The Many Ways Governments can Kill Growth

1. The Many Ways Governments can Kill Growth Xavier Sala-i-Martin

2. Hyperinflations • Fiscal disarray leads to PRINT MONEY • Money Printing leads to Hyperinflation • French Revolution and American Civil War • Versailles Treaty and the HP of the 1920s • Post WWII (China, Greece, Hungary (*)) • 1980s: Bolivia, Israel, Argentina, … • 1990s: Former Socialist Countries • (*) World Record, inflation = 1027

3. Black Market Premium • Governments want to fix the Exchange Rate Market at e* (say, e*=80 pesos/$) • It forces all exporters to sell dollars at 80 • But an (illegal) Black Market develops and pays 160 pesos/$ (the difference is the Black Market Premium) • There is a shortage of $ (at e*=80, demand is larger than supply) so importers who need dollars need to buy them in the black market at 160. • The BMP is, effectively, a tax on exporters.

4. BMP (continuation) Source: Easterly (2002), page 223.

5. Financial Repression (Killing Banks) • Governments force banks to issue loans to them at below market rates (so Banks lose money) • Governments impose CAPS on interest rates the bank can charge or pay EVEN IF INFLATION IS HIGH • If R=5% and inflation is 50%, the saver gets a negative return of 45%. IMPLICATION: No Savings in Financial Sector • Financial Repression is, effectively, a tax on Savings so it affects growth adversely

6. Financial Repression (Killing Banks, Continuation)

7. Large Budget Deficits • Ricardian Equivalence Theorem says that if taxes are LUMP SUM, then Budget Deficits are equivalent to current taxes so deficits do not matter • But taxes are NOT lump sum. They are distortionary. • And budget deficits today mean more distortionary taxes tomorrow (including more hyperinflations, financial repression, BMP, etc). • This lowers incentives to invest today and reduces growth rates today NOTE: Careful with current financial crisis: US government is absorbing 80% of the world’s savings…

8. Budget Deficits (continuation) Source: Easterly, Ch 11.

9. Bureaucracy, Corruption and Red Tape • Hernando de Soto in “The Other Path” (referring to the Peruvian terrorist group, “The Shining Path”, he calls government bureaucracy, “The Other Path”) • Tried to set up a clothing factory in Lima without paying any bribes to see how long it took. • He could not. • In order not to halt experiment, he bribed twice (he was asked 10 times by government officials) • It took 10 months. • NOTE: it takes 4 hours to do the same thing in NYC

10. From Wolf… • .

11. Closing The Economy • Import Substitution (infant industry) • Picking Winners by Government Officials

12. Case Studies on Industrial Policies • Michael Porter (1999) for Japan (“Can Japan Compete?”) • Nolan and Pack (2003) for Export Promotion Policies in Korea • Nolan and Pack (2003) for Import Substitution Policies in Latin America

16. Korea • Policies of Export Promotion • Reduced taxes for “Favored Sectors” • Cheap Loans for “Favored Sectors” • Integration of various industries (Chaebols) to finance and promote exports • Protection of “Favored Sectors”

17. Korea • Evidence of success is mixed: • Lee (1997) examines a panel of 38 Korean industries finds that trade protection (tariff and non-tariff barriers) are NOT correlated with productivity (TFP) in a particular sector. • He also finds that tax and financial incentives are uncorrelated with sectoral TFP • Park and Kwon (1995) argue that Chaebols, by preventing competition, retarded technological progress

18. Korea • Pack and Westphal (1986) argue that infant industries grew without significant losses in efficiency thanks to protection in the early stages (1960-1970). These were subject to significant externalities and, therefore, were good for the economy. However, little (positive) effect can be found after 1973, where the government encouraged the chemical and engineering sectors. • Yoo (1999) says that Chaebols are “survival of the fattest”. “Implicit Insurance” induces risky behavior that can end up in terrible situation. • The 73 billion bankrupcy of Daewoo (2nd largest Chaebol in Korea) is LARGEST corporate failure in history. • The largest Chaebol (Hyundai) is in trouble

19. Latin America in the Import Substitution Era • Latin America after Great Depression: promote industrialization at all costs • 1940s: Import Substitution • State Enterprises created in electricity, steel, petroleum, and other heavy industries • Growth was 7% between 1940 and 1950 • But light industry failed to materialize • Heavy industry was inefficient and expensive (a Chilean car was 8 times more expensive than an American car: unaffordable for regular Chileans… who were poor) • Copper was the main source of international money • Policies were abandoned in 1980s. Chile has had the largest growth in Latin America since • Problems with Import Substitution in Latin America: • Closed economies have dynamic (slow technological transfers) and static costs (lack of specialization) • Lack of competition does not provide incentives to be efficient or incentives to innovate and grow • Economies that abandoned IS earlier (Korea and Taiwan) grew faster than those that did it later (Latin America, Africa and South Asia).

20. Government “Services” (or “Disservices”) • Governments are usually in charge of providing: roads, law and order, electricity, water and sanitation. • In many countries, governments are also in charge of phone companies, trains, airlines, postal service, irrigation, waste disposal • In most developing countries, governments fail to provide any of these things,… yet they do not allow the private sector to do it either.

21. Regulation • Current Financial Crisis

22. Growth US Financial Sector Regulation Optimal Venezuela?

23. Regulation is new Mantra • Trade off: risk vs innovation • Speed of regulation vs speed of accidents • How much do regulators know?