Optimal investment and growth: why institutions matter

CentralKigaliHow much investment is optimal for sustained economic growth? Two recent blog posts present contrasting views on the answer to this question. The first, from Michael Burke on the Socialist Economic Bulletin, puts forward a simple theory: the greater the share of investment in GDP, the faster is economic growth, within certain limits. Furthermore, he argues that widespread economic stagnation in the growth of output and productivity among the richest countries today can be remedied by a large increase in public investment. In other words, the state can lead a recovery.

The second, by Michael Pettis on his blog China Financial Markets, discusses the role of what he calls ‘social capital’, or economic, social and political institutions in a broad sense. For Pettis, it is not enough for governments to enact policies which raise the investment share in output, if the institutional framework leads to it not being utilized effectively. If there is a high level of social capital, which might include levels of education, government competence, a lack of corruption, law and order, property rights etc, then policies which increase investment should have a better chance of increasing productivity and output. If these institutions are lacking, then more investment is not enough, and it will be used unproductively.

Pettis’ argument is more sophisticated than Burke’s, and I tend to favour the former over the latter, although I admit that higher public investment may often be needed to support private sector growth. But institutions are important, both in developing and developed economies. There is such a thing as overinvestment, or investment that is excessive relative to output and that tends to lead to a falling output-capital ratio and capital productivity. China is distinctive in that its investment share has been as high as 50% of GDP in recent years, while nominal GDP (GDP plus inflation) growth rates have been steadily declining from year to year.

Pettis has argued that overinvestment and an unsustainable rise in private debt have created problems for the Chinese economy, which needs reform in order to increase the share of household income and consumption in GDP, and to reduce the investment share. It may even face a ‘lost decade’ of slow growth, as its economic imbalances are in some way resolved. Slower growth overall may not matter if the share of household income and wealth rise, as this may prevent unrest among the general population. But for this to happen, the state may need to change its relationship to the economy and relinquish certain controls.

The argument that low corruption is essential for development has been made in the past by the World Bank, but Mushtaq Khan of SOAS, my alma mater, has suggested in his work that, while low corruption may be desirable, countries such as South Korea, Thailand, Malaysia, Indonesia and China as well, have been through periods of rapid growth despite high levels of government corruption. What matters in these cases is that state intervention has managed to create ‘rents’ that encourage rapid growth; also that the balance of power in society between the state and other social groups is such as to make development consistent with some inevitable ‘rent-seeking’, which is present in all countries. The difference in rich countries is that rent-seeking tends to take forms that are legal, such as lobbying.

As Pettis admits, corruption will not prevent development if private sector growth due to state intervention creates financial rewards for officials, so that both public and private sectors gain. Growth and corruption can go together. While we might see this as undesirable, it has been part of development in a number of countries undergoing industrialisation.

Khan argues that corruption in developing countries is structural, and can only really be removed once a certain level of development has been reached, which should be possible if the state increases its competence and its relationship to civil society evolves as incomes rise.

This can also apply to the institution of democracy. According to the argument, it is hopeless to try to transplant democracy into poor and often politically and socially unstable countries. More important is to create state institutions which encourage the development process. As new social classes emerge and strengthen under capitalist development, the conditions for democracy can also emerge and are more likely to be sustained by the different underlying structure of society.

It is therefore unrealistic to expect the poorest developing countries to create and sustain the institutions that took today’s rich countries many decades to develop. Their emergence is made possible by the development process itself, but in many cases, rich countries seem to have the wrong idea about the order in which they were introduced. This can lead to mistaken interventions in poor countries by rich states and NGOs.

The right institutions are clearly important to growth and development for all nations. As the latter takes place, the nature of these institutions will need to evolve, and this can often lead to social and political problems, which prevent necessary reforms from taking place. This is why it remains important to use the tools of political economy when analysing development processes.

Pettis gives the example in his post of bankruptcy law, which allows the writing down of loss-making assets, and allows structural change to take place as capital is reallocated from weaker to stronger firms and sectors. Such change is essential to growth under capitalism. It can also, at various stages of development, require the state to set up public enterprises which the market has failed to provide, and shut down or consolidate loss-making ones. This is so as to accelerate structural change beyond the level achievable by the market, as happened during South Korea’s ‘growth miracle’.

In sum, a high volume of investment may be necessary for rapid growth, but it is not sufficient. Having the right institutions which encourage and enable rising productivity and structural change is vital. It is also vital to recognize that these will need to change over time. It is maybe unsurprising that few late-developers have made the transition from poor to rich country status, while many others have failed to escape from the ‘middle-income trap’ and have even gone backwards as growth has stagnated and populations have continued to grow. This is not simply a matter of economics, but of political economy.

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