MGE #2 and #3 Long-run Productivity Growth, and lack thereof

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1 MGE #2 and #3 Long-run Productivity Growth, and lack thereof Long-run economic growth is productivity growth Long-run Growth in the United States: Sources of economic growth: Capital, Education and Innovation Convergence vs. divergence Europe and Japan, over the last 50 years The developing countries: growth miracles and growth disasters Promoting growth in developing nations Determinants of economic success for developing nations China in the 21st century

2 From last session I GDP and GDP per capita: world distribution and changes over time. Dramatic differences in GDP per capita in the world are evidence of differences in living standards Potential Output and Business Cycle Oscillations drive the movement of GDP Log scale Output at time t The economy in the short-run Reversion to Potential Actual Output Potential Output The economy in the very long run Business Cycle Fluctuations and GDP per capita over time, in the longrun and short-run, respectively. Business Cycle Oscillations do not The economy in the long-run matter in the long-run. t time

3 From last session II What explains differences in GDP per capita across countries, over time? Productivity, Labor markets, Demographics Productivity is the main driver of a country s GDP per capita in the long-run (potential output), and thus explains most of the differences between countries. 1. What contributes to productivity changes over time, and why do countries experience it differently? Oscillations in labor market performance (unemployment rate, hours worked) explain the short-term business cycle oscillations of GDP (and GDP per capita), but play no role in the long-run or in differences across countries. 2. Why does unemployment fluctuate so much in the short-run? The exception: Over the last 30 years, worsening labor market conditions have played the key role in the weak long-run growth performance in Europe. 3. What happened in Europe over the last 30 years, that has risen unemployment and contributed to a slowdown in the growth of potential output?

4 GDP per capita and Productivity Differences in productivity drive the GDPpc gap between countries Labor Productivity Business Sector, OECD 2001 Rising productivity drives the longrun increase in GDPpc (Potential output) GDP per capita (US$) The theme for today What contributes to productivity changes over time, and why do countries experience it differently?

5 The emergence of Modern Growth Before 1820 GDP pc (i.e. living standards) barely grew. Availability of resources determined population growth After 1820 in Weil (2005) GDP per capita in leading industrial countries grew rapidly, doubling every forty years. Modern productivity growth begins.

6 Modern Economic Growth: the US, since 1870 Remarkably stable rates of growth Real GDP per capita Log scale

7 Forecasting the long-run using the trend growth Real GDP per capita Put yourself in You have data for income per capita since 1870 and have to forecast income per capita in the year Real GDP per capita The simplest is a linear trend on the log scale, taking a constant growth rate. If we fit such a trend, the result is 1.9% Real GDP per capita Real GDP per capita S Use the fitted trend to forecast US GDP per capita in the year 2000 Check how well you did Forecast: $32, 770. Actual: $33, 292. An error of 1.5%!! Log scale

8 A Framework for Economic Growth Human Capital Accumulation Education, Training Nutrition, Health (Labor) Productivity growth Growth of GDP per capita = Growth of Total Factor Productivity Expansion of knowledge frontier (e.g. technology) Efficiency in allocation of resources (e.g. economies of scale, less corruption) + Accumulation of factors of production net of population growth + Physical Capital accumulation Investment (Public & private) + Accumulation of Natural Resources (Land, Oil)

9 Sources of growth I Accumulation of (measurable) factors of production Land and natural resources No viable accumulation Capital (investment) No viable long-run growth, due to decreasing returns Education (expenditure, resources) No viable long run growth, due to decreasing returns Factor accumulation cannot be the long-run driver of growth, due to decreasing returns

10 TFP growth and GDP in the long-run TFP growth (measured as the residual) drives GDP pc growth, in the longrun Strong correlation with growth performance over extended timeintervals Productivity slowdown in the 1980 s and 1990 s.

11 Sources of growth II Total factor productivity Knowledge accumulation embodied in Technology, Education, Processes Viable long-run growth through innovation Over time, returns to resources in innovation do not decline, as innovation builds on previous innovation. Social Capital (relatively understudied) Efficiency in resource allocation Viable short-run improvements moving toward the economy s frontier Long-run growth must be driven by an element of TFP accumulation that is not bound by decreasing returns (e.g. knowledge accumulation)

12 Modern Innovation and R&D Expansions of the frontier of knowledge (innovation) is a key contributor to rises in TFP Technology (e.g. electricity, TV, Internet) Process (just-in-time inventory, assembly plants) R&D is considered key component of modern innovation Knowledge must be useful and have commercial application Strong role for entrepreneurs Innovation works through creative destruction This creates winners and losers, and opposition by losers may hinder economic growth

13 Is the New Economy unique in history? We are in a period of the most wonderful progress in science and invention, especially as applied to communication and transportation, this or any other country has ever known. It is obviously our present great fortune to live in what, in the light of history, will be recognized as a golden age of American industry. Written in 1929, just before the onset of the great depression

14 Europe and Japan over 100 years Convergence in income per capita GDP per capita: US, Europe and Japan US log scale US$ UK France Italy Germany Japan

15 Convergence Forces for Convergence Knowledge diffusion: Transfer of technology and knowledge through trade and investment, and deliberate imitation. Implications of Convergence Poor countries should grow faster than rich countries, all else constant. Factor accumulation: Decreasing returns to physical and human capital imply higher returns in poorer countries, where factors are scarce. This creates incentives for higher savings and capital inflows in poorer countries to finance investment in physical and human capital As a country grows and approaches the leader, i.e. the United States, its rate of GDP per capita growth should slow down towards 2% (the US steady state). This explains the slowdown in growth in Europe and Japan, since the 1960 s

16 The countries at the frontier today Key industrialized countries share the frontier of knowledge. Intensity in R&D is similar across countries, but specialization varies across different industries Differences remain across countries, due to differences in efficiency (e.g. mobility of labor, emergence of new firms). In these countries, main components of growth of productivity will come from innovation (investment in R&D) and fast adoption of foreign knowhow, not from investment per se.

17 Long run trends in Industrialized Countries Long-run growth in the United States has been quite stable around % over the last 130 years. This is often called the steady-state With population growth stable at %, the long-run growth for the US economy is % The driver of the rise in GDP per capita (productivity) has been modern innovation (creation of knowledge) - in the pursuit of profits, in the aftermath of the industrial revolution The EU countries and Japan have been catching up, particularly after WWII. This catch-up is almost done, although differences in efficiency remain. The potential for productivity growth in advanced EU countries and Japan is close to the US steady-state ( %). Population growth and labor markets will make the difference.

18 The rest of the world over 50 years The Rest of the World - Real GDP per capita USA Ireland Argentina Chile Japan Brazil Korea log scale India China

19 Is there convergence? Starting with the sample of OECD economies where we saw there was convergence (poor countries grew faster than rich countries Average Growth GDP per capita GDP Per Capita in 1960

20 Is there convergence? we add some Asian economies. There is still some pattern of convergence but there are countries that violate the rule: they were poor and stayed poor (e.g. Philippines). Average Growth GDP per capita Thailand Philippines GDP Per Capita in 1960

21 Is there convergence? when we put together over 100 economies there is no pattern of convergence. Countries that were poor in 1960 did not, on average, do better than rich countries. If any, we see a pattern of divergence. Average Growth GDP per capita GDP Per Capita in 1960

22 Growth Miracles and Growth Disasters Average annual growth rates of GDP per capita ( ) KOREA Miracles HONG KONG Growth NIGER Disasters NICARAGUA Growth Since the mid-1960 s a few successful countries (e.g. East Asia, Chile, Botswana) have begun their catch up. They have been growing steadily and still have space to catch-up, growing above US rates. BOTSWANA THAILAND CHINA JAPAN IRELAND PORTUGAL SPAIN MOZAMBIQUE MADAGASCAR ZAMBIA VENEZUELA SENEGAL RWANDA MALI But the bulk of developing countries is not catching up (e.g. Venezuela, Philippines, most of Africa). The long-run growth rates of most developing countries remain below the US Steady-state, and their gap is increasing.

23 Lack of convergence and global inequality Due to divergence, inequality between countries is today the key contributor to global inequality and poverty around the world Of the world s 6 b people, 2.8 b live on less than $2 a day and 1.2 b on less than $1 a day. Eight of every 100 infants die before reaching five years old. Nine of every 100 boys and 14 of every 100 girls in school-age do not attend school.

24 Lagging developing countries Factors vs. Productivity Key explanation for variance in GDP per worker (productivity) are differences in TFP. More than differences in capital accumulation or education levels The focus on TFP is recent. In the 1960 s the belief was that lack of development was lack of capital. Hence the focus, at the time, on Aid to finance infrastructure projects. Why is TFP so poor in developing countries, and why does it not converge? Country Output/ Worker Capital/ Output Educ. TFP U.S.A Australia Italy Germany, West France U.K Hong Kong Singapore Japan U.S.S.R Korea, rep Portugal Brazil South africa Poland Namibia Romania Botswana India Cameroon China Mozambique Zaire Chad Niger Variance Average Decomposition of output per worker relative to United States, 1988 Source: Barro and Jones, 1999

25 Why is TFP so much weaker in developing countries? Inappropriate technologies and tacit, nontransferable know-how impede knowledge transfers e.g. digital divide Lack of absorptive capacity Human capital Infrastructure Weak social capital and institutions Weak rule of law Lack of judicial efficiency to enforce contracts Poor government institutions and policies impede efficiency Regulatory hurdles Inefficiency of public services Political Instability and policies Wrong and unstable policy prescriptions Political risk Lack of support of developed countries (?) Aid policies Market access (e.g. Agriculture) IMF/ World Bank action

26 Promoting growth in developing countries I Raising Appropriate Knowledge Access to foreign technological and managerial knowledge Imports of capital goods by openness to trade Foreign direct investment and transfers of tacit knowledge Local Innovation, Imitation and Adaptation Stimulate local entrepreneurs, including diasporas Improve financial market to promote entrepreneurship Promote adaptation of products and methods from industrialized countries Improve absorptive capacity Create human capital with absorptive capabilities Better regulation of business and competitive pressure to innovate Provision of infrastructure and public goods (e.g. roads)

27 Promoting growth in developing countries II The role of Institutions Political and social stability and the ability to reform in response to changing circumstances (political system, income inequality) Macroeconomic stability and efficient mechanisms for allocation of resources (central bank, financial system, competition authorities) Create environment of safety for investors (rule of law, fight corruption, judicial system)

28 Promoting growth in developing countries II Fighting Corruption Corruption is associated with lower GDP and a higher incidence of poverty A one-standard-deviation improvement in the corruption index (BI) causes investment to raise by 5% of GDP and the annual rate of growth of GDP to rise by 0.5% (Mauro, 1996). The concern with corruption is recent, and frameworks to fight corruption are scant. There are many exceptions, where corruption has not hindered growth e.g. Indonesia, China

29 Promoting growth in developing countries III Accumulation of Physical Capital Rising Capital per Worker (Investment Rate) is necessary for GDP growth, but not sufficient. Investment only creates growth, if (i) it is properly allocated and (ii) there is TFP to produce returns, Otherwise, it only produces short-run growth (e.g. Soviet Union) by creating jobs producing capital goods (e.g. real estate, machinery). Why is there little investment in poor countries? Poor countries have constraints in their access to capital; or They simply lack of profitable investment opportunities.

30 Promoting growth in developing countries IV Human Capital Higher Human Capital is associated with higher GDP per capita. Human Capital includes Schooling, but also Health and Nutrition However, despite convergence in educational levels in the last 50 years, GDP per capita has failed to converge

31 Promoting growth in developing countries V The benefits of Openness Internationalization Through trade and investment, poor countries have access to better technologies and goods Countries benefit from specializing in goods of comparative advantage Global competition increases pressure and forces higher productivity Average rate of GDP per capita growth High Income Low Income Closed Countries Sachs and Warner (1997) Open Countries (6) 2.45 (23) 1.03 (71) 4.75 (12) But, liberalization of Financial Flows, particularly short-term capital, has a negligible effect on growth, and can lead to dramatic crisis Closed countries Trade restrictions Socialist Distorted exchange rate regimes Marketing boards for agricultural exports

32 Promoting growth in developing countries (conclusion) Emerging Doubt!... Development thinking has changed dramatically over the last 50 years : capital matters Foreign Aid is the solution : policies matter The Washington Consensus is the solution Now: institutional reform matters What is the solution? [A]s far as the LDC s are concerned, it is probably fair to say that at least a crude sort of justice prevails in the economic policy realm. Countries that have run their economies following the policy tenets of the professionals have on the whole reaped good fruit from the effort; likewise, those that have flown in the face of these tenets have had to pay the price Arnold C. Harberger (1985) When you get right down to business, there aren t too many policies that we can say with certainty deeply and positively affect growth Arnold C. Harberger (2003)

33 Promoting growth: The Five I s Initial conditions Provides the potential for catching up. Poor countries can grow faster, but only when they set on a convergence path to the rich economies. Innovation / Imitation Institutions The incentives to innovate (e.g. respect of intellectual property rights) will drive up the productivity growth in the country. This is the main force behind growth in the developed countries. For developing countries, knowledge development relies on the imitation and adaptation of knowledge goods and technology to local conditions. To ensure sound macroeconomic and political stability, there must be solid institutions (rule of law, transparency, property rights). Institutions (political and social) are also key for policy reforms, which ensure the robustness of the system to a changing environment. Investment A key ingredient is building up the capital stock, which requires high investment rates. Miracle countries invest of over 25% of GDP. Another key factor is to invest in human capital, through schooling and training Internationalization Countries that are more open to international trade and investment can import new technologies, knowledge and capital from other countries. The competitive pressure of global markets forces domestic producers to shape up and eke out productivity gains.

34 The Miracle of the 21 st century? GDP per Capita Growth, China % China Middle income Low income

35 Challenges in China Dependence on Investment (50% GDP) Growth of Total Factor Productivity around 2%( ). Ineffective State-Owned companies siphon credit into unproductive business activities and are kept alive for fear of creating unemployment In the short-term, this compromises macroeconomic stability, creating inflation and an overheated economy (large focus on real-estate) In the long-run, investment returns are likely to be low, as TFP growth is weak and investment is poorly allocated. This may undermine growth and endanger the stability of the financial system, due to build up of nonperforming loans. Weak Socio-Political Institutions Government legitimacy depends on delivering of high growth rates, which undermines the ability to undertake costly reforms and increases the pressure for short-term results. Rampant corruption, particularly in the provinces, raises risk of investment, especially for foreigners, and hinders reform Income inequality across regions and urban unemployment may giver rise to political opposition and create instability

36 Summary I Very stable long-run economic growth in the United States. The steady-state: % growth in GDP per capita Based on productivity growth, driven from technological and process innovation Sources of growth: TFP and resource accumulation Resource accumulation works only for while, until decreasing returns hit. TFP growth, based on technological and knowledge development, drives long-run growth Modern TFP growth is driven by investment in R&D, which produces new knowledge. Convergence EU and Japan are converging to the US. Their growth rates are slowing down to the US steady-state rate. Forces sustaining convergence: (i) diffusion of technology, (ii) difference in returns to capital, due to decreasing returns, affect rates of capital accumulation through savings and international capital flows. Consequences of convergence: poor countries to grow faster (e.g. Japan in the 1960 s) and, as a country converges, growth rates should decline.

37 Summary II TFP (not physical or human capital) explains most of the differences in the weaker labor productivity in developing nations Promoting growth in developing countries Creating appropriate knowledge: Appropriate innovation, imitation and transfers of technology through trade and FDI. Institutions are key. Corruption hinders growth and fosters poverty and income inequality Accumulation of physical and human capital are necessary but not sufficient. Allocation of investment and proper returns through rising TFP are key Openness to trade and FDI have promote growth through specialization (comparative advantage), transfers of technology and increased competitive pressure The Five I s of growth: Initial Conditions, Innovation, Institutions, Investment, Internationalization China s institutions are weak and raise questions on the sustainability of the miracle