Sources of Growth

1. Sources of Growth Thorvaldur Gylfason Livingstone, Zambia 10-21 April 2006

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

5. 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

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

7. 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 +

8. 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 +

9. 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

10. The New Theory of Endogenous Economic 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

11. 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 • A. the saving rate • B. the capital/output ratio • C. the depreciation rate

12. 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

13. 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 - 

14. 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

15. What this means Three implications for growth Saving is good for growth Efficiency helps growth Depreciation hurts growth

16. Botswana and Nigeria: GDP per capita 1960-2002 (1995 USD) Case 1 Botswana 6.3% (1.061)42 = 12.0 Nedadi Usman, Nigeria’s economy minister: Oil has made us lazy Nigeria 0.2%

17. Spain and Argentina: GDP per capita 1960-2002 (1995 USD) Case 2 Spain 3.3% Argentina 0.6% (1.027)42 = 3.1

18. Madagascar and Mauritius: GDP per capita 1960-2002 (1995 USD) Case 3 Mauritius 4.4% (1.058)42 = 10.7 Madagascar -1.4%

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. A Tale of Two Countries

25. A Tale of Two Countries

26. A Tale of Two Countries

27. Madagascar and Mauritius: GDP per capita 1960-2002 (1995 USD) Case 3 Mauritius 4.4% (1.058)42 = 10.7 Madagascar -1.4%

28. 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)

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 What is the empirical evidence? r = 0.65 Botswana Botswana Quantity and quality China Thailand 1% 4% An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year Jordan Nicaragua Niger 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 • 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. South Korea and Singapore • Applies to trade in goods, services, capital

35. Darkness in North-Korea China Japan

36. Exports and growth 1965-98 What is the empirical evidence? An increase in exports by 20% of GDP is associated with an increase in per capita growth by 1% per year r = 0.33 87 countries

37. 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

38. Model 1 Inflation distortion -2.51 (2.07) Natural resources Initial income Investment Secondary education Population growth Adj. R2 0.04 Stabilization and economic growth: Regression results What is the empirical evidence? Inflation distortion =  /(1+ ) Inflation impedes growth Note: 87 countries, method is OLS, t-statistics are shown in parentheses.

39. Table 1. Regression results on economic growth Model 1 Model 2 Inflation distortion -2.51 (2.07) -2.46 (2.37) Natural resources -0.09 (5.75) Initial income Investment Secondary education Population growth Adj. R2 0.04 0.30 Stabilization and economic growth: Regression results Natural resource curse

40. Table 1. Regression results on economic growth Model 1 Model 2 Model 3 Inflation distortion -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) Natural resources -0.09 (5.75) -0.10 (6.52) Initial income -0.45 (2.67) Investment Secondary education Population growth Adj. R2 0.04 0.30 0.35 Stabilization and economic growth: Regression results Convergence

41. Table 1. Regression results on economic growth Model 1 Model 2 Model 3 Model 4 Inflation distortion -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) Natural resources -0.09 (5.75) -0.10 (6.52) -0.07 (5.01) Initial income -0.45 (2.67) -0.45 (3.05) Investment 0.15 (5.41) Secondary education Population growth Adj. R2 0.04 0.30 0.35 0.51 Stabilization and economic growth: Regression results Investment is good for growth

42. Table 1. Regression results on economic growth Model 1 Model 2 Model 3 Model 4 Model 5 Inflation distortion -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) -1.97 (2.49) Natural resources -0.09 (5.75) -0.10 (6.52) -0.07 (5.01) -0.04 (2.93) Initial income -0.45 (2.67) -0.45 (3.05) -1.10 (5.39) Investment 0.15 (5.41) 0.09 (3.36) Secondary education 1.24 (4.24) Population growth Adj. R2 0.04 0.30 0.35 0.51 0.60 Stabilization and economic growth: Regression results Education boosts growth

43. Table 1. Regression results on economic growth Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Inflation distortion -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) -1.97 (2.49) -1.61 (2.14) Natural resources -0.09 (5.75) -0.10 (6.52) -0.07 (5.01) -0.04 (2.93) -0.04 (2.49) Initial income -0.45 (2.67) -0.45 (3.05) -1.10 (5.39) -1.27 (6.42) Investment 0.15 (5.41) 0.09 (3.36) 0.10 (3.74) Secondary education* 1.24 (4.24) 1.07 (3.82) Population growth -0.56 (3.42) Adj. R2 0.04 0.30 0.35 0.51 0.60 0.64 Stabilization and economic growth: Regression results Population drag * An increase in secondary-school enrolment by a third increases growth by 1%.

44. 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

45. State-owned enterprises and economic growth r = -0.35 38 countries

46. 4 Education, health, 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

47. 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

48. Growth and education, 1965-98 What is the empirical evidence? r = 0.72 Positive but decreasing returns to education Thailand Finland New Zealand Jamaica An increase in secondary-school enrolment by 25% of each cohort goes along with an increase in per capita growth by 1% per year 87 countries

49. 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 (foreign capital) • Rent seeking (social capital) • Education (human capital) • Investment (real capital)

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