Growth Diagnostics in Practice

1. Growth Diagnostics in Practice Applied Inclusive Growth Analytics Course March 23, 2009 Susanna Lundstrom, PRMED

2. Outline • What is so special about diagnostics? • Three common tools, with pros and cons: • Cross-country regressions • (Growth Accounting) • International Benchmarking and Indices All are used in Inclusive Growth Analytics, but more is added • Basic Principles in Growth Diagnostics • Applications throughout the course! See Hausmann, Klinger and Rodrigo (2008)

3. Growth research vs. Growth diagnostics • In growth research the subject is growth with countries as observations • What do policy X do on average, to a randomly selected country? • In growth diagnostic, the subject is the country • What particular problem does the country in question have? How would this specific country react to policy X? • Informed by growth research… • Analogy: Medical research and practice

4. Cross-country growth regressions • “What factors affect growth in a typical country?” • Countries are just observations • Very important in understanding potential constraints • If used with interaction terms – more context specific • Given the presence of X2t,X1t will have this effect on gt

5. Cross-country growth regressions- Some characteristics • Normally assumes separability (if no interaction terms) • The impact of variable x1 on growth is independent of the level of the other x’s • No context-specific interactions taken into account • Assumes linearity • All x’s are substitutes of each other • You can compensate failures in one area by over-performance in other areas. But if there are binging constraints…. • Assumes monotonicity and linearity in the x’s - in the absence of squared forms • Increases in x from any level increases g • Increases in x from any level has the same effect on g • All β’s are the same for all countries

6. Cross-country growth regressions- Some characteristics, cont • Only data that you have for all countries can be included – often outcome rather than policy based • Example: Private credit/GDP ratio instead of a policy-based index of financial liberalization • No price information in the equation • Supply or a demand problem? • Low supply, high price – potential constraint • Low supply, low price – low demands and not necessarily a constraint • Results sensitive to the elimination of outliers • Sensitivity to groups of outlier – indicates context-sensitive effects

7. International Benchmarking - Comparative countries • Similar countries (landlocked, conflict…) but with different GDP • Ideally, one should aspire to a “natural experiment” where the selected benchmark is a replica in all but one respect to the country under study • “Role models” • Where would we want to be in 2, 10 and 20 years? • A particular country or set of countries which performance or welfare indicator wants to be attained by the studied country • Partial correlation with a group of countries • Compare with the expected value (fitted line) given the GDP level in the country

8. International Benchmarking- Indices and rankings • See examples on the IG website (“Data and References”) • Complex systemic outcomes • Does not map easily into policy • How to collapse to a single dimension? • Take the average • Assumes linearity and separability • Assumes monotonicity and linearity in x:s • Is the optimal number of licenses zero? • Is an increase from 1 to 2 the same as from 9 to 10?

9. International Benchmarking - Surveys • Sample selection bias • The binding constraint causes firms not to exist and biases the survey • You talk to “camels” rather than “hippos” • International comparison of opinions • What does it take for a Swede to complain about corruption? • Do all nationalities have a tendency to complain more about taxes than human capital?

10. International Benchmarking- General problem • Not obvious the focus should be on the areas where you perform poorly compared to other countries • Poor supply (and hence a constraint) ..or low demand (and hence not obvious)? • Depends on the economic structure (human capital more important in the US than Zambia)

11. Basic principles of country diagnosis- Examples will follow throughout the course… If a constraint is binding, then… • The (shadow) price of the constraint should be high • Movements in the constraint should produce significant movements in the objective function (e.g. GDP, or income of a specific group of ind.) • Agents in the economy should be attempting to overcome or bypass the constraint • Camels and Hippos: Agents less intensive in that constraint should be more likely to survive and thrive, and vice versa

12. 1. The (shadow) price of the constraint is high • Relative scarcity of a factor. • Look at prices (interest rates, wages, etc.) • Estimate prices using regressions • Example: Mincerian regressions • In other cases no market: • Infrastructure:congestion as the “price to pay” • Non-market valuation techniques, either based on revealed or in stated preferences. • Ex: Hedonic prices, ICAs stated preferences

13. 2. Differences in the constraint should produce differences in growth • A constant cannot explain a change • Differences • Between time periods (look at trend breaks) • Do growth periods following a relaxation of the constraint? Do growth decrease when it is present? • Between regions • Why are some prosperous and some lagging? The constraint in question present in one but not the other? • Between groups of firms differently affected by the potential constraint

14. 3. Agents in the economy must be engaging in efforts to overcome or by-pass the constraint • Examples:  • Border controls  smuggling • Poor financial intermediation  growth occurs within business groups (conglomerates) • Industry specific public goods binding  growth in sectors less sensitive to specific inputs or unusual level of cooperation among successful producers. • Property rights and contracting binding  Mafia

15. 4. Camels vs. hippos • The surviving sector (“camels”) are those least intensive in or least dependent on the binding constraint (“water in a desert”) • In a good investment climate (“environment with water”) the economy, and the thought comparative advantages, may look differently (“hippos”) • What do analysis of camels reveal about potential constraints? • Are successful groups particularly connected to the political system? • Any “missing factors” within the successful industry? • The importance of analyzing hippos? • Example: Informal ICAs