Growth diagnostics

1. Growth diagnostics Elena Ianchovichina PRMED, World Bank Joint Vienna Institute June, 2009

2. Analytics of reform • Welfare may decline if reforms tackling some distortions are implemented as long as other distortions remain • In formal terms, • u is welfare; τi is a distortion in activity i • Distortions drive a wedge between social and private valuation of activities • represents the net marginal valuations of activityiby society s,and by private agents • λiis the Lagrange multiplier corresponding to the constraint associated with the distortion in activity i and is the direct effect of removing the distortion • the distortion associated with the biggest multiplier effect is the binding constraint • The direct effect is always welfare improving, but the indirect effect may not be, implying that welfare may decline if the indirect effect is negative and larger than the direct effect

3. Reform strategiesThe idea about the most binding constraint • Targeting all distortions at once raises welfare but may be infeasible due to: • financial and capacity constraints, especially in LICs • limited political capital to engage in wholesale reform • Targeting the biggest distortion or a number of large distortions may not lead to welfare improvement due to large second best effects • Targeting the most binding constraint • Increases the chances of an overall positive impact • The most binding constraint is associated with the biggest multiplier • The second best effects are hard to estimate with accuracy

4. Heuristic approach to identifying the most binding constraint to growth • The multipliers are typically hard to estimate • HRV use the “Keynes-Ramsey rule” • It captures the most important factors affecting economic growth in the short run • HRV construct a framework that guides the growth analysis at the aggregate level • Helps identify a bundle of major constraints • In practice, it is very difficult to identify the most binding constraint to growth with the heuristic approach

5. Growth diagnostics Problem: Low levels of private investment and entrepreneurship High cost of finance Low return to economic activity Low appropriability bad international bad local finance Low social returns finance government market failures failures information poor coordination bad infra externalities: geography externalities structure “self discovery” - micro risks: macro risks: low poor low property rights, financial, domestic inter - human corruption, monetary, fiscal saving mediation capital taxes instability - Source: HRV (2005)

6. Growth diagnostic questions • Is private investment low in a country? If yes: • Is it because of high cost of capital? • In this case the economy is considered liquidity-constrained • Is it because of low returns to capital? • In this case the economy is considered inefficient

7. Why is the cost of capital high or access to capital poor? • Limited access to external capital markets due to: • Country risk • Unattractive FDI conditions • Vulnerabilities in the debt maturity structure • Excessive regulations of the capital account • Bad local finance • Low domestic savings • Poor domestic financial intermediation

8. Why are returns to capital low? • Low social returns due to: • Geography • Insufficient investment in complementary factors • Poor natural resource management • Low private returns to capital due to: • Government failures affecting negatively private appropriability • Macro-instability, high taxes, property rights issues, corruption, labor-capital conflicts • Market failures affecting negatively the ability to adopt new technologies • Coordination externalities • Information externalities

9. Coordination failures • Coordination failures are defined as the failure of the market to respond to potential investors’ demands for a diverse set of services: • That allow firms to innovate, market their products successfully, and make a profit • These services require public investments in various sectors of the economy and can benefit all economic agents at a limited marginal cost of an extra user • In this situation, there are positive externalities where the social returns are higher than the private returns to investment • Consequently, the incentives to establish these kinds of services is limited for an individual firm, and if left to the private sector, these public goods and services will be underprovided

10. Role of government and public investment • Education, some types of infrastructure, health and security are some areas where government have to play a key role • A study by Moreno-Dodson (2008) shows the positive relationship between public spending and growth, particularly when the allocation of spending focuses on the provision of public goods rather than on subsidizing or providing private goods and inputs • Recognition that smart industrial policy can play an important role: • Strategic support for certain activities including provision of infrastructure and services: • That benefit firms in a specific geographic location (special economic zones) • That benefit firms in a specific industry but have positive spillover effects on other economic activities • Access to technology to comply with international sanitary and health standards; • Marketing information, e.g. knowledge about international consumer preferences, trends, fairs • Special training to update skills of local experts • Regional and international agreements that govern trade in good, services and immigration policies

11. Information failures • Information failures are defined as the failure of firms to “discover” which products they can produce at low enough cost to be profitable and competitive • Focus is on the private sector since when it comes to development of “new” products the private sector is more effective than the governments at generating the kind of innovation and productivity growth needed for sustained growth rates • Private firms are profit driven, whereas governments have a much broader set of objectives that may lead to an inefficient management of government-owned enterprises • Public investment can crowd out private investment since businesses may fear unfair competition from SOEs. • Firms must experiment with new product lines, adapt new technologies from abroad to local conditions • Diversification of the productive structure requires “discovery” of an economy’s cost structure

12. Pros of HRV • Country-specificity • Selectivity via trade-offs • Organizational framework • Adaptability to analysis at the national or sub-national levels

13. Limitations of HRV • Difficult to reject constraints as not binding • Important to acknowledge information gaps to avoid drawing wrong conclusions • Analysis demonstrated at the aggregate level offering little insight about the distributional impacts of growth across economic agents • Focus is on the short-run, rather than on determinants of long-run growth • Human capital is viewed as a complementary factor, although skills are a key determinant of exclusion from the labor market

14. Three problems with the neoclassical models Solow and optimal growth • Do not predict the large differences in income observed in the data • Predict conditional convergence but at a much more rapid speed than estimated empirically • Predict greater rate of return differentials between rich and poor countries than is empirically plausible

15. How can one reconcile Solow with the data? • Traditional view of capital • Tangible, includes the economy’s stock of equipment and structures • Return to capital is the profit received by the owners of equipment and structures • A new view on capital (Mankiw, Phelps and Romer 1995) • Capital with externalities • If new ideas arise as capital is built and others benefit • Human capital • Capital is much broader concept than suggested by the national income accounts • People accumulate capital whenever they forgo consumption today in order to produce more income tomorrow • Schooling and on-the-job training is also investment

16. Endogenous growth models • Romer (1986): growth is an outcome of externalities in capital accumulation • Lucas (1988): growth is an outcome of externalities in human capital accumulation • Romer (1990): growth is an outcome of knowledge accumulation

17. Growth accounting with human-capital-adjusted labor input • Modified production function to capture the contribution of education (“brains”) and the size of the labor force (“brawn”) • S is the years of schooling • P is participation rate • ω is returns to education • So that

18. Determinants of income per capita • After rearranging (A), substituting (B) into (A), and representing income in per capita term we get: • where gx is the growth rate of variable x • Income growth per capita is a result of: • Growth in technology gA • Changes in capacity which are determined by: • Growth in the capital stock per unit of labor adjusted for skills • Growth in the labor participation rate • Growth in returns to education and years of schooling • Demographic changes leading to changes in the dependency ratio