OPENNESS CAN BE GOOD FOR GROWTH The Role of Policy Complementarities

1. OPENNESS CAN BE GOOD FOR GROWTHThe Role of Policy Complementarities Roberto Chang (Rutgers U.) Linda Kaltani (American U.) Norman Loayza (World Bank) Inter-American Development Bank March 2006

2. A long and contested debate Ever since D. Ricardo’s objection to the “Corn Laws” to J. Stiglitz’ critique of globalization, economists have hotly debated: Does international integration contribute to economic development?

3. The arguments in favor • (Neo) classic perspective: Openness promotes, • an efficient distribution of resources • the diffusion of knowledge • competition • Endogenous growth literature: Specialization can render increasing returns (Young 1991, Grossman and Helpman 1991)

4. The doubts • In the presence of market or institutional imperfections, openness can • cause unemployment (Brecher 1974) • promote specialization in “non dynamic” sectors (Matsuyama 1992) • induce a concentration in extractive activities (Sachs and Warner 1999)

5. What does the empirical evidence show? • It is also ambiguous • In favor: international comparisons of the levels oftrade volumes and economic growth • Dollar 1992, Sachs and Warner 1995 • The objections: loose indicators, omitted variables, endogeneity • Rodríguez and Rodrik 2000

6. The empirical response in favor of openness International comparisons of the effects of changes in openness on changes in growth: • Using large samples: positive average effects • Dollar and Kraay 2004; Calderón, Loayza, and Schmidt-Hebbel 2005 • Case studies: also positive average effects, but with a noticeable heterogeneity • Wacziarg and Welch 2003

7. A first conclusion:  The average effect of openness on growth is positive, but the individual country experiences vary from each other

8. Question: Is there a systematic pattern to this diversity?

9. The growth effect of openness increases with income – Calderón, Loayza, and Schmidt-Hebbel 2005:

10. Changes in GDP growth vs. Changes in Openness between the 1980s and 90s

12. The role of complementary reforms The success of openness depends on the economic and institutional characteristics that allow firms to adjust to the new conditions imposed by international competition • Education • Public infrastructure • Financial depth • Labor and regulatory flexibility • Rule of law • Macroeconomic stability

13. An illustrative model • An application of the theory of second best: • A change in policy is evaluated in the context of a distorted economy • Stylized model: Extension to open economies of Harris-Todaro model • Evaluation of international trade policy in a segmented economy • Segmentation occurs because of a sector-specific distortion in labor markets • Labor flexibility as representative of all complementary reforms

14. The mechanism • The distorted economy: • 2 sectors • One of them (formal sector) is subject to a minimum wage • Loss of efficiency: under-employment in the formal sector • Trade policy: • Protection to formal sector through a tariff • Result: • The effect of a tariff reduction on productive efficiency is ambiguous. • Trade liberalization increases income/production only if the labor distortion is not too large • Conclusion: The effect of openness depends on complementary reforms

15. The econometric evidence • An empirical growth model of interactions: • Sample: 82 countries, 8 non-overlapping five-year observations per country, 1960-2000 • Methodology: Generalized Method of Moments (GMM) for models using panel data

16. Econometric methodology • Estimation challenges: • Joint endogeneity • Unobserved country factors • Dynamic equation • Methodology: GMM for dynamic models of panel data (Arellano and Bond 1991, Arellano and Bover 1995) – GMM system estimator • Joint endogeneity: “Internal instruments” -lagged levels and differences • Unobserved country factors: Differencing and stationarity assumptions • Specification tests: Sargan and serial correlation tests • Previous applications: • Growth: Levine, Loayza, and Beck (2000) • Saving: Loayza, Schmidt-Hebbel, and Serven (2000) • Crime: Fajnzylber, Lederman, and Loayza (2002)

17. GMM for dynamic models of panel data • GMM system estimator: Combines regression in differences and regression in levels into one system • Regression in levels: • Instruments: lagged differences of the explanatory and lagged dependent variables • Regression in Differences: • Instruments: previous observations of the explanatory and lagged dependent variables in levels

20. The effect of openness on growth • Growth = (OPEN + INT REF) Openness • Simulations: • Effect of a 1-standard-deviation change in openness • Depending on the level of each complementary reform • Where do countries stand? • Let’s consider some representative examples

24. Lesson (I) International integration is not necessarily beneficial... But it can become beneficial

25. Lesson (II) We can design a growth strategy based on openness by addressing the reforms that help the country to face and take advantage of foreign competition : • What is needed? • What is lacking? • What is lacking more?

26. The limitations ... • Deeper country analysis is needed: • Reforms require analysis beyond rough proxies • Ex. Education quantity vs. quality • Why are necessary reforms not undertaken? • Are they too costly? • What’s the role of political economy? • Ex. Infrastructure in Peru

27. Education in Peru

28. Infrastructure in Peru

29. A final (very policy oriented) analogy: It’s not a good idea to do aerobics wearing a steel body armor

30. OPENNESS CAN BE GOOD FOR GROWTH: The Role of Policy Complementarities Roberto Chang (Rutgers U.) Linda Kaltani (American U.) Norman Loayza (World Bank) October 2005