Openness and Thorvaldur Gylfason Or why international trade is good for economic growth Growth

Growing Apart Different national economies have grown at different rates in the past Nations that started out in similar circumstances a few decades ago can have vastly different standards of living today Reasons for differences Different economic systems Different economic policies

Time National economic output Rapid growth Slow growth West-Germany : East-Germany Austria : Czech Republic Finland : Estonia Taiwan : China South Korea : North Korea Botswana : Nigeria Kenya : Tanzania Thailand : Burma Tunisia : Morocco Spain : Argentina Mauritius : Madagascar Economic system Economic policy? Growing Apart

Botswana and Nigeria: GNP per capita Case 1 Current US$, Atlas method

Spain and Argentina: GNP per capita Current US$, Atlas method Case 2

Mauritius and Madagascar: GNP per capita Current US$, Atlas method Case 3

Economic Systems and Policies Economic systems and growth As a rule, mixed market economy grows more rapidly than centrally planned economy Economic policies and growth Policies that promote economic efficiency are also good for growth Liberalization, stabilization, privatization Education, diversification

Extensive and Intensive Growth Main determinants of economic growth Saving and high-quality investment Economic efficiency, including technology Extensive growth through accumulation Saving and investment Intensive growth through better use of existing resources More efficiency, better technology Education

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

++ + Adam Smith knew this, and more, as did Arthur Lewis Sources of growth: Investment and education Robert Solow raised doubts on long-run linkages Growth is exogenous

More sources of growth denotes a positive effect in the direction shown + Arthur Lewis: x is mainly trade, stable politics, good weather Growth is endogenous

Sources of Endogenous Growth East Asia OECD Africa High saving rates Medium saving rates Low saving rates Income per capita

Growth and Investment, countries 10% 1½%1½% Botswana Each ten percentage point increase in the investment ratio is associated with an increase in per capita growth by 1½% per year. Let’s be more specific

Growth and Investment, countries An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year. r = 0.65 How about initial income?

Growth and Education, countries An increase in secondary-school enrolment by 40% of each cohort goes along with an increase in per capita growth by 1% per year.

Growth and Education, countries How about initial income? Positive but diminishing returns to education

Efficiency is Key Need economic policies that increase efficiency Produce more output from given inputs Takes fewer inputs to produce given output More efficiency, better technology are two ways of increasing output per unit of input So is more and better education Trade increases efficiency and thereby also economic growth

A Simple Model of Endogenous Growth Four building blocks: Four building blocks: S = I S = I Saving equals investment in equilibrium S = sY S = sY Saving is proportional to income I =  K +  K I =  K +  K Investment means addition to capital stock Y = EK Y = EK Output depends on quality and quantity of capital

A Simple Model of Endogenous Growth Let´s do the arithmetic: Let´s do the arithmetic: S = sY = I =  K +  K S = sY = I =  K +  K =  Y/E +  Y/E =  Y/E +  Y/E Rearranging terms we find Rearranging terms we find  Y/E = sY -  Y/E  Y/E = sY -  Y/E Multiplying by E and dividing by Y gives Multiplying by E and dividing by Y gives  Y/Y = sE -   Y/Y = sE - 

A Simple Model of Endogenous Growth Growth equation: g = sE -  g = sE -  Rate of economic growth equals n Saving rate times n Efficiency minus n Depreciation

Sources of Endogenous Growth 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

Sources of Endogenous Growth Five main sources of increased efficiency Five main sources of increased efficiency 1.Liberalization of prices and trade increases efficiency, and thus is good for growth 2.Stabilization reduces the inefficiency associated with inflation, and thus is good for growth 3.Privatization reduces the inefficiency associated with state-owned enterprises, and thus … 4.Education makes the labor force more efficient 5.Technological progress also enhances efficiency The possibilities are virtually endless!

So What to Do to Encourage Economic Growth Maintain strong incentives to save Keep inflation low and real interest rates positive Maintain financial system in good health so as to channel saving into high-quality investment Place strong emphasis on efficiency 1. Liberal price and trade regimes 2. Low inflation 3. Strong private sector 4. More and better education 5. Limited natural resources

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 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. Compare North Korea with Hong Kong and Singapore Compare North Korea with Hong Kong and Singapore More efficiency is good for growth.

Market Equilibrium and Economic Welfare Supply Demand E Producersurplus Consumersurplus Quantity Price A B C Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE)

Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss equivalent to the triangle EFG A B C Consumer surplus = AFGH H J Market Intervention and Economic Welfare Producer surplus = CGH Total surplus = AFGC

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

Liberalization Increases Economic Efficiency Modern output Traditional output Traditional output World price ratio D D G Domestic, distorted price ratio Domestic, distorted price ratio F E A B C Price distortion Price distortion H H O If output gain = E and price distortion = c, then E = mc 2 Output gain OC = modern output CA = traditional output OA = total output

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

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

How Trade Increases Efficiency Autarky breeds inefficiency Trade with other nations increases efficiency by allowing 1.Specialization through comparative advantage 2.Exploitation of economies of scale 3.Promotion of free competition Not only trade in goods and services, but also in capital and labor “Four freedoms”

How Trade Increases Efficiency Trade also encourages international exchange of Ideas Information Know-how Technology Trade is education Which is also good for growth

Large and Small Countries Small countries need trade to extend their markets beyond their national borders Large countries need trade less than small Domestic trade replaces foreign trade Evidence from around the world Small countries have higher ratios of exports to GDP than large countries

Selected Countries: Exports (% of GDP)

Empirical Evidence Openness can be defined as export ratio adjusted for country size (e.g., population) Evidence shows that open economies tend to grow more rapidly than closed economies Trade encourages growth Growth encourages trade Other measures of openness yield a similar conclusion

Openness and Growth countries An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year.

Bottom Line Increased openness stimulates economic efficiency and growth as long as the gains from trade are well distributed Continued globalization is thus by no means sure to succeed Need to pay attention to distribution as well as growth The End