Growth diagnostics

Elena Ianchovichina

PRMED, World Bank

Joint Vienna Institute

June, 2009

Analytics of reform Welfare may decline if reforms tackling some distortions

are implemented as long as other distortions remain In formal terms,

u is welfare; τi is a distortion in activity i Distortions drive a wedge between social and private valuation

of activities represents the net marginal valuations of activity i by society

s, and by private agents λi is the Lagrange multiplier corresponding to the constraint

associated with the distortion in activity i and is the direct effect of removing the distortion

the distortion associated with the biggest multiplier effect is the binding constraint

The direct effect is always welfare improving, but the indirect effect may not be, implying that welfare may decline if the indirect effect is negative and larger than the direct effect

j

ipj

sjjiiddu /)(/

si

pi

Reform strategiesThe idea about the most binding constraint

Targeting all distortions at once raises welfare but may be infeasible due to: financial and capacity constraints, especially in LICs limited political capital to engage in wholesale reform

Targeting the biggest distortion or a number of large distortions may not lead to welfare improvement due to large second best effects

Targeting the most binding constraint Increases the chances of an overall positive impact The most binding constraint is associated with the biggest

multiplier The second best effects are hard to estimate with accuracy

Heuristic approach to identifying the most binding constraint to growth

The multipliers are typically hard to estimate HRV use the “Keynes-Ramsey rule”

It captures the most important factors affecting economic growth in the short run

HRV construct a framework that guides the growth analysis at the aggregate level Helps identify a bundle of major constraints In practice, it is very difficult to identify the most binding

constraint to growth with the heuristic approach

High cost of finance

Low return to economic activity

Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:

property rights, corruption,

taxes

macro risks: financial,

monetary, fiscal instability

information externalities:

“self

-

discovery”

coordination externalities

bad international finance

bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics

Problem: Low levels of private investment and entrepreneurship

Source: HRV (2005)

Growth diagnostic questions Is private investment low in a country? If yes:

Is it because of high cost of capital? In this case the economy is considered liquidity-

constrained

Is it because of low returns to capital? In this case the economy is considered inefficient

Why is the cost of capital high or access to capital poor?

Limited access to external capital markets due to: Country risk Unattractive FDI conditions Vulnerabilities in the debt maturity structure Excessive regulations of the capital account

Bad local finance Low domestic savings Poor domestic financial intermediation

Why are returns to capital low? Low social returns due to:

Geography Insufficient investment in complementary factors Poor natural resource management

Low private returns to capital due to: Government failures affecting negatively private

appropriability Macro-instability, high taxes, property rights issues, corruption,

labor-capital conflicts Market failures affecting negatively the ability to adopt

new technologies Coordination externalities Information externalities

Coordination failures Coordination failures are defined as the failure of the market

to respond to potential investors’ demands for a diverse set of services: That allow firms to innovate, market their products successfully, and

make a profit These services require public investments in various sectors of the

economy and can benefit all economic agents at a limited marginal cost of an extra user

In this situation, there are positive externalities where the social returns are higher than the private returns to investment

Consequently, the incentives to establish these kinds of services is limited for an individual firm, and if left to the private sector, these public goods and services will be underprovided

Role of government and public investment

Education, some types of infrastructure, health and security are some areas where government have to play a key role A study by Moreno-Dodson (2008) shows the positive relationship between

public spending and growth, particularly when the allocation of spending focuses on the provision of public goods rather than on subsidizing or providing private goods and inputs

Recognition that smart industrial policy can play an important role: Strategic support for certain activities including provision of infrastructure

and services: That benefit firms in a specific geographic location (special economic zones) That benefit firms in a specific industry but have positive spillover effects on other

economic activities Access to technology to comply with international sanitary and health standards; Marketing information, e.g. knowledge about international consumer preferences, trends,

fairs Special training to update skills of local experts Regional and international agreements that govern trade in good, services and immigration

policies

Information failures Information failures are defined as the failure of firms to

“discover” which products they can produce at low enough cost to be profitable and competitive Focus is on the private sector since when it comes to development of

“new” products the private sector is more effective than the governments at generating the kind of innovation and productivity growth needed for sustained growth rates Private firms are profit driven, whereas governments have a much broader set of

objectives that may lead to an inefficient management of government-owned enterprises

Public investment can crowd out private investment since businesses may fear unfair competition from SOEs.

Firms must experiment with new product lines, adapt new technologies from abroad to local conditions

Diversification of the productive structure requires “discovery” of an economy’s cost structure

Pros of HRV

Country-specificity Selectivity via trade-offs Organizational framework Adaptability to analysis at the national or

sub-national levels

Limitations of HRV Difficult to reject constraints as not binding Important to acknowledge information gaps to avoid drawing

wrong conclusions Analysis demonstrated at the aggregate level offering little

insight about the distributional impacts of growth across economic agents

Focus is on the short-run, rather than on determinants of long-run growth

Human capital is viewed as a complementary factor, although skills are a key determinant of exclusion from the labor market

Three problems with the neoclassical models Solow and optimal growth

Do not predict the large differences in income observed in the data

Predict conditional convergence but at a much more rapid speed than estimated empirically

Predict greater rate of return differentials between rich and poor countries than is empirically plausible

How can one reconcile Solow with the data? Traditional view of capital

Tangible, includes the economy’s stock of equipment and structures Return to capital is the profit received by the owners of equipment and

structures A new view on capital (Mankiw, Phelps and Romer 1995)

Capital with externalities If new ideas arise as capital is built and others benefit

Human capital Capital is much broader concept than suggested by the national income

accounts People accumulate capital whenever they forgo consumption today in order

to produce more income tomorrow Schooling and on-the-job training is also investment

Endogenous growth models Romer (1986): growth is an outcome of

externalities in capital accumulation Lucas (1988): growth is an outcome of

externalities in human capital accumulation Romer (1990): growth is an outcome of

knowledge accumulation

Growth accounting with human-capital-adjusted labor input

Modified production function to capture the contribution of education (“brains”) and the size of the labor force (“brawn”)

S is the years of schooling P is participation rate ω is returns to education

So that

SLPeH

HAKY

)1(

(B) )ˆˆ(ˆˆˆ

(A) ˆˆ)1(ˆˆ

SSPLH

AHKY

Determinants of income per capita After rearranging (A), substituting (B) into (A), and

representing income in per capita term we get:

where gx is the growth rate of variable x

Income growth per capita is a result of: Growth in technology gA

Changes in capacity which are determined by: Growth in the capital stock per unit of labor adjusted for skills Growth in the labor participation rate Growth in returns to education and years of schooling Demographic changes leading to changes in the dependency ratio

N

LP

H

KA

N

Y gSSgggg )ˆˆ(.