NU Eco Dev - Chapter 2 Course Pack PDF

#02 Chapter 2: Growth and the Asian Experience FLEX Course Material Students will be acquinted Population with production curves, as this module explores the concepts that relate to efficiency in pr...

#02 Chapter 2: Growth and the Asian Experience FLEX Course Material Students will be acquinted Population with production curves, as this module explores the concepts that relate to efficiency in production. Students will also get to distinguish various growth theories, and see how these theories were Basic Concepts successfully applied in the development effort of countries in the Asian Region. Module Goals  #02 At the end of this module, the students are expected to have: Explained through essay format one of the three questions given below: ✓ What are the difference between the Solow and the Harrod- Domar models? ✓ Other developing regions of the world have not been as successful in raising their standards of living in this period. Can you identify several factors that might have been responsible for these poorer results? ✓ What measures can the poorer countries take to Learning Goals accelerate their growth to bring their standards of living more in line with the rest of the world?  Economic Development in Asia Chapter 2 – Growth and the Asian Experience  Introduction Why do economies grow? Why should they grow? Why do we want them to grow faster? These are the types of questions that economic development is concerned with. Theory of Economic Growth Traditionally labor and capital were introduced as the only variables determining the level and the growth of output. Y = f (K,L). Land was assumed to be included within capital. Other factors were not considered until it was noted by Solow that there was a large residual factor that was unexplained. http://www.freeimages.co.uk/ Theory of Economic Growth Substantial time has been spent explaining this residual. This residual has been called total factor productivity (TFP) or sometimes multifactor productivity. TFP is very large in industrial countries, explaining as much or more than 50 percent of economic growth in the postwar era.  Total Factor Productivity Question: What factors are contained in the residual? Y = f (K, L, A) Such a list might include: – the adoption of new technology, – better educated workers, – better management, – better coordination within the organization, – more efficient production techniques, – better inventory management, – better and cheaper distribution and marketing skills and organization. Testing Different Growth Theories Many different approaches have been devised to test these alternatives. In doing this, it is useful to distinguish between embodied and disembodied technical progress (TFP). Embodied TFP can be measured by adjusting the factor inputs of labor and capital. Disembodied TFP cannot – it has to go into the residual.  Growth Theories Keynesian Theory/Harrod-Domar Model Solow Model Power Balance Theory Structuralist Approaches New Growth Theory  The Harrod-Domar Model Keynesian Theory stresses the accumulation of capital. This theory include Rostow’s stages of growth and the Harrod-Domar growth model. The Harrod-Domar model is the simplest macroeconomic model. This model begins from the assumption that saving is a constant proportion of income. Thus, s = S/Y and Y = C + S, where C is consumption S is saving S = I. , where I is investment Then, Y = C + I  The Harrod-Domar Model Growth is dependent on the rate of capital formation and the efficiency of the use of capital (capital/output ratio). Population growth can be added and it reduces the rate of growth ceteris paribus.  The Solow Model It introduces diminishing returns to capital and focuses on the long run. Convergence to a steady state level of per capita income occurs despite differences in initial conditions. Total income grows at the same rate as population. The higher the rate of saving, the higher the steady state level of per capita income.  The Solow Model When we add technical progress to the Solow model in the form of more efficient workers, then we have growth in per capita income at the same rate as the rate of growth in worker efficiency. There is still a steady state but it now relates to efficiency units of capital.  Power Balance Theory Emphasized exploitation of poor “southern” economies by the rich industrial “northern” economies. Deterioration of terms of trade of agricultural products in poor economies further aggravates the situation. The theory has generally been discredited. A busy street in India  Structuralist Approach The structural approach was developed in the 1960s and 1970s by Hollis Chenery. Chenery was initially trained as an engineer and this approach reflects his training. Structural approaches stress the shift in output among the sectors of the economy and the rigidities that hinder them. A shifting balance between the three major sectors of the economy – agriculture, industry and services.  Structuralist Approach The structural approach was developed in the 1960s and 1970s by Hollis Chenery. Chenery was initially trained as an engineer and this approach reflects his training. Structural approaches stress the shift in resources among the sectors of the economy. This approach stresses rigidities that hinder the shift in resources. A shifting balance between the three major sectors of the economy – agriculture, industry and services.  Structuralist Approach Agriculture diminishes over time and industry increases. Productivity is higher in industry so higher growth depends upon this shift. A stereotypical pattern of economic growth which has been observed in many countries. Initially, agriculture has a large share of output when the economy is at a low level of development. Share of industry and services are small. As industrialization takes place, the share of agriculture declines and that of industry and services grow.  Two Sector Model of Growth The Lewis-Fei-Ranis model (LFR), named after the three economists that developed it, is a two sector model – a Market Place in local Thai village modern and a traditional sector. Resources move from the traditional to the modern sector and this spurs growth. More on this in chapters 4 and 5. Tokyo, Japan Two Sector Model of Growth The beauty of the LFR model is that it describes many of the characteristics of the Asian economies Market Place in local Thai village when they were just beginning on the path to rapid development in the 1960s and 1970s. That is why it has become so popular among development economists studying Asia. Tokyo, Japan  Solow Growth Model (1+ ) k (t+1) = (1- ) k (t) + s y (t) where k and y denote the per capita units of capital and output, respectively, i.e. k(t)= K(t)/P(t) and y(t)=Y(t)/P(t). This fundamental Solow equation says that the amount of per capita capital in the current period depends upon the per capita capital in the last period, the saving rate in the previous period and the rate of population growth.  Solow Model From the foregoing, it follows that as the economy moves to a steady state level of per capita capital stock regardless of initial conditions. In the steady state, there is no deepening of capital and the amount of capital per capita remains unchanged from period to period as does the level of per capita income. That is, there is no long run growth in per capita income. Total income growth rate  is thus assumed to be the same as the rate of growth for population.  Solow Model Further, in the Solow model framework, the saving rate has no effect on the long run growth rate of per capita output which is zero. However the saving rate does affect the equilibrium level of per capita income. The higher the saving rate, the higher the steady state level of per capita income.  New Growth Theories New growth theories that go beyond Solow have been developed in the past decade. They stress the importance of externalities and the possibility of increasing returns to scale rather than the decreasing returns to scale of the Solow model. The key to this is human capital formation. Higher per capita incomes tend to slow growth because of diminishing returns but higher endowments of human capital tend to speed up growth. Returns to such investments may be increasing.  The Asian Growth Miracle For the last forty years, a group of countries in East and Southeast Asia have grown at remarkably high rates. Japan led the way, beginning right after World War II. It was joined by Thailand, Taiwan, Korea, Singapore and Korea in the 1960s. Southeast Asia followed in the 1970s.  The Asian Growth Miracle Although individual experiences vary, South Asia did not generally begin to grow more rapidly until the late 1980s and early 1990s, when government policy shifted toward supporting a more open and competitive environment. Patiala, India  Policy Environment Before the Transition to Rapid Growth The policy environment in most developing countries throughout the world stressed import substitution policies for industry. The theory was that developing countries had a comparative advantage in primary products and so they should export these products. The import substitution theory also argued that since incomes were low, savings rates were also low. Inflows of investment and financial aid were needed to lift growth.  Policy Environment Before the Transition to Rapid Growth To minimize on foreign exchange outflows, industries that substituted for some imports were promoted by government policy. Such a strategy, which was followed for several decades after World War II in many developing countries, simply perpetuated the cycle of North-South trade and reinforced protectionist policies that contributed to a lack of competition and economic inefficiency.  Policy Environment What Japan and later the countries of East Asia did was to begin to develop an environment that stressed outward looking trade policies and the acquisition of foreign technology. In the case of Japan, many believe it was an attempt to develop a mercantilist strategy to help it recover its influence after the defeat in World War II.  The Asian Growth Miracle Primary factors - Openness - Macroeconomic Stability - Labor Market Flexibility - Education Policies Secondary factors - Initial Conditions - Sector Policies  Primary Factors-Openness The first factor in the primary strategy was outward looking policies and emphasis on exports and acquisition of foreign technology. First, some industrial capability was built up by focusing on import substitution in industries with ties to agriculture - footwear, food processing and textiles. Silk Factory, China Primary Factors-Openness Second, after some years, industrial policy shifted to promoting external markets. Initially, this focused on extending the scope of the industries that were producing for the domestic markets such as textiles and apparel, leather products and footwear and food processing. Primary Factors-Openness In Southeast Asia, the focus was also put on rubber, sugar, coconut and palm oil products as well as some specialized textile products such as silk. Slowly the emphasis shifted toward labor intensive industries that were not necessarily tied to the agricultural base such as electronics assembly and apparel. Primary Factors-Openness The shift from import substitution to export promotion was led by a shift in the trade regime so that there were lower tariff rates on exports and imports (see Table 2.3). Non-tariff barriers, including bureaucratic procedures and graft/corruption as well as import bans on some items, were also reduced.  Primary Factors-Openness Transformation to labor intensive export oriented industry was supported by flow of foreign direct investment – initially from Japan and the US, particularly in Korea, Taiwan and the Philippines. Later the volume increased and more flows began coming in from Europe.  Primary Factors-Openness A virtuous cycle of growth was created by this shift in emphasis from import substitution to export promotion (see Tables 2.4 and 2.5). In South Asia, on the other hand, the shift occurred much more slowly. Technological transfer served to reinforce the shift in export emphasis.  Primary Factors-Openness Foreign technology acquired by buying from foreign companies under license. By copying it without license – sometimes legally and sometimes not. By entering into joint ventures (FDI). East Asia (Korea, Japan, Taiwan) by and large followed the first route while Southeast Asia followed the second.  Primary Factors-Openness The flow of FDI increased following the Plaza accord in 1985 when the yen appreciated and Japan began to move some of its labor intensive industries offshore.  Primary Factors-Macroeconomic Stability The second set of primary factors focused on the importance of macroeconomic policies and the role of the government. Governments generally followed polices that created and supported a competitive environment for export oriented industries but not necessarily for the domestic market. Japan is a good example of the latter.  Primary Factors-Macroeconomic Stability The amount of government intervention didn’t seem to have a direct effect on performance. There was a lot of government intervention in the industrial and financial sectors in some countries and little in others. In Korea, Japan and Singapore, there was a lot while there was less in Malaysia and Taiwan. In Hong Kong and Thailand, on the other hand, there was virtually no intervention. What was important was the efficiency and incorruptibility of the bureaucracy.  Primary Factors-Macroeconomic Stability In the Philippines and Sri Lanka, policy environments were similar to those in the successful countries but growth was slowed by other factors such as corruption, lack of political will, corruption and domestic unrest. The efficiency of government as well as policies followed were important. Taiwan and Singapore are good examples. Primary Factors-Macroeconomic Stability Efficient governments are characterized by little rent seeking, salaries are competitive and promotions are based on performance not on seniority, patronage or crony connections. Some policies such as financial repression and directed government lending programs were wasteful. But the flow of resources for investment were substantial and the wastefulness and distortions created by these policies didn’t surface until the 1990s bubble broke. Primary Factors-Education and Labour Productivity The third set of primary factors focused on education and labor productivity. As stressed by the new growth theories, education played a critical role in both the transition to an export led growth strategy and to the ability to sustain it (see Tables 2.8 and 2.9). By 2000, some of the educational advantages of Asia had began to erode.  Primary Factors-Education and Labour Productivity There were two reasons for this: – diminishing returns since more resources had to be devoted to secondary and tertiary education. – rapid rate of income growth that tended to outstrip the corresponding growth in human development. Behrman and Schneider concludes that schooling attainment in miracles economies was not particularly outstanding. Primary Factors-Education and Labour Productivity The conclusion is that labor market flexibility has to be considered along with education. The miracles economies did not have strong unions until recently (Korea) and weak minimum wage legislation. ILO rates the miracle economies as among those with the most flexible labor markets. Mobility from rural to urban is also high. Secondary Factors-Differences in Initial Conditions Initial conditions played a part in the success of the miracle conditions. Land, income and wealth distribution in the miracle economies were generally more even than in other countries and regions. Average educational attainment was high at the beginning of the high growth period. Secondary Factors-Sector Policy Sector policies were influential to the growth of the miracle economies. Agricultural sector policies were not particularly onerous. There were taxes on agriculture but sector was still viable as we will see in Chapter 4. Industrial policies were benign and competition flourished in most countries.  Secondary Factors-Sector Policy In Korea and Taiwan, “infant industry” protection policies were strictly enforced and favored export industries were monitored for efficiency and export performance. Subsidies were withdrawn if performance was below expectations. There is considerable debate about whether industrial policy in these two countries was beneficial or not. Whatever the outcome of these discussions, it is a fact that growth was rapid in both countries. Aspects of Economic Performance High levels and growth rates of savings and investment in miracle economies. Both of these variables increased dramatically as a percent of income (see Tables 2.6 and 2.10). Furthermore, the saving-investment gap was small or even negative for some countries (see Table 2.11). Aspects of Economic Performance Increased productivity in miracle economies. Measures of TFP show a modest contribution to output growth until the middle of the 1980 and an acceleration afterwards. The latter is the combined result of previous transfer of technology and more rapid FDI following the Plaza accord.  Convergence of Income Question: The Solow model tells us that incomes will converge to a steady state irrespective of where they started out. This assumes that the technical progress coefficient, , remains constant across all countries. Is this a realistic inference?  Convergence of Income To test this hypothesis of absolute convergence, we can see if there is a relationship between per capita income in an initial period and the growth in income in successive periods. Using logs to denote growth we have, for the period 1960 to 1990, log[Y (1990) − Y (1960)] = a + b log Y (1960)  Convergence of Income Tests of this model for several sets of countries shows that it doesn’t hold for a heterogeneous group of countries around the world. It does hold for OECD countries and for OECD and Asian countries together. It does not hold for developing countries in general.  Convergence of Income A less restrictive form of convergence is called conditional convergence. In this form of the model, we allow the various parameters of the growth equations to change between different countries or groups of countries There would still be a convergence in growth rates of income but the level of income in the steady state would differ. This level would depend upon saving rates, population growth rates and depreciation rates of capital.  Tests of this model show that there is still a lot of unexplained variation in per capita income, although variations in population growth rates and saving rates did explain about half of the variation in per capita income across countries. However these results imply that the rate of convergence is very slow. What is likely is that a number of other factors are involved aside from the saving and population growth rates, such as the spread of technology and the role of education. We return to these issues later.  Convergence There is evidence that there is convergence within groups of countries with similar geographic and economic similarities such as the European Union or countries in East Asia. However there is less evidence that there is convergence between rich and poor countries  Convergence For example globally there is strong evidence for divergence. Rich countries get richer and poor countries get poorer. This does not hold within countries although the convergence is slow. German states and Japaneses prefectures and states of the US are converging.  Summary Review of the various economic growth theories. Application of the growth theories to the Asian growth miracle. The importance of primary and secondary factors in the success of the Asian miracle economies.