Growth Diagnostics in Practice Applied Inclusive Growth Analytics Course June 29, 2009 Susanna Lundstrom, PRMED

Outline  What is so special about diagnostics?  Three common tools, with pros and cons: Cross-country regressions (Growth Accounting) International Benchmarking and Indices All are used in Inclusive Growth Analytics, but more is added  Basic Principles in Growth Diagnostics  Applications throughout the course! See Hausmann, Klinger and Rodrigo (2008)

Growth research vs. Growth diagnostics  In growth research the subject is growth with countries as observations What do policy X do on average, to a randomly selected country?  In growth diagnostic, the subject is the country What particular problem does the country in question have? How would this specific country react to policy X? Informed by growth research…  Analogy: Medical research and practice

Cross-country growth regressions  “What factors affect growth in a typical country?” Countries are just observations But running out of degrees of freedom  Very important in understanding potential constraints  If used with interaction terms – more context specific Given the presence of X 2t, X 1t will have this effect on g t But running out of degrees of freedom…

Cross-country growth regressions - Some characteristics  Normally assumes separability (if no interaction terms) The impact of variable x 1 on growth is independent of the level of the other x’s I.e., no context-specific interactions taken into account  Assumes linearity All x’s are substitutes of each other I.e., you can compensate failures in one area by over- performance in other areas. But if there are binging constraints….  Assumes monotonicity and linearity in the x’s - in the absence of squared forms Increases in x from any level increases g Increases in x from any level has the same effect on g  All β’s are the same for all countries

Cross-country growth regressions - Some characteristics, cont  Only data that you have for all countries can be included – often outcome rather than policy based Example: Private credit/GDP ratio instead of a policy- based index of financial liberalization  No price information in the equation Supply or a demand problem?  Low supply, high price – potential constraint  Low supply, low price – low demands and not necessarily a constraint  Results sensitive to the elimination of outliers Sensitivity to groups of outlier – indicates context- sensitive effects

International Benchmarking - Comparative countries  Similar countries (landlocked, conflict…) but with different GDP Ideally, one should aspire to a “natural experiment” where the selected benchmark is a replica in all but one respect to the country under study  “Role models” Where would we want to be in 2, 10 and 20 years? A particular country or set of countries which performance or welfare indicator wants to be attained by the studied country Partial correlation with a group of countries Compare with the expected value (fitted line) given the GDP level in the country

International Benchmarking - Indices and rankings  See examples on the IG website (“Data and References”)  Complex systemic outcomes Does not map easily into policy  How to collapse to a single dimension? Take the average  Assumes linearity and separability  Assumes monotonicity and linearity in x:s Is the optimal number of licenses zero? Is an increase from 1 to 2 the same as from 9 to 10?

International Benchmarking - Surveys and perception data  Sample selection bias The binding constraint causes firms not to exist and biases the survey You talk to “camels” rather than “hippos”  International comparison of opinions What does it take for a Swede to complain about corruption? Do all nationalities have a tendency to complain more about taxes than human capital?

International Benchmarking - General problem  Not obvious the focus should be on the areas where you perform poorly compared to other countries Poor supply (and hence a constraint)..or low demand (and hence not obvious)? Depends on the economic structure (human capital more important in the US than Zambia)

Basic principles of country diagnosis - Examples will follow throughout the course… If a constraint is binding, then… 1. The (shadow) price of the constraint should be high 2. Movements in the constraint should produce significant movements in the objective function (e.g. GDP, or income of a specific group of ind.) 3. Agents in the economy should be attempting to overcome or bypass the constraint 4. Camels and Hippos: Agents less intensive in that constraint should be more likely to survive and thrive, and vice versa

1. The (shadow) price of the constraint is high  Relative scarcity of a factor. Look at prices if they exist (interest rates, wages, etc.)  Estimate prices using regressions Example: Mincerian regressions  In other cases with no market price: Infrastructure: congestion as the “price to pay” Non-market valuation techniques, either based on revealed or in stated preferences.  Ex: Hedonic prices, ICAs stated preferences

2. Differences in the constraint should produce differences in growth  A constant cannot explain a change  Differences Between time periods (look at trend breaks)  Do growth periods following a relaxation of the constraint? Do growth decrease when it is present? Between regions  Why are some prosperous and some lagging? The constraint in question present in one but not the other? Between groups of firms differently affected by the potential constraint

3. Agents in the economy must be engaging in efforts to overcome or by-pass the constraint  Examples: Border controls  smuggling Poor financial intermediation  growth occurs within business groups (conglomerates) I ndustry specific public goods binding  growth in sectors less sensitive to specific inputs or unusual level of cooperation among successful producers. Property rights and contracting binding  Mafia

4. Camels vs. hippos  The surviving sector (“camels”) are those least intensive in or least dependent on the binding constraint (“water in a desert”)  In a good investment climate (“environment with water”) the economy, and the thought comparative advantages, may look differently (“hippos”)  What do analysis of camels reveal about potential constraints? Are successful groups particularly connected to the political system? Any “missing factors” within the successful industry?  The importance of analyzing hippos? Example: Informal ICAs