#newstructuraleconomics

Financial Structure

Reference

Chapter V - Financial Structure & Economic Development

Summary

 

Assumptions

Theory/Model

Bank-based: better at reducing the market frictions related to short-run lower risk well collateralized projects

Security markets are better at financing more innovative, longer-run and higher risk projects that rely on more intangible inputs like human capital.

Four views on banks vs. markets

  1. Financial-structure-irrelevancy view: what matters is the interest rate and which projects have positive net return. Only financial depth, not structure, matters. A variation of this determines that financial depth is a function of the legal system. However, assumptions about perfect information between investors and managers ('hidden action' and 'hidden information') don't hold.
  2. Bank-base view says in early stages of development, banks are better than markets because powerful banks can make up for weak legal and accounting systems and frail institutions. 
  3. Markets-based view argues that diversification and risk management are only possible in stock markets. Also they promote competition whereas banks extract large rents for information-gathering costs which reduces the incentives to undertake risky projects (particularly as debt doesn't benefit from the upside).
  4. Structural view argues that banks and markets offer distinctly differ services that are, at different stages of development better suited or worst suited to a country. At early stages of development small regional banks work best, at later stages large established capital markets.

Application

Evidence

Financial systems are more developed in developed countries. And stock markets in higher-income countries are more active and efficient than banks which tend to  be more common when the country lacks good accounting, low levels of corruption, strong legal system.

Although previous efforts found no relationship between financial structure and economic development for the average country, when the level of development is taken into account a difference emerges (Demirguc-Kunt, Feyan and Levine 2011). Crucially as countries become richer their sensitivity to bank development decreases but their sensitivity to securities markets increases (note only use OECD countries). Furthermore, the financial structure gap, the difference between the ideal financial structure for a given level of development and the actual financial structure, has a negative relationship with economic activity.

 

Evaluation

Comparative Advantage

In 1817 David Ricardo invented comparative advantage which says that a poor country, which may be worse at producing every possible good than the rich country, can still make gains from trade. This is counter-intuitive because competitive advantage would suggest that if your friend, Lee Hsien Loong, is better than you at both mathematics and politics it would be best not to compete against him in either because you'll lose. What comparative advantage says is that even if a country is better than you in many things, how much better they are will vary, and they should focus on what they are relatively best at, and you in turn as the developing country should focus on what you are relatively least bad and and trade. So in the previous example, Lee Hsien Loong should go into politics and full-time and you mathematics and then trade.

New Structural Economics

Summary

New Structural Economics uses markets as the mechanism for resource allocation but government plays a role in coordinating investments and compensating first movers.

Assumptions

  • Economic structure = f(factor endowment structure)
  • Endowments are given but changeable = factor endowments (resources, labour, capital) and infrastructure (soft and hard). 
  • Economic development is a point along the continuum from a low-income agrarian economy to a high income post-industrialized economy (not a dichotomy of poor vs rich).
  • Market is needed for capital allocation according to comparative advantage (so relative factor prices = relative factor abundance).
  • Backwardness advantage = developing countries can borrow and adapt existing technologies rather than having to invent them themselves.
  • Increased risks to firms with industrial upgrading as they face product and technology risk in addition to managerial risk

Model/Theory

  • Sustained development = f(changes in factor endowments, technological progress).
  • Optimal industrial structure = Comparative Advantage Following (CAF)

CAF maximise economy's competitiveness, economic surplus and therefore the fastest possible capital accumulation and upgrading of endowment structure. 

However need government to 

  1. Coordinate investments in improvements in infrastructure.
  2. Compensate information externalities of first movers about where comparative advantage is.

Applications

Growth Identification & Facilitation Framework (GIFF) is a guide to help policymakers facilitate structural change.

  1. Government can identify the list of tradeable goods and services that have been produced for about 20 years in dynamically growing countries with similar endowment structures about roughly 2x their GDP/capita.
  2. Among the industries in that list, give priority to private firms that have already entered and try to identify 1. the obstacles to improving the quality of their products 2. barriers that limit the entry of other private firms. E.g. Hausmann's Growth Diagnostic Framework or Duflo's RCE.
  3. For completely new industries encourage firms from example countries to move and take advantage of lower labour costs.
  4. Should also encourage other successful firms.
  5. Improve infrastructure and business environment with industrial parks or export processing zones, rather than whole economy.
  6. Provide limited compensation to domestic pioneer firms or foreign investors e.g. corporate income tax holiday, direct credits or priority access to foreign reserves.

 

Predictions

Every developing country can grow at 8% for several decades.

Evidence

  • Other schools of economic development have failed because 2/3 of low income countries in 1960 failed to reach middle income in 2009 and those in middle income have stayed the same or regressed.
  • Bulk of empirical work (McMillan & Rodrik 2011) shows difference between Asia and Latin America and Africa is due to the contribution of structural change to overall labour productivity.

Evaluation

  • Anne Krueger asks how would government sectors be chosen without leading to the same corruption/protection problems of previous structural efforts? Also asks whether need tech changes and industrial upgrading from the beginning.
  • Dani Rodrik agrees that developing and developed countries are structurally different and agrees that market incentives are good but says that Lin argues for a CAD form of CAF development.
  • Stiglitz agrees with new structural approach but argues there are more market failures and that comparative advantage is often endogenous. Stiglitz argues that key is knowledge and human capital and transition to a learning society.
  • Ha Joon-Chang argues that first there isn't perfect factor mobility so there are losers from trade liberalization, second capital is discrete and industry-specific, third you can only learn-by-doing with different levels of technology, fourth there are many successful examples of countries like Korea and Japan significantly deviating from its CAF and succeeding.

Laissez-faire growth economics

Summary

Laissez-faire economics failed to deliver economic growth to poor countries

Assumptions

  • Market is best allocation mechanism
  • Diminishing returns to capital
  • Technology was exogenous so in endogenous growth models, technology modelled as non-rivalrous (but partially excludability) therefore not a pure public good.

Theory/Model

Solow model & Endogenous growth models

Application

Predictions

Conditional convergence, assuming diminishing returns to capital, implied poor economies with lower k (=K/L) compared to its long-term steady state will grow faster.

Evidence

Evaluation

To include technology, endogenous growth theories assumed technology is non-rivalrous but partially excludability  however Yifu Lin despite partial excludability, not sufficient to mean the market will provide a socially optimum level. Therefore need government intervention.

Washington Consensus

Summary

Washington consensus argued for an astructural approach focused on liberalization, privatization and stabilization of markets.

Assumptions

  • Government failure was crucial to failure of Keynesian Development Economics.
  • Rational Expectations.

Theory/Model

Rational expectations refuted government's structural role in monetary, fiscal and trade policy. Instead the focus was on the 'right price', stable market environments, strengthening institutions and building human capital.

Predictions

Evidence

  • Justin Yifu Lin argues that Washington Consensus, despite being promoted by mulitlateral institutions is 'at best controversial.'.

Evaluation

Keynesian Development Economics

Summary

Post WW2 development economics focused on structural change towards modern advanced industries through government intervention.

Assumptions

  • Structural change is key to economic development.
  • Keynesian macroeconomic foundation.
  • Dirigiste dogma.
  • Rosenstein-Rodan (1943) suggested modern methods only > traditional at scale o/w not worth paying higher wages. Scale itself depended upon on size of market therefore if countries didn't develop at scale they could be trapped in poverty.
  • Worsening terms-of-trade from exporting primary commodities to manufacturing economies
  • Failure to develop capital industries is exogenously determined by structural rigidities (monopolies), labour's perverse response to price signals and or the immobility of factors.

Theory/Model

Government intervention to facilitate structural change through import substitution by: 

  • Exchange controls
  • Quantitative restrictions on imports

Application

According to Yifu Lin Comparative Advantage Defying (CAD) development and the protection of nonviable industries typically lead to:

  1. Increase in the price of imports and import-substituting goods relative to the world price and distortions in incentives and economically inefficient consumption.
  2. Fragmentation of markets and therefore too many small-scale goods.
  3. Decreased competition from foreign firms and support for the monopoly power of domestic firms - which were run by politically well connected owners
  4. Opportunities for rents and corruption which raised input and transaction costs.

Predictions

Evidence

  • Justin Yifu Lin argues that other schools of economic development have failed because 2/3 of low income countries in 1960 failed to reach middle income in 2009 and those in middle income have stayed the same or regressed.
  • Keynesian theories decline with stagflation, Latin American debt crisis and collapse of the socialist planning systems in the 1980s

Evaluation