Sources of Economic Growth

1. Sources of Economic Growth Thorvaldur Gylfason

2. Outline • Pictures of growth • Determinants of growth • Saving and investment • Efficiency • Liberalization • Stabilization • Privatization • Education • Diversification • Distribution • Empirical evidence of growth

3. Economic growth: The short run vs. the 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: 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

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 Case B: 2% a year • 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 this, and more, as did Arthur Lewis Solow raised doubts on long-run linkages + + denotes a positive effect in the direction shown +

9. More sources of growth Arthur Lewis: x is trade, stable politics, good weather But Solow carried the day: long-run growth is exogenous! + + + denotes a positive effect in the direction shown +

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

11. 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

12. The New Theory of Endogenous Economic Growth • Traces the rate of growth of output per capita to two main sources: • Saving • Efficiency “The proximate causes of economic growth are the effort to economize, the accumulation of knowledge, and the accumulation of capital.” W. ARTHUR LEWIS

13. Botswanaand Nigeria: GNP per capita 1962-2001 Case 1 Current US$, Atlas method Nedadi Usman: Oil has made us lazy

14. Egypt, Morocco, and Tunisia: GNP per capita 1962-2001 Case 2 Current US$, Atlas method

15. Madagascar and Mauritius: GNP per capita 1962-2001 Case 3 Current US$, Atlas method

16. A Tale of Two Countries

17. A Tale of Two Countries

18. A Tale of Two Countries

19. A Tale of Two Countries

20. A Tale of Two Countries

21. A Tale of Two Countries

22. A Tale of Two Countries

23. A Tale of Two Countries

24. Madagascar and Mauritius: GNP per capita 1962-2001 Case 3 Current US$, Atlas method

25. 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)

26. 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

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

28. Absolute convergence? Do poor countries catch up? r = rank correlation r = -0.09 Botswana No sign that poor countries grow faster than rich China Korea Thailand Indonesia Conditional convergence does not entail absolute convergence Nicaragua 85 countries

29. Sources of endogenous growth I • Saving • Fits real world experience quite well • No coincidence that, in East Asia, saving rates of 30-40% 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

30. Investment and economic growth An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year Botswana Thailand Jordan 1% 4% Nicaragua r = 0.65 85 countries

31. 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

32. Sources of endogenous growth II • Five sources of increased efficiency • Liberalization of prices and trade increases efficiency, which is good for growth • Stabilization reduces the inefficiency associated with inflation, which is good for growth • Privatization reduces the inefficiency associated with state-owned enterprises, which … • Education makes the labor force more efficient • Technological progress also enhances efficiency • The possibilities are virtually endless!

33. 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

34. 1 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 • Liberalization of trade allows specialization according to comparative advantage • Free trade is more efficient than self-sufficiency • North Korea and Cuba vs. Hong Kong and Singapore • Applies to trade in goods, services, capital

35. Openness to trade and growth 1965-98 87 countries r = 0.40 An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year

36. 2 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 thus involves a tax, the inflation tax • An inefficient tax compared with most other taxes • 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

37. 3 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

38. 4 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 tertiary education to a greatly increased number of people • 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

39. 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

40. Growth and education, 1965-98 An increase in secondary-school enrolment by 25% of each cohort goes along with an increase in per capita growth by 1% per year r = 0.72 Positive but decreasing returns to education 87 countries

41. 5 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 • Rent seeking • Education • Investment What is the evidence?

42. Recent literature Four main linkages: • Dutch disease Hurts level or composition of exports • Rent seeking Protectionism, corruption • Education • False sense of security Poor quality of policies and institutions 5.Investment

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

44. 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 8 Asian countries S/Y = 0.32 Australia r = rank correlation 8 African countries S/Y = 0.05 Venezuela Notice two clusters r = -0.64 85 countries

45. 6 Inequality and economic growth Two views: • Inequality is good for growth • Too much equality weakens incentives to work, save, and acquire an education • Inequality is bad for growth • Too much inequality reduces social cohesion and creates conflict What is the empirical evidence?

46. Growth and inequality, 1965-98 An increase in Gini index by 12 points goes along with a decrease in per capita growth by almost 1% per year r = rank correlation Korea France No discernible sign that equality stands in the way of economic growth Thailand Lesotho Brazil South Africa Sweden Central African Republic r = -0.50 75 countries

47. What is the upshot? • Economic growth responds to public policy • In particular, by encouraging • saving and investment of high quality • foreign trade and investment • education • economic diversification • and perhaps also equality • ... the government can help foster rapid economic growth

48. 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 (1968)

49. What else? • These lessons are borne out by experience from around the world • Additional lessons: • Too much inflation hurts saving, investment, and trade — and thereby also 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 rapid population growth also tends to impede economic growth

50. 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 — 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 • Many of the constraints on growth are man-made, and can be removed