2. To Grow or Not to Grow: That is the Question Thorvaldur Gylfason

3. Outline I.Pictures of growth II.Determinants of growth 1.Saving and investment 2.Efficiency a)Liberalization b)Stabilization c)Privatization d)Diversification III.Empirical evidence of growth

4. Economic growth: The short run vs. the long run Time National economic output Actual output Potential output Business cycles in the short run Economic growth in the long run Downswing Upswing The crisis of 1997-98 is irrelevant to Asia’s long-term growth potential.

5. Economic growth: The short run vs. the long run To analyze the movements of actual output from year to year, viz., in the short run Need short-run macroeconomic theory Keynesian or neoclassical To analyze the path of potential output over long periods Need modern theory of economic growth Neoclassical or endogenous

6. Growing together, growing apart 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?

7. Growing apart Years Output per capita Country B: 2% a year Country A: 0.4% a year Efficiency Efficiency Economic system Economic system Economic policy Economic policy Threefold difference after 60 years 0 60 Divide into 72 by the growth rate to find the number of years it takes of income per head to double

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

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

10. More sources of growth + + + denotes a positive effect in the direction shown + Arthur Lewis: x is trade, stable politics, good weather But Solow carried the day: long-run growth is exogenous

11. Botswana and Nigeria: GNP per capita 1964-99 Case 1 Current US$, Atlas method

12. Kenya, Tanzania, and Uganda: GNP per capita 1964-99 Case 2 Current US$, Atlas method

13. Burma and Thailand: GNP per capita 1960-97 Case 3 Local currency, 1988 prices, 1960 = 100

14. Barbados, Dominican Republic, and Haiti: GNP per capita 1964-99 Case 4 Current US$, Atlas method

15. Egypt, Morocco, and Tunisia: GNP per capita 1964-99 Case 5 Current US$, Atlas method

16. Argentina, Uruguay, and Spain: GNP per capita 1964-99 Case 6 Current US$, Atlas method

17. Madagascar and Mauritius: GNP per capita 1964-99 Case 7 Current US$, Atlas method

18. Chile and Zambia: GNP per capita 1964-99 Case 8 Current US$, Atlas method

19. Ireland and Greece: Ireland and Greece: GNP per capita 1964-99 Case 9 Why? Current US$, Atlas method

20. More sources of growth + + + denotes a positive effect in the direction shown + Arthur Lewis: x is trade, stable politics, good weather But Solow carried the day: long-run growth is exogenous

21. Investment is good for growth, but hardly explains the growth differential between Ireland and Greece Ireland and Greece: Ireland and Greece: Investment 1960-99 (% of GDP)

22. Education is good for growth Ireland and Greece: Ireland and Greece: Expenditure on education 1960-96 (% of GNP)

23. Foreign trade is good for growth Ireland and Greece: Ireland and Greece: Exports 1960-99 (% of GNP)

24. 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

25. The New Theory of Endogenous Economic Growth Traces the rate of growth of output per capita to three main sources: SavingEfficiencyDepreciation “The proximate causes of economic growth are the effort to economize, the accumulation of knowledge, and the accumulation of capital.” W. ARTHUR LEWIS

26. 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 spectacular growth performance of Asia since the 1960s. The new view that long-run growth depends on saving, efficiency, and depreciation is more illuminating. Besides, it’s not really new, because Adam Smith knew this (1776).

27. One crucial implication of exogenous growth The neoclassical view If two countries are identical (same saving rate, same population growth, same technology), then their income per head will ultimately be the same. This means that poor countries must grow faster than – catch up with! – rich countries: “conditional convergence” Endogenous growth theory does not have this implication.

28. Enter initial income + + + – + denotes a positive effect in the direction shown – denotes a negative effect in the direction shown ? Conditional convergence

29. Absolute convergence? Do poor countries catch up? r = -0.09 Botswana China Korea Nicaragua Thailand Indonesia No sign that poor countries grow faster than rich 85 countries r = rank correlation Conditional convergence does not entail absolute convergence

30. Enter natural resources + + + –– + denotes a positive effect in the direction shown – denotes a negative effect in the direction shown ? Endogenous growth: x can be almost anything! Dutch disease and rent seeking

31. A simple model of endogenous growth Four building blocks: n S = I Saving equals investment in equilibrium. Saving equals investment in equilibrium. n S = sY Saving is proportional to income. Saving is proportional to income. n I =  K +  K Investment involves addition to capital stock. Investment involves addition to capital stock. n Y = EK Output depends on quality and quantity of capital. Output depends on quality and quantity of capital.

32. A simple model of endogenous growth Implication: n g = sE -  Rate of economic growth equals n Saving rate times n Efficiency (i.e., the output/capital ratio) minus n Depreciation

33. 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 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

34. 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.

35. Sources of endogenous growth I 100 400 300 200 1965 1990 East Asia OECD Africa High saving rates Medium saving rates Low saving rates Income per capita

36. Growth and investment, 1965-98 109 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. South Africa

37. Growth and investment, 1965-98 33 sub- Saharan African countries Each ten percentage point increase in the investment ratio is associated with an increase in per capita growth by 1½% per year.

38. Growth and investment, 1975-1998 Each ten percentage point increase in the investment ratio is associated with an increase in per capita growth by 1½% per year. 11 MEFMI countries

39. Investment and economic growth r = 0.65 Jordan Botswana Nicaragua 85 countries An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year. 4% 1% Thailand

40. Sources of endogenous growth II Depreciation The effect of depreciation on growth is related to that of saving and investment on growth. The effect of depreciation on growth is related to that of saving and investment on growth. Unprofitable investment in the past reduces the quality of capital and makes it depreciate more rapidly, necessitating more replacement investment to make up for economic and physical wear and tear. Unprofitable investment in the past reduces the quality of capital and makes it depreciate more rapidly, necessitating more replacement investment to make up for economic and physical wear and tear. The more national saving has to be set aside for replacement investment, the less will be available for the buildup of new capital. The more national saving has to be set aside for replacement investment, the less will be available for the buildup of new capital.

41. Investment: Quantity and quality Compare Botswana and Tanzania: In Botswana, the share of State-Owned Enterprises in total investment fell from 16% in 1985-90 to 12% in 1990-97. In Tanzania, the SOE share of investment fell from 46% in 1985-90 to 23% in 1990-97. This is probably a good sign. Privatization helps improve investment.

42. Investment: Quantity and quality Investment quality, however, is not only a question of public vs. private enterprise. Sound banking is also important. It takes sound commercial banks, usually privately owned banks motivated by profit rather than by political concerns, to channel household savings into high-quality investment.

43. 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.

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

45. 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.

46. What to do to encourage economic growth Recap 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 Foster efficiency 1. Liberal price and trade regimes 2. Low inflation 3. Strong private sector 4. More and better education 5. Limited, or well managed, natural resources 6. Reasonable equality

47. 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. North Korea and Cuba vs. Hong Kong and Singapore North Korea and Cuba vs. Hong Kong and Singapore Applies to trade in goods, services, capital. 1

48. Growth and trade, 1965-98 105 countries NB: UAE, Hong Kong, and Singapore. Singapore Hong Kong United Arab Emirates China Korea Botswana Each 50 percentage point increase in the trade ratio is associated with an increase in per capita growth by almost 1% per year.

49. Growth and trade, 1965-98 32 sub- Saharan African countries Each 20 percentage point increase in the trade ratio is associated with an increase in per capita growth by 1% per year.

50. Growth and trade, 1975-1998 Each ten percentage point increase in the trade ratio is associated with an increase in per capita growth by almost 1% per year. 11 MEFMI countries

51. Openness and growth 1965-98 87 countries An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year. r = 0.40

52. Growth and foreign direct investment, 1965-98 100 countries Qualification: Relationship rests on Botswana and Singapore. Botswana Singapore Each three percentage point increase in the FDI ratio is associated with an increase in per capita growth by almost 1% per year.

53. Growth and foreign direct investment, 1965-98 Each one percentage point increase in the FDI ratio is associated with an increase in per capita growth by almost 1% per year. 31 sub- Saharan African countries Relationship depends on the inclusion of Botswana. Botswana

54. Growth and FDI, 1975-1998 Each ten percentage point increase in the FDI ratio is associated with an increase in per capita growth by 1% per year. 11 MEFMI countries

55. Openness to FDI and growth 1965-98 Botswana An increase in openness to FDI by 2% of GDP is associated with an increase in per capita growth by more than 1% per year. r = 0.62 85 countries

56. 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 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. Inflation thus involves a tax, the inflation tax. An inefficient tax compared with most other taxes. An inefficient tax compared with most other taxes. Inflation also creates uncertainly which tends to discourage trade and investment. 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. Inflation also tends to result in overvaluation of currency, thus hurting exports and growth. 2

57. Money and inflation, 1990-1998 A 10 percentage point increase in annual inflation is associated with a decrease in money and quasi-money by 3% of GDP.

58. 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. 3

59. 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

60. Same story time and again Can describe this by simple arithmetic The efficiency gain from eliminating an economic distortion (trade restrictions, inflation, unnecessary state intervention, insufficient education) is directly proportional to the square of the distortion: E = mc 2 E stands for efficiency gain, m is a multiplicative constant, and c is the distortion

61. E = mc 2 If the distortion is substantial (severe trade restrictions, high inflation, big SOE sector, poor education), then reducing or eliminating the distortion can increase efficiency and growth a great deal. We can see this by plugging appropriate numbers into the formula and also by econometric research, where the theory is compared with experience (i.e., economic statistics).

62. Education 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 primary and secondary education to all, especially females Need to provide tertiary education to a greatly increased number of people Need to provide tertiary education to a greatly increased number of people Need increased public commitment to education 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. This requires both increased public expenditure on education and probably also increased scope for private sector involvement in education. 4

63. Growth and education, 1965-98 86 countries An increase in secondary-school enrolment by 4% of each cohort goes along with an increase in per capita growth by 1% per year.

64. Growth and education, 1965-98 Each two percentage point increase in the education expenditure ratio is associated with an increase in per capita growth by about 1% per year. 33 sub- Saharan African countries

65. Growth and education, 1975-1998 Each two percentage point increase in the education expenditure ratio is associated with an increase in per capita growth by almost 1% per year. 11 MEFMI countries

66. Growth and education, 1965-98 Positive but decreasing returns to education An increase in secondary-school enrolment by 25% of each cohort goes along with an increase in per capita growth by 1% per year r = 0.72 87 countries

67. Natural resources and economic growth Natural resources, if not well managed, may turn out to be, at best, a mixed blessing. Three possible channels Dutch disease Dutch disease Rent seeking Rent seeking Education Education What is the evidence? 5

68. Natural resource abundance and economic structure Resource poor, resource dependent (Chad, Mali) Resource rich, resource dependent (OPEC) Resource rich, resource free (Canada, USA) Resource poor, resource free (Jordan, Panama) Resource dependence Resource abundance

69. Natural resources and economic growth 1965-98 Abundant natural resources, if not well managed, appear harmful to growth. 86 countries A ten percentage point increase in the natural capital share goes along with a decrease in per capita growth by nearly 1% per year.

70. Natural capital and economic growth 85 countries What is the empirical evidence? r = rank correlation An increase in the natural capital share by 8% goes along with a decrease in per capita growth by 1% per year. r = -0.64 8 African countries I/Y = 0.05 8 Asian countries I/Y = 0.32 Notice two clusters A new measure of natural resource abundance A new measure of natural resource abundance Confirms results based on other measures Confirms results based on other measures Venezuela Australia

71. Recent literature Four main linkages: 1.Dutch disease Hurts level or composition of exports 2.Rent seeking Protectionism, corruption 3.Education 4.False sense of security Poor quality of policies and institutions 5. Investment But Norway is, so far at least, an exception Foreign capital Social capital Human capital Real capital Natural capital tends to crowd out

72. + + + –– – – Enter natural resources ? Natural resource abundance hurts investment and education, and hence also growth

73. Growth and agriculture, 1975-1998 A 25 percentage point decrease in the share of agriculture in GDP is associated with a increase in per capita growth by 1% per year. 11 MEFMI countries

74. Natural resources and education 90 countries An 18 percentage point increase in the natural capital share is associated with a decrease in public expenditure on education by 1% of GNP. Abundant natural resources appear to crowd out human resources.

75. Secondary-school enrolment and natural capital r = -0.66 Finnland Niger Vietnam Uruguay An increase in natural capital by 5% of national wealth goes along with a reduction in secondary-school enrolment by almost 10% of each cohort 91 countries Congo Increased natural resource abundance hurts education and growth

76. Natural capital and investment An increase in the natural capital share by 10% is associated with a decrease in investment by 2% of GDP. r = -0.38 Congo Sierra Leone Mali 85 countries

77. Natural capital and financial depth 85 countries r = -0.68 Italy Portugal New Zealand

78. Financial depth and economic growth 85 countries r = 0.66 Jordan Switzerland Japan Indonesia

79. Natural resources and corruption Abundant natural resources appear to go along with corruption. 45 countries

80. 6 Inequality and economic growth Two views: 1.Inequality is good for growth Too much equality weakens incentives to work, save, and acquire an education Too much equality weakens incentives to work, save, and acquire an education 2.Inequality is bad for growth Too much inequality reduces social cohesion and creates conflict Too much inequality reduces social cohesion and creates conflict What is the empirical evidence?

81. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Gini coefficient: An index of inequality

82. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Gini coefficient and the 20/20 ratio Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio

83. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio Gini coefficient and the 20/20 ratio

84. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio Gini coefficient and the 20/20 ratio

85. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio Gini coefficient and the 20/20 ratio

86. Gini = 25  20/20 ratio = 3 (Scandinavia) Gini = 30  20/20 ratio = 4 (Germany) Gini = 35  20/20 ratio = 6 (UK) Gini = 40  20/20 ratio = 8 (USA) Gini = 50  20/20 ratio = 15 (Nigeria) Gini = 60  20/20 ratio = 26 (Brazil) Increase in Gini coefficient by 10 points roughly doubles the 20/20 ratio Gini coefficient and the 20/20 ratio

87. An increase in Gini index by 12 points goes along with a decrease in per capita growth by almost 1% per year r = rank correlation r = -0.50 Growth and inequality, 1965-98 What do the data say? Sweden Thailand Central African Republic South Africa France Brazil No discernible sign that equality stands in the way of economic growth Korea 75 countries Lesotho

88. Inequality and natural resource abundance An increase in natural capital by 3% of national wealth goes along with an increase in Gini index by 1 point 7 African countries where investment is 5% of GDP and per capita growth is -1% per year Notice a cluster Increased natural resource abundance increases inequality and reduces growth Rwanda Mauritania Norway Bangladesh r = 0.41 75 countries

89. What is the upshot? Economic growth responds to public policy. In particular, by encouraging saving and investment of high quality saving and investment of high quality foreign trade and investment foreign trade and investment education education economic diversification economic diversification... the government can help foster rapid economic growth.

90. Sir Arthur Lewis got it right Since the second world war it has become quite clear that rapid economic growth is available to those countries with adequate natural resources which make the effort to achieve it. W. ARTHUR LEWIS (1968)

91. What else? These lessons are borne out by experience from around the world. Additional lessons: Too much inflation hurts saving, investment, and trade and thereby also growth. Too much inflation hurts saving, investment, and trade — and thereby also growth. Too much SOE activity hurts the quality of investment and education and growth. Too much SOE activity hurts the quality of investment and education — and growth. Too much agriculture and, more generally, natural resource dependence, if not well managed, hurts education and trade and thereby also growth. Too much agriculture and, more generally, natural resource dependence, if not well managed, hurts education and trade — and thereby also growth. Too rapid population growth also tends to impede economic growth. too much inequality also tends to impede economic growth. And too much inequality also tends to impede economic growth.

92. Reservations Even so, the question of rapid growth is, of course, a bit more complicated. We also need to address a host of political, social, and cultural questions as well as questions of natural conditions, climate, and public health — which would take us too far afield. But the main point remains: To grow or not to grow is in large measure a matter of choice. To grow or not to grow is in large measure a matter of choice. Many of the constraints on growth are man- made, and can be removed. Many of the constraints on growth are man- made, and can be removed.

93. Conclusion: It can be done Economic growth makes a difference, especially in poor countries. A question literally of life and death And not only in poor countries, for there is poverty amid plenty in rich countries Recall the main point of Gunnar Myrdal’s Asian Drama (1968): It was that the Asian economies were incapable of rapid economic growth! New growth theory suggests that similar claims about Africa will also be proven wrong.

94. To grow or not to grow is in large measure a matter of choice. These slides can be viewed on my website: www.hi.is/~gylfason/lesotho.htm Conclusion: It can be done The End