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A Strategy for Economic Growth
4. Much Has Been Learned
Productivity change and growth begin at the firm
To understand how to encourage faster and more sustained growth, it is essential to understand how increases in productivity occur. Economist Arnold Harberger reminds us that “all economic growth takes place at the level of the productive enterprise” 13 – a term encompassing producers in all sectors and of all sizes, from microenterprises and family farms to multinational corporations. A country’s income increases as its producers find ways to increase sales and reduce their costs of production – by using new and better machinery, hiring more and better-skilled workers, or more generally finding lower-cost ways to organize production and distribution, and improve the quality of their goods and services in order to serve or create new markets. To sustain a higher rate of growth, producers must face incentives that motivate them to adopt a never-ending stream of such improvements. Any single improvement in technology or management boosts growth only temporarily.
Incentives “drive” the growth process
Competition provides the most powerful incentive for producers to raise productivity. Where markets are open to entry by new firms, existing producers must continue to behave as entrepreneurs, working relentlessly to improve their products and reduce costs in order to stay in business and earn profits. Instead, governments in many developing (and developed) countries shelter established producers from competitive pressure, undermining incentives for higher productivity. It is in this arena – encouraging host country governments to adopt policies and practices of economic governance conducive to competition and productivity, and helping build the institutional capacity needed to develop and apply growth-supporting policies – that USAID can play the strongest role in supporting economic growth.14
The role of the public sector in supporting economic growth extends beyond simply promoting competition. It must also establish and maintain:
- macroeconomic stability, especially avoiding high inflation and unsustainable fiscal policies;
- a predictable and transparent system to enforce property rights and contracts; and
- a transparent, accountable, and efficient system for resolving economic disputes among firms and individuals.
Public policies, regulations, property rights, and other aspects of economic governance shape the incentives for productive effort. As such, they represent the drivers of economic growth, in the sense that they primarily determine the rate and sustainability of growth (see Figure 1). If public policies create incentives that are seriously misaligned, economies will stagnate or decline. Broadly speaking, the drivers of growth include macroeconomic policies (fiscal, monetary, and exchange-rate policies) along with those microeconomic aspects of governance most relevant to entrepreneurial activity (business regulation, property rights and the rule of law, trade policies, and the extent to which market forces are allowed to operate in product, financial, and labor markets.)
Other factors “enable” growth to move forward
Other factors – such as the availability of credit or other financial resources; the availability of roads, telecommunications, and electrical infrastructure; and the human resources embodied in the education, training, and health of those working in any particular sector or in the labor force overall – represent enablers of growth. Where the enablers are missing, the pace of growth can be undermined and its pattern distorted – problematic because improvements in these areas require substantial resources and sustained, long-term effort. But improvements in growth enablers cannot by themselves cause economic growth to occur where the drivers are not in place.15
There are no insurmountable obstacles
Many explanations have been put forward for the failure of countries to grow – including geographical disadvantage, climate, difficult terrain, lack of natural resources, over-abundance of natural resources, overpopulation, endemic disease, high illiteracy, and culture to name a few. Such conditions may indeed pose special challenges. But countries facing each of these challenges have found ways to overcome them and achieve rapid, broad-based, and sustained economic growth. Bangladesh, Indonesia, Uganda, and Mauritius are only the most conspicuous cases of growth under allegedly “impossible” conditions.
Political economy is key to reform
The greatest obstacles to growth stem not from nature, but from politics. Growth takes place within a complex setting of social and political conditions and forces. Most policy reforms involve a political cost – overriding the vested interests of those who benefit from the current situation. As a result, identifying the correct economic prescription is rarely enough to ensure that it is adopted. Change can be slow and circuitous as a result. Almost every rapidly growing developing country today, for example, first introduced economic reforms in limited areas of the country -- typically industrial or free-trade zones – to demonstrate their value and override political opposition before extending them to the rest of the economy.16 Patience, along with a clear understanding of the interests and politics of domestic groups, are critical to focus decisions about the pace and sequence of reforms, and to identify potential allies in the government and private sector.
These considerations also mean that donors need to react quickly to changes in local political circumstance. For example, recent research shows that among the top microeconomic reforming countries, 85 percent of such reforms occurred within the first 15 months of a change of government.17 This means that being able to move fast when an opportunity arises to facilitate reform is important to success.
Politics affects growth on a deeper level as well. Achieving rapid and sustained growth requires secure property rights, so that producers can invest without fear that the product of their efforts will be seized by the government or by politically favored private interests. Similarly, sustained growth benefits from honest and efficient administration of well-designed policies and regulations, to ensure that producers devote their energies to creating value and raising productivity, rather than paying bribes and lobbying for favors from government. These and other dimensions of economic governance depend on the domestic political context. As the economist Robert Barro recently stated, “A country’s economic performance depends on various aspects of government policy, but no aspect is more important than the quality of political, legal, and economic institutions.”18 Well-functioning democracies, complete with effective checks on government power and mechanisms to ensure accountability, can achieve these goals. On average, democracies tend to achieve faster growth than autocracies. By comparison, autocracies include both the growth superstars of East Asia – where leaders committed themselves to support growth – as well as many slow-growing or stagnant countries whose rulers have sacrificed growth out of greed, ideology, or incompetence. Progress toward effective democracy and good political governance can strengthen the institutions that support and sustain growth over time.19
One size does not fit all
Although policies and the incentives they create play a central role in driving economic growth, this does not mean that all countries can or should adopt a one-size-fits-all set of policies. As Dani Rodrik has emphasized, fundamental economic principles – “protection of property rights, contract enforcement, market-based competition, appropriate incentives, sound money, debt sustainability” – can be applied in different ways, depending on local constraints and opportunities.20 Where governments have made growth a priority, they have sometimes found new and surprising ways to apply those core principles. One lesson for donors is that identifying and supporting governments committed to growth is essential to ensure the effective use of aid. A second lesson is that not all policy and institutional weaknesses need be resolved simultaneously. Rather, the challenge is to identify and address those weaknesses that pose the binding constraints to faster growth for a particular country at a particular time, and whose reform is politically feasible.21 For this purpose, understanding local circumstances can be as important as identifying “best practices” based on the experience of other successful countries. Those best practices may need to be applied differently, depending on the local context.
Macroeconomic “drivers” are the first consideration
Macroeconomic stability is essential. Without it, domestic entrepreneurs perceive the returns to investment as too uncertain to risk tying up their funds in factories and other fixed capital, and often look for safer options abroad. Banks and other financial institutions limit their lending to only the safest borrowers, while international investors look elsewhere for better business climates. Historically, the main threat to macro stability in poor countries has arisen from the temptation to run budget deficits in order to increase public spending beyond the limits permitted by domestic revenues. In countries undertaking financial sector reform, high levels of non-performing loans in the portfolios of commercial banks – especially those owned by the government – have emerged as a second serious threat to macroeconomic stability.22 A third major macro issue concerns the exchange rate, which affects overall stability as well as the profitability of producing for export versus for domestic markets.
Most poor countries have learned the principal macroeconomic lessons and made the basic reforms. As more and more governments have come to recognize the harm imposed by high inflation, for example, hyperinflation has almost disappeared. In fact, most countries have reduced inflation below 10 percent. The previously widespread and damaging use of multiple exchange rates has also become rare. In addition, most governments have learned that stability requires that deficits be controlled, and that openness to the international economy contributes to growth.
Nevertheless, macroeconomic stabilization may emerge as the highest economic priority in particular countries, especially those emerging from conflict. In such cases, technical support to stop hyperinflation, establish new currencies, stabilize macroeconomic conditions, and rebuild economic institutions can be vital for esta23 blishing political stability and restoring economic growth. More generally, developing countries remain vulnerable to economic shocks in an increasingly open world, so that macroeconomic assistance is likely to remain relevant in certain additional cases.
Microeconomic “drivers” are the new frontier
In contrast to their gains in macroeconomic policy, poor countries have made much less progress in reforming microeconomic policies, regulations, enforcement of contracts and property rights, and related forms of economic governance, which together shape the incentives that drive economic behavior in individual markets and sectors. In part, this lack of progress has reflected the difficulty of quantifying microeconomic policy problems, which vary among sectors and across countries. A lack of good data has, until recently, contributed to a relative neglect of microeconomic issues.
Microeconomic issues have drawn growing attention, especially since 2004 when the World Bank began issuing its Doing Business reports. These reports offer annual country data on a wide range of measures of microeconomic governance, including: How hard is it to enforce a contract if the buyer refuses to pay? How hard is it to export or import goods? To start a business? To hire a new worker? To dismiss a worker? If a borrower defaults, what recourse does the lender have?
The central conclusion from this new source of data – and complementary indicators from other sources – is that government regulation of business is dramatically more extensive and time-consuming for firms in poor countries than in rich ones. Some regulations serve essential economic or social purposes, but these should be designed so as to minimize costs, uncertainty, and the potential for abuse. In practice, many regulatory obstacles exist because of inattention, or because a lack of broad representation and accountability in decision-making has given rise to regulations that serve special interests – including the interest of powerful incumbent firms in blocking competition by newcomers. In addition, because they place substantial discretion in the hands of government officials, many regulatory systems have become “seedbeds of corruption”24 and rent-seeking behavior: each additional required signature creates another opportunity to offer or demand a bribe or other favor in exchange for preferential treatment.
The burden of overregulation falls disproportionately hard on small and micro firms, which employ a large share of the labor force in most developing countries. For example, barriers to business registration and operation force these firms to remain in the informal sector, where they lack legal status.25 Operating in the legal shadows imposes a wide range of disadvantages on informal firms – restricting their access to financial services, to the courts when disputes arise with other firms, and to legal services such as property registration.26 The net effect is to slow growth and to skew the distribution of income toward the (usually politically well-connected) owners of established firms.
Efforts to improve the microeconomic dimensions of economic governance – whether focused on the regulatory processes measured by Doing Business and other indices or on competition policy, company law, land tenure and other property rights, and reducing corruption – must be grounded in a good understanding of local politics and institutional strengths and weaknesses if they are to succeed.
The impact of improved microeconomic governance can be dramatic. Independent estimates suggest that through modest improvements in their regulatory environments, poor countries could boost their growth rates by 1.4 to 2.2 percentage points per year – enough to raise incomes by 32-54 percent within two decades.27
Growth is good for the poor
The evidence overwhelmingly confirms that growth is good for the poor. Survey data from the 1970s through the 1990s consistently show that, on average across countries, consumption among poor households grew at the same rate as consumption among non-poor households, with no general trend toward greater or lesser inequality. On average, growth was as good for the poor as it was for the non-poor., 28
However, the impact of growth on the poor varies considerably from one country to another. Much depends on how strongly poor households “connect” to the overall growth process, allowing them to gain access to the opportunities created by growth. In part, this is a matter of where growth is taking place in the country, regionally and across sectors. Among a sample of countries studied by the World Bank, the most rapid growth tended to occur outside of agriculture, whereas most poor households were agricultural. In these circumstances, the impact of growth on the poor partly depends on whether workers can easily migrate out of agriculture and find jobs in the emerging non-agricultural sectors, which depends in turn on the flexibility of labor markets and on whether those workers have the literacy and other skills needed for those new jobs.29 Meanwhile, poverty reduction also depends on whether agriculture itself is living up to its economic potential.30 Education and labor market flexibility also strongly affect the impact of trade reform on the poor, affecting how easily workers can move from sectors that have lost trade protection to sectors that have become more competitive due to reform.31
The distribution of assets also affects the distribution of income and opportunity. In general, government redistribution of existing assets is politically explosive and economically damaging except under highly unusual circumstances. But policies that broaden opportunities for the poor to accumulate assets can reduce large income disparities over time. In particular, governments play a key role in providing education, which plays a large and growing role in the distribution of income as countries develop. Public funding of basic education can help break the transmission of poverty from one generation to the next, by ensuring that the children of the poor gain the skills they will need to take advantage of emerging economic opportunities. Other examples include financial sector reforms and easier titling of small farms, business property, and homes.
Growth depends on more than what happens at home
The policy choices that governments make, and their capacity to implement them, are the main determinants of a country’s growth. But forces beyond national borders also matter. Faster growth in the world economy, for example, boosts demand for the exports of poor countries. Lower barriers to trade have the same effect, while also creating opportunities for poor countries to expand the range of goods and services they export. Stable international financial markets offer well-managed countries access to funds at far lower cost than attainable domestically, while global financial turmoil can drive up interest rates on existing debt and cut off the availability of private finance. Regional cooperation can provide access to more reliable and lower-cost power, while disruptions to global or regional sources of energy can bring growth to a sudden halt. The pace and direction of technological advance affect poor countries in many ways, including the extent to which scientific and technological effort is directed to the specific problems that poor countries face, such as the need to achieve higher yields on the crops that feed their populations and to combat diseases that mainly affect tropical countries. This list could be expanded, but helps illustrate the point that efforts to improve economic prospects for poor countries as a group are needed alongside those directed toward individual countries and regions.
14 To avoid ambiguity, this strategy uses the word “institutions” as a synonym for “organizations,” rather than in the much broader sense of “formal and informal rules, enforcement mechanisms, and organizations” associated with the New Institutional Economics and World Bank (2002).
15 Easterly and Levine (2001); Pack and Paxson (1999); Devarajan, Easterly, and Pack (2003); Bils and Klenow (2000); Pritchett (2006).
19 A large and growing body of literature provides insights into the important links between democracy and economic growth. Examples include Rivera-Batiz (2002); Shen (2002); Halperin, Siegle, and Weinstein (2004); Barro (2000); Rodrik and Wacziarg (2005); Collier, Hoeffler, and Söderbom (2006); Gehlbach and Keefer (2007); and Keefer and Teksoz (2007).
21 Hausmann, Rodrik, and Velasco (2005).
22 Since 1994, an increasing number of macroeconomic crises have originated in the financial sector rather than in budgetary imbalances. With the important exception of Indonesia, most of the affected countries have been upper-middle-income countries like Mexico and Thailand, where private financial institutions had gained access to international capital markets but where the government had not developed the capacity or political will to exercise adequate prudential supervision over the more complex financial transactions involved. In keeping with its overall organization and to avoid repetition, this strategy treats financial sector issues and interventions as primarily microeconomic, rather than providing a separate discussion of their potential macroeconomic impacts. Mishkin (2001) provides a good overview of these complex issues against the backdrop of recent crises.
23 Address to Economic Freedom of the World Network, 2006; cited with permission.
24 Research conducted in connection with the Doing Business series demonstrates a strong link between the severity of business regulation and the size of the informal sector. World Bank (2004a).
26 Loayza, Oviedo, and Servén (2005).
27 Dollar and Kraay (2002). Moreover, Kraay (2004) shows that for periods averaging around 10 years, differences in country growth rates account for fully 90 percent of cross-country differences in the rate of poverty reduction.
28 Lopez (2006) suggests that a new pattern may have emerged in the 1990s, with inequality increasing in countries that achieve especially rapid growth. See also World Bank (2004b). The problem seems to be that most rapid growth is taking place in non-agricultural sectors, whereas most of the poor live in rural areas and work in agriculture. The implication is not that growth has become less important for poverty reduction, but rather that complementary measures to ensure that the poor can gain access to the new opportunities created by growth have become more important – measures such as those discussed under the second approach, “enhance access to economic opportunities.”
30 Lucas and Timmer (2005).
31 USAID and Woodrow Wilson Center for International Scholars (2006).
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