1. Thorvaldur Gylfason Joint Vienna Institute/ Institute for Capacity Development Distance Learning Course on Financial Programming and Policies Vienna, Austria N OVEMBER 26–D ECEMBER 7, 2012

2. I.Determinants of growth 1)Saving and investment 2)Efficiency a)Liberalization b)Stabilization c)Privatization d)Education e)Finance f)Diversification g)Institutions II.Pictures of growth III.Empirical evidence

3. Time National economic output Actual output Potential output Business cycles in the short run Economic growth in the long run Downswing Upswing

4. actualoutput shortrun To analyze changes in actual output from year to year – in the short run Need short-run macroeconomic theory Keynesian or neoclassical potentialoutput longperiods To analyze the path of potential output over long periods theory of economic growth Need modern theory of economic growth Neoclassical or endogenous

5. 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?

6. Years Output per capita Case B: 2% a year Case A: 0.4% a year Aspects of efficiency Economic system Economic system Economic policy Economic policy Threefold difference after 60 years 0 60 China – Europe: 1:1 in 1400 1:20 in 1989

7. Growth InvestmentEducation ++ + denotes a positive effect in the direction shown

8. Growth InvestmentEducation ++ Adam Smith knew all this, and more, as did Arthur Lewis

9. Growth InvestmentEducation ++ Robert Solow raised doubts about long-run linkages

10. Growth InvestmentXEducation ++ Arthur Lewis: X X can be trade, stable politics, good weather

11. Growth InvestmentXEducation ++ But Solow carried the day: long-run growth is exogenous!

12. Growth InvestmentTradeEducation ++ X Suppose X is openness to trade; then … +

13. Traces the rate of growth of output per capita to a single source: Technological progress Technological progress economic policy Hence, long-run growth 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

14. Traces the rate of growth of output per capita to three main sources: Saving Saving Efficiency Efficiency Depreciation Depreciation “The proximate causes of economic growth are the effort to economize, the accumulation of knowledge, and the accumulation of capital.” W. ARTHUR LEWIS

15. Harrod-Domar model You may recognize the endogenous growth model as a reinterpretation of the Harrod-Domar model where growth depends on The saving rate The saving rate The capital/output ratio The capital/output ratio The depreciation rate The depreciation rate

16. 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

17. 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  Y/E = sY -  Y/E  Y/E = sY -  Y/E Multiplying by E and dividing by Y gives  Y/Y = sE -   Y/Y = sE - 

18. Bottom line n g = sE -  Rate of economic growth equals n Saving rate times n Efficiency (i.e., the output/capital ratio) minus n Depreciation

19. Three implications for growth Saving is good for growth Efficiency helps growth Depreciation hurts growth g = sE - 

20. economic growth  Our standard of living today depends solely, by definition, on economic growth  Rich countries grew rapidly  Rich countries are rich because they grew rapidly over long periods  Poor countries did not grow rapidly enough  Poor countries are poor because they did not grow rapidly enough  So why do some countries grow more rapidly than others?  Why, e.g., did Thailand leave Zambia so far behind in one generation?  Hard to think of anything else (Lucas)

21.  Thailand and Zambia started out in a similar position and grew apart growth-friendly policies  Thailand pursued growth-friendly policies, stressing liberal trade, stability, private enterprise, and education GDP per capita 1965-2004 GDP per capita 1965-2004 (US$ at 2000 prices) Thailand 4.7% per year Zambia -1.5% per year 1.062 39 = 10.4

22. GDP per capita 1900-2003 GDP per capita 1900-2003 (US$ at 1990 prices)  Argentina and Sweden went hand in hand 1900-1930, and then grew apart free tradeliberal democracy income equality  Sweden pursued free trade, liberal democracy, and income equality, and avoided high inflation  Argentina did not Sweden 2.1% per year Argentina 1.0% per year 1.011 103 = 3.1

23. GDP per capita 1965-2004 GDP per capita 1965-2004 (US$ at 2000 prices)  Argentina and Spain went hand in hand 1965-1970, and then grew apart EU membership democracy  Spain pursued free trade and price stability through EU membership and adopted democracy  Argentina lacked stability Spain 2.7% per year Argentina 0.6% per year 1.021 39 = 2.2

24. GDP per capita 1965-2004 GDP per capita 1965-2004 (US$ at 2000 prices)  Botswana and Nigeria went hand in hand 1965-1970, and then grew apart  Botswana stressed education and resisted corruption  Nenadi Usman, Nigeria’s finance minister: “Oil has made us lazy” Botswana 7.1% per year Nigeria 0.6% per year 1.065 39 = 11.7

25. GDP per capita 1965-2004 GDP per capita 1965-2004 (US$ at 1990 prices)  Mauritius did many things right and reaped rapid growth  Madagascar’s economy has remained at a standstill all this time for many reasons, as we will see shortly Mauritius 4.3% per year Madagascar -1.2% per year 1.055 39 = 8.1

26. Country A Country B

27. In % Country A Country B Girls at primary school 10072

28. In % Country A Country B Girls at primary school 10072 Investment ratio 2511

29. In % Country A Country B Girls at primary school 10072 Investment ratio 2511 Export ratio 5823

30. In % Country A Country B Girls at primary school 10072 Investment ratio 2511 Export ratio 5823 Primary export ratio 3380

31. In % Country A Country B Girls at primary school 10072 Investment ratio 2511 Export ratio 5823 Primary export ratio 3380 Inflation1018

32. In % Country A Country B Girls at primary school 10072 Investment ratio 2511 Export ratio 5823 Primary export ratio 3380 Inflation1018 Growth per capita 1960-2002 4.3-1.2

33. And the countries are: Country A Country B Girls at primary school 10072 Investment ratio 2511 Export ratio 5823 Primary export ratio 3380 Inflation1018 Growth per capita 1960-2002 4.3-1.2

34. And the countries are: MauritiusMadagascar Girls at primary school 10072 Investment ratio 2511 Export ratio 5823 Primary export ratio 3380 Inflation1018 Growth per capita 1960-2002 4.3-1.2

35. GDP per capita 1965-2004 GDP per capita 1965-2004 (US$ at 1990 prices)  Mauritius did many things right and reaped rapid growth  Madagascar has been at a standstill all this time for many reasons, including too little investment, trade, and education, as we will see shortly Mauritius 4.3% per year Madagascar -1.2% per year 1.055 39 = 8.1

36.  The neoclassical view technology  that economic growth in the long run is merely a matter of technology does not throw much light on the impressive growth performance of Asia since the 1960s, or on growth differentials  The new view efficiency  that long-run growth depends on saving and efficiency is more illuminating  Besides, it’s not really new, because Adam Smith knew this (1776)

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

38. + denotes a positive effect in the direction shown – denotes a negative effect in the direction shown Growth InvestmentTrade Initial income Natural capital Education + + + – – Conditional convergence

39. negative  Once the main determinants of growth have been taken into account, initial income will have a negative effect on growth  Conditional convergence absolute convergence  Conditional convergence does not entail absolute convergence  164 countries from 1960 to 2000

40.  Poor countries grow faster than rich ones if  Growth is inversely related to initial income, or if  Regression of current income on initial income produces a slope coefficient that is smaller than one 45 o

41.  Fits real world experience quite well 30-40%  In East Asia, saving rates of 30-40% of GDP went along with rapid economic growth 10%  In several African economies, saving rates of around 10% of GDP went for a long time hand in hand with economic stagnation 20%  In OECD countries, saving rates of about 20% of GDP went along with respectable growth policy  Important implication for policy low inflation good for growth  Economic stability with low inflation and positive real interest rates spurs saving, which is good for growth

42.  An increase in investment by 8% of GDP is associated with an increase in per capita growth by one percentage point per year  Quantity and quality  Cause and effect  World Bank data for 164 countries and 40 years, 1960-2000 r = rank correlation r = 0.42

43. experience  Also fits experience quite well squeeze more output out of given inputs  Technical progress is good for growth because it allows us to squeeze more output out of given inputs efficiency  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 policy good for growth  Everything that increases efficiency, no matter what, is also good for growth

44.  First things first: Output is produced by labor, capital, and other inputs saving investment  Output per capita can grow through accumulation of capital through saving and investment, as we have seen  Output per capita, however, cannot grow through population growth, as we will see improvements Education health care  But, output per capita can grow through improvements in labor, via investments in human capital: Education and health care  Investmenteducation  Investment and education: Key drivers of growth

45.  Education health care  Education and health care make labor force more efficient  Technological progress  Technological progress enhances efficiency  Liberalization good for growth  Liberalization of prices and trade increases efficiency: good for growth  Stabilization good for growth  Stabilization reduces the inefficiency associated with inflation: good for growth  Privatization good for growth  Privatization reduces the inefficiency of state-owned enterprises: good for growth  The possibilities are virtually endless!

46.  Why do education and health care matter? labor productivity  Because they increase labor productivity technological progress  This is also why technological progress is good for growth squeeze more output from given inputs  Technological progress enables firms to squeeze more output from given inputs  But so does increased efficiency!  Latin American story about air fares  Increased efficiency helps growth  Increased efficiency is tantamount to technological progress, which helps growth

47.  If growth were merely a matter of technology, we could not do much about it R&D  Except follow technology-friendly policies by supporting R&D and such can do  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 growth everything that is good for saving and efficiency is also good for growth  Because everything that is good for saving and efficiency is also good for growth

48. quantityquality  In sum, output per capita depends on the quantity and quality of inputs accumulation  Quantity of inputs can be increased through accumulation, esp. capital accumulation  Quality increased efficiency  Quality of inputs – their productivity! – can be increased through increased efficiency  Education and health  Liberalization  Stabilization  Privatization  Aspects of institutions Check them out one by one Policies

49.  Education health care more efficient  Education and health care make the work force more efficient o Need to provide primary and secondary education to all, especially females o Need to provide tertiary education to a greatly increased number of people o Need increased public commitment to education as well as health care public expenditure private sector involvement o Need both increased public expenditure on education and probably also increased scope for private sector involvement in education and health care

50.  Education lifts labor productivity  Education lifts labor productivity, thereby increasing overall economic efficiency and growth of output  From unskilled to skilled labor  Data for 131 countries, 1960-2000 r = 0.50 POLICIES

51.  Interpretation of regression line:  An increase in secondary-school enrolment by 25% of each cohort goes along with an increase in per capita growth by one percentage point per year r = 0.50 POLICIES

52.  There is another way to provide more and better education to children fewer children  Produce fewer children to increase their average “quality”  163 countries, 1960-2000 POLICIES r = -0.54

53. longevity  Good public health, reflected in longevity, is also conducive to increased labor productivity and economic growth  156 countries, 1960-2000 POLICIES r = 0.54

54. health care  Increased spending on health care also spurs economic growth  Close connection between public health and health care, i.e., between output and input  162 countries, 1960-2000 POLICIES r = 0.40

55. Liberalization of prices o Markets, not bureaucrats, set prices more efficient o Mixed market economy is more efficient than central planning o Former Soviet Union vs. the US and Europe Liberalization of trade o Specialization according to comparative advantage more efficient o Free trade is more efficient than self- sufficiency o North Korea vs. South Korea and Singapore POLICIES

56. prices resource allocation  Liberalization of prices increases efficiency in resource allocation trade division of labor  Liberalization of trade increases efficiency in division of labor  163 countries, 1960-2000 POLICIES r = 0.26

57. size matters  Exports are not a good indicator of openness because size matters import duties  So look at import duties as well hurt growth  Higher duties hurt growth, but connection is weak  147 countries, 1960-2000 r = 0.20 POLICIES r = -0.23

58. trade is good for growth  Economic theory is clear, from Adam Smith (1776) on: external as well as internal trade is good for growth  Good external governance  Good external governance is good for growth  Autarky spells disaster  Autarky spells disaster, always and everywhere Darkness in North-Korea POLICIES

59. Stabilization of prices Reduces distortions due to inflation o Inflation creates inefficiency o Inflation distorts the choice between real and financial capital by punishing money holdings, and thus creates inefficiency in production inflation tax inefficient o Implicit inflation tax is an inefficient tax uncertainly o Inflation creates uncertainly that tends to discourage trade and investment overvaluation o Inflation tends to result in currency overvaluation, hurting exports and growth Finance matters for growth POLICIES

60.  Stabilization increases efficiency  Stabilization increases efficiency by reducing production distortions, uncertainty, inflation tax, and overvaluation  164 countries, 1960-2000 r = -0.46 POLICIES r = -0.46

61. sound policies support rapid growth  High inflation is a sure sign of lax fiscal and monetary policies, so sound policies support rapid growth independent central banks  Sound financial institutions, incl. independent central banks, also support rapid growth r = -0.46 POLICIES r = -0.46

62. Model 1 Inflation distortion -2.51 (2.07) Natural resources Initial income Investment Secondary education Population growth Adj. R 2 0.04  /(1+  ) Inflation distortion =  /(1+  ) Inflation impedes growth Note: t-values are shown within parentheses.

63. Model 1Model 2 Inflation distortion -2.51 (2.07) -2.46 (2.37) Natural resources -0.09 (5.75) Initial income Investment Secondary education Population growth Adj. R 2 0.040.30 Natural resource curse

64. Model 1Model 2Model 3 Inflation distortion -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) Natural resources - -0.09 (5.75) -0.10 (6.52) Initial income -0.45 (2.67) Investment Secondary education Population growth Adj. R 2 0.040.30 Convergence

65. Model 1Model 2Model 3Model 4 Inflation distortion -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) Natural resources -0.09 (5.75) -0.10 (6.52) -0.07 (5.01) Initial income -0.45 (2.67) -0.45 (3.05) Investment0.15 (5.41) Secondary education Population growth Adj. R 2 0.040.300.350.51 Investment is good for growth

66. Model 1Model 2Model 3Model 4Model 5 Inflation distortion -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) -1.97 (2.49) Natural resources -0.09 (5.75) -0.10 (6.52) -0.07 (5.01) -0.04 (2.93) Initial income -0.45 (2.67) -0.45 (3.05) -1.10 (5.39) Investment 0.15 (5.41) 0.09 (3.36) Secondary education 1.24 (4.24) Population growth Adj. R 2 0.040.300.350.510.60 Education also boosts growth

67. Model 1Model 2Model 3Model 4Model 5Model 6 Inflation distortion -2.51 (2.07) -2.46 (2.37) -2.26 (2.25) -1.95 (2.25) -1.97 (2.49) -1.61 (2.14) Natural resources -0.09 (5.75) -0.10 (6.52) -0.07 (5.01) -0.04 (2.93) -0.04 (2.49) Initial income -0.45 (2.67) -0.45 (3.05) -1.10 (5.39) -1.27 (6.42) Investment 0.15 (5.41) 0.09 (3.36) 0.10 (3.74) Secondary education* 1.24 (4.24) 1.07 (3.82) Population growth -0.56 (3.42) Adj. R 2 0.040.300.350.510.600.64 Population drag Note: An increase in secondary-school enrolment by a third increases growth by 1%.

68. Privatization o Profit-oriented owners and able managers are allowed to direct enterprises o Profit motive o Profit motive replaces political considerations as the guiding principle of business operations o Profit-maximizing owners generally appoint managers and staff on merit rather than on the basis of political connections more efficient o Private enterprise is generally more efficient than state-owned enterprises POLICIES

69. profit motive  Privatization replaces political motives by profit motive in business  Private enterprise  Private enterprise is usually more efficient than state- owned enterprises  38 countries, 1978-92 POLICIES r = -0.35

70. Free trade Free trade is good for growth o Reduces the inefficiency that results from restrictions on trade Price stability Price stability is good for growth o Reduces inefficiency resulting from inflation Privatization Privatization is good for growth o Reduces inefficiency resulting from SOEs Education Education is good for growth o Reduces the inefficiency that results from inadequate education, and health care POLICIES

71. mixed blessing  Natural resources, if not well managed, may turn out to be, at best, a mixed blessing  Four possible channels o Dutch disease (foreign capital) o Rent seeking (social capital) o Education (human capital) o Investment (real capital)

72.  Dutch disease through overvaluation  Hurts level or composition of exports and FDI  Rent seeking takes many forms  Protectionism, corruption, oppression  Education falters  False sense of security  Poor quality of policies and institutions  Investment: Same story  One more thing: Resource drag  Nonrenewable natural resources are a fixed factor of production  Decreasing returns to scale

73. + denotes a positive effect in the direction shown – denotes a negative effect in the direction shown Growth InvestmentTrade Initial income Natural capital Education + + + – – Resource curse + – –

74. technological innovation and progress  Manufacturing is an important source of technological innovation and progress and thereby also of economic growth  156 countries, 1960-2000 INSTITUTIONS r = 0.48

75. few spillover benefits  Agriculture and mining are low-skill labor intensive and offer few spillover benefits to other industries Mixed blessing  Natural resources: Mixed blessing if not well managed  156 countries, 1960-2000 r = 0.48 INSTITUTIONS r = -0.59

76.  An increase in primary production by 11% of GDP goes along with a decrease in per capita growth by one percentage point per year r = 0.48 INSTITUTIONS r = -0.59

77.  Foreign aid has sometimes been compared to natural resource discoveries  Aid and growth are inversely related across countries  Cause and effect  156 countries, 1960-2000 INSTITUTIONS r = -0.36

78.  Three aspects of social capital  Equality  Honesty  Democracy  What do the data tell us?

79.  Two views  Inequality sharpens incentives  Inequality sharpens incentives and thus helps growth  Inequality endangers social cohesion  Inequality endangers social cohesion and hurts growth  117 countries, 1960-2000 INSTITUTIONS r = -0.27

80.  Equality is good for growth  No visible sign here that equality stands in the way of economic growth Gini index  An increase in Gini index by 16 points goes along with a decrease in per capita growth by one percentage point per year INSTITUTIONS r = -0.27

81. Democracy Oligocracy Autocracy INSTITUTIONS

82.  Two views  Political oppression restrains special interest groups  Political oppression restrains special interest groups and thus helps growth  Political oppression breeds inefficiency  Political oppression breeds inefficiency and hurts growth  117 countries, 1960-2000 INSTITUTIONS r = -0.64

83.  Again, two views  Democracy plays into hands of special interest groups  Democracy plays into hands of special interest groups that hurt growth  Democracy facilitates change of government  Democracy facilitates change of government and helps growth  143 countries, 1960-2000 r = 0.48 INSTITUTIONS r = 0.50

84.  Democracy is good for growth  No visible sign here that democracy stands in the way of economic growth  A rise in democracy index by 7 points goes along with an increase in per capita growth by one percentage point per year r = 0.48 INSTITUTIONS r = 0.50

85.  Once more, two views  Corruption greases wheels  Corruption greases wheels of production and exchange and thus helps growth  Corruption breeds inefficiency  Corruption breeds inefficiency and hurts growth  88 countries, 1960-2000 More corruption INSTITUTIONS r = 0.69

86. good business governance is good for growth  So, good business governance is good for growth secure property rights effective bankruptcy laws  Argument can be extended to other aspects, such as secure property rights and effective bankruptcy laws  Same story More corruption INSTITUTIONS r = 0.69

87. public policy  Economic growth responds to public policy  In particular, by encouraging investment o saving and investment of high quality trade o foreign trade and investment o education and health care o economic diversification o sound institutions economic growth ... the government can help foster rapid economic growth

88. 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 (Accra, 1968)

89.  These lessons are borne out by experience from around the world  Additional lessons: SOE  Too much SOE activity hurts the quality of investment and education — and growth agriculture natural resource dependence  Too much agriculture and, more generally, natural resource dependence, if not well managed, hurts education, investment, and trade — and thereby also growth population growth  Too rapid population growth also tends to impede economic growth

90.  Even so, the question of rapid growth is, of course, a bit more complicated politicalsocialcultural natural  We also need to address a host of political, social, and cultural questions as well as questions of natural conditions, climate, and public health

91.  But the main point remains:  To grow or not to grow matter of choice  To grow or not to grow is in large measure a matter of choice man-made  Many of the constraints on growth are man-made, and can be removed These slides – and more! – can be viewed on my website: www.hi.is/~gylfason