Economic Growth and the Balance-of-Payments Constraint: An Introduction

1. Economic Growth and the Balance-of-Payments Constraint: An Introduction John McCombie Director Cambridge Centre for Economic and Public Policy University of Cambridge

2. Introduction This lecture provides an introduction to the concept of the demand-oriented approach to economic growth and the concept of balance-of-payments equilibrium growth. First put forward in a short paper in 1979 by Tony Thirlwall in BNL Quarterly Review entitled “The Balance of Payments Constraint as an Explanation of International Growth Rate Differences”. Led to a huge literature testing, and theoretically, extending the model. What is it, how successful is it and what are the criticisms of model?

3. Introduction Approaches to economic growth Two distinct paradigms (1) The neoclassical supply-oriented approach, based on the production function and full employment. Often perfect competition is assumed. (i) The Solow growth model (ii) Endogenous growth models Generally closed economy models, no role for monetary factors or demand. Theoretical and empirical problems with the aggregate production function.

4. Introduction (2) Demand oriented and balance-of-payments constrained growth Why does demand matter for growth? (i) Harrod-Domar model (ii) The endogeneity of the natural rate of growth (iii) Kaldorian approach and cumulative causation But trade needs to be balanced in the long-run...... (iv) Balance-of-payments constrained growth

5. Introduction (2) The Demand Oriented Approach (including the balance of payments growth model) (i) Harrod – Domar model: yA = s/v where yA = actual growth rate; s = savings ratio and v = the incremental output ratio. Generalisation of the Keynesian model to the long-run and used until recently by the World Bank. Focus on the difference between yA and yn .yw and yA Solow model or Cambridge growth models

6. The Endogeneity of the Rate of Growth • Endogeneity of the natural rate of economic growth or the growth of productive potential. • In the neoclassical approach both the Solow and the endogenous growth model) this is taken as exogenous, independent of the growth of demand. y = a - bU% Yn = a when U%=0 But what happens if growth is above the natural rate?

7. The Endogeneity of the Natural Rate Including a dummy variable y = a - b%U + cD It can be seen that there is a shift of the natural rate of growth from a (a2) to a + c (a2 + b2)

8. Empirical results for the advanced Countries. “The implication for growth Theory and policy is that it Makes little economic Sense to think of growth as supply constrained, if Demand, within limits, Creates its own supply” (Thirlwall, 2002, p.95) Supported by other more recent evidence.

9. The Endogeneity of the Natural RateLanzafame (2014)

10. Growth and Cumulative Causation (ii) The Kaldorian view of growth (cumulative causation) The rate of capital accumulation and the savings ratio are not exogenous determinants of economic growth but endogenous. Because of increasing returns to scale, growth proceeds in a cumulative and circular manner (Myrdal, 1957). “In the case of industrial activities (‘manufactures’) the impact effect of exogenous changes in demand will be on production rather than on prices. “Supply’, at any rate long run supply, is normally in excess of demand – in the sense that producers would be willing to produce more, and to sell more, at the prevailing price (or even a lower price) in response to an increased flow of orders.

11. Growth and Cumulative Causation Capital accumulation is the result of output growth (derived from profits from increased production not an exogenous determined savings ratio). The most important exogenous component of demand is that from exports.

12. Export growth  output growth  productivity growth  greater price and non-price competitiveness  faster export growth ... • Demand orientated: What determines the growth of exports? • Crucial role of increasing returns to scale (cf the Solow model). • Supply responds to the growth of demand... Capital accumulation is a function of the expected growth of demand; as is labour (disguised unemployment; greater efficiency, in migration).

14. Structure of the ModelComplete overview yt = xt (1) [output growth is determined by export growth] xt = -t-1 + w + z (2) [export growth is determined by the growth of prices and world income] t = w – pt (3) [growth of regional prices is determined by growth of money wages and productivity] pt = re + yt (4) [Productivity growth is determined by the growth of output] • growth is a “circular and cumulative” process

15. The model in diagrammatic formConvergent growth

16. Growth and Cumulative Causation (i) The solution to the model is that countries/regions converge to (different) equilibrium paths (Dixon & Thirlwall) or (ii) There is explosive growth which is limited by bringing in supply side constraints (labour shortages or land rents) (Kaldor) But there is a problem that in equilibrium the growth of exports and imports can differ. There has to be a mechanism for ensuring that this cannot happen indefinitely.

17. If there is no feedback through the Verdoorn effect and the growth of relative prices, then the model reduces to y =  (z) which brings us to a consideration of Thirlwall’s law and balance-of-payments constrained growth.

18. Balance-of-Payments Constrained Growth (2) Balance-of-payments constrained growth For Keynesians, demand drives the economic system, but there is a constraint imposed by the balance of payments. If demand is increased, imports also increase but exports are remain the same (determined by the growth of its world markets), so the economy moves into a balance-of-payments deficit. But this cannot last indefinitely. Two hypotheses • Deficit cannot be financed indefinitely by international borrowing (capital inflows). • Changes in (international) relative prices are ineffective.

19. The Balance-of-Payments Constraint The key proposition “At the theoretical level, it can be stated as a fundamental proposition that no country can grow faster than the rate consistent with balance of payments equilibrium on current account unless it can finance ever-growing deficits, which in general it cannot”. (A. P Thirlwall) Evidence from the IMF suggests that as a rule of thumb international financial markets become distinctly nervous if the overseas debt to GDP ratio exceeds around 50% or the current account /GDP ratio is about 10% It does, however, depend on the size and level of development of the country concerned.

20. The Growth Rates of Countries are Interlinked • The growth rates of even the advanced countries are inextricably linked – LINK model • If there is a slowdown in growth of the US (or more recently China), this impacts on the rest of the world. • The beggar-my-neighbour policies of the advanced countries in the 1930s. “Exporting unemployment” by tariffs and quotas. • Rapid post-war growth led by first the US and then Germany as the engine of growth. Rapid reduction of tariffs under GATT. It was the growth of world demand that became crucial for the Golden Age.

21. The Growth Rates of Countries are InterlinkedThe Case of the US The impact of the “Great Recession” :

22. The Balance-of-Payments Constrained Growth ModelA Quick Overview The approach concentrates on the determinants of export and import growth; such as the relative prices of exports and imports (price competition) and the income elasticities of demand (non-price competition). The causation is from export growth  output growth import growth Not the Rodrik approach of undervaluation of REER  changes in price of tradables/nontradables  greater investment  faster output/export growth.

23. But did not the floating exchange rates essentially delink the economies of the world? No..... • In the current crisis, attention is still focused on the degree to which the US and China can lead the world out of recession. • The “lost decade of growth” in Latin American associated with balance of payments crisis and collapse of the currency. Mexico, Brazil and Russia • The 1997 Asian Crisis; Globalisation has exacerbated the situation. Excessive borrowing; rapid turnaround from inflows to outflows, collapse of the currency; internal liquidity crisis as the repayments of debt in the domestic currency rocketed. Evidence discussed later

24. The Balance-of-Payments Constrained Growth ModelA Quick Overview A very parsimonious model. Three equations: • A dynamic Keynesian demand for export function (x = z) • A dynamic Keynesian demand for imports function (m = y) • A balance-of-payments constraint that the growth of exports and imports must be equal (although the growth of capital flows can be incorporated into the model) (m = x) Substituting (i) and (ii) into (iii) gives yBP = z/

25. The Balance-of-Payments Constrained Growth Model Thirlwall’s law yBP = x/ = z/ This is the locus of growth rates for which the balance of payments is in equilibrium. It is a function of the ratios of the income elasticity of demand for exports and for imports. These reflect differences in a country’s non-price competitiveness. It also demonstrates the importance of export led growth,

26. The Balance-of-Payments Constrained Growth Model • It is explicitly demand oriented; the supply side adjusts to the long term growth of demand. • The balance of payments constrained growth rate is the maximum a country can grow at without encountering balance of payments problems. • The supply side can be incorporated into the model (later). • The simplest case can be illustrated in the next figure.

28. The Balance-of-Payments Equilibrium Growth Model Let us now justify the model in greater detail. Categories of growth yP = the growth of productive capacity (maximum growth rate). yBP = the balance-of- payments constrained growth rate. yA= the actual growth rate. yP > yBP  yA Balance-of-payments constrained growth (lower rate of capital accumulation, technical progress, disguised unemployment)

29. The Balance-of-Payments Equilibrium Growth Model • Not all countries can be simultaneously balance-of-payments constrained. (An exception is a deep recession and is due to the dynamics of adjustment). • Some countries will be either resource constrained (or supply-side constrained) or policy constrained (currently Germany?) • Therefore, failure to find one country is not balance-of-payments constrained does not refute the theory as a whole.

30. The Balance-of-Payments Equilibrium Growth Model The Extended Model

31. The Balance-of-Payments Equilibrium Growth Extended Model (1)Export demand equation x = z - (pd - pf - er) The growth of exports (x) is determined by the growth of world income (z) and the rate of change of relative prices. is the price elasticity (2) Import demand equation m = y +  (pd - pf - er) The growth of imports (m) is determined by the growth of domestic income (y) and the rate of change of relative prices.  is the price elasticity.

32. The Balance-of-Payments Equilibrium Growth Model (3) Balance-of-payments identity x + (1-)f  m + (pf – pd – er) The (weighted) growth of exports and the (weighted) growth of capital flows (f) must equal the growth of imports plus the rate of change of prices in a common currency.

33. The Balance-of-Payments Equilibrium Growth Model (3) Balance-of-payments identity x + (1-)f  m Suppose relative prices do not change, then if the growth of imports is greater than export growth, there must borrowing from abroad; hence the growth of capital flows into the country.

34. Solution to the model We substitute the three equations into each other and solve for the growth of domestic income. The growth of output yis determined by the growth of world incomez (as this determines the growth of exportsx), the rate of change of relative prices (relative price competitiveness) and the growth of capital inflows f .

35. Solution to the model • The first term z/is the effect of the exogenous growth of world income. • The second term (1--)(pd -pf -er)/gives the effect of the changes in relative prices. • The third term (1-)/fgives the effect of real capital inflows/outflows.

36. Solution to the model (1-  -)(pd -pf -er)/ = 0 • Marshall-Lerner condition is only just met • Pricing to market under oligopoly • J-curve effects • Non-price competitiveness more important (1-)/f = 0 • A country cannot finance a deficit indefinitely. Incorporating the growth of capital flows for plausible values makes little difference to the balance of payments growth rate.

37. This Gives Thirlwall’s Law yB = z/ = x/ UK e = 0.5 p = 1.0 z = 4.0% x =2% yBP = 2% JAPAN e = 3.5 p = 1.0 z = 4.0% x= 14% yBP = 14% If y = yB then we can infer that (i) the growth of capital flows is negligible (ii)  price effects are also minimal 

38. How do we Test the Law?

39. How do we Test the Law? • Estimate (Keynesian) export and import demand functions (including relative price effects). • Obtain statistical estimates of and . Estimate the export and import demand functions • Calculate the growth of the country’s export markets, z. • Calculate Thirlwall’s law.

40. Testing the Law Estimate • LnXt = c + b1lnZ + b2ln(RXP) + error term • lnMt =c + b2lnY + b4ln(RMP) + error term Note: No time-trend Originally OLS (Houthakker and Magee); now ECM, ADRL, testing for cointegration, panel data etc. Does not make a great deal of difference. Obain estimates of the long-run income elasticities ,  Calculate long-run growth rates (average over, say, ten years) of Z (weighted growth of country’s export markets) and Y. Calculate /z = yBP

41. Testing the Law Qualifications • Appropriate estimation technique(s) • Specification. Should an export supply function be included? • XS = f (RMP), Y or K)? But Y and K are assumed here to be exogenous, so misspecification to include them. They are assumed to be endogenous in the BoP approach. • High frequency data, in the short-run, firms have excess capacity to meet extra demand; long-run induced investment increases supply. Nearly all estimations of import and export demand functions make this assumption. • Difficulty in measuring REER, RXP, RMP. Proxies have to be used.

42. A Digression As Why not simply estimate y = c + b5z + b6(RP) + error term? • Loss of information • High frequency (annual) data • Serious misspecification omitting f,  not constant. What happens when f switches from > 0 to <0? • Problem using two price terms (RXP, RMP). The term used above convenient for theoretical modelling. • Nothing really to be gained.

43. The Weak and Strong Tests of the Law Compare actual growth rate y andyBP (1) Weak TestyBP = x/ (2) Strong TestyBP= z/ If they are close, then it shows that the growth of relative prices and capital flows are important and the country cannot grow faster than yBP. If they diverge, then the rate of change of relative prices and/or the growth of capital flows are quantitatively important.

44. Parametric Tests of the Balance-of-Payments Constrained Growth Model • Regress y on yBP across countries i.e. y = a + b yB (a = 0; b = 1) But, possibility of bias: • Incomplete sample • Outlying observations • McCombie Test Calculate  () separately for each individual country (y  x/) and compare with estimated  (*). If  not significantly different from *, yB will be a good predictor of y.

45. Calculations of the Growth Rate Consistent with Balance-of-Payments Equilibrium 1951-1973

46. Comparing African with Asian Countries, (in percentage points)

48. Estimates of Balance-of-Payments Constrained Growth for Asian and Latin American Countries Sources: a. Ansari, Hashemzadeh and Xi, ‘The Chronicle of Economic Growth in South East Asian Countries: Does Thirlwall’s Law Provide an Adequate Explanation?’ Journal of Post Keynesian Economics, 2000. b. Moreno-Brid and Perez, ‘Balance of Payments Constrained Growth in Central America’, Journal of Post Keynesian Economics, 1999

49. Considering Price and Non-price Competition Further • The “Kaldor Paradox” 2. Is the growth of relative prices important? If not, why not? 3. Is Non-price competitiveness important? The results of recent research. 4. “What you export Matters” (Hausmann et al.)

50. 1. The “Kaldor Paradox” Countries with deterioration in price competitiveness experienced an increase in export shares.