Abstract

A revival of interest in economic growth in the mid-1980s led to the development of a new wave of models that established a synthesis now known as endogenous growth theory, which has produced a large volume of empirical studies of growth. The first element of this synthesis is the earlier prevailing doctrine on economic growth, the “neoclassical” model of Solow-Swan and Cass-Koopmans from the 1950–60s, which attributed growth to the expansion of capital and labor, augmented by exogenous technological progress. Simple factor input and factor productivity calculations of the sources of growth are based on this paradigm and continue to be used widely, including in many IMF background studies.

New Growth Theory and Empirical Evidence

A revival of interest in economic growth in the mid-1980s led to the development of a new wave of models that established a synthesis now known as endogenous growth theory, which has produced a large volume of empirical studies of growth. The first element of this synthesis is the earlier prevailing doctrine on economic growth, the “neoclassical” model of Solow-Swan and Cass-Koopmans from the 1950–60s, which attributed growth to the expansion of capital and labor, augmented by exogenous technological progress. Simple factor input and factor productivity calculations of the sources of growth are based on this paradigm and continue to be used widely, including in many IMF background studies.

The second element is the set of models developed in the mid-1980s, and synthesized in Romer (1990), then Barro and Sala-i-Martin (1995). While retaining the role of factor inputs, these models added an explanation of technical progress based on increasing returns, research and development and imperfect competition, human capital, and—an important addition—government policies. The role of policies was initially focused on narrow economic measures such as macroeconomic stability, openness of the economy, and degree of distortion in key price signals. A third element has been added from what might be considered political economy models of growth. Olson (1996), in particular, summarizes well the conceptual basis for the role of policy areas such as property rights, the rule of law, institutions, and corruption. Olson argued that both of the preceding theories assume, incorrectly, that countries (and policymakers) make the most efficient use of resource inputs and available technology; instead, he posited that many countries are poor simply because they waste a lot of resources. On the basis of earlier work on the political economy of interest groups, he then added that the waste was greatest where the institutional bases of property rights and rule of law were least well developed or observed; an association with a high degree of corruption readily follows from this.

A synthesis of these three elements characterizes growth theory today. In the long run, initial conditions and expansion of factor inputs still play a role; but the magnitude of such factor expansion, the efficiency with which factors are employed, and the long-term technological improvements, which also increase efficiency, depend very much on policy. Good policy includes an effective legal support of property rights. The past decade has seen numerous empirical studies based on this model that seek to explain the observed wide differences in growth patterns across countries and that include as determinants factor inputs (investment, human capital); government policies (monetary and fiscal policy distortions); and institutional indicators of the security of property rights (tax burden and fairness, corruption, transparency, political stability, and the like).

Some general conclusions can be drawn from this recent literature.1 First, initial conditions are important in explaining cross-country differences in growth. In particular, most studies have found that per capita growth is inversely related to the initial level of output and that once other factors are accounted for, poor countries tend to grow faster than rich ones. Further, greater availability of resources does not necessarily ensure growth, while unfavorable geographic circumstances (tropical climate, a landlocked position) can hinder it. Second, there is a strong consensus that good economic policy (macro-economic stability and nondistortive interventions) has a strong effect on growth. Thus, reducing inflation not only to levels of 30 to 40 percent but even lower seems to be a necessary condition for achieving sustained growth.2 Thus, inflation or the adoption of policies that lower the rate of return on private capital, such as high taxes and exchange or import controls, are highly likely to reduce the growth potential of a country. Third, the underlying legal, political, and institutional bases also matter a great deal. Most recent empirical studies make some attempt to capture these considerations and usually find that growth is higher with better institutional quality, political stability, government credibility, and similar indicators of a market-friendly environment.

Special Circumstances of Transition Economies

A decade ago it was popular to say that there is no theory to guide the practical process of transition, only theories of capitalism and socialism. This may still be true in the sense that consensus on a new paradigm is only beginning to emerge from the vast literature on transition, but it is not at all clear how much a unified, cohesive theory is needed. Besides, to the extent that it is useful to have a compact rather than complex analytical framework, it is not that difficult to cobble together from a few of the key writings a workable “model” of transition or transformation. Kornai (1994), in describing the special circumstances of the “transformational” recession compared to a market economy recession, has highlighted two key changes that are needed: forcing a move from a sellers’ to a buyers’ market(via price liberalization), and enforcing a hard budget constraint(via privatization and elimination of various government support mechanisms). These are the two principal incentives for profit-maximizing market behavior by all economic agents. Blanchard (1997) defines the core process of change as comprising two elements: reallocation of resources from old to new activities(via closures and bankruptcies, combined with establishment of new enterprises), and restructuring within surviving firms(via labor rationalization, product line change, and new investment). These can be thought of as the dynamic movements resulting from the establishment of the new incentives and are reminiscent of the Schumpeterian concept of “creative destruction” by entrepreneurial activity, only with very much larger impact than what Schumpeter’s model envisioned. The policy actions needed to put in place Kornai’s new initiatives—which also promote Blanchard’s Schumpeterian changes in economic activity—are outlined in many works (including Kornai and Blanchard) and are well exemplified in an early study by Fischer and Gelb (1991). The key measures of reform are

  • Macroeconomic stabilization;

  • Price and market liberalization;

  • Liberalization of the exchange and trade system;

  • Privatization;

  • Establishing a competitive environment with few obstacles to market entry and exit; and

  • Redefining the role of the state as the provider of macrostability, a stable legal framework, enforceable property rights, and occasionally as a corrector of market imperfections (see Box 6 in Section IV).

From such a core concept of transformation there follow some implications for growth that differentiate the transition economies from market economies. First, output will most likely decline initially under the new buyers’ market and hard budget constraints, since unsalable goods accumulate and signal the need for cutbacks in production. Further elimination of waste under the old scheme (perhaps through “destruction” or closure) necessarily precedes creation of the new, adding to the production cuts. A second implication is that growth of the new will not occur until the new incentives are in place and made credible; that is, the sooner reforms achieve a hard budget constraint and liberal price environment, the sooner reallocation and the restructuring of the old and the creation of new production can begin. Third, one can infer from this that the proximate mechanisms in the early recovery period are not likely to depend so much on the conventional factor inputs that explain medium-term growth (investments, new technology); rather, the initial output expansion will come primarily from a variety of efficiency improvements. Five types of mechanisms conducive to increased output may be postulated, many of which may be simultaneous or overlapping:

  • Recovery of underutilized capacity;

  • Elimination of egregious waste of labor, capital, and materials (X-efficiency, in theoretical terms);

  • Efficiency gains from a more appropriate combination of capital and labor (factor efficiency);

  • Efficiency gains from resource reallocation toward goods in which a country has a comparative advantage or in which there is unsatisfied consumer demand; and

  • Output expansion via new net investment and employment increases (see Annex I).3

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