Sources of Sources of Economic Economic GrowthGrowth

Thorvaldur Gylfason

Growing Together, Growing Apart

Time

Nati

on

al eco

nom

ic o

utp

ut

Spain vs. ArgentinaThailand vs. Burma

Finland vs. Estonia

West Germany vs. East Germany

South Korea vs. North Korea

Botswana vs. Nigeria

Tunisia vs. Morocco

Mauritius vs. Madagascar

Taiwan vs. China

Rapid growth

Slow growth

Austria vs. Czechoslovakia

Botswana, Ghana, and Nigeria: GNP per capita, 1964-1997 (Current US$, Atlas method)

0

500

1000

1500

2000

2500

3000

3500

Botswana

Ghana

Nigeria

Example 1

Kenya, Tanzania, and Uganda: GNP per capita, 1964-1997 (Current US$, Atlas method)

0

50

100

150

200

250

300

350

400

450

500

Kenya

Tanzania

Uganda

Example 2

Burma and Thailand: GDP per capita, 1960-1997 (Local currency, 1988 prices)

0

100

200

300

400

500

600

700

Burma

Thailand

Example 3

Barbados, Dominican Republic, and Haiti: GNP per capita, 1964-1997 (Current US$, Atlas method)

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

Barbados

Haiti

Dominican Republic

Example 4

Egypt, Morocco, and Tunis: GNP per capita, 1964-1997 (Current US$, Atlas method)

0

500

1000

1500

2000

2500

Egypt

Morocco

Tunisia

Example 5

Argentina, Uruguay, and Spain: GNP per capita, 1964-1997 (Current US$, Atlas method)

0

2000

4000

6000

8000

10000

12000

14000

16000

Argentina

Spain

Uruguay

Example 6

Madagascar and Mauritius: GNP per capita, 1964-1997 (Current US$, Atlas method)

0

500

1000

1500

2000

2500

3000

3500

4000

4500

Madagascar

Mauritius

Example 7

Economic Growth: The Short Run vs. the Long Run

Time

Nati

on

al eco

nom

ic o

utp

ut

Actual output

Potential output

Business cyclesin the short run

Economic growthin the long run

Downswing

Upswing

The crisis of 1997-98 is irrelevant to Asia’s long-term growth potential.

Economic Growth: The Short Run vs. the Long Run

To analyze the movements of To analyze the movements of actualactual output from year to year, viz., in the output from year to year, viz., in the shortshort run runNeed short-run macroeconomic theoryNeed short-run macroeconomic theory

Keynesian or neoclassicalKeynesian or neoclassical

To analyze the path of To analyze the path of potentialpotential output output over over longlong periods periodsNeed modern Need modern theory of economic growththeory of economic growth

Neoclassical or endogenousNeoclassical or endogenous

Traces the rate of growth of output per capita to a single source:

Technological progressTechnological 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

The Neoclassical Theory of Exogenous Economic Growth

The New Theory of Endogenous Economic Growth

“The proximate causes of economic growth are the effort to economize, the accumulation of knowledge, and the accumulation of capital.”

W. ARTHUR LEWIS

Traces the rate of growth of output Traces the rate of growth of output per capita to three main sources:per capita to three main sources:

SavingSaving

EfficiencyEfficiency

DepreciationDepreciation

Exogenous vs. Endogenous Growth

The neoclassical viewThe neoclassical viewthat economic growth in the long run is that economic growth in the long run is

merely a matter of merely a matter of technologytechnology does not does not throw much light on the spectacular growth throw much light on the spectacular growth performance of Asia since the 1960s.performance of Asia since the 1960s.

The new viewThe new viewthat long-run growth depends on that long-run growth depends on savingsaving, ,

efficiencyefficiency, and , and depreciationdepreciation is more is more illuminating.illuminating.

Besides, it’s not really new, because Adam Besides, it’s not really new, because Adam Smith knew this (1776). Smith knew this (1776).

A Simple Model of Endogenous Growth

Four building blocks:Four building blocks: S = IS = I

Saving equals investment in equilibrium. Saving equals investment in equilibrium.

S = sYS = sY Saving is proportional to income.Saving is proportional to income.

I = I = K + K + KK Investment involves addition to capital stock.Investment involves addition to capital stock.

Y = EKY = EK Output depends on quality and quantity of Output depends on quality and quantity of

capital. capital.

A Simple Model of Endogenous Growth

Implication:Implication: g = sE - g = sE -

Rate of economic growth equalsRate of economic growth equals Saving rateSaving rate

timestimes

EfficiencyEfficiencyminusminus

DepreciationDepreciation

Endogenous Growth in tEndogenous Growth in the he Harrod-Domar Harrod-Domar ModelModel

You may recognize the You may recognize the endogenous growth model endogenous growth model as a reinterpretatation of as a reinterpretatation of the the Harrod-Domar modelHarrod-Domar modelwhere growth depends onwhere growth depends on

A.A. the saving rate the saving rate

B.B. the capital/output ratio the capital/output ratio

C.C. the depreciation rate the depreciation rate

You may recognize the You may recognize the endogenous growth model endogenous growth model as a reinterpretatation of as a reinterpretatation of the the Harrod-Domar modelHarrod-Domar modelwhere growth depends onwhere growth depends on

A.A. the saving rate the saving rate

B.B. the capital/output ratio the capital/output ratio

C.C. the depreciation rate the depreciation rate

Sources of Endogenous Growth

Saving Saving Fits real world Fits real world experienceexperience quite well quite well

No coincidence that, in East Asia, saving rates of No coincidence that, in East Asia, saving rates of 30-40%30-40% of GDP went along with rapid economic growthof GDP went along with rapid economic growth

No coincidence either that many African economies with No coincidence either that many African economies with saving rates around saving rates around 10%10% of GDP have been stagnant of GDP have been stagnant

OECD countries: saving rates of about OECD countries: saving rates of about 20%20% of GDP of GDP

Important implication for Important implication for economic policyeconomic policy::Economic stability with Economic stability with low inflationlow inflation and positive real and positive real

interest rates encourages saving, and thus is interest rates encourages saving, and thus is good for good for growth.growth.

Sources of Endogenous Growth

100100

400400

300300

200200

19651965 19901990

East AsiaEast Asia

OECDOECD

AfricaAfrica

High saving rates

High saving rates

Medium saving rates

Low saving rates

IncomeIncomeper capitaper capita

Sources of Endogenous Growth

Depreciation Depreciation The effect of depreciation on growth is The effect of depreciation on growth is

related to that of saving on growth.related to that of saving on growth.Unprofitable investment in the past reduces Unprofitable investment in the past reduces

the the quality of capitalquality of capital and thus makes it and thus makes it depreciate more rapidly, necessitating more depreciate more rapidly, necessitating more replacement investment to make up for wear replacement investment to make up for wear and tear.and tear.

The more national saving has to be set aside The more national saving has to be set aside for replacement investment, the less will be for replacement investment, the less will be available for the available for the buildup of new capitalbuildup of new capital. .

Sources of Endogenous Growth

EfficiencyEfficiencyAlso fits real world experience quite wellAlso fits real world experience quite well

Technical progress good for growth because it allows us Technical progress good for growth because it allows us to to squeeze more output from given inputssqueeze more output from given inputs..

But that is exactly what increased But that is exactly what increased efficiencyefficiency is all is all about! about!

Thus, technology is best viewed as an aspect of general Thus, technology is best viewed as an aspect of general economic efficiency. economic efficiency.

Important implication for Important implication for economic policyeconomic policy::Everything that increases economic efficiency, no Everything that increases economic efficiency, no

matter what, is also matter what, is also good for growthgood for growth..

Sources of Endogenous Growth

Five sources of increased efficiencyFive sources of increased efficiency1.1. LiberalizationLiberalization of prices and trade increases of prices and trade increases

efficiency, and thus is efficiency, and thus is good for growthgood for growth..

2.2. StabilizationStabilization reduces the inefficiency associated with reduces the inefficiency associated with inflation, and thus is inflation, and thus is good for growthgood for growth..

3.3. PrivatizationPrivatization reduces the inefficiency associated with reduces the inefficiency associated with state-owned enterprises, and thus …state-owned enterprises, and thus …

4.4. EducationEducation makes the labor force more efficient. makes the labor force more efficient.

5.5. Technological progressTechnological progress also enhances efficiency. also enhances efficiency.

The possibilities are virtually endless!The possibilities are virtually endless!

Sources of Endogenous Growth

This is This is good newsgood news..If growth were merely a matter of technology, we If growth were merely a matter of technology, we

would not be able to do much about it …would not be able to do much about it …… … except to follow technology-friendly policies by except to follow technology-friendly policies by

supporting supporting R&DR&D and such. and such.

But if growth depends on saving and efficiency, But if growth depends on saving and efficiency, there are things that we there are things that we can docan do, in the private , in the private sector as well as through the public sector, to sector as well as through the public sector, to foster rapid economic growth.foster rapid economic growth.

Because Because everything that is good for saving and everything that is good for saving and efficiency is also efficiency is also good for growthgood for growth..

What to Do to Encourage Economic Growth

Recap

Maintain strong incentives to Maintain strong incentives to savesaveKeep Keep inflationinflation low and low and real interest ratesreal interest rates positive positive

Maintain Maintain financial systemfinancial system in good health in good healthso as to channel saving into high-quality investmentso as to channel saving into high-quality investment

Place strong emphasis on Place strong emphasis on efficiencyefficiency1.1. Liberal price and trade regimes Liberal price and trade regimes

2.2. Low inflation Low inflation

3.3. Strong private sector Strong private sector

4.4. More and better education More and better education

5.5. Limited natural resources Limited natural resources

Liberalization and Economic Growth

Liberalization of pricesLiberalization of prices means that markets, means that markets, not bureaucrats, are allowed to set prices. not bureaucrats, are allowed to set prices. Mixed market economy is Mixed market economy is more efficientmore efficient than than

central planning.central planning. Compare former Soviet Union with the US and EuropeCompare former Soviet Union with the US and Europe

Liberalization of tradeLiberalization of trade allows specialization allows specialization according to comparative advantage.according to comparative advantage.Free trade is Free trade is more efficientmore efficient than self-sufficiency. than self-sufficiency.

Compare North Korea with Hong Kong and SingaporeCompare North Korea with Hong Kong and Singapore

More efficiency is More efficiency is good for growthgood for growth..

Market equilibrium and economic welfare

SupplySupply

DemandDemand

EE

ProducerProducersurplussurplus

ConsumeConsumerrsurplussurplus

Quantity

Price

AA

BB

CC

Total Total welfare gainwelfare gain associated associatedwith market equilibrium equalswith market equilibrium equalsproducer surplus (= ABE) plusproducer surplus (= ABE) plusconsumer surplus (= BCE).consumer surplus (= BCE).

Market intervention and economic welfare

SupplySupply

DemandDemand

Price ceilingPrice ceiling

EE

FF

GG

Quantity

PriceWelfareWelfarelossloss

Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss equivalent to equivalent tothe triangle the triangle EFGEFG..

AA

BB

CC

Consumer surplus = AFGHConsumer surplus = AFGHProducer surplus = CGHProducer surplus = CGHTotal surplus = AFGC

HH

JJ

Increased Openness Goes Alongwith Higher Income

10

100

1000

10000

100000

-100% -50% 0% 50% 100% 150%

Openness (actual exports minus predicted exports in percent of GNP, 1994)

GN

P pe

r ca

pita

in 1

995

(USD

)G

NP

per

capi

ta in

199

5 (U

SD)

SingaporeAustralia

United KingdomChile

Cape Verde

Guyana

Mongolia

Japan

MalaysiaBulgaria

Azerbaijan

Denmark

Central African Rep.

Sweden

What is the evidence?

More Foreign Investment Goes Along with Higher Income

10

100

1000

10000

-0,05 0,00 0,05 0,10 0,15

Foreign direct investment 1970-1995 (share of GNP)

GN

P pe

r ca

pita

in 1

995

(USD

)G

NP

per

capi

ta in

199

5 (U

SD)

Madagascar

Nigeria

Ghana

Thailand BotswanaMauritius

St. Kitts and Nevis

Yemen

Slovenia

More evidence

Stabilization and Economic Growth

Stabilization of pricesStabilization of prices means that distortions means that distortions associated with inflation are reduced.associated with inflation are reduced. InflationInflation distorts the choice between real and financial distorts the choice between real and financial

capital by punishing money holdings, and thus capital by punishing money holdings, and thus creates creates inefficiency inefficiency in production.in production.

Inflation thus involves a tax, the Inflation thus involves a tax, the inflation taxinflation tax.. An An inefficient taxinefficient tax compared with most other taxes. compared with most other taxes.

Inflation also creates Inflation also creates uncertainlyuncertainly which tends to which tends to discourage trade and investment. discourage trade and investment.

Inflation also tends to result in Inflation also tends to result in overvaluationovervaluation of of currency, thus hurting exports and growth.currency, thus hurting exports and growth.

The effect on economic growth per capita of a decrease in inflation from 50% to 5% per year

Number ofcountries

Period Data Effect ongrowth (inpercent)

Fischer (1991) 73 1970-1985 Cross section 2.1

Gylfason (1991) 37 1980-1985 Cross section 2.0

Roubini and Sala-i-Martin (1992)

98 1960-1985 Cross section 2.2

De Gregorio (1993) 12 1950-1985 Cross section 0.7

Fischer (1993) 80 1960-1989 Cross section 1.8

Barro (1995) 100 1960-1990 Cross section 1.0-1.5

Gylfason andHerbertsson (1996)

145-170 1960-1992 Panel data 0.6-1.3

Barro (1997) 80-87 1960-1990 Panel data 1.3-1.8

Bruno and Easterly(1998)

97 1961-1992 Panel data 1.2

Gylfason (1999) 160 1985-1994 Cross section 2.4

What is the evidence?

More Inflation Goes Along with Lower Income

100

1000

10000

100000

0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1

Inflation distortion 1970-1995

GN

P pe

r ca

pita

in 1

995

(USD

)G

NP

per

capi

ta in

199

5 (U

SD)

Argentina

BrazilMexico

Uruguay

Austria

Nicaragua

Latvia

Spain

Zambia

Ecuador

Burundi

Israel

Barbados

Sierra Leone

More evidence

Privatization and Economic Growth

PrivatizationPrivatization means that profit-oriented means that profit-oriented owners and able managers are allowed to owners and able managers are allowed to direct enterprises.direct enterprises.Profit motiveProfit motive replaces political considerations as replaces political considerations as

the guiding principle of business operations.the guiding principle of business operations.Profit-maximizing owners generally want to appoint Profit-maximizing owners generally want to appoint

managers and staff on merit rather than on the basis managers and staff on merit rather than on the basis of political connections, for example.of political connections, for example.

Private enterprise is generally Private enterprise is generally more efficientmore efficient than than state-owned enterprises.state-owned enterprises.

More State Enterprise Goes Along with Less Income

100

1000

10000

0,00 0,10 0,20 0,30 0,40 0,50 0,60 0,70 0,80

Share of state-owned enterprises in employment 1970-1995

GN

P pe

r ca

pita

in 1

995

(USD

)G

NP

per

capi

ta in

199

5 (U

SD)

Madagascar

Mauritius

Korea

Grenada

Colombia

GhanaBenin

Trinidad and Tobago

Sri Lanka

Mali

Gabon

Tunisia

Bolivia

Guinea

What is the evidence?

Education and Economic Growth

EducationEducation means a better trained and hence means a better trained and hence more efficientmore efficient work force. work force. Need to provide primary and secondary education Need to provide primary and secondary education

to all, especially femalesto all, especially females Need to provide tertiary education to a greatly Need to provide tertiary education to a greatly

increased number of peopleincreased number of people Need increased public commitment to educationNeed increased public commitment to education This requires both increased This requires both increased public expenditurepublic expenditure on on

education and probably also increased scope for education and probably also increased scope for private sector involvementprivate sector involvement in education. in education.

Secondary-School Enrolment Varies Directly with Income

0,00

0,20

0,40

0,60

0,80

1,00

1,20

100 1000 10000 100000

GNP per capita in 1995 (USD)

Seco

ndar

ySe

cond

ary --

scho

ol e

nrol

men

t in

sc

hool

enr

olm

ent

in

1993

1993

Finland

Italy

Madagascar

Maldives

Mauritius

Niger

Peru

Slovak Rep.

Swaziland

Tanzania

TogoVietnam

Zimbabwe

What is the evidence?

Income and Inequality(20/ 20 Ratio)

100

1000

10000

100000

0 5 10 15 20 25 30 35

20/20 ratio

GN

P pe

r ca

pita

in 1

995

(USD

)G

NP

per

capi

ta in

199

5 (U

SD)

Brazil

Guinea-Bissau

Switzerland

Netherlands

Estonia

South Africa

Kenya

Slovakia

Lao PDRBangladesh

Norway

United Kingdom

Costa Rica

Panama

Sweden

Related evidence

Natural ResourcesNatural Resources and and Economic GrowthEconomic Growth

Natural resources, if not well Natural resources, if not well managed, may turn out to be, at managed, may turn out to be, at best, a best, a mixed blessingmixed blessing..

Three possible channelsThree possible channels EducationEducation Dutch diseaseDutch disease Rent seekingRent seeking

What is the evidence?What is the evidence?

More Primary Exports Go Along with Less Income

100

1000

10000

100000

0,00 0,10 0,20 0,30 0,40 0,50 0,60 0,70 0,80 0,90 1,00

Share of primary exports in total exports in 1995

GN

P pe

r ca

pita

in 1

995

(USD

)G

NP

per

capi

ta in

199

5 (U

SD)

Saudi Arabia

Venezuela

Nigeria

Norway Sweden

Mexico

Finland

Denmark Iceland

New Zealand

Cote d'Ivoire

Rwanda

Seychelles

EcuadorCongo

What is the evidence?

Natural Resources and Economic Growth

Abundant natural resources, if not well managed, appear harmful to growth.

Economic Growth and Natural Capital 1960-1997

y = -0.0792x + 2.7807

R2 = 0.2575

-4

-2

0

2

4

6

8

0 10 20 30 40 50 60

Share of natural capital in national wealth 1994 (%)

An

nu

al g

row

th o

f G

NP

pe

r ca

pit

a 19

60-1

997

(%)

More evidence

Natural Resources and Corruption

Abundant natural resources appear conducive to corruption.

Natural Capital and Corruption

y = -0,1514x + 6,4915

R2 = 0,1074

0

1

2

3

4

5

6

7

8

9

10

0 5 10 15 20 25

Share of natural capital in national wealth 1994 (%)

Co

rru

pti

on

ind

ex 1

996

New Zealand

Still more evidence

In ConclusionIn ConclusionMuch progress in economic policy Much progress in economic policy and and

performance performance around the world in the around the world in the 1990s1990s

Growth-friendly reforms Growth-friendly reforms have been have been widely widely embracedembraced

among ordinary people and politicians across the among ordinary people and politicians across the political spectrum, not only in Asia, but also, political spectrum, not only in Asia, but also, increasingly, in other parts of the worldincreasingly, in other parts of the world, including Africa, including Africa

Therefore, the medium-to-long-term growth Therefore, the medium-to-long-term growth outlook for outlook for the world economythe world economy is is brightbrightas long as ...as long as ...

Much progress in economic policy Much progress in economic policy and and performance performance around the world in the around the world in the 1990s1990s

Growth-friendly reforms Growth-friendly reforms have been have been widely widely embracedembraced

among ordinary people and politicians across the among ordinary people and politicians across the political spectrum, not only in Asia, but also, political spectrum, not only in Asia, but also, increasingly, in other parts of the worldincreasingly, in other parts of the world, including Africa, including Africa

Therefore, the medium-to-long-term growth Therefore, the medium-to-long-term growth outlook for outlook for the world economythe world economy is is brightbrightas long as ...as long as ...

In ConclusionIn Conclusion

‘Reformers have the idea that change can be achieved by brute sanity’

‘Reformers have the idea that change can be achieved by brute sanity’ George Bernard ShawGeorge Bernard ShawGeorge Bernard ShawGeorge Bernard Shaw

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.

… economic and institutional reforms continue so as to preserve a healthy climate for saving, high-quality investment, and increased efficiency across the board