RDP 9507: Macroeconomic Policies and Growth 3. Growth Theories and Empirical Evidence

3.1 Growth Theories

For three decades, growth theory was dominated by the neoclassical Solow-Swan model in which output growth is determined by technical progress and growth in capital and labour inputs.[4] This model provides few channels for macro-policy influences. Thus, technical progress is assumed to be exogenous and most empirical studies do not suggest macro-policies have much influence on labour force growth. Capital growth, however, could be influenced by policies and, as further discussed below, the neoclassical model is often used to analyse the growth effect of policy-induced changes in capital stock growth or changes in the investment/GDP ratio. Moreover, when the Solow-Swan model is extended to include human as well as physical capital, it is possible to explain per capita income growth in a broad range of countries and show that, after controlling for the determinants of steady-state income levels, poor countries grow faster than rich ones: i.e. that there is ‘conditional’ convergence in per capita income levels (Mankiw, Romer and Weil 1992).

It is also possible to disaggregate changes in capital into various types of investment, including public investment in infrastructure. Of course, as long as the framework of the neoclassical model is maintained, policy-induced changes in the growth of capital or the investment/GDP ratio do not change steady-state output growth but only the steady-state output level. In practice, however, this may be of limited importance because the transition period between steady states is very long, so that growth over extended periods (as opposed to steady-state growth) is affected.[5]

Romer (1986) initiated an explosion of research on how to explain or ‘endogenise’ technical progress in theories of long-run growth (Dowrick 1995). For the purpose of this paper, the most important features are the emphasis on capital or a specific type of capital as the principal determinant of growth and the possibility of externalities or imperfect competition implying that markets may not generate a Pareto optimum in general. Or, to put the second point differently, if firms and other economic agents cannot internalise all the benefits of their investments, the growth of capital will be below the socially optimal rate.

3.2 What Do We Learn From Cross-Country or Panel Studies of Long-Run Growth?

Most of the specific policy measures suggested by endogenous growth theories are microeconomic in nature and macroeconomic policies as defined in this paper rarely appear. Nonetheless, based on the experience of the 1970s and 1980s, many economists came to believe that sound macroeconomic policies were conducive to long-run sustainable growth. Fischer (1993) lists five conditions which together imply that a macroeconomic framework is conducive to growth: a low and predictable inflation rate; an appropriate real interest rate; a stable and sustainable fiscal policy; a competitive and predictable real exchange rate; and a balance of payments that is regarded as viable.

Fischer stresses uncertainty, arguing that a government that allows a high budget deficit or a high rate of inflation has lost control and generates uncertainty. Uncertainty and its effects on volatility are also the transmission channels stressed by Pindyck and Solimano (1993) who attempt to identify the principal determinants of variations in investment/GDP ratios over time and between countries. In all their regressions, they find inflation to be the main source of volatility in the marginal return to investment and of variations in the investment/GDP ratio.[6]

Indeed, with capital accumulation the principal determinant of long-run growth in both the neoclassical model and most versions of endogenous growth models, the determination of capital expenditure is likely to be an important transmission channel for macroeconomic policies and it might even be argued that macroeconomic policies should be designed with a view to stimulating capital expenditure. Moreover, if capital flows are less than perfectly mobile internationally or, for other reasons, balance-of-payments considerations act as a constraint on growth, the level of national saving and ways to raise it through policies – notably fiscal policy – become relevant as well. We address these issues in Section 3.3, following a brief discussion of measurement issues and problems of interpretation.[7]

Returning to Fischer's five conditions, note that they are not independent of each other, and there are plenty of individual country cases showing that satisfying one or two of these conditions is not enough. The most striking recent example is Mexico which in the 1990s, but before the December 1994 crisis, achieved a low inflation rate and consolidated its fiscal situation. However, growth remained low, because the real exchange rate was not competitive, leading to a nonviable balance of payments, combined with volatile but mostly quite high real interest rates. The members of the African franc zone provide another example. Because of the currency link with the French franc until early 1994 inflation was low, but over time the real exchange rate became increasingly uncompetitive and growth was well below even the modest rates of other African countries. Turning to the developed countries, several members of the European Community achieved low inflation, competitive exchange rates and viable balances of payments in the eighties and early nineties, but growth remained low because real interest rates were generally high and in several countries the fiscal situation was regarded as unsustainable. At the other end of the spectrum, many of the fast-growing Asian countries are often seen as being helped by their stable macroeconomic policies (Hughes 1995) including low inflation, sound fiscal policies, competitive exchange rates and balance of payments deficits that are generally regarded as viable because they reflect high imports of capital goods. Chile, which has achieved very high growth rates since the mid 1980s should also be mentioned as one country where macro-policies appear to have been instrumental in generating a transition from stabilisation to high and sustainable growth.[8]

The above list is by no means exhaustive. Nonetheless, finding clear evidence of policy influences from empirical studies has proven difficult. There seem to be four reasons for this. First, because all five conditions need to be satisfied, analyses including only a subset are unlikely to produce conclusive evidence. On the other hand, because the five conditions are not independent of each other, multicollinearity problems often mar studies that include indicators of all conditions. Second, several countries have managed to grow strongly even over rather long periods (most notably Latin America in the 1960s and 1970s) before the accumulation of macroeconomic imbalances caused a slowdown. These exceptions from the general rule have lasted long enough to have exerted a distorting influence on analyses based on cross country comparisons. Third, none of the conditions can be directly related to policy instruments or ‘executable’ policies, but need to be proxied by other measures that are not necessarily exogenous with respect to general economic developments. In other words, analyses of policy effects will suffer from simultaneity or dual causality problems. Finally, even if these problems could be overcome, the coefficients estimated from cross-country regressions measure the strength of partial correlations and care must be exercised when interpreting them as behavioural relations and in deriving policy implications.

We conclude with a final point concerning the relative persistence of growth and macro-policy indicators. For most countries, levels of output and country characteristics, including many policy-related variables, are highly persistent through time, while growth rates are not (Easterly et al. 1993). In the Appendix, we verify this pattern of persistence for the OECD countries and discuss its relevance. As Easterly et al. argue, it suggests that while the differential shocks that hit countries play a big role in determining the cross-country variation in growth rates, macro-policies and other country characteristics are also important in explaining growth, in particular when countries are far from their steady-state incomes but also through the reaction of policies to shocks.

3.3 Specific Effects on Growth

Despite the problems raised above, we now turn to empirical estimates of specific policies, starting with fiscal policy and issues relating to investment and continuing with a discussion of possible balance-of-payments constraints on growth and the role of national saving. We then turn to the relationship between exchange rate policies and growth, the role of financial markets and the implications of path dependence for macroeconomic policy.[9]

3.3.1 Fiscal policy and public investment

A large number of cross-country analyses of growth have included measures of fiscal policy, focusing on three issues in particular: the relationship between the size of the public sector and growth; the likely adverse impact of fiscal imbalances and public debt; and whether certain types of public expenditure are associated with special positive or negative growth effects. Easterly and Rebelo (1994) is one of the most recent and most comprehensive studies dealing with the fiscal policy issues. It uses a new database for the public sector and analyses various indicators of fiscal policy and their effect on long-run per capita growth, including the budget balance, average tax rates, government consumption expenditure and public investment. The indicators are imbedded in a Barro (1991)-type equation estimated across 50–75 countries. Among the many results reported the following are worth noting:

  • like most other analysts, Easterly and Rebelo find that the coefficients obtained for measures of the size of the public sector are fragile;
  • the budget balance has a significant and positive coefficient, meaning that countries running large fiscal deficits tend to have lower growth (implying, of course, a failure of Ricardian debt neutrality); and
  • public consumption seems to have a negative effect on growth, whereas public investment has a positive effect, with the strongest effects found for central and general government investment and for investment in education and transport facilities.

These results on public investment are consistent with a number of other recent studies which have looked at investment in infrastructure. While there has been a secular decline in the ratio of public investment to GDP in virtually all industrial countries, the implications of this decline were largely ignored until Aschauer (1989a, 1989b) found that a 1 per cent increase in the stock of public capital in the United States raised private sector capital productivity by 0.4 per cent, implying very high returns on public sector investment.[10] Equally high estimates have been obtained for Australia (Otto and Voss 1994a, 1994b) and for other countries as well.

Following Aschauer's startling results numerous other studies appeared, many of which cast doubt on his estimates (Gramlich 1994). While it would go too far to review this debate, there appear to be two principal implications for macroeconomic policies. First, reducing public investment merely as a means of cutting the government borrowing requirement is not an optimal long-run policy. Second, while federal grants encouraging infrastructure investment projects (which are mostly undertaken by State and local governments) with particularly high returns might be an area of policy relevance, the current consensus is for increased reliance on user fees or privatisation of infrastructure capital.

3.3.2 Aggregate investment

The above conclusion still leaves open the question whether, given the role of capital growth in both the neoclassical and endogenous growth models, fiscal policy should provide special incentives for investment in general. As a starting point, consider the neoclassical model assuming a Cobb-Douglas production function with constant returns to scale as given in footnote 4 above. For most countries with capital stock data, estimates yield values for b of about 0.3, implying that increasing the rate of growth of the capital stock per worker by 1 percentage point raises annual output growth per worker by 0.3 points. When capital stock figures are not available or subject to large measurement errors, Δk may be approximated by the investment/GDP ratio and the growth equation estimated as:

where δ denotes the rate of depreciation and r the required net rate of return.

When equation (1) is estimated across both developed and developing countries, Fischer (1993) and Dowrick (1994) find (r+δ) in the range 0.15–0.20 while Englander and Gurney estimate (r+δ) at 0.09 and at only 0.06 when the sample is confined to the OECD countries. For δ of approximately 0.05 (based on data for all OECD countries and assuming an average capital/output ratio of 2.5) the net return will be in the range 0.05–0.15 for the whole sample, but only around 0.01 for OECD countries. Moreover, when estimating the determinants of total -factor productivity growth, Englander and Gurney find that growth in the capital/labour ratio has no significant influence.[11]

On balance, the empirical evidence on aggregate investment does not point to very large positive externalities, nor does it provide strong support for special incentives.[12] Since in most countries there are numerous examples of distortions in relative prices due to the existing tax and subsidy structure, the current consensus appears to be that policies to encourage investment should mainly consist of reducing or eliminating existing distortions rather than attempting to ‘pick winners’ (see also Auerbach (1992)). In particular, tax systems in several countries, including Australia, distort relative prices in favour of residential investment, encouraging a type of capital expenditure and a composition of total investment which does not encourage long-run growth.

3.3.3 Growth and the balance of payments

A country's balance of payments position may influence its level or rate of growth of output in several plausible ways. In our discussion, we examine a range of possible influences, and focus particularly on the Australian experience.

If international capital flows are highly mobile, saving acts as a constraint on investment and growth for the world as a whole, but not for any individual country, as capital flows from countries with excess saving to those where profitable investment exceeds domestic saving. Access to foreign savings enables individual countries to fund higher domestic investment than would otherwise be possible.

The extent of international capital mobility, however, remains an unresolved issue. On the one hand, tests based on comparisons of interest rates such as onshore-offshore differentials suggest a high degree of capital mobility between countries. On the other hand, research examining the behaviour of real variables, like saving and investment correlations, consumption behaviour across countries, and the implications of the intertemporal approach to the balance of payments, suggest that even without institutional or legal barriers inhibiting the flow of capital internationally, the owners and managers of each nation's savings act to keep almost all of it at home (Feldstein and Horioka 1980; Tesar and Werner 1992; Lewis 1993; Obstfeld 1994; Feldstein 1995a, 1995b; Bayoumi and Klein 1995). This evidence therefore suggests that the balance of payments does act as a constraint, in the sense that countries with current account deficits invest less, and grow more slowly, than they would if domestic savings were higher. (A similar constraint would apply if domestic policy was aimed at maintaining external balance.)

One version of the idea that the balance of payments imposes a constraint on growth is presented by McCombie and Thirlwall (1994), hereafter MT. MT develop a demand-side model in which the growth rate ‘consistent with balance-of-payments equilibrium’ is determined by the rate of growth in total revenues available for expanding imports, allowing for the effect of terms-of-trade changes, changes in export volumes and net capital flows, and by the income elasticity of imports. Applying the MT approach to Australia suggests a growth rate consistent with balance-of-payments equilibrium of between 2 and 3 per cent per annum, well below the trend rate of growth of the Australian economy (see the Appendix for details).

The MT analysis uses an elasticities approach to the balance of payments, and as such, ignores the response of domestic savers and investors to the aggregate wealth implications of rising external indebtedness. It also excludes any real exchange rate change as part of the adjustment process. In reality, however, a depreciating real exchange rate is part of the economy's response to higher external indebtedness (Blundell-Wignall, Fahrer and Heath 1993). We therefore turn to the potential implications of this depreciation for real output.

A current account deficit of 4.5 per cent of GDP (the Australian average over the past decade) means that the ratio of net external liabilities to GDP currently rises at about 1.7 percentage points per annum (again, see the Appendix for technical details). As a consequence, the Australian dollar depreciates in real terms, at an estimated average rate of about 0.9 per cent per annum. This slow real depreciation is needed to generate a surplus on the trade and services account in the longer-run – which is required to fund the income payments on foreign liabilities. As the external liabilities ratio rises, the extent of required real depreciation also rises.

A depreciating real exchange rate, however, exerts upward pressure on the domestic price of imports, and creates domestic inflationary pressure. To keep inflation from rising then requires real unit labour costs to fall at an estimated average rate of about 0.4 per cent per annum (or, equivalently, real wages to rise at an average of 0.4 per cent per annum slower than labour productivity growth).[13]

In principle, if real exchange rate depreciation proceeds smoothly and gradually, the labour market can deliver the required gradual fall in real unit labour costs without adverse consequences on the level of output in the economy. In practice, the gradual real depreciation is superimposed on large, medium-term, movements of the exchange rate (predominantly caused by fluctuations in the terms of trade). Hence, at times it may not be possible for the labour market to adjust sufficiently quickly, and price inflation will rise. According to estimates presented in the Appendix, in such situations, the level of output must be kept an average of 0.9 per cent lower than if there was no real depreciation to be absorbed. This estimate of the average output cost associated with keeping inflation steady may, however, be overstated as it assumes the labour market generates no reduction in real unit labour costs without a fall in output.

Turning to other possible influences, a high and rising level of foreign liabilities may well generate uncertainty because economic agents are unsure how the situation will be resolved. As previously discussed, more uncertainty may adversely affect investment (Pindyck and Solimano 1993) and therefore growth (Fischer 1993). There is also empirical evidence that, in general, real interest rates are higher in countries with large current account deficits (Orr, Edey and Kennedy 1995) and, in particular, in Australia (Gruen and Smith 1994) which also has an adverse effect on investment and growth.

To conclude our discussion, we should point out that we have not directly addressed the question of whether the rising external liabilities are optimal or not (Pitchford 1990). Even with limited access to foreign savings, domestic investment will be higher than would otherwise be possible. Ultimately, the extent to which a country can rely on foreign savings to fund domestic investment and growth, depends on the rate of capital inflow the market accepts as sustainable. While it is impossible to be definitive, the sustainable rate of capital inflow may well be higher for Australia, with abundant natural resources and a stable political environment, than for many other capital importing countries.

3.3.4 National saving

As foreshadowed in the previous section, if savings do not move completely freely between countries, the level of national saving becomes an important determinant of the level of domestic investment, and hence of domestic growth. As can be seen from Figure 1, national saving relative to GDP in the world as a whole has fallen since the 1960s. The decline was slightly more pronounced for Australia, though Australia is not the only country with a steep decline in national saving. In six other OECD countries, the savings rate has fallen by 4 ½ percentage points or more and, in Figure 2 and Table 4, the experience of these countries with respect to developments in total saving and its components is compared with that of three other OECD countries where the national savings rates have been relatively stable or increased slightly.[14]

Figure 1: National Savings, World and Australia
(Percentage of GDP)
Figure 1: National Savings, World and Australia

Sources: IMF (1995) and ABS Cat. No. 5206.0.

Figure 2: Composition of National Saving
(Percentage of GDP)
Figure 2: Composition of National Saving

Sources: Elmeskov et al. (1991); OECD, National Accounts; OECD, Economic Outlook; IMF, International Financial Statistics; and authors' estimates.

Table 4: Changes in Saving, Growth and the Current External Account
(1960s–1990s, percentage points)
Italy −9.6 −8.9 −0.8 −0.8 0.0 −4.6 −1.9
Australia −8.7 −8.7 0.0 1.6 −1.6 −3.2 −1.9
Canada −6.9 −7.3 0.4 −1.9 2.3 −4.2 −2.3
France −6.2 −5.3 −0.9 3.4 −4.3 −4.5 −0.1
Germany −5.3 −6.8 1.5 0.1 1.4 −1.5 −0.9
United Kingdom −4.9 −6.2 1.3 −0.8 2.1 −2.0 −1.5
United States −4.5 −2.6 −1.9 −1.4 −0.5 −1.8 −2.0
Belgium −0.5 −5.7 5.2 −0.6 5.8 −3.3 3.5
Japan −0.5 −0.2 −0.3 −1.0 0.7 −8.2 2.4
Switzerland 1.6 −3.1 4.7 −1.0 5.7 −4.1 6.8

Note: NSAV = national saving, GSAV = government saving, PSAV = ESAV + HSAV = private saving, ESAV = enterprise saving, HSAV = household saving and BoP = current external account, all measured as percentages of GDP, and g = rate of growth of GDP, annual rate. 1960s and 1990s refer to 1960–69 and 1990–94 respectively.

Sources: Elmeskov, Shafer and Tease (1991); OECD, National Accounts; OECD, Economic Outlook; IMF, International Financial Statistics; and authors' estimates.

From the figure and the table the following points are worth noting:

  • In all but one of the countries where the national savings rate has fallen by 4½ percentage points or more, the main factor has been the decline in government saving.[15] In fact, in three of the countries, government saving has fallen by more than national saving. The one exception to this pattern is the United States, where the decline in national saving is almost equally split between government and private saving, with lower enterprise saving accounting for most of the latter.
  • The experiences of the three countries with only minor changes in national saving, Belgium, Japan and Switzerland, show that maintaining a high national savings rate is not sufficient for generating or maintaining high growth. In all three countries, average growth fell sharply and this, combined with the weakening of enterprise saving, obviously had a much stronger adverse impact on investment than the improvement in household saving. In fact, there is growing evidence (see Carroll and Weil (1994) for industrial countries and World Bank (1993) for eight Asian countries) that the direction of causality goes, at least to some extent, from growth to saving. In other words, countries that grow faster tend to generate more saving.[16]
  • While private saving has generally been stable (main exceptions are Belgium and Switzerland), in underlying terms they may have fallen, once a partial Ricardian equivalence effect is taken into account.[17] There have also been significant changes in the composition of private saving. In 7 of the 10 countries shown in the table, enterprise saving has tended to decline, while household saving has strengthened, in some cases quite significantly. Of the three remaining countries, only Australia and France show declines in the rate of household saving, possibly suggesting that in these two countries household saving is particularly sensitive to the different cyclical conditions of the 1960s and the 1990s or disincentives to household saving have become stronger.

The fall in government saving being the dominant influence in virtually all countries points to fiscal consolidation as the crucial policy measure to raise national saving, rather than, for example, special incentives to boost private saving.[18] Note, however, that the recent weakening of national saving appears to be a reversion towards longer-term ‘norms’ after an unusual postwar boom in saving. As can be seen from Table 5, the 1950–73 period was not only an unusual period with respect to growth but also with respect to gross national saving. In fact, the only country with a relatively smooth pattern of saving is the United States which, as noted earlier, also had a relatively smooth pattern of growth.

Table 5: Saving and Growth Over Longer Periods in Selected Countries
Countries 1870–1913 1913–1950 1950–1973 1973–1989
S/Y g S/Y g S/Y g S/Y g
Australia 12.1 0.9 12.8 0.7 24.4 2.4 22.0 1.7
Canada 10.7 2.3 16.2 1.5 22.5 2.9 21.5 2.5
United Kingdom 13.7 1.0 6.3 0.8 17.9 2.5 19.2 1.8
United States 18.7 2.0 16.5 1.6 19.7 2.2 18.0 1.6
Japan 12.3 1.4 18.7 0.9 32.8 8.0 32.9 3.1

Note: S/Y = Ratio of gross national saving to GDP, in percentages and g = per capita GDP growth, in per cent per annum.

Source: Maddison(1992).

3.3.5 Exchange rate policies

One of Fischer's conditions for growth-conducive macroeconomic policies is that the exchange rate must be competitive and predictable. Very little empirical work has been done, however, on the relationship between exchange rates and economic growth, especially for the industrial countries. It has proven very difficult to identify equilibrium values for real exchange rates, making it almost impossible to quantify the extent to which they were over or under-valued compared to equilibrium. Further, while there is some evidence that large and persistent movements in real exchange rates affect short-run growth, very few studies have looked into the medium-term implications, partly because exchange rates have started to reverse before possible effects could be detected.

For developing countries, there is more evidence of exchange rate policies influencing growth rates. One variable frequently included in cross-country growth regressions is the differential between the official and the ‘black market’ exchange rate and in most cases there is significant evidence that maintaining an overvalued official exchange rate tends to reduce long-run growth.

Additional support for Fischer's condition may be obtained by comparing the experience of Asian countries with those of Africa and Latin America. Though exchange rate policies in Asia range from a currency board arrangement (Hong Kong) to various versions of pegging (Thailand), managed floats (Singapore) and a flexible rate (the Philippines) a number of countries have used exchange rate policies to promote export growth. As a result, real exchange rates have mostly been stable and tended to be undervalued. By contrast, Latin American countries have frequently relied on a fixed nominal exchange rate against the US$ or a slowly crawling peg as a means of reducing inflation. However, because other policies (notably fiscal policy) were not consistent with this target and indexation created a high degree of inertia, the rate of inflation exceeded that of the anchor country, resulting in appreciating real exchange rates and adverse effects for export growth and the development of the manufacturing sector. A similar experience, though at much lower rates of inflation and mainly affecting agriculture and resource-based industries, has already been noted for the members of the African franc zone.

While these comparisons do not yield definitive conclusions, they do suggest that countries have some medium-term influence on their exchange rates and that exchange rate policies have potential growth effects. Promotion of international competitiveness and exports of manufactured goods was part of the ‘Asian growth strategy’ and keeping the exchange rate slightly undervalued was an important instrument in this strategy. In Latin America and Africa, on the other hand, exchange rates have not been used to promote exports and growth but as a means to reducing inflation. Moreover, because these policies did not succeed in sufficiently reducing inflation and eventually failed in most cases, exchange rates have tended to be overvalued for long periods, with detrimental effects for exports and for aggregate growth.

3.3.6 Financial markets and financial systems

Financial market developments is another area where it has proven difficult to identify a clear relationship between policy-related variables and growth. For many years, this has been an area of intensive research efforts but also controversy. Early works (McKinnon 1973; Shaw 1973) suggested rather large potential growth impacts on the assumption that liberalising repressed systems would boost aggregate saving. This link, however, has found little empirical support, whereas alternative models focusing on the impact that financial liberalisation might have on the allocation of capital and the efficiency and cost of financial intermediation seem more consistent with the experience of liberalising countries (Lee 1991; Pagano 1993).[19] Nonetheless, many have remained sceptical, pointing to the financial crises often following liberalisation (Dornbusch and Reynoso 1989) or arguing that there is no role for finance or the cost of finance in neoclassical growth models (Lucas 1988).

More recently, new approaches based on endogenous growth models have been developed, stressing the role of financial systems in gathering information, evaluating innovative entrepreneurs and pooling financial resources to make successful innovations operational. Galetovic (1994) and King and Levine (1993) are two examples of this new approach and the latter test the empirical validity of their model on cross-country data, using four alternative indicators of financial activity and the depth of private financial markets. All four indicators are based on money and credit aggregates and appear to be robust when included in the crosscountry regressions discussed in Section 4.

Nonetheless, this evidence should be considered with some caution. First, the indicators used are rather crude approximations to the services provided by modern financial systems. Second, the potential role of interest rates remains a puzzle. In Galetovic's model, a principal function of financial intermediaries is to reduce the costs of credit, but in most empirical estimates nominal and real interest rates are statistically insignificant. Third, when confining the cross-country regressions to OECD countries, Englander and Gurney (1994) find no effects of financial variables on productivity growth, suggesting that the four variables proposed by King and Levine are not the appropriate indicators for industrial countries or that the impact of financial systems on growth becomes less important beyond a certain level of economic development (Berthelemy and Varoudakis 1995). Finally, while in theory financial deregulation should improve long-run efficiency, a typical feature of liberalising countries (industrial as well as developing) is that private sector saving has declined in step with the greater availability of credit. In several industrial countries, liberalisation of financial systems in the 1980s also led to asset price bubbles with severe and long-lasting repercussions for the financial system and for private sector balance sheets.

The empirical implementation of models of financial developments based on new theories of growth is still in its infancy and until indicators which better capture the underlying models have been constructed, it is difficult to draw any firm conclusions. It does appear, however, that financial markets are neither an ‘engine of growth’ nor are they purely passive. In the early phase of development, strong growth would be difficult to achieve unless it is supplemented by rapid development of the financial system, in particular intermediated finance, and at a later stage information gathering, pooling of financial resources and diversification of risks are important in promoting innovation and technical progress. Moreover, liberalised financial systems promote a more efficient distribution of capital and may enhance policy efficiency in general. On the other hand, moving from a regulated to a deregulated environment, when more fundamental factors such as a high investment/GDP ratio, low budget deficits and low inflation are absent, can have long-lasting and negative effects on growth.

3.3.7 Path dependence and macroeconomic policies

If, for some reason, the long-run or steady-state growth rate depends on the past history of actual growth, the scope for macroeconomic policies to influence growth widens: a policy mistake causing a recession in one year will have long-lasting and adverse effects on future growth while, conversely, policy measures that smoothly offset shocks will keep the economy on a higher growth path than it otherwise would have been. Whatever the source, the notion of path dependence creates an important link between short-term demand management policies and long-run output and is a challenge to those versions of the natural -rate hypothesis which postulate that policies have no long-run effect on output.

It is, of course, well known that productivity growth changes within the cycle, but there may also be effects on the medium-term evolution of productivity. Internal funds for investment are more readily available during booms than in recessions and banks are probably more willing to finance investment projects, especially those with high risks and high potential returns. At relatively low rates of unemployment, resistance to technological change may be lower than in periods when workers fear that labour productivity gains add further to the number of unemployed. On the other hand, recessions increase the pressure to improve efficiency and may be necessary to ‘clean out’ inefficient firms (Schumpeter 1939). Moreover, even if faster output growth has a positive net effect on productivity, there are clearly limits to how much can be gained, as an aggressive policy of ‘going for growth’ inevitably pushes up inflation.

The impressive growth performance after World War II, compared to the pre-Depression era, is attributed by some to a combination of path dependence, automatic fiscal stabilisers and macro-policy activism. Pre-eminent proponents of this view, De Long and Summers (1988), show that expansionary nominal demand shocks appear to have more effect on prices and less on output than contractionary shocks, and they point to a marked rise in output persistence and a significant decline in the average output gap in the post-war period, which they interpret as a consequence of successful counter-cyclical macro-policies after World War II.

While De Long and Summers probably go too far in their positive appraisal of demand management policies (Mankiw 1988) the asymmetric response to positive and negative nominal shocks they report supports the perception of most policy-makers who, having experienced the large output costs associated with reversing inflationary forces, have become more aware of the need to avoid excess demand pressures. It has also recently been supported by an analysis of the trade-off between inflation and the output-gap for the G7 countries. Laxton, Meredith and Rose (1995) find that a positive demand shock in an initial situation of zero excess demand leads to a rise in inflation of more than 1 ½ percentage points while a negative shock of the same size reduces inflation by less than a ½ of a percentage point. As a consequence of this asymmetric response, the average level of trend output is raised when the variability of output is lowered.[20]

Some simple policy prescriptions flow from these empirical results. First, when the trade-off is asymmetric and policy makers are faced with the risk of a permanent rise in inflation, prompt policy responses reduce the output costs of keeping inflation low and thus raise the long-run output level compared with a strategy of lagged and largely ex post interventions. In other words, the existence of an asymmetric trade-off supports the use of a pre-emptive policy strategy.

The second prescription also arises from the relationship between output variability and the long-run output level. Because of the numerous shocks to which an economy is exposed, there is a policy trade-off between minimising fluctuations in output from its potential and inflation from its target (Taylor 1992; Debelle and Stevens 1995). A policy strategy aimed at always keeping inflation close to its target and restoring price stability quickly after a shock generates larger fluctuations in output and thus lowers the long-run output level. By contrast, provided medium-term inflation remains close to the target, policy-makers tolerating short-term deviations from this inflation target can reduce output fluctuations and thereby increase the long-run output level. Assuming that credibility is not adversely affected, some tolerance in meeting the inflation target is thus likely to have a favourable impact on long-run output, compared with a more rigorous strategy which only allows deviations in the case of major supply shocks.


More formally, the Solow-Swan model assumes that output, Y, is determined by an aggregate production function, Y = F(L,K,E) where L is labour, K is the gross capital stock and E is technical progress. The production function is often assumed to be Cobb-Douglas with constant returns to scale, which implies that Δ1nY= (1 − b)Δ1nL + bΔ1nK + ε or Δq= bΔk + ε where q = ln(Y/L), k = ln(K/L), 1−b and b are the output elasticities of labour and capital, respectively, and ε is the rate of technical progress. [4]

For example, assuming the parameter estimates in Mankiw et al. (1992), a 20 per cent rise in the savings ratio raises the steady-state level of labour productivity by 10 per cent. However, only half the adjustment is completed in 35 years and during the transition phase, labour productivity growth is approximately 0.15 percentage points (5/35) higher than prior to the change in saving. [5]

This result also implies that attempts to capture the adverse effects of inflation in growth equations that control for the investment/GDP ratio will fail if inflation only affects growth via changes in investment; a point we return to in Section 4. [6]

Investment and saving are, however, not the only channels by which policies can affect growth over long periods. As suggested by Boltho and Holtham (1992), one empirical fact that a theory of growth needs to explain is why some countries grow at very high rates over long periods without encountering signs of decreasing returns to capital and/or labour. As discussed by Dowrick (1995), one reason for this is that these countries are on a transition path, catching up with the technological leader. Second, long-run growth could contain important elements of hysteresis, due to the existence of non- linearities and asymmetries, which again would make the growth path sensitive to macroeconomic policies. These issues will be further discussed in Section 3.3. [7]

On a different tack, Sachs and Warner (1995) stress policies that protect property rights and promote openness, arguing that reversible policy mistakes in these two areas rather than initial conditions are the principal reasons for the absence of convergence in growth rates across countries. [8]

We don't address the relationship between incomes policies and growth. For differing views on the implications of the Australian Prices and Incomes Accord for growth, see Blandy (1990), Chapman (1990), Fane (1990), and Gruen and Grattan (1993). [9]

In this context, note that the ratio of public investment to total government expenditure has averaged 17 per cent in South-East Asia but only 8 per cent in Latin America; see Adams and Davis (1994). [10]

Gordon (1995), who analyses the adjustments of unemployment and the capital stock to various supply shocks to the labour market, reports results that are even more ‘damaging’. Looking at the slowdown in labour-productivity growth between 1960–73 and 1979–92 in six of the G7 countries, he finds that it is mostly due to slower growth of total-factor productivity, whereas there is no systematic relation between changes in the contribution of capital per working hour and labour productivity. [11]

Furthermore, while higher investment boosts economic growth, higher output growth also encourages investment. As a consequence, the estimated coefficient in equation (1) is likely to overstate the extent to which higher investment causes higher output growth. There have also been a number of recent studies dealing with the growth effects of special types of investment, especially expenditure on machinery and equipment (see Dowrick, 1995). [12]

See the Appendix for this estimate. An alternative way to view the issue may also be helpful. With traded goods prices determined in world markets, traded goods inflation is higher than domestic inflation when the real exchange rate is depreciating. For domestic inflation to remain steady, therefore, requires non-traded prices to rise more slowly than domestic inflation which, in turn, requires domestic nominal unit labour costs to rise more slowly than inflation. This generates widening profit margins in the traded goods sector (since economy-wide real unit labour costs are falling while the real depreciation is delivering higher output prices for traded goods) and thereby attracts resources into this sector, as required. [13]

Apart from Turkey, for which a sectoral breakdown of saving is unavailable, Belgium, Japan and Switzerland are the only OECD countries with relatively stable national savings rates. On the other hand, while Denmark, Iceland, Sweden and Spain have also seen national savings rates falling by 5–8 per cent of GDP, again their national accounts data do not allow a sectoral breakdown of saving. [14]

This differs markedly from patterns of change in the developing world (IMF 1995; Edwards 1995). In Asia, national saving rates have been rising, almost entirely because of private saving. In Latin America, by contrast, lower private saving caused a sharp fall in national saving in the 1980s. IMF (1995) finds that most of the rise in world real interest rates between 1960–72 and 1981–93 can be ascribed to lower government net saving and higher public debt in the industrial countries and estimates that the resulting fall in capital formation has led to a permanent loss equivalent to 2 per cent of world consumption. [15]

See also Masson, Bayoumi and Samiei (1995) who agree that there is a positive correlation between savings and growth across a broad range of countries, but argue that the causality is unclear. There is also cross-country evidence of a non-linear relationship between national savings rates and per capita income levels, with savings rates very low in countries with per capita income near the subsistence level, sharply higher for middle-income developing countries and then about the same or lower for high-income industrial countries. [16]

Recent estimates of Ricardian equivalence find that about one-half of a fall on government saving is offset by higher private saving (IMF 1995; Edwards 1995; Masson et al. 1995). [17]

Australia is an exception to this general rule, with the figures in Table 4 understating the deterioration in household saving. From its peak in the early 1970s, household saving relative to GDP has fallen by almost 7 percentage points. [18]

Pagano identifies three channels through which financial market liberalisation can raise growth: more efficient investment, a less costly transmission and intermediation process and higher saving. The empirical evidence clearly points to the first channel as the most important one whereas changes in the savings ratio have mostly had a negative effect and the impact of improvements in the transmission process is uncertain. [19]

This is a general feature of a convex aggregate supply or Phillips curve (Mankiw 1988). In the Laxton et al. specification, potential output, at which inflation is steady, exceeds average trend output. The difference rises with the variance of output growth, and has averaged about half a per cent for the G7 countries. [20]