Growth diagnostics

1. Growth diagnostics Elena Ianchovichina PRMED March 23, 2009

2. Reform strategiesThe idea about the most binding constraint • Targeting all distortions at once may be infeasible due to financial and capacity constraints, especially in LICs • 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

3. 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

4. Growth diagnostics Problem: Low levels of private investment and entrepreneurship High cost of finance Low return to economic activity Low appropriability bad international bad local finance Low social returns finance government market failures failures information poor coordination bad infra externalities: geography externalities structure “self discovery” - micro risks: macro risks: low poor low property rights, financial, domestic inter - human corruption, monetary, fiscal saving mediation capital taxes instability - Source: HRV (2005)

5. 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

6. 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

7. 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

8. Market failures • Coordination failures are defined as the failure of the market to respond to potential investors’ demands for a diverse set of services: • Allow firms to innovate, market their products successfully, and make a profit • These services require simultaneous, large-scale investments in various sectors of the economy • The incentive to establish these kinds of services is limited for an individual firm • 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 • 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

9. Pros and cons of HRV • Advantages • Country-specificity • Selectivity via trade-offs • Organizational framework • Limitations • Difficult to reject constraints as not binding • Analysis demonstrated at the aggregate level offering little insight about constraints • Emphasis is placed on private investment ignoring other factors determining long-run growth

10. 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

11. 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

12. 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

13. 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

14. 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