Determinants of Growth (General) and Regional Growth, Theory and Evidence

Contents

I. Introduction
1.1 Purpose of the Paper

II. Main Part
2.1 Growth (General)
2.1.1 Introduction to Growth (General)
2.1.2 Determinants of Growth (General)
2.2 Regional Growth
2.2.1 Introduction to Regional Growth
2.2.2 Determinants of Regional Growth

III. Conclusion

Bibliography

I. Introduction

1.1 Purpose of the Paper

The aim of this term paper is to find out what causes economic growth through analyzing determinants of growth in general and of regional growth, both in theory and evidence. The question why some countries grow significantely slower than others has been discussed intensively over the last decades. By thorough study of literature the main determinants will be indicated and similarities and differences between general and regional growth become visible. After this short introduction, in the second chapter the main growth determinants will be presented individually for the general and the regional area, each time also an introduction to the extensive literature (theory and empirics) of the specific area will be given beforehand. In the last chapter a conclusion will be drawn and an answer given to the question on which are the key determinants by comparing them with each other and in how far the results do distinguish on general and regional level.

II. Main Part

By understanding the high divergences in long-term growth rates of some countries, the extreme differences in standards of living get obvious. Even minor differences accumulated over long time-periods have much bigger consequences than short-term fluctuations, on which many economists focussed during the 1960s and 1970s. If it is possible to find out which governmental policies have effects on long-term growth rates, it will be possible to contribute to improvements in living standards (Barro and Sala-i-Martin 2004, p. 6). Thus, there is no doubt why searching for an explanation of the underlying forces behind economic growth is so important. As the study of growth has increased so rapidly in recent years, it is impossible to analyze the entire field in the limited scope of this paper. Therefore, in this part, only the most important determinants of economic growth will be introduced according to a literature analysis. During this research it became obvious that it is rather difficult to find articles or books dedicated to the theoretical foundation of each determinant, although they are heavily discussed and analyzed in empirical work. Due to the fact that the general growth models are well known there will only be a short introduction to the common theory models of neoclassical and endogenous growth and the focus is set on the individual growth determinants. However, an absolutely individual observation cannot be made as those determinants interact with one another. Hence, it is not possible to find the one and only determinant that can be used as a panacea for economic growth shifting the objective of this paper to find the “deep” determinants meaning those that exert the main influences on growth.

2.1 Growth (General)

2.1.1 Introduction to Growth (General)

To explain the determinants of a country’s growth rate and to show the reasons for the differences in growth rates and per capita income between countries is the aim of economic growth theory (Dornbusch and Fischer 2002, p. 32). The basis of modern growth theory was principally laid by Robert Solow’s path breaking contributions in the late 1950s (see Solow 1956 and 1957). Later on Solow’s model became the standard neoclassical approach. When discussing growth, especially long-term growth, this model is still the basis (Mankiw 1995). Main implications are that (1) growth slows down as the stock of capital increases at a faster rate than the labour force and returns to the point where the economy must benefit from repeated inputs of technological progress to keep growing and also (2) the presence of diminishing marginal returns – the more of a given input is being used, the more marginal (additional) units of it are needed to produce the same marginal unit of output. As a result of diminishing marginal returns poor countries should grow faster than rich countries (De Ruyter van Steveninck et al. 2000). Neoclassical models are also called exogenous growth models, as long-term growth rates are determined by variables, which are not explained by the model. There is also a certain disapproval of the neoclassic approach as some economists argue that eventually it does not elucidate economic growth. In the steady state of this model the entire growth is caused by technological progress, which is determined outside of the model. It might appear that the neoclassical model solves the problem of economic growth by the simply assumption that there is economic growth. Another critical aspect is the question whether the model provides an empirically adequate theory of growth. In principal three reasons that allow to doubt the validity of the neoclassical approach exist: the magnitude of international difference (much more disparity in income is observed in reality than the model predicts), the rate of convergence (the model predicts convergence at about twice the rate that in reality occurs) and the rates of return (the model can be evaluated by examining how the return to capital differs across countries, whereby the larger the elasticity of substitution between capital and labor, the smaller the return differentials; for the traditional Cobb-Douglas production function, the return differentials predicted are much larger than actually observed) (Mankiw 1995). There is a general view that this approach does neither offer an explanation of the experience of the countries in the developing world nor practical assistance for persistent economic development (Bloch and Hak Kan Tag 2004). Due to the differences between the neoclassical approach and the empirical facts, new theoretical models where developed with the aim to determinate sustained growth with avoidance of assuming exogenous technological progress since the mid-1980s. These models are known as endogenous growth theory models. The endogenous growth models focus on increasing returns, R&D, and knowledge spillovers, learning-by-doing and technology diffusion (see Barro and Sala-i-Martin 2004). The advantages of these models are that they help to explain the existence of technological progress and offer a more realistic description of R&D. Disadvantages are that for practical economists trying to understand international differences, the payoff from endogenous theory is still not apparent. Furthermore it is also difficult to proof models that put emphasis on unmeasureable variables, like knowledge, with empirical data (Mankiw 1995). However, along with the questioning of certain assumptions of the neoclassic growth model researchers tried to relate these new growth theories to data and evidence. The main distinction between the theories developed in the late 1950s and the 1990s is the attention on this relation. Thus, evidence and data increasingly gained importance (Barro and Sala-i-Martin 2004, p. 21). In the last years there has been a large amount of empirical work on economic growth intended to explain growth experiences of the post-1960s. A common finding of this research is that it has regularly confirmed the explanatory power of the original style neoclassic growth model. The Summers-Heston (1991) data set made international data for cross-sectional analysis available for most countries covering growth rates, inflation rates, government spending, etc. of three decades. It was primarily intended as a means of comparing income levels and is also used to derive growth rates, but there is uncertainty about whether or not this is appropriate. Also some researchers are unaware that growth rates obtained from this data will usually differ from those the countries’ own national accounts indicate (Temple 1999). A typical empirical paper on economic growth runs a cross-sectional regression based on a chosen sample of countries. Variables expected to determine the growth rate vary among studies and interpretations of results differ but the basic setup is almost the same. Nonetheless, these cross-country growth regressions are not indisputable for determining growth due to the problems of simultaneity, multicollinearity and degrees of freedom. The problems of empirical emphasis in recent work on economic growth are also the subtlety of the theories and data limitations. Admitting that those theories have subtle implications leads to the conclusion that cross-country regressions cannot simply distinguish among them (Mankiw 1995). Nonetheless, cross-country research is a useful complement to other exploratory techniques and for some important questions there is no other possibility (Temple 1999). Due to the fact that this paper is a term paper with a limited scope, only the most important theoretical basics and empirical analyses on specific determinants and their results will be presented in the following sections.

2.1.2 Determinants of Growth (General)

Regarding the plurality of linkages between the determinants it is not possible to make a strict division. Nonetheless, to give a better overview, the determinants are presented as individually as possible.

Government Policies

Neoclassical and endogenous growth models do not treat the role of government explicitly and thus the impact of governmental policies was not focussed. Recent empirical work has put emphasis on the government’s role and its policies on growth. However, a pervasive theoretical basis is still missing. A large amount of policy-oriented studies has been carried out in the past decade (see e.g. Temple 1999 for a survey). Nevertheless, the specific mechanisms, which link policy settings to growth, are still being disussed. In the case of diminishing returns to reproducible factors and exogenous saving rates, growth of population and technological progress, as in the neoclassical approach, government policies do not play a significant role in growth. (Even in the neoclassical models this view may not be maintained, when assuming that policy may have an effect on saving behaviour through influencing the resource allocation across individuals.) On the other side, government policies may affect the rate of growth persistently if physical and human capital investment is regarded as endogenous and shows constant or even increasing returns to scale. In the second case, the cross-country convergence process does not exist any longer, even after controlling for some country-specific factors such as natural resource endowment or geographical location (OECD 2003, p. 57). Endogenous growth theories relax the neoclassical postulation of efficient markets and recognize market failures and the possibility of allocative and dynamic inefficiency. Consequently, the potential role for the government in the reduction of market failures is included in these theories. Nonetheless, as the governmental role is analyzed only superficially, policy implications are more general. Most endogenous growth theories focus on market versus government dichotomy without taking in mind alternative private or third sector solutions to market failures and do not deal with government failures (Hämäläinen 2000, p. 14). Barro carried out a study on about 100 countries of different levels of economic development which examines three time periods (1965-1975, 1975-1985, 1985-1990), in which different kinds of governmental policies are analyzed for their impact on growth rates (Barro 2000). The investigated policies are government consumption, the rule of law, democracy, inflation, education and public debts. Results concerning government consumption expenditures (excluding education and defense expenditures) showed a negative effect on growth rates. The results indicate statistically significant that rising the spending ratio by five percentage points lowers the economic growth rate by 0.7 percent per year. Government consumption expenditures also affect the investment negatively, both in quantity and quality. The rule of law including solid property rights and a strong legal system, showed a significantly positive effect on economic growth and level and quality of investment. The impact of democracy on growth showed an overall weak relation. A statistically significant inverted U-curve is found respecting growth and investment indicating that after reaching a certain level of democratization further democracy leads to a decline in economic performance. The negative effect of inflation on economic growth is statistically significant when it comes to inflation rates of more than twenty percent annually, probably due to the effects of inflation on the efficiency of investment.

Effects of education have a strong impact on economic growth when it comes to school attainment at secondary level and upwards. The ratio of public debts – the choice of public financing between current and future taxation or between taxes and public borrowing – does not have a significant impact on growth and investment. Levine and Zervos (1993) also could not find robust linkages between indicators of monetary or fiscal policy and long-term growth. Temple (1999) states that government policies are beneficial for building up infrastructure. Easterly (2001, p. 21) concludes that activities such as foreign aid and investment, education, family planning, etc. will not have an impact on economic development in the developing world unless these countries meet the basic institutional requirements: protection of property rights, rule of law, efficient bureaucracy, corruption-free government and political constraint on executive. This opinion comes along with Burnside and Dollar (2000), who found out that aid has a positive effect on growth in developing countries with good fiscal, monetary and trade policies. This effect goes far beyond the direct impact of policies on growth. Aid would be more effective when thoroughly conditioned on good policies because in the case of poor policies aid resulted only in unproductive government expenditures. The essential point is that policies can have a major impact on a country’s welfare level. Poor countries can maximize their chances to grow by the right policies, although the precise content of these policies still remains under discussion. Nonetheless, the importance of political stability for economic growth – for poor and for rich countries – becomes obvious. Empirical results also confirm that policy influences do not only have a direct impact on growth but also an indirect one through mobilisation of resources for fixed investment (OECD 2003, p. 55).

Openness to Foreign Trade

Lucas (2002, p. 7) states that the most striking economic growth successes since World War II. were related to international trade growth. Thus, another aspect of attention is the openness to foreign trade, which also can be influenced by a government’s policies as studies conducted by Dollar (1992), Barro and Sala-i-Martin (2004) or Sachs and Warner (1995) found out, via use of cross-country regressions, that trade distortions caused by government intervention slow down growth rates.

Theory often focuses on the relationship between international trade, knowledge spillovers and growth, while empirical research has usually examined the relationship between exports or openness and growth. Endogenous growth theory, unlike neoclassical theory, predicts – in absence of knowledge spillovers – divergence (or only conditional convergence) among countries. Traditional trade theory mostly emphasises that increased openness and not necessarily the actual volume of trade should lead to an equalization of incomes, while empirical work stresses a strong relationship between the two factors. A conclusion might be that the trade level is a suitable proxy for the degree of openness. Various empirical studies show that income convergence is a main trait among countries that have strong trading relations with each other (Brons et al. 2000). Due to his research Easterly (2000) concludes that the connection between growth and openness is strong. More detailed, openness can be divided in trade and capital flows and leads to certain advantages. By reducing price distortions of inputs and investment goods it promotes the level of domestic investment and improves the allocation of investment. Openness also promotes the convergence between poor and rich countries in contradiction to observances among closed economies. Nonetheless, negative aspects can occur because free trade also involves higher vulnerability to terms-of-trade shocks and abrupt interruptions of capital flows. There is a risk-return trade-off due to the fact that the more open an economy is, the stronger negative and positive effects of terms-of-trade shocks can be. Openness to capital imports also increase growth as well as vulnerability. Lewer and Van den Berg (2004) focus on the size of the relationship between trade and growth to proof whether the statistically-significant relationship is also economically-significant. Across many samples, data sets and regression models the quantitative relationship is robust and the average quantitative result is that for every percentage point increase in the growth of trade, the economic growth rate (increase in real GDP or real per capita GDP) raises by more than one-fifth of a percent (indeed Frankel and Romer (1999) come to the result that it is at least one-half percent). Many economists have stressed the positive impact of trade openness because through absolute and/or comparative advantage it can raise per capita income directly and it can increase efficiency via channels like increasing scale economies, technology transfer and competitive influence of interaction with foreign firms indirectly (Bloch and Hak Kan Tang 2004). Wacziarg (2001) distinguished the channels through which open trade influences economic performance. He analyzed six potential channels: macroeconomic policy quality, government size, price distortions or black market premium, investment share of GDP, technology and FDI. He concludes that investment is the most important channel (responsible for 63% of trade’s total growth effect), followed by technology and stabilising macroeconomic policy, which account for nearly the rest of the trade’s positive influence on growth. These results underline Levine and Renelt’s (1992) finding that openness to foreign trade has only an indirect effect on economic growth through higher investment. Thus, the direct effect is not robust. Rodriguez and Rodrik (1999) reveal that the positive correlation between openness and growth is not robust, due to problems in the measures of openness (neither obviously exogenous nor constant across studies) or lack of suitable control variables. Based on a sample of more than 100 countries Sachs and Warner (1995) analyzed governmental policies as tariff and nontariff barriers, the black market premium on foreign exchange, and subjective measures of open policies and found out that, ceteris paribus, open countries grow two percent per annum more rapidly than closed ones. Thus, they conclude that openness to foreign trade promotes economic growth. Frankel and Romer (1999) emphasize that trade appears to raise income by spurring the accumulation of physical and human capital and by increasing output for given levels of capital. Although the results do not provide key evidence for the benefits of trade they strengthen the importance of trade and trade-promoting policies. Due to the importance of this topic many cross-sectional regression studies were carried out; most of them show a linkage of greater openness either to higher income levels or faster growth (e.g. Dollar 1992, Sachs and Warner 1995, Frankel and Romer 1999). Berg and Krueger (2003) stress the importance of positive spillovers of openness on other aspects of reform. Thus, the link of trade to other pro-reform policies underlines the key role of openness as part of a reform package. However, emerging literature shows either the difficulty to distinguish the growth effects of openness and the institutional structure of the economy, or that institutions are more important (Fischer 2003). All in all, in the many studies on the link between trade openness and growth the results have been mostly positive and statistically significant, especially cross-section and time-series growth regressions suggest that promoting free trade policies is important for growth and human welfare.

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