rapid growth • Madagascar has been at a standstill all this time for many reasons, including too little investment, trade, and education, as we will see shortly GDP per capita 1965-2004 (US$ at 1990 prices) Mauritius 4.3% per year Madagascar -1.2% per year 1.05539 = 8.1

36. Endogenous vs. exogenous growth • The neoclassical view • that economic growth in the long run is merely a matter of technologydoes 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 efficiencyis more illuminating • Besides, it’s not really new, because Adam Smith knew this (1776)

37. One crucial implication of Endogenous growth • The neoclassical view • If two countries are identical (same saving rate, same population growth, same technology), then their income per head will ultimatelybe 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

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

39. conditional convergence • Once the main determinants of growth have been taken into account, initial income will have a negative effect on growth • Conditional convergence does not entail absolute convergence • 164 countries from 1960 to 2000

40. absolute convergence? • Poor countries grow faster than rich ones if • Growth is inversely related to initial income, or if • Regression of current income on initial income produces a slope coefficient that is smaller than one 45o 45o

41. Sources of growth i: saving and investment • Fits real world experience quite well • In East Asia, saving rates of 30-40%of GDP went along with rapid economic growth • In several African economies, saving rates of around 10%of GDP went for a long time hand in hand with economic stagnation • In OECD countries, saving rates of about 20%of GDP went along with respectable growth • Important implication for policy • Economic stability withlow inflation and positive real interest rates spurs saving, which is good for growth

42. Investment and growth • An increase in investment by 8% of GDP is associated with an increase in per capita growth by one percentage point per year • Quantity and quality • Cause and effect • World Bank data for 164 countries and 40 years, 1960-2000 r = rank correlation r = 0.42

43. Sources of growth ii: efficiency • Also fits 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 efficiencyis all about! • Thus, technology is best viewed as an aspect of general economic efficiency • Important implication for policy • Everything that increases efficiency, no matter what, is also good for growth

44. Again: What makes countries grow? • First things first: Output is produced by labor, capital, and other inputs • Output per capita can grow through accumulation of capital through saving and investment, as we have seen • Output per capita, however, cannot grow through population growth, as we will see • But, output per capita can grow through improvements in labor, via investments in human capital: Educationand health care • Investment and education: Key drivers of growth

45. What makes countries grow? A longer list • Educationandhealth care make labor force more efficient • Technological progress enhances efficiency • Liberalizationof prices and trade increases efficiency: good for growth • Stabilizationreduces the inefficiency associated with inflation: good for growth • Privatizationreduces the inefficiency of state-owned enterprises: good for growth • The possibilities are virtually endless!

46. What makes countries grow • Why do education and health care matter? • Because they increase labor productivity • This is also why technological progress is good for growth • Technological progress enables firms to squeeze more output from given inputs • But so does increased efficiency! • Latin American story about air fares • Increased efficiency is tantamount to technological progress, which helps growth

47. This is good news • If growth were merely a matter of technology, we could not do much about it • Except 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 growth • Because everything that is good for saving and efficiency is also good for growth

48. efficiency and growth • In sum, output per capita depends on the quantity and quality of inputs • Quantity of inputs can be increased through accumulation, esp. capital accumulation • Quality of inputs – their productivity! – can be increased through increased efficiency • Education and health • Liberalization • Stabilization • Privatization • Aspects of institutions Policies Check them out one by one

49. Education, health care, and growth • Educationand health care make the work force more efficient • Need to provide primary and secondary education to all, especially females • Need to provide tertiary education to a greatly increased number of people • Need increased public commitment to education as well as health care • Need both increased public expenditureon education and probably also increased scope for private sector involvement in education and health care

50. Education and growth POLICIES • Education lifts labor productivity, thereby increasing overall economic efficiency and growth of output • From unskilled to skilled labor • Data for 131 countries, 1960-2000 r = 0.50