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Appendix I. Growth Acceleration Episodes
Appendix II. Numerical Solution
Appendix III. Limited Legal Enforcement
I want to thank my advisors Christopher Carroll, Jon Faust and Olivier Jeanne for insightful and stimulating discussions, and seminar participants at various institutions and conferences.
Eastern European emerging markets have instead experienced large current account deficits. As discussed in Section IV, this can be due to the higher level of financial development.
Similar results are obtained if considering the median. The improvement in the current account is even more pronounced if including growth accelerations only in the first half of the sample period (1960-1985), thus suggesting that the positive correlation between growth and capital flows is not only a recent phenomenon possibly driven by the wave of financial globalization over the last 20 years. Note that among the growth acceleration episodes there are also a few countries recovering from severe crises. Dropping countries with negative growth rates at any time over the considered time interval leads to an even stronger improvement in the current account.
Aghion, Comin, Howitt and Tecu (2009) propose a model for developing countries in which domestic saving preserves its growth enhancing potential even under international capital mobility: they suggest that the involvement of foreign investors is crucial to catch up with the technology frontier and that this is possible only if locals have the capital to co-finance investment projects to reduce moral hazard. Their model, however, still predicts that growth should be associated with larger capital inflows.
Hurst and Lusardi (2004) have shown that financial constraints are unlikely to be playing an important role in restraining business start up in the US. However, this does not rule out their relevance in shaping the saving and investment decisions of entrepreneurs while scaling up businesses. External financing seems to be limited even for the US corporate sector, as suggested by the sensitivity of investment to internal cash; see Hubbard (1998) for an excellent survey.
If occupational choices were reversible, entrepreneurs who face capital losses after an unproductive investment may prefer to return to a wage occupation for a few years and accumulate savings prior to start a new enterprise, from which we want to dispense. Ruling out the possibility of returning to wage employment increases somewhat the risk of entrepreneurial failure and the need for precautionary savings. In our model, this effect is however extremely small, since entrepreneurs are always allowed to start up a new equally productive business.
We will relax this assumption and investigate the implications for growth, capital flows, and welfare in Section IV.
For simplicity we do not require
The case in which the shock involves the loss of only a share of the invested capital is observationally equivalent to the case of partial risk sharing discussed in Section IV. The musical symbol ♭ (flat) is mnemonic since the entrepreneur is badly flattened by this shock.
We exclude from net worth the net equity value of the primary house and quasi-liquid retirement accounts, since the model does not incorporate retirement savings nor housing decisions. To further leave out retirement savings, we use data only on agents younger than 50. These adjustments increase the share of business wealth in net worth, thus leading to a lower estimate of the failure risk. The structural estimation is performed following Cagetti (2003) by matching medians rather than means to be more robust to the high degree of skewness in the data that the model is not particularly suited to account for. Note that the estimation can be performed under an arbitrary wage rate for workers since it does not affect the targeted moments.
This can be easily seen by considering that at the optimal investment scale under perfect foresight, the income to capital ratio is equal to (R − 1 + δ)/φ.
The level of farming income has interesting implications for inequality dynamics: while in the benchmark calibration inequality monotonically increases, using a lower farming income leads to non-monotonic dynamics. As in Kuznets (1955), inequality increases early in the transition as entrepreneurs benefits from stable low wages, and then shrinks as the absorbtion of the all the rural labor force leads to inflationary pressure on wages.
Limits on the pledgeable share of the return from risky investment can arise for various reasons that we are not here interested in identifying (see Appendix III for an example).
Entrepreneurs may also have the incentive to borrow against future income in order to finance current consumption. As for workers, we prevent this possibility by imposing ct ≤ xt.
For a more extensive analysis of how idiosyncratic investment risk influences the economy steady state in a closed economy see Angeletos (2007).
The emphasis of the paper on entrepreneurial risk suggests also an additional factor which can be relevant to explain the Eastern European dynamics. Even though not explicitly modeled here, if investment risk is borne by foreigners, the country would not need to accumulate precautionary savings. Consistent with this implication, the net inflows of FDI as a percentage of GDP over the last decade have been twice as large in emerging Europe than in emerging Asia.
We identify these growth acceleration episodes using GNI rather than GDP since the former also includes net income from abroad and is therefore the relevant variable to which consumption and saving should respond. In the case of multiple years for a given country satisfying the above criteria (and less than 5 years apart), the relevant episode is selected by considering the year with the highest explanatory power as the breaking point of a spline regression of growth over time.