Three Lectures on Economic Efficiency and Growth CES ifo Thorvaldur Gylfason

Outline and aims Present a policy-oriented overview of the theory and empirical evidence of economic growth Trace linkages between economic growth and its main determinants: saving, investment, and economic efficiency Exogenous vs. endogenous growth Liberalization, stabilization, privatization Education, institutions, natural resources

Outline and aims Lecture I Lecture II Lecture III Saving, efficiency, and economic growth Lecture II Economic policy and growth Lecture III Education, natural resources, institutions, and empirical evidence

1 Introduction Growth theory Why important? As old as economics itself Smith, Marshall, Schumpeter, Keynes Explicit growth theory started with Harrod and Domar in 1940s Why important? Unfashionable in 1960s and 1970s Limits to growth, etc. Growth and development

Growing apart Investment Efficiency Institutions Policy Country B: 2% a year Investment Efficiency Institutions Policy GNP per capita Threefold difference after 60 years Country A: 0.4% a year 60 Years

The short run vs. the long run 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

Other comparisons West-Germany vs. East-Germany Austria vs. Czech Republic US vs. USSR South Korea vs. North Korea Taiwan vs. China Finland vs. Estonia See my Pictures of Growth www.hi.is/~gylfason/pictures2.htm China vs. Europe: 1:1 in 1400 1:20 in 1989

Further comparisons Thailand vs. Burma Mauritius vs. Madagascar Botswana vs. Nigeria Tunisia vs. Morocco Spain vs. Argentina Dominican Republic vs. Haiti

Singapore and Malaysia: GNP per capita 1962-2001 6.1% Current US$, Atlas method (1.02)40 = 2.2 4.1%

Botswana and Nigeria: GNP per capita 1962-2001 Current US$, Atlas method

Spain and Argentina : GNP per capita 1962-2001 Current US$, Atlas method

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

Ireland and Greece: GNP per capita 1962-2001 Current US$, Atlas method

Basic growth theory Harrod-Domar model Solow model Endogenous growth model Let’s do the algebra

Harrod-Domar model A Two assumptions Implications for growth gross net Fixed saving rate Fixed capital/output ratio Implications for growth gross net replacement

Harrod-Domar model Three propositions about growth v = K/Y 1/v = Y/K Saving increases growth Efficiency increases growth v = K/Y 1/v = Y/K Depreciation reduces growth

Solow model B Four assumptions Output growth equals labor force growth Full employment Constant growth of labor force Constant returns to scale Saving equals investment

Solow model Endogenous output/capital ratio Exogenous Exogenous Need to determine k and hence y/k

Solow model Dynamic stability of output/capital ratio Stable equilibrium

Solow model Dynamic stability of output/capital ratio E Stable equilibrium E

Solow model Two equations in two unknowns, y and k Long-run equilibrium

Solow model E Comparative statics: Output per head Comparative statics: E moves in response to changes in s, A, n, and  Output/capital ratio Capital per worker

Solow model Four propositions about long-run growth Increased saving increases income per capita Increased efficiency increases income per capita Increased population growth reduces income per capita Increased depreciation reduces income per capita

Closed-form solution to Solow model Labor-augmenting technological progress

Closed-form solution to Solow model

Closed-form solution to Solow model a(+n+q) is the speed of convergence

Closed-form solution to Solow model time

Solow model: Convergence Takes 17 years to close half the gap Takes 40 years to close 80% of the gap

Solow model: Convergence Output per head Rich country’s initial income per head Poor country must grow faster if it is to catch up Poor country’s initial income per head Capital per worker

An Increase in the Saving Rate P F Output per head E Capital per worker

An Increase in Static Efficiency P’ F P Output per head E Capital per worker

An Increase in Population Growth or Depreciation Output per head F Capital per worker

An Increase in Dynamic Efficiency (Technical Progress) Output per head E Capital per worker

Solow model: Conclusion Three main points to note Long-run growth is exogenous: g = n + q No role for economic forces, policy or institutions, just technology But education is good for growth Model implies convergence Poor countries grow more rapidly than rich The medium term can be quite long Growth is endogenous for a long while

Solow model with education H = skilled labor L = raw labor, b = years of schooling AH grows at n + q + b Education stimulates long-run growth

Endogenous growth C Two equations in two unknowns, g and q E = efficiency E = 1/v in Harrod-Domar Harrod-Domar, again, without the drawbacks Two equations in two unknowns, g and q

Endogenous growth Let’s take four examples C A B O Saving rate times efficiency minus depreciation Economic growth, g C A B 45° O Technological progress, q Population growth

1 A tax on education and endogenous growth A tax to finance education G = government spending on education G is financed by tax on capital Constant returns to capital A tax to finance education is good for growth

2 Inflation, money, and endogenous growth Inflation impedes growth Output is made by financial and real capital Inflation reduces the use of financial capital Inflation impedes growth

3 Education and endogenous growth, again R&D model (Romer) b = fraction of labor force engaged in R&D bL = number of workers engaged in R&D A = stock of existing knowledge Growth depends on R&D

4 Education and endogenous growth, once more Human capital model (Lucas) c = human capital Less education means less growth h = fraction of time spent on work Let’s look at some evidence, but first …

How growth becomes endogenous Solow model: when s rises, E = Y/K falls due to decreasing returns to capital, so g stays put Endogenous growth: when s rises, E stays put due to constant returns to capital, so g rises

Empirical growth research Cross-country regressions Large samples, beginning in 1960 or 1970 Cross sections vs. panels Averages vs. initial values of independent variables Cost of simultaneity bias vs. cost of discarding available data Recursive modeling vs. instruments Levels of income vs. rates of growth

Recursive modeling Growth regression g = a0 – a1y0 + a2x + a3z (1) where x is exogenous and z is endogenous z = b0 + b1y0 – b2x (2) where z is, say, education and x is natural resource reliance Eq. (2) makes z exogenous, so (1) and (2) can be estimated by OLS TSLS calls for instruments that help explain z without being correlated with g: Not easy

Levels of income vs. rates of growth

Levels of income vs. rates of growth

Levels of income vs. rates of growth

Levels of income vs. rates of growth

Levels of income vs. rates of growth Conditional convergence requires b > 0  < 1 One-to-one correspondence between parameters

Absolute convergence: Growth rates Equatorial Guinea b = 0.864 165 countries

Absolute convergence: Levels of income = 0.658 = 1 – 0.40.864 Equatorial Guinea Conditional convergence is stronger, as we will see 45º 165 countries

From efficiency to growth Basic result If it – anything! – increases economic efficiency, it is also good for growth Follows from Harrod-Domar model as well as from endogenous-growth theory and also, as a proposition about the medium run, from the Solow model In practice, Solow model and endogenous growth are hard to distinguish So, let’s look more closely at efficiency

Liberalization Increases Economic Efficiency D Domestic, distorted price ratio H E Traditional output C G Modern output O

Liberalization Increases Economic Efficiency World price ratio D Domestic, distorted price ratio H E If output gain = E and price distortion = c, then E = mc2 Traditional output Output gain Price distortion OC = modern output CA = traditional output OA = total output F C A G B Modern output O

Liberalization Increases Economic Efficiency Welfare gain World price ratio Exports D Domestic, distorted price ratio J K H E Traditional output Output gain Price distortion Imports F C A G B Modern output O

Liberalization Increases Economic Efficiency Transition takes time: From E to F via M, N, and Q Welfare gain D J H E M Traditional output N Price distortion Q F C A G B Modern output O

Liberalization Increases Economic Efficiency Welfare gain World price ratio K D J Productivity gain E Traditional output AB = static gain BC = dynamic gain AC = AB + BC = total gain Price distortion H F A G Modern output O B C

Stabilization Increases Economic Efficiency Distorted price ratio If output gain = E and inflation distortion = c, then, again, E = mc2 D Inflation distortion C E Output gain F Undistorted price ratio Real capital G Output after Output before 45° H Financial capital O A B

Privatization Increases Economic Efficiency Undistorted price ratio D E Distorted price ratio H Public output Price and quality distortion F J Output gain 45° O N Private output A K G B

From efficiency to growth: 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

Investment and growth, 1965-1998 An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year Botswana Thailand r = rank correlation Jordan 1% 4% Nicaragua r = 0.65 85 countries

Education and growth, 1965-1998 87 countries A 25 point increase in secondary-school enrolment goes along with an increase in per capita growth by 1% per year Thailand Japan Finland Diminishing returns: The additional benefit from education becomes smaller as enrolment increases Ghana r = 0.72 87 countries

Natural resources and growth, 1965-1998 An increase in the natural capital share by 8% goes along with a decrease in per capita growth by 1% per year Mauritius Cameroon Mali Madagascar r = -0.64 85 countries

Democracy and growth, 1965-1998 Democracy and growth go together Equatorial Guinea Botswana Singapore Korea Cyprus Saudi-Arabia Malaysia China Now, let’s run some regressions r = 0.48 144 countries

Growth regressions Based on World Bank data World Development Indicators, published each year on CD Wide coverage: 208 countries, 42 years Could also use Penn data (compiled by Summers and Heston), but they cover fewer countries Here, we report cross-sectional evidence, representing each country by a single observation for each variable

POLITY2 describes democracy on a scale from -10 to 10 Keep an eye on the number of observations An increase in democracy by 15 points (e.g., from –7 to 8) increases growth by 1 percentage point

INITIAL is the log of per capita GNP in 1960, so the coefficient describes the speed of convergence

PRIMGDP is the share of primary production in GDP An increase in the share of primary production in GDP by 14% increases growth by 1 percentage point

INVEST is the ratio of investment to GDP An increase in investment by 9% of GDP increases growth by 1 percentage point

LOGENROL is the log of secondary-school enrolment (net) An increase in secondary-school enrolment by 100% (e.g., from 40% to 80%) increases growth by nearly 1 percentage point

DISTORT = /(1+ ) A decrease in inflation from 50% to zero increases growth by nearly 1 percentage point

DUMMYAFR is a dummy for sub-Saharan Africa

Dependent variable is now the level of per capita GNP: same story Conditional convergence, as before

BIRTHS is the number of births attended by skilled medical staff (%) BIRTHS makes African dummy redundant

Grand finale Dependent variable: per capita growth 1960-2000, R2 = 0.68 If Panama became like Costa Rica, growth would rise by 1% Effects of democracy Growth equation Total effect of democracy on growth is 0.051 + 0.013 + 0.019 + 0.020 = 0.103 Investment equation Education equation Health equation Democracy equation

Grand finale Dependent variable: per capita growth 1960-2000, R2 = 0.68 Effect of primary production on growth Effects of natural resources Growth equation Total effect of primary share on growth is 0.026 + 0.014 + 0.010 + 0.012 = 0.062 Investment equation Education equation Health equation Democracy equation

The End Conclusion Saving and efficiency are good for growth Efficiency gains take many different forms The End Liberalization, stabilization, privatization Conversion of inputs into output is not solely a matter of technology, but also efficiency, so economic policy matters

Classroom discussion