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WORKING PAPER CONTENTS No. 1 The Republic of Korea’s Infrastructure Development Okyu Kwon ……………………….………………………….........................

No. 2 Growth Economies and Policies Shahid Yusuf ………………………………………………………………….

No. 3 Growth Policy and the State

Page 04 Page 51

Philippe Aghion ……………………….…………………………...................

Page 88

W O R KI N G PA P E R N O . 1

The Republic of Korea’s Infrastructure Development Experiences and Some Lessons for Africa’s Developing Economies Okyu Kwon

© 2011 The Growth Dialogue 2201 G Street NW Washington, DC 20052 Telephone: (202) 994‐8202 Internet: www.growthdialogue.org E‐mail: info@growthdialogue.org All rights reserved 1 2 3 4 14 13 12 11 The Growth Dialogue is sponsored by the following organizations: Canadian International Development Agency (CIDA) UK Department for International Development (DFID) Korea Development Institute (KDI) Government of Sweden The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the sponsoring organizations or the governments they represent. The sponsoring organizations do not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the sponsoring organizations concerning the legal status of any territory or the endorsement or acceptance of such boundaries. All queries on rights and licenses, including subsidiary rights, should be addressed to the Growth Dialogue, 2201 G Street NW Washington, DC 20052 USA; fax: 202‐522‐2422; e‐mail: info@growthdialogue.org , fax: (202) 994‐2286 Cover design: Michael Alwan

Contents About the Author ........................................................................................................... iv I. Introduction ................................................................................................................... 1 II. Korea’s Experiences in Infrastructure Development ............................................. 2 III. Korea’s PPP Experiences and Impact of Financial Crisis on PPP ....................... 9 III. Some Lessons for African Emerging Economies ................................................. 17 Annex 1. Korea’s PPP Implementation Process ......................................................... 21 Annex 2. Regional Cooperation in Infrastructure Development in Northeast Asia Region ............................................................................................................... 30 Concluding Remarks ..................................................................................................... 39 Boxes Box 1. The Economic Planning Board (EPB) ................................................................ 4 Box 2. The Five‐Year Economic Development Plan .................................................... 4 Box 3. Energy Supply ...................................................................................................... 7 Box 3 (continued) ............................................................................................................. 8 Figures Figure 1. Legal Framework for PPP in Korea ............................................................ 11 Figure A1.1. Implementation Procedure for BTO Project ........................................ 24 Figure A1.2. Implementation Procedure for BTL Project ......................................... 25 Figure A1.2. BTO Projects ............................................................................................. 26 Figure A1.3. BTL Projects .............................................................................................. 26 Figure A2.1. Ferry Operations ...................................................................................... 31 Figure A2.2 Zarubino Port ............................................................................................ 31 Figure A2.3. Mongol‐China Railroad Project ............................................................. 32 Figure A2.4. Hunchun‐Makhalino Railroad .............................................................. 33 Figure A2.5. Satellite Picture of Hunchun‐Rajin Road ............................................. 34 Figure A2.6. Undersea Tunnels .................................................................................... 36 Tables Table 1. Major Indicators of Performance, 1962–71 ..................................................... 3 Table 2. Share of Infrastructure in Gross Fixed Capital Formation .......................... 5 Table 3. Composition of Energy Sources at the Beginning of Development ........... 7 Table 4. Major Indicators of Electricity Supply ............................................................ 8 Table 5. Share of Transportation Investment in GDP ................................................. 8 Table 6. Share of PPP in Government Infrastructure Investment ........................... 11 Table 7. Foreign Participation in Projects ................................................................... 14 Table A1.1. Types of Eligible Infrastructure Activities ............................................. 22

The Republic of Korea’s Infrastructure Development

iii

About the Author Okyu Kwon is Visiting Professor at the Graduate School of Finance and Accounting, KAIST, Seoul, The Republic of Korea. His previous positions included the Deputy Prime Minister and Minister of Finance and Economy, The Republic of Korea (2006‐2008); Chief Secretary to the President for National Policy in June, 2006; and Senior Secretary to the President for Economic Policy in April, 2006. Prior to taking up his current position at the Ministry, Dr. Kwon was appointed his country’s Ambassador and Permanent Representative to the OECD in July 2004. Dr. Kwon was also Senior Secretary to the President for National Policy in February 2003 after he held a post of Administrator of the Public Procurement Service in July 2002. Amongst his prominent positions, he was Deputy Minister of Finance and Economy in April 2001; Secretary to the President for Finance and Economy, Office of the President in July 2000; and Alternate Executive Director of the International Monetary Fund in May 1997. In September 1999, he joined the Ministry of Finance and Economy as Director‐ General of the Bureau of Economic Policy. Dr. Kwon has published several books, including Strategies for the Opening of Korea’s Service Markets (The Korea Chamber of Commerce, 1984) and The Challenges and Tasks for Korea’s Capitalism (co‐author) (The Korea Chamber of Commerce, 1991). His forthcoming publications include: Restructuring of the Korean Economy after Asian Financial Crisis and Lessons from European Economies’ Experiences in Economic Development (Three‐I Strategic Institute, Seoul, Korea).

Okyu Kwon

The Republic of Korea’s Infrastructure Development: Experiences and Some Lessons for Africa’s Developing Economies Okyu Kwon 1

I. Introduction Infrastructure development plays a crucial role in economic growth, poverty alleviation, and enhancing the competitiveness of developing countries. However, many developing countries don’t have the necessary infrastructure, and investment in infrastructure is urgently needed. According to the research done by the Infrastructure Development Finance Company (IDFC), a private investment company, overall infrastructure investment in developing countries needs to be doubled from the current 2–3 percent level of GDP to at least 5.5 percent per annum.2 The problem is particularly acute in Africa’s developing economies, which continue to lag far behind in areas such as telecommunication, electricity, roads, and sanitation.3 As a result, potential growth as well as delivery of basic welfare services has been substantially limited.

1 This paper was prepared for the forum “Regional Infrastructure for Africaʹs Transformation and Growth” (June 7, 2011, Lisbon, Protugal). 2 According to estimation of IDFC, in 2008 1 billion people were without access to roads, 1.2 billion without safe drinking water, 2.3 billion without reliable energy, 2.4 billion without sanitation, and 4 million without modern communication. (Source: M.K. Sinha, “Challenges in Infrastructure Development in Emerging Markets,” IIA Seminar on Investing in Infrastructure Assets, 10–12 June 2008, Singapore.) 3 The following are the OECD’s estimates:

Africa

East Asia

Eastern Europe

South America

Middle East and North Africa

South Asia

Teledensity*

357

438

416

237

Electricity (%)**

Roads (%)***

Sanitation (%)**

* Fixed line and mobile subscribers per 1,000 people. **% of population with access to electricity or improved sanitation. ***% of rural population living within 2 kilometers of all season road. Source: Promoting Pro-Poor Growth, OECD, 2007.

The Republic of Korea’s Infrastructure Development

The purpose of this paper is to introduce the Republic of Korea’s experiences in infrastructure development, which had successfully supported economic development. Lessons learned from Korea’s experiences during the second half of the twentieth century can be shared with currently developing economies of Africa. The paper is organized as follows. Section II discusses Korea’s experiences in infrastructure development in the 1960s, the 1970s‐80s, and the 1990s and thereafter. Section III focuses on public private partnerships (PPPs) with a discussion of how PPPs were successfully adopted in Korea. The section also touches upon the impact of the recent global financial crisis on PPPs. The paper concludes with some lessons for African developing countries.

II. Korea’s Experiences in Infrastructure Development The Korean economy has performed remarkably well over the past 50 years. It has grown from a war‐devastated, subsistence‐level economy to an advanced industrial economy. Korea has the world’s thirteenth largest GDP and is the seventh largest exporter in terms of value. It is the largest producer of many high‐tech products such as semiconductors, LCDs, and mobile phones and has an average per capita GDP of more than US$20,000. Korea also has shown its economic strength by overcoming the recent global financial crisis ahead of other advanced countries. Korea’s infrastructure development has played a key role in terms of fast growth and alleviation of poverty. Development has progressed through distinct stages. First, in the 1960s, the top priority was to meet the most urgent infrastructure needs, particularly in the transportation and energy sectors. Second, during the 1970s and 1980s, under the medium‐ to long‐term development framework, preemptive and sufficient supply of infrastructure was available. Third, during the 1990s and thereafter, PPPs were widely adopted to complement limited government budgets for infrastructure investment. 1. Characteristics of Infrastructure Development in the 1960s <h2> In the early 1960s, Korea had a typical poor agrarian economy with most of the industrial facilities of the colonial legacy devastated by the Korean War. Per capita GDP stayed at around US$60–80 and a vicious circle connecting low investment to low production, to low income, and again to low investment prevailed. More than 40 percent of the government revenues were concessionary aid from a few donor countries. In 1962, the military government started the First Five‐Year Economic Development Plan (1962–67) based on the following principles: First, market mechanisms and economic principles were well respected, but for key industries substantial government intervention was to be allowed through the planning process. Second, considering the narrowness of the domestic market and the

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paucity of domestic natural resources, an outward‐oriented development strategy was adopted by fostering export industries that utilized labor, the only abundant resource. Third, foreign capital inducement was encouraged to cover capital shortages.4 Major indicators of economic performance for the First and Second Five‐ Year Development Plans were remarkably good as is shown in Table 1. Table 1. Major Indicators of Performance, 1962–71

GNP growth rate (%, 1975 constant price) Per capita GNP (US$) Investment ratio (%) Domestic savings ratio (%) Commodity export (US$ million) Commodity import (US$ million)

1961

1971

1962–71 average growth rate

5.6 82 13.2 3.9 41 316

9.4 278 31.5 14.2 1,132 2,178

8.7 13.0 — — 39.3 21.3

Source: Handbook of Korean Economy, Economic Planning Board, 1980.

Key characteristics of infrastructure development of this era are as described below. First, infrastructure investment was made in advance under the framework of the overall economic development plan. The First Five‐Year Development Plan, enacted in 1962–66, was aimed at enhancing independent growth away from depending on foreign aid and enlarging the base for industrialization. In terms of infrastructure, investment was focused on the security of energy supply including electricity, construction of industrial sites, and building transportation capacity in order to ensure that infrastructure shortages would not cause bottlenecks on the path to economic growth. The success of Five‐Year Development Plans in Korea was mainly the result of efforts and hard work of a government ministry called the Economic planning Board (EPB). The role of the EPB and main tenets of the Five‐Year Plans are described in Box 1 and Box 2. 4 Foreign capital played an important role to maintain Korea’s relatively high investment ratio. During the early stage of development, the investment ratio stayed at around 15 percent of GDP, half of which was financed by foreign capital. In the late 1960s the investment ratio jumped to around 25 percent, and around 40 percent of investment was financed by foreign capital since domestic savings began to pick up as income had grown. In the 1970s, the investment ratio once again jumped to around 30 percent of GDP and foreign capital accounted for around 25 percent of the investment in the early 1970s. As domestic savings grew, the role of foreign capital diminished from the late 1980s, as the balance of payment position turned to surplus, capital inflow changed to outflow.

1961

1962–66 average

1967–71 average

1972–76 average

1977–81 average

1982–86 average

1987–91 average

Investment ratio (%)

13.2

16.3

26.3

28.6

29.4

31.7

Domestic savings ratio (%)

2.9

8.0

15.6

20.3

24.8

28.6

36.9

Foreign savings ratio (%)

8.6

10.1

6.8

3.8

0.7

-5.9

Note: Numbers are on the current price basis. Source: Handbook of Korean Economy, EPB, 1980 and Major Statistics of Korean Economy, EPB, 1992.

The Republic of Korea’s Infrastructure Development

Box 1. The Economic Planning Board (EPB) The EPB was established in July 1961 and merged with the Ministry of Finance to form the Ministry of Finance and Economy in December 1994. The main function of the EPB was to pursue a systemic economic development plan with a long-term goal, which had the utmost importance especially at the beginning of development. To this end, the head of the EPB took the position of the Deputy Prime Minister (DPM) as well as the chair of Economic Ministers Meeting. He had full power in coordinating economic policies, mobilizing financial resources including budget and foreign capital (which was one of the scarcest resources), and hosting a monthly economic conference and reporting to the President. This meant that the DPM could effectively coordinate economic policies and support development plans by taking a strong hold on financial resources. Without any clients or vested interest group, the EPB maintained its unrivaled position as a leading, neutral, and professional organization in economic policy making. The success story of the EPB was also indebted to continuous overseas training opportunities given to its staff using almost 10 percent of foreign loans rendered to the Korean government during the development era.

Box 2. The Five-Year Economic Development Plan Korea’s First Five-Year Development Plan (1962–66) started in 1962 and the Sixth (1992–96) was the last, finished in 1996. The government-led industrialization was possible mainly thanks to highcaliber government officials inherited from the traditional Confucian culture, strong financial and tax incentives, ample supply of skilled manpower, and government-funded R&D activities. The targetoriented Five-Year Plans worked well in Korea, but a more important tenet of the plan was to conduct policy-planning exercises that anticipated the future policy environment. During the planning procedure, the relevant government officials, government think tanks, the private sector including business federations and research organizations, and even journalists and academia experts joined together seriously thinking about the future. Through this process, the participants had opportunities to consider advanced country models as benchmarks and prepare for the necessary changes. To materialize five-year plan goals and targets, every year the EPB formulated the annual economic management plan reflecting changes in the environment. In the late 1990s as private sector capabilities grew, five-year planning was replaced by longer-term spatial planning that has continued to this day.

Second, the symbolic importance of large‐scale infrastructure projects to stimulate people’s desire and will to develop cannot be overemphasized. In case of Korea, it was the Kyungbu Expressway, the first cross‐country expressway of 428 kilometers connecting Seoul, the capitol city, and Busan, the largest seaport on the Korean peninsula. It was initiated by late President Park, who was much impressed by German autobahns. Naysayers among the experts doubted the economic feasibility of the project, citing expectations of low traffic on the route. However, President Park followed his own expectations of a much bigger increase. He also saw that the new expressway would symbolize the country’s strong will to develop, and would shorten the travel time between cities and rural areas, an essential factor of modernization. This project demanded a tremendous amount of money, equivalent to more than 4 percent of the total annual government budget. The president himself drew detailed routes through aerial surveys in helicopters. With the president driving the project, the biggest project till then in Korean history was completed in just two and a half years, from February 1, 1968 to July 7, 1970. Of course, supply created demand so that the capacity of the road was saturated rapidly. After that, a series of expressway construction projects followed, eventually forming a nationwide network that included the Kyungin Expressway (constructed March 1967–December 1968), the

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Honam Expressway (constructed April 1970–November 1972), and the Yungdong Expressway (constructed March 1971–October 1975). Thanks to these efforts, the first round of expressway networks was finished and dispersion of industrial site development was further promoted. Third, sufficient investment on infrastructure could be realized thanks to successful financing. The portion of infrastructure investment in gross fixed capital formation during 1962–71 was more than 30 percent (Table 2). For financing, a Special Account was introduced for infrastructure investment. Revenues in that account came from a petroleum tax, tolls, government road bonds, and borrowings from international financial organizations such as the World Bank and Asian Development Bank. Commercial loans were also actively utilized. Of course, all these efforts could not have brought sufficient investment on infrastructure without the government’s healthy operation of public finances. Table 2. Share of Infrastructure in Gross Fixed Capital Formation (KRW billion in 1970 constant price) Gross fixed capital formation (A) Electricity, water, sanitation

1962

1965

1968

1971

133.9

195.3

498.3

680.6

14.0

11.4

55.1

60.0

Transportation, storage, telecom

30.9

37.1

131.2

177.8

Sub-total (B)

44.9

48.5

186.3

237.8

B/A (%)

33.5

24.8

37.4

34.9

Source: The Korean Economy: Six Decades of Growth and Development, Korea Development Institute (KDI), 2010.

Fourth, efficient infrastructure construction was possible thanks to well‐ established institutions and an effective legal framework. Traditionally infrastructure was provided by government‐controlled monopolies in many countries and because of that, infrastructure investment faced many weaknesses such as high costs and poor performance of infrastructure investments, bureaucratic decision making leading to delays in infrastructure construction, underpricing of services due to political interests, opaque legal frameworks that led to collusion and corruption, and so on. In the case of Korea, however, well‐ established institutions and an effective legal framework allowed the country to avoid such common pitfalls. The public corporation in Korea, as a monopoly supplier of infrastructure, could attract high‐quality manpower by offering adequate compensation and job security. A legal framework, particularly the bidding system, also could prevent collusion and corruption to some extent.5

5 For example, in international open bidding when foreign loans were used, a very strict rule‐ compliance was required from feasibility study to execution drawing to construction supervision, which helped prevent collusion and corruption. In addition, as famous foreign engineering companies were invited, domestic companies could learn from them through joint participation, which provided stimulus and a momentum for development of domestic construction industry.

The Republic of Korea’s Infrastructure Development

Characteristics of Infrastructure Development in the 1970s and 1980s After the successful completion of the First and Second Five‐Year Economic Development Plans, priority was given in the 1970s and the 1980s to manufacturing facility expansion and infrastructure construction to support it. The dominant goal of the Economic Development Plan, i.e. an outward‐oriented industrialization, was maintained. Also, after experiencing oil shocks, energy security issue became top priorities. Characteristics of infrastructure investment of this era were as follows. First, the infrastructure investment plan was formulated under a longer‐ term and more comprehensive framework. The First (1972–81) and Second (1982–91) Ten‐Year Long‐Term Comprehensive National Land Development Plans provided that framework. According to the vision of national land set forth in the Plan, dispersion of industrial sites, construction of utility network including energy, and comprehensive transportation network connecting roads, railways, harbors, and airports should be determined with the same long‐term strategy. In the case of roads, the nationwide expressway network was expanded, followed by the construction of national roads (a lower‐class road below expressways that the central government constructs and maintains) to link industrial sites, ports, and big cities. The goal was to address potential traffic increases; enlargement and pavement of roadways were also emphasized. For financing purposes, a Road Construction Special Account was introduced and for its revenue, a Special Excise Tax on Petroleum was levied as an object tax. Development in regions that had lagged behind could now be substantially promoted thanks to the nationwide expressway network, which made possible dispersion and connection of industrial sites as well as improved mobility of people. In addition, deep‐rooted regional conflicts between the southeast and southwest parts of the peninsula were moderated thanks to these dispersion and connection functions of the new roads. In the case of railways, in order to expand transportation capacity, railway electrification projects continued, and the metropolitan subway system was built in the Seoul area in 1974 as well as in five other big cities: Busan, Daegu, Incheon, Gwangju, and Daejeon. Second, after experiencing the first and second oil shocks, securing a stable energy supply became a top priority. To cope with such circumstances, a comprehensive approach was undertaken as described in Box 3. Third, development of the construction industry by actively participating in overseas construction could bring in higher levels of technology, and, as a result, greatly contribute to efficient domestic infrastructure development and to the successful adoption of PPP in later stages. Korean construction companies had a comparative advantage due to their abundant supply of high‐quality skilled workers, strong work discipline, and relatively low wages. Wages were at least by 10 percent less than those of competitors, and therefore, in 1982 alone, overseas construction orders exceeded US$13 billion. Korean construction companies were

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then able to learn advanced construction technology, construction management skills, financial know‐how, etc. from their advanced foreign partners, which contributed to more efficient domestic infrastructure development. Box 3. Energy Supply From the beginning of economic development, the energy issue has had top priority because Korea’s energy endowment was extremely poor. As is seen in the Table 3, per capita energy consumption in 1961 was a meager 0.38 thousand tonnes of oil equivalent (TOE), and more than 50 percent of that was from wood charcoal. During the First Five-Year Plan period, the Korea Electric Power Corporation (KEPCO) and Korea Coal Corporation, both government corporations, played a key role in securing energy supply by maximizing development of domestic energy sources such as coal mining and hydroelectric generation. Table 3. Composition of Energy Sources at the Beginning of Development (Unit: Thou. TOE, %) 1956

1961

1966

1971 20,868 (100)

Total Consumption

8,756 (100)

9,711 (100)

13,057 (100)

Coal

1,634 (18.7)

3,103 (32.0)

6,029 (46.2)

5,872 (28.1)

518 (5.9)

809 (8.3)

2,167 (16.6)

10,559 (50.6)

Petroleum Hydro power Wooden charcoal Per capita consumption

129 (1.5)

163 (1.7)

246 (1.9)

330 (1.6)

6,473 (73.9)

5,636 (58.0)

4,611 (35.3)

4,101 (19.7)

…

0.38

0.44

0.64

Note: Shares of composition are in the parenthesis. Source: Korea Energy Resource Institute, Annual Yearbook of Energy, 1984.

From the Second Five-Year Economic Development Plan, the government started to foster heavy and chemical industries, which demanded high energy intensity. Although during 1967–68 there were occasional shortages in power generation capacity due to rapidly increasing demand, the government put the highest priority on power supply security. By allocating more funds from the budget and foreign loans, the government successfully promoted an ambitious plan to secure power supply. As a result, by 1971, power generation capacity had increased to 2.63 million kilowatts, which was less than 4 percent of generating capacity in 2010, but seven times more capacity than in 1961. Most of the increase in electricity supply was from new thermal power generation plants due to exhaustion of hydro generation potential. In addition, since energy security was closely related to independence from global major petroleum companies, many Korean conglomerates, such as LG, Lotte, Hyundai, Ssangyong, and Hanhwa, made joint ventures with global petroleum companies as well as with suppliers in the Middle East to construct refinery plants. After experiencing the first oil crisis, the government established the Ministry of Power and Resources in 1978, and formulated the Long-Term Power Resource Development Plan. According to the plan, energy supply structure was to be changed away from the highly petroleum dependent system toward a more diversified system. Since then, liquefied natural gas (LNG) and flaming coal have been actively imported and utilized. Particularly, the government began to build nuclear power plants to meet rapidly increasing electricity demand. In 1978, the first nuclear power plant was put in commercial operation and a total of six units were constructed during the 1970s. Of course, at the beginning, Korean companies did not have any experience in constructing or operating nuclear power plants, and advanced country contractors constructed plants on a turnkey basis. Soon, however, many Korean companies, which jointly participated in construction of nuclear power plants, accumulated relevant experiences and technologies. Later, KEPCO established its own Korean standard model and Korean companies fully localized construction technology including turbines and plant operational know-how. Currently, 28 nuclear power plants are being operated in Korea, which is the fourth highest number in the world after the United States, France, and Japan. (Box continues on next page)

The Republic of Korea’s Infrastructure Development

Box 3 (continued) In 2009, Korea won a US$4 billion bid to construct and operate four units of nuclear power plants for the United Arab Emirates by Korean standard model. In Korea, a stable electricity supply was possible during most of the development era thanks to continuous construction of nuclear power plants, and the share of nuclear power is now around 43 percent of the total supply of electricity. In terms of financing, the government established the Petroleum Business Fund, the revenue of which came from surcharging on petroleum. Although high oil prices eventually subsided, by maintaining high domestic oil prices, the government could secure a substantial amount of money to invest in the construction of nuclear power plants. KEPCO also successfully issued global bonds with the government’s repayment guarantees and secured enough funds to expand power supply capacity. The government’s high energy price policy for KEPCO to cover investment costs also helped KEPCO make a continuous timely expansion of power supply capacity. Table 4. Major Indicators of Electricity Supply 1980

1985

1990

1995

1998

Generation capacity (MW)

10,375

17,640

24,056

35,356

47,983

Generation quantity (GWh)

40,078

62,667

118,461

203,546

237,197

Supply buffer ratio (%)

40.1

31.3

8.3

7.0

14.9

Shutdown min. per household

891

523

295

39.2

21.2

Source: KEPCO, Korea Electricity Statistics, 1999.

Characteristics of Infrastructure Development in the 1990s and Thereafter During the 1980s, infrastructure investment lagged behind the pace of development. Therefore distribution costs and congestion costs increased substantially, resulting in a deterioration of national competitiveness. The share of infrastructure investment in GDP in 1990 was 2.28 percent, which was considered very low compared to the 1970s. As a result, distribution costs as a percentage of GDP were estimated to be 15.4 percent in 1993, and private companies’ average distribution costs compared to sales value to be 17 percent.6 Congestion costs were also estimated to be 6 percent of GDP. All this contributed to the deterioration of industrial competitiveness. Therefore, the government put a higher priority on expenditure for infrastructure investment and began actively utilizing private capital through PPP. Characteristics of infrastructure development of this era were as follows. First, in order to save distribution costs, the government substantially increased investment on transportation (Table 5). Table 5. Share of Transportation Investment in GDP Transportation investment/GDP (%)

1990

1993

1996

2.28

4.30

4.33

Source: The Korean Economy: Six Decades of Growth and Development, KDI, 2010.

6 These numbers were considered to be extremely high compared to that of the United States and

Japan, estimated at 7 percent and 11 percent respectively (The Korean Economy: Six Decades of Growth and Development, KDI, 2010.)

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However, due to political pressure, infrastructure investment was somewhat skewed toward some roads and airports, which led to delays in construction of other urgent infrastructure projects and brought about inefficiencies since those less urgent projects only handled small amounts of traffic. Second, facing government budget constraints, PPP was introduced in 1994 and thereafter widely used. Success factors of PPP in Korea are as follows; (i) various government supports such as financial support, risk sharing structures, credit guarantee schemes, and tax incentives were provided; (ii) the Public and Private Infrastructure Investment Management Center (or PIMAC) was established to provide professional services throughout the PPP procedure including feasibility studies, value for money (VFM) tests, proposal evaluations, and support for negotiations; and (iii) foreign investors were successfully invited. Details of Korea’s PPP experiences will be discussed in the next section.

III. Korea’s PPP Experiences and Impact of Financial Crisis on PPP Major Functions of PPP Korea introduced Public‐Private Partnership programs with the enactment of the Act on Promotion of Private Capital into Infrastructure Investment in 1994.7 Major functions of PPP that the Korean government expected were as follows: (i) to be an effective alternative to tackle the financial constraints that the government faces; (ii) to provide better and more efficient public services by taking advantage of the private sector’s know‐how and creativity; and (iii) to create stable and long‐term investment opportunities for private investors by providing safe and reliable places to invest. Toward this end, the government role in PPP projects is to plan, evaluate, approve detailed execution plans of the concessionaire, and support implementation of the projects, while the private partner’s role is to design, build, finance, and operate the facilities. Evolvement of the PPP Act Just before adoption of the PPP Act, the government introduced the Total Project Cost Management System to control the ever‐increasing cost of infrastructure investment by escalation clauses or changes in design. In 1994 when the PPP Act was introduced, the government seemed to consider PPP projects based on the existing type of business permit with strong government discretion. However, when the Incheon Airport Expressway project, which was the first PPP project in Korea, was undertaken, it was based on an execution agreement that defined 7 In 1994 when Korea seriously introduced PPP for the first time, Korea’s per capita GDP was

US$9,727. In 1998 when more market contract–oriented PPP was introduced, per capita GDP deteriorated to US$7,607 due to Asian financial crisis.

The Republic of Korea’s Infrastructure Development

several important market contract–oriented components, including profitability. Since then, every year the government has formulated the Basic Plan for PPP, but the actual number of projects undertaken was small.8 In 1998, the Act was revised and clearly stipulated that the PPP projects were to be undertaken on the basis of execution agreement between the relevant ministry and concessionaire. In this agreement, the concessionaire’s responsibility was increased and at the same time many supporting measures were introduced such as the minimum revenue guarantee (MRG),9 request for government’s buyout, credit guarantee expansion, etc. In particular, the Private Infrastructure Investment Center of Korea (PICKO), a supporting agency, was established under the Korea Land Institute, a government think tank, to undertake feasibility studies and provide other necessary services. Thanks to these reform measures, the PPP contracts could take on more characteristics of market contracts and lead to an open and fair competition through public participation procedure. In 2003, in order to promote competition further, other market‐type measures were allowed, including participation of financiers, the introduction of an infrastructure fund, a proposed compensation scheme for dropout of concessionaires, relaxation of concessionaire’s floor plan, and so forth. In 2005, additional reform measures were undertaken: private proposals without effective competition were not to be selected and in evaluation, and the price factor came to take on more than 50 percent weight. Changes of the Act after the global financial crisis are described in a later section. Implementation Methods of PPP Projects in Korea In Korea, the most sought‐after PPP implementation methods were Build‐ Transfer‐Operate (or BTO) and Build‐Transfer‐Lease (or BTL). In the beginning, PPP projects were centered on transportation infrastructure using BTO. After the revision of the PPP Act in 2005, the PPP projects also used the BTL method to cover social infrastructure projects such as schools, healthcare facilities, culture and sports centers, and public rental housing. In BTO projects, the private partner realized a reasonable return on its investment by charging a user fee, while in BTL projects the private partner recovered its investment through payments made by the central or local government. According to the PPP Act and its Enforcement Decree, 46 types of facilities in 15 categories were defined as eligible infrastructure types for PPP projects (see Annex 1.) 8 During 1995‐98, despite the government announced 45 projects amounted to 35 billion US dollars, only 10 projects were actually undertaken. 9 MRG contributed at the beginning to vitalization of PPP by lessening the burden of the concessionaire. However, MRG was weakened after 2003 and finally abolished in 2009 due to the moral hazard problem created by concessionaire demand and continuously increasing fiscal burdens.

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Achievements of PPP in Korea Private investment has been continuously increasing since the introduction of the PPP Act and has played a key role in providing infrastructure in a timely manner, complementing public investment. The proportion of private investment to public investment in infrastructure increased from 3.9 percent in 1998 to 15.4 percent in 2009. By the end of 2009, 461 PPP contracts had been awarded, of which 106 BTO and 145 BTL projects were completed to provide services to the public. Table 6. Share of PPP in Government Infrastructure Investment (Unit: KRW trillion, %) 1998

2003

2005

2007

2009

Sum

0.5

1.0

3.0

6.0

9.6

70.9

BTO

0.5

1.0

2.9

3.0

3.1

51.1

BTL

—

0.1

3.0

6.5

19.8

3.9

5.6

16.1

17.0

19.7

—

Private investment by PPP

Share in gov’t investment

Source: The Korean Economy: Six Decades of Growth and Development, KDI, 2010.

Success Factors of Korea’s PPP Projects First, the PPP Act provided a very clear legal framework. According to the Act, the Ministry of Strategy and Finance (MOSF), considered to be the most competent government ministry, was designated as the main regulator to draw up the Basic Plan for PPP and to direct government policy. Implementation of procedures, rights and obligations, as well as a risk‐sharing mechanism, are clearly defined in the Act to effectively reduce potential business risks for private sector participants. Figure 1. Legal Framework for PPP in Korea

Second, the supporting agency was established under government think tanks. PICKO in the 1988 Act was initially established under the Korea Land Institute, providing services such as feasibility studies. Later, PICKO was expanded to become the Public and Private Infrastructure Investment Management Center (PIMAC) by the 2003 Act under the Korea Development Institute (KDI) in order to provide a wide range of professional support for PPP projects and to conduct research on PPP policies as the demand for professional services increased and as experiences were accumulated. PIMAC consists of experts from various fields including economics, finance, accounting, law,

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engineering, urban planning, and more, and is providing various professional services throughout the entire PPP procurement process such as carrying out feasibility studies and VFM tests,10 formulating the Request for Proposal (RFP), evaluating proposals, and supporting negotiations. PIMAC also offers training programs for government officials, and explores cooperation opportunities with international organizations and foreign countries. In short, thanks to PIMAC, PPP implementation conditions are thoroughly considered, while transparency can be enhanced with a competitive bidding process for the selection of private partners. Third, the government has rendered strong support to stimulate investment in PPP projects. There are two types of support to the private sector: financial support and risk‐sharing measures. Six measures that can be considered as financial supports and/or risk‐sharing supports are being provided: (i)

(ii)

(iii)

Support for land acquisition by concessionaires. Concessionaires are granted land acquisition rights as well as the right to use national and state or public land free of charge. Concessionaires can entrust the relevant government authority with the execution of land purchase, compensation of loss, resettlement of local residents, and other related administrative tasks. Financial support. In order to maintain an appropriate user fee level, the government covers 100 percent of land acquisition costs for any projects, and construction subsidies to the concessionaire, if necessary.11 Risk sharing. When PPP projects are terminated for unavoidable reasons during construction or operation, the government takes over management and operation rights of the facility, and offers a certain amount in termination payment to the concessionaire.12 The concessionaire could request a government buyout of the project if termination of construction or operation of facility was due to unavoidable incidents including force majeure. However, some of the measures, adopted to invite more foreign capital right after the Asian financial crisis, were all abolished to avoid moral hazard. Measures abolished included foreign exchange rate risk sharing and the minimum revenue guarantee. Excessive incentives to attract capital,

feasibility study evaluates and determines whether or not to pursue a project, while a VFM test determines whether it is more beneficial to pursue it as a PPP project rather than a government‐funded project. 10 A

11 For road projects, the subsidy is given up to 30 percent of the total investment. For railway projects, it’s given up to 50 percent of the total investment. For ports, it’s given up to 30 percent of the total investment. 12 The government guarantees redemption of the minimum costs of the projects which are the private investment capital plus investment return ratio that is comparable to the interest on government bonds.

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(iv)

(v)

when combined with inaccurate prospects for interest rates, exchange rates, or demand, may result in a substantial future fiscal burden, the opposite of a PPP’s intended purpose. Credit guarantee. Credit guarantee schemes can be given by the Korea Infrastructure Credit Guarantee Fund (KICGF) according to the PPP Act to provide credit guarantees for concessionaires who obtain bank loans from financial institutions or issue infrastructure bonds for PPP projects. The maximum guarantee limit is KRW 300 billion, with guarantee fees being determined within the range of 0.3–1.3 percent, depending on the degree of the project risk and the company’s credit standing. The guarantee for subordinate debt is up to 20 percent of the total guaranteed amount. Tax benefits. Various tax benefits are granted for PPP projects including the following:  A zero percent value‐added tax is assessed for construction services of revertible infrastructure facilities.  Acquisition and registration taxes for BTO projects are exempt.  A separate tax rate of 14 percent is applied to income generated from the interest on infrastructure bonds with maturity of 15 years or longer.  A separate tax rate is applied to dividends from infrastructure fund investment. (The 5 percent tax rate is applied to investments below KRW 300 million, and the 14 percent to investments above KRW 300 million. The dividends from the SPC are tax‐exempted if more than 90 percent of their profits are distributed as dividends.)

Fourth, success in inviting foreign investors is also an important factor. Foreign investors are treated the same as domestic investors and further entitled to additional benefits including tax credits and financial support. Additional support for foreign investors is provided as follows: 



When foreigners invest more than US$10 million to build PPP facilities in a Foreign Investment Area, tax breaks are granted in the areas of corporate tax, income tax, acquisition tax, registration tax, and property tax. When foreign exchange losses arise from loans in foreign currency for construction due to fluctuation in the foreign exchange rate, the government can offer subsidies or long‐term loans. For projects in which foreign investments account for a significant portion of the total investment, each foreign investor’s position is respected to the fullest extent with respect to language and provisions for conflict resolution in the concession agreement.

Table 7 shows the extent of some foreign participation in projects.

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Table 7. Foreign Participation in Projects Instrument

Projects

Equity

Busan New Pore Phase 1 (25%), Incheon Bridge (23%), Yongin LRT (26%), Busan New Port Phase 2, 3 (18.5), Daejeon Riverside Expressway (67%), Songdo-Mansu Sewage Treatment Facility (80%), Busan Aquarium (100%)

Debt

Busan New Port Phase 1 (43%), Daejeon Riverside Expressway (83%), Daegu-Busan Expressway (10%), Seoul Beltway (11%), Busan Aquarium (100%)

Lastly, since the recent financial crisis, Korea’s PPP projects have been allowed to use flexible financing conditions. For example, for the financial security of the project, private partners need to maintain a minimum required equity ratio. Thus, during the construction period, project companies are required to maintain an equity ratio of at least 20 percent for a BTO project, or 5 percent or more for a BTL project. However, when the investment ratio of financial investors is above 50 percent of the total equity, the minimum required equity ratio during construction could be lowered from 20 percent to 15 percent. The concessionaire is also allowed to refinance according to changes in the macroeconomic environment, project risk, and so forth. Refinancing gain is shared between the concessionaire and the government to benefit both parties. The refinancing gain can be used to lower the user fee so that facility users can also benefit from refinancing. Financing through the Infrastructure Fund is also encouraged to diversify investor profile.13 Impact of Recent Financial Crisis on PPP Global PPP trend after the financial crisis The global financial crisis that began in 2008 has made financing for PPP projects more difficult to secure. Both existing and planned PPP projects have been affected through various channels, such as availability and cost of credit, lower growth, and unforeseen exchange rate movements. Depending on the contractual arrangement between the public and private parties, changed distribution of risks can shift the cost burden between parties, weakening the attractiveness of PPP projects. As a result, some planned PPP projects have been delayed, restructured, and to a lesser extent, cancelled. Transport and energy have been the worst affected sectors so far, while middle‐income countries have been the most affected, especially in the Eastern Europe and Central Asia region where the domestic capital market was dominated by severely hit western financial institutions. In comparison to these regions, East Asia, Sub‐Saharan Africa, and the Middle East and North Africa returned to a stable position in PPP The Infrastructure Fund is an indirect investment facility that collects funds from investors to lend and invest in PPP projects, while also distributing profits to multiple investors. Regulations on asset management and financing have been eased to promote the use of the Infrastructure Fund. Investments through the Infrastructure Fund increased from KRW 80 billion in 1999 to KRW 3.3 trillion in 2008, with a total of 10 funds being managed at present. 13

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investments after a short period of stagnation. Latin America and South Asia were the least affected and even attracted higher investments. In most of the region, recovery has been driven by large PPP projects, where there was enough liquidity in domestic financial markets and government assumed more risk sharing.14 Government responses Most countries, with their objectives to support their PPP programs, are revising their basic risk assignment framework and financing role. The tendency appears to be for the government to assume either a larger share of the risks or assume risk that otherwise would not have assumed. For example, more governments are taking the following measures:     

reviewing their PPP framework including strengthening of PPP laws and units to provide solutions in an equal and timely manner; allowing a minimum revenue guarantee either in an absolute level or an annual basis and increasing the level; facilitating bank lending or even providing it through government financial institutions or infrastructure investment fund; providing broader guarantees covering a broad reach of contract terms; and providing upfront government payments to facilitate private sector financing.

Korea’s policy responses In the case of Korea, the impact of the financial crisis on PPP was also substantial at the beginning by decreasing PPP project profitability, leading to a sharp decline in the number of new PPP projects as well as failures of pipeline project financing closure. Facing these difficulties, the government implemented the PPP Revitalization Plan twice, in February and August, 2009; the main objective was to provide liquidity and mitigate the risks. The February measures included the following: 

providing a special loan program in collaboration with Korea Development Bank, i.e. a one‐year bridge loan to be redeemed upon formal financial closure with a guarantee by the Korea Infrastructure Guarantee Fund;  increasing the guarantee limit per project from KRW 200 billion to KRW 300 billion, and for subordinate debt guarantees, from 4.5 percent to 20 percent of the total amount guaranteed;  lowering the ratio of required equity to total project costs by 5 to 10 percent; 14

Luis Guash, “PPPs: Impact and Responses to the Crisis and Moving Forward,” (ASEM PPP Conference, Seoul Korea, October 2009).

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 

shortening resettlement period for the base bond rate from five to two years, in order to reduce the risk of interest rate fluctuation; and introducing a new compensation standard for the gap between the base bond rate and interest rate for loans by allowing sharing of the upside and compensation of the downside.15

Thanks to the February 2009 measures, BTL was substantially revived, but BTO needed additional measures. Therefore, the August 2009 measures were implemented as follows:  



encouraging supplementary projects to improve profitability; increasing the coverage for compensation on termination for unavoidable reasons from up to 55 percent to 85 percent of the investment cost; and developing a risk‐sharing system for the government to undertake more risks by compensating the raw cost of projects.

Additional measures in the August plan to improve financing conditions included the following: 



revitalizing infrastructure bonds by expanding the scope of eligible institutions for bond issuance and securing guarantee support from Korea Infrastructure Credit Guarantee Fund; and establishing the Public Infrastructure Fund in which both public and private institutions may participate with greater tax incentives for investors.

However, as mentioned above, the government does not intend to adopt extreme supportive measures such as a general buyout right, foreign exchange rate risk sharing, and minimum revenue guarantee. Having recorded a fast recovery from the global financial crisis ahead of other advanced countries, and thanks to appropriate policy adjustments made in a timely manner, Korea has shown a very positive rebound of PPP projects.

15 For risk‐sharing, the government set up a new standard called the risk‐sharing revenue. This is the amount of operation revenue that guarantees the investment return ratio that is comparable to the government bond’s rate of return. If actual operation revenue falls short of the risk‐sharing revenue, then the private sector’s internal rate of return (IRR) is less than government bond’s rate of return, which is not satisfactory to the concessionaire. So, in this case, the government will pay the amount of shortfall to the concessionaire. Vice versa, if actual operation revenue exceeds the risk‐sharing revenue, government subsidies will be redeemed on the basis of the realized payments. On the part of private sector, they also should share the risk. So, if actual operation revenue is less than 50 percent of the risk‐sharing revenue, the government assumes it as private sector’s delinquency and therefore does not provide subsidy for the amount of shortfall. All in all, the concessionaire must also try to keep up the revenue level above 50 percent of the risk‐sharing revenue.

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III. Some Lessons for African Emerging Economies Considering Korea’s successful implementation experiences in infrastructure development, some lessons can be drawn for current African developing economies suffering from shortages in infrastructure. First, efficient infrastructure development requires that the government formulate a concrete vision for the future of the nation, which can be laid out in a high‐quality, medium‐term comprehensive economic or land development plan. Since infrastructure is closely related to current and future industry placement, urbanization, and daily lives of the general public, and since it takes considerable time to arrange infrastructure investment, a comprehensive and medium‐term approach is essential. Unfortunately, many African countries lack planning and implementation capacity, and institutional infrastructure is frequently inhospitable to business. Under these circumstances, it would be useful to establish a strong planning organization, or strengthen an existing one. An example is the Economic Planning Board of Korea in the development era, which had full power in economic policy coordination and a strong hold on domestic and foreign finance. In addition, it is also important to provide continuous training opportunities for staff of that organization. In this regard, Korea’s knowledge sharing program could draw upon the country’s own experiences to provide planning exercises, a roadmap for a national agenda, guidelines for institution building, and on‐the‐ job training for staff of planning organizations. Another institution that helped Korea’s fast transformation was KDI, a government think tank established in 1971. The researchers at KDI were recruited with a good compensation and included PhD degree holders educated in developed countries like the United States, United Kingdom, Germany, France, and Japan. Once a strong planning organization and a supporting think tank are set up, a high‐quality medium‐ to long‐term infrastructure development plan can be formulated in a close consultation with international financial organizations. Second, a leading role of infrastructure development for economic growth as well as poverty alleviation should be emphasized. In order for infrastructure not to be a bottleneck for economic development, preemptive, sufficient, and steady infrastructure investment is necessary. If infrastructure is neglected at any stage of development, future social costs such as deterioration of competitiveness, loss of opportunities for more equitable development by region, or congestion cost would be tremendous. To this purpose, as the private sector does not have enough capacity to get involved yet in many African countries, the government should take initiatives and a top‐down approach is essential. Capital should be attracted from developed countries, and foreign companies should be

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encouraged to jointly work with local companies.16 Through these efforts, the local private sector could accumulate relevant experiences and technologies. In order to avoid collusion and corruption, a transparent bidding procedure as well as strict construction supervision is essential. Third, in the case that infrastructure is still provided mainly by government‐ controlled monopolies, it is desirable to adopt a wide use of PPP. This surely provides a useful solution to many problems that the public sector has faced such as inefficiency and low capital availability. For the government, infrastructure services are essentially monopolistic in nature and, therefore, outright privatization may not be a good public policy option since efficiency versus equity issues arise. In addition, as budget constraints are being intensified in many countries, PPP, with government supervision, could provide competition, efficiency, and capital. In the case of Korea, PPP started to be utilized when Korea reached the middle‐income level, not because PPP is relevant to income level, but because the country came to know PPP at that time. Therefore, it seems that current African countries need not to wait until they reach middle‐income levels of development; regardless of income level, there should always be a possibility to use PPP. If domestic companies do not have the capacity to supply infrastructure development, then foreign suppliers can become development partners and domestic partners can learn from joint participation as many Korean companies did in the past. In Asia as a whole, regardless of income level or market maturity, PPP is widely used. This also indicates that there is potential for African countries to adopt PPP once better environments for PPP are provided.17 Fourth, for vitalization of PPP, it is essential to establish a strong framework to coordinate the interests of different stakeholders involved in PPP. The government is interested in ensuring the growth of infrastructure and formulating effective public policy while the private sector is interested in maximizing the return on their investment. PPP regulators are interested in ensuring transparency and balancing interests of different stakeholders while consumers seek to realize their value for money. Considering the diverse 16 In cases where infrastructure construction is funded by foreign aid and carried out by the donor country’s workers, it is necessary for domestic companies to join together with local workers. Without a joint participation of local companies and workers, the effects of foreign aid will be limited in fostering domestic construction companies and skilled workers. 17 According to the UK subsidiary of RREEF, the real estate division for the asset management activities of Deutsche Bank AG., attractiveness of infrastructure investment depends on population, market size, GDP growth rate, interest rate, country risk, legal framework, and maturity of market. In this regard, India and China, as medium‐matured markets, are the key infrastructure investment destination in terms of power generation, electricity distribution, water, ports, airports, road, and railways. For high‐matured market like Korea and Taiwan, China, power, water, ports, airports, road, and railways have potential to attract PPP. For other high‐matured markets like Singapore, power, ports, and road have potential. For low‐matured market like Vietnam, power, ports, road, and railways have potential. (Peter Hobbes, “The Opportunities and Challenges Associated with Investing in Asian Infrastructure,” IIA Seminar paper, 10‐12 June 2008, Singapore).

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interests of different stakeholders, a good framework for coordination should be established. The framework should include the following elements: 



The role of policy makers should be given to the most competent government organization, like the Ministry of Strategy and Finance in Korea, in order to formulate transparent, predictable, and streamlined policies. All the important aspects of PPP, such as planning, financing, and implementation should be handled by this organization, which will help minimize regulatory risks. The regulatory framework should be clearly stipulated by law as in Korea’s Act of Private Participation in Infrastructure of 1998, a revised version of the original 1994 Law, and Presidential Decrees under the Act. A transparent and efficient PPP process should be put in place, which may need an independent and professional regulator like Korea’s PIMAC providing professional services throughout the PPP process to ensure transparency and efficiency. However, it is noteworthy that the regulatory capacity of PIMAC had to be developed from modest beginnings. At an initial stage, PICKO could only provide limited services like feasibility study. As experience accumulated and capacity was developed, PIMAC expanded to provide a wide range of professional services. A reasonable level of incentives is necessary to attract domestic and foreign private investors by securing an appropriate rate of returns. Note that the private sector also faces challenges in pursuing PPP such as high up‐front costs, late returns on investment, multi‐faceted risks and uncertainties, and limited access to financial markets. Therefore, the government may need to find innovative ways to resolve financial bottlenecks and to achieve optimal risk allocation and mitigation between the parties, if necessary. Given Korea’s positive outcomes, the six government support schemes—support for land acquisition, credit guarantee, termination payment, risk‐sharing structure, tax benefit, and construction subsidy—seem to be well designed.

However, overly protective incentives, such as a minimum revenue guarantee, an unconditional government’s buyout scheme, or foreign exchange rate risk sharing, are not desirable since they may cause moral hazard and may increase future fiscal burden when combined with inaccurate predictions of interest rates, exchange rates, or demand. This would be the opposite of the intended result of PPP. Soft infrastructure also needs to be developed in terms of legal, accounting, taxation, capital markets, banking, etc. to provide a stable environment for PPP development. This also cannot be completed overnight, and therefore continuous efforts are necessary to upgrade the relevant framework.

The Republic of Korea’s Infrastructure Development

Fifth, investment of foreign capital, including loans from international financial organizations, needs to be encouraged. It not only complements domestic capital shortages for infrastructure development but also provides a momentum to adopt international standards in infrastructure development, from bidding to construction management to supervision, which are essential elements for efficient infrastructure investment. Domestic companies will have opportunities to learn from their foreign partners by joint participation. Lastly, many developing economies may face political pressure in the decision‐making process for infrastructure investment, just like Korea did in the 1980s. To avoid political pressure, a transparent and professional decision‐ making process is necessary. For example, the PPP Act clearly stipulates a strict compliance to the law. Furthermore, all projects should be subject to neutral and a professional organization’s study results such as PIMAC in Korea. A two‐step feasibility study (including a preliminary feasibility study and reassessment of feasibility study), a VFM test, and reassessment of demand forecast are all necessary to contribute to commercial decision making based on economic principles. Vigorous surveillance by civic groups to alleviate political pressure also could be a great help.

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Annex 1. Korea’s PPP Implementation Process Institutional Framework Ministry of Strategy and Finance. The Ministry of Strategy and Finance (MOSF) is responsible for directing and coordinating major economic policies and formulating fiscal policies including budget formulation, treasury management, and the tax system. As the central body in charge of national PPP programs, major roles of the ministry include the development of PPP policies and the establishment of comprehensive investment plans. MOSF is responsible for administering the PPP Act and its Enforcement Decree, as well as the Basic Plan for the PPP. It also chairs the PPP Review Committee, which deliberates on matters concerning the establishment of major PPP policies and makes key decisions about the implementation of large‐scale PPP projects. Procuring Ministries. Procuring ministries are responsible for establishing and coordinating sector‐specific PPP investment plans and policies. They also implement and monitor PPP projects. Public and Private Infrastructure Investment Management Center (PIMAC). PIMAC was established under the PPP Act in order to provide comprehensive and professional support for the implementation of PPP projects. Its main duties are as follows:  

 

support the government in developing PPP policies and guidelines; provide technical assistance throughout the procurement process of PPP projects including VFM tests, formulation of request for proposals (RFPs), evaluation of project proposals, and negotiations with potential concessionaires; organize capacity‐building programs and provide support for foreign investors through investment consultation; and promote international cooperation for knowledge sharing.

PIMAC, which is also in charge of the ex ante evaluation of public investment projects, contributes to enhancing efficiency and transparency in national infrastructure planning through comprehensive and systematic management of both public and PPP investment for infrastructure. Korea Infrastructure Credit Guarantee Fund (KICGF). KICGF is a public fund established under the PPP Act in order to guarantee the credit of a concessionaire that intends to obtain loans from financial institutions for PPP projects. It is managed by the Korea Credit Guarantee Fund (KODIT) and funded by MOSF.

The Republic of Korea’s Infrastructure Development

Comparison of BTO and BTL In BTO projects, the private partner realizes a reasonable return on its investment by charging a user fee, while in BTL projects the private partner recovers its investment through payments made by the central or local government. Types of PPP According to the PPP Act and its Enforcement Decree, 46 types of facilities in 15 categories are defined as eligible infrastructure types for PPP projects (Table A1.1). Table A1.1. Types of Eligible Infrastructure Activities

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Implementation Process of BTO and BTL Proposal Both the government and a private company can initiate a PPP project. 1. Solicited projects: The government finds a potential PPP project and then seeks concessionaires. Competent authorities develop a potential project after considering related plans and demands for the facility. They then weigh the procurement options in order to determine whether the PPP procurement is more efficient than the conventional procurement. Major points to consider before making decisions on a PPP project are as follows:     

Is the facility qualified for a PPP project prescribed in the PPP Act and the Enforcement Decree? Is the project a high priority for medium‐ and long‐term infrastructure investment plans? Does it offer more timely benefits than a conventional government‐ procured project that has budget constraints? Will operational efficiency and services improve by taking advantage of creativity and know‐how from the private sector? Will it be profitable considering the level of user fees and subsidies (for BTO projects)?

An appropriate implementation method (BTO, BTL, etc.) is selected with regard to the nature of the project, profitability, and other related factors. BTL projects can only be implemented as solicited projects. 2. Unsolicited project: The private sector can propose a PPP project that is in high demand but has been delayed due to government budget constraints. After considering factors such as demand, profitability, project structure, construction and operating plans, and funding, the private partner creates a project plan and submits the proposal to the competent authority. The private sector may propose profitable and creative ancillary/supplementary projects related to the main PPP project. The competent authority reviews and evaluates the contents and value for money of the private proposal.

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Procedure 1. BTO projects: After conducting a VFM test to evaluate its potential as a PPP project, competent authorities announce Request for Proposals (RFPs) and evaluate proposals for selection. RFPs include the project plan and implementation terms and conditions, such as the project outline, total project cost, operational profit, construction and operation plans, and government supports. Figure A1.1 shows the BTO implementation procedure. Figure A1.1. Implementation Procedure for BTO Project

2. BTL projects: A BTL project is initiated by the competent authority, reviewed by the Ministry of Strategy and Finance to decide on an aggregate investment ceiling for BTL projects, and then approved by the National Assembly. The investment ceiling for BTL projects is the aggregate BTL investment cost for the fiscal year. An amount detailing the total limit of all BTL projects as well as the limits for each facility type is submitted to the National Assembly along with the budget plan. Figure A1.2 shows the BTL implementation procedure.

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Figure A1.2. Implementation Procedure for BTL Project

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Performance of Korean PPPs BTO projects are centered on transportation services including roads, railways, and seaports (Figure A1.3). Road projects account for more than half of all investment, and environmental facilities top the list for the highest number of projects (while having the least cost per project). Figure A1.3. BTO Projects

BTL projects, which first began in 2005, have been actively pursued especially in building and reconstructing old educational facilities like elementary and middle schools, vocational colleges, and university dormitories (Figure A1.4). Furthermore, BTL projects are making a great contribution to expanding and improving sewage systems and military residences, as well as to building new railways. Figure A1.4. BTL Projects

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Project Case Studies BTO Projects 1. Incheon International Airport Expressway Incheon International Airport Expressway was the first BTO road project carried out under the 1994 PPP Act. It originally started as a government‐financed project but was turned into a BTO project later on to help ease the fiscal burden. Its early completion has played a significant role in the successful operation of Incheon International Airport. Since its completion in 2000, the project has undergone a refinancing process and now all equity holders are financial institutions.       

Total project cost: KRW 1,334 billion Length: 40.2 kilometers, 8 lanes Competent authority: Ministry of Land, Transport, and Maritime Affairs Construction period: 1995~2000 Operation period: 30 years Capital structure: Equity/Debt/Subsidies = 25%/59%/16% Major shareholders: MKIF (Macquarie Korea Investment Finance, 24.1 percent) and other 10 financiers mostly life insurance companies of Korea

2. Incheon Bridge Incheon Bridge is a cable‐stayed bridge with the world’s fifth longest main span, and the first PPP project in Korea led by AMEC, a UK company. The private sector implemented the construction of 12.34 kilometers section of the bridge, while the government took charge of 9.04 kilometers section, which includes the access road. The bridge connects the Second and Third Kyungin Expressways and Seohaean Expressway, thereby reducing the travel time to and from Incheon International Airport and south of Seoul by more than 40 minutes.  Total project cost: KRW 1,096 billion  Capital structure: Equity/Debt/Subsidies = 10%/41%/48%  Length: 12.3 kilometers, 6 lanes (21.4 kilometers including access road)  Competent authority: Ministry of Land, Transport, and Maritime Affairs  Construction period: 2005~2009  Operation period: 30 years  Major shareholder: AMEC and 7 Korean construction companies 3. Busan New Port Phase 1 The project aims to expand and improve Busan’s dilapidated ports, establishing a logistics hub port for Northeast Asia. Nine of the 30 berths have been allocated as BTO projects, with the first six of them completed in 2006 and 2007. In addition to Korean contractors and financial institutions, DP World of the UAE, a

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global port developer and operator, holds a 29.6 percent equity stake to participate in its operation.       

Total project cost: KRW 1,640 billion Capital structure: Equity/Debt/Subsidies = 20% /55%/25% Work scope: 9 berths (50,000 tons), 3.2 kilometers Competent authority: Ministry of Land, Transport, and Maritime Affairs Construction period: 2001~2009 Operation period: 50 years Major Shareholders: DP World (29.6%), Samsung Construction (23.9%), Korea Container Terminal Authority (9.6%), four Korean construction companies and others (36.9%)

BTL Projects 1. The Chungju Military Apartment Housing Project The Chungju Military Apartment Housing project was the first BTL project carried out in Korea. The modernization of military residential facilities had been delayed due to insufficient budgets, but was implemented at a rapid pace with the introduction of the BTL method. A total of 200 families moved into the 12 apartment buildings, with more than 95 percent of residents expressing satisfaction with the facilities in a survey.  Total project cost: KRW 18.6 billion  Work scope: 200 households and convenience facilities  Competent authority: Ministry of Defense  Construction period: 2005~2007  Operation period: 20 years 2. Ulsan National Institute of Science and Technology Ulsan National Institute of Science and Technology is the first campus ever built entirely by the BTL method utilizing a state‐of‐the‐art, environmental‐friendly, and digitized design. The project company is not only responsible for facility maintenance, management, cleaning and security, but also operates and manages the school’s dormitories, gymnasiums, shops, and parking lots.  Total project cost: approximately KRW 250 billion  Work scope: site 1,028,200 square meters, total floor area 153,691 square meters  Competent authority: Ministry of Education, Science and Technology  Construction period: 2007~2010 (1st phase: 2007–February 2009)  Operation period: 20 years 3. Anhwa High School Anhwa High School is one of Korea’s leading BTL school projects. In 2007 it was the recipient of an award in recognition of its excellent facilities from the Minister of Education and Human Resource Development. There are currently more than

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1,000 students enrolled at the school, which opened in 2007 with state‐of‐the‐art facilities and equipment, and is now under the management of the project company.     

Total project cost: approximately KRW 962 million Work scope: site 13,264 square meters, 5 stories above ground Competent authority: Gyeonggi Province Office of Education Construction period: 2006~2007 Operation period: 20 years

The Republic of Korea’s Infrastructure Development

Annex 2. Regional Cooperation in Infrastructure Development in Northeast Asia Region In the Northeast Asia region, there are many cooperative movements in infrastructure development. This annex discusses three initiatives in which Korea has been involved: (1) Great Tumen Initiative (GTI), (2) Northeast Asia Undersea Connection Initiative, and (3) Infrastructure Cooperation Projects between the Republic of Korea and the Democratic People’s Republic of Korea. Great Tumen Initiative (GTI) GTI is an intergovernmental consultative body in which Korea, China, the Russian Federation, and Mongolia are participating for regional cooperation. It started originally in 1992 as TRDP (Tumen River Development Program) under the auspices of the United Nations Development Programme (UNDP). Later in September 2005, TRDP strengthened its implementation system and changed its name as GTI by enlarging coverage of the region and installing a common fund. At the beginning, the Democratic People’s Republic of Korea also joined, but withdrew in 2009 in resistance to international sanctions following its second nuclear test. Important decisions at GTI are made by the Consultative Commission, which consists of member countries’ representatives at the vice minister level. GTI has contributed to the formation of a regular consultation table for regional cooperative issues in the East Asia region, including the exchange of views and information on infrastructure investment. After the Ninth Consultative Commission Meeting at Vladivostok in 2007, 12 projects were identified for promotion in the transportation, energy, tourism, trade, and environment sectors. Currently, however, financial resources to undertake big projects are not available. Therefore, basic research work is ongoing, such as transportation system and environmental effects evaluation. The current status of the projects is discussed below. 1. North East Asia (NEA) Ferry Project A shipping company, NEA Ferry, was established as a joint company comprising the Republic of Korea (Gangwon Province, Sokcho City, Bumhan Shipping), China (Hunchun City), Japan (Niigata City, North East Ferry), and Russia (Primoravtotrans). A test operation was made from July to September, 2009, but NEA gave up the business due to low demand for both passenger and freight, high visa fees from Russia, cumbersome entry procedures, and inconvenience at border checkpoints in Russia and China. Instead, the Sokcho‐Zarubino line by Korea’s Dongchun Shipping and Donghae‐Vladivostok line by DBS Cruise are in normal operation (Figure A2.1). Discussion is going on to make NEA Ferry’s

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business more competitive compared to other transportation means by lifting cumbersome entry procedure and decreasing relevant costs. Figure A2.1. Ferry Operations

* Dot Lines: currently stopped.

*Red Lines: in normal operation

2. Zarubino Port Modernization Project Zarubino Port has strategic importance due to its location at the contact point of three country borders: the Democratic People’s Republic of Korea, China, and Russia. The port is also very important for Mongolia and Manchuria to secure a transportation route to proceed to East Sea (Figure A2.2). In 2004, the Zarubino Port Authority announced a modernization plan, and an agreement was made in May 2008 between the Zarubino Port operator and a Russian railway company to invest more than US$100 million. In 2009, because the Russian railway company abrogated the agreement, GTI Secretariat contacted potential investors from the Republic of Korea and Germany. However, the chance of additional investment seems small because of the recent global financial crisis and a substantial decrease of freight due to Russia’s tariff increases. Figure A2.2 Zarubino Port

The Republic of Korea’s Infrastructure Development

3. Mongol‐China Railroad Project In November 2007, China, Mongolia, and Japan agreed to construct a railroad of 443 kilometers named the Orient Grand Passage connecting Choibalsan of Mongolia and Arxan of Inner Mongolia, China (Figure A2.3). A feasibility study is nearing completion. Japan’s motivation is related to importation of exploited mineral resources in East Mongolia such as coal, but there are still constraints to the use harbors of the Democratic People’s Republic of Korea and Russia on East Sea basin. Therefore, it is not easy to invite private capital for the project. In early 2010, China and Mongolia agreed to build Sino‐Mongolia railroad by 2020, but due to low marketability, implementation of the project is also in a difficult situation for financing. It is expected to take more time to solicit potential investors by securing marketability since development of mineral resources in Choibalsan region is now at an exploration stage. Figure A2.3. Mongol-China Railroad Project

4. Reopening of Hunchun‐Makhalino Railroad In February 2000, the Hunchun‐Makhalino Railroad opened to provide the shortest route to transport freights of Jilin Province to Russia’s East Sea harbors (Figure A2.4). However, in September 2004, travel on the route was closed stopped due to legal disputes between two railway companies of Russia. The companies were running a branch line and TSR connection, respectively, without a business agreement. The companies brought the case to the court and it will take some time to fully settle. In 2008, at a working‐level meeting between China

Okyu Kwon

and Russia, both countries agreed to build Makhlino station by 2010 and help to expedite resolution of disputes between the two Russian companies by signing a business agreement promptly. Figure A2.4. Hunchun-Makhalino Railroad

Notes: The gray dotted line is run by JSC Golden Link, a private railway company, from the Sino-Russia border to the Far East TSR branch. JSC Russian Railways owns the remaining portion as well as Makhlino station.

5. Utilization of Roads and Harbors of China at the Borders of China and the Democratic People’s Republic of Korea In 2008, the Democratic People’s Republic of Korea and China signed the Agreement on Motor Vehicle Transportation to jointly use roads and harbors on borders of the Democratic People’s Republic of Korea and China. the However, because the Democratic People’s Republic of Korea withdrew from GTI in 2009, this project became difficult to promote under the GTI framework. Instead, when Wen Jiabao, the Chinese premier, visited Pyongyang in October 2009, both governments agreed to give development rights of Rajin harbor to Qangli Group of China in return for construction of Hunchun‐Rajin road costing 3 billion yuan. China wanted to use this road transport mineral resources produced in Jilin and Heilungkiang provinces through Rajin and Chungjin harbors of the Democratic People’s Republic of Korea to the southern part of China. Haihua Group of China also acquired exclusive right to develop Chungjin harbor in return for $US10 million for repairing Tumen‐Chungjin railroad. Premier Wen Jiabao also

The Republic of Korea’s Infrastructure Development

promised to construct a new Yalu River bridge and Sinuiju‐Pyongyang express highway. Basically, infrastructure cooperation projects the Democratic People’s Republic of Korea and China were being promoted by local provinces of China. However, actual investments have not undertaken much because of poor demand forecast and high construction cost due to rough terrain. For example, in case of Rajin harbor, mass transportation would not be possible because large cranes could not be installed due to weak ground conditions of docks. In addition, electricity shortages and nonexistence of a distribution base mean it will take a long time to fully develop the harbor. In terms of freight forecast, rough mountainous road conditions between Hunchun and Rajin will limit operation of heavy duty trucks even though the roads are expanded and paved (see Figure A2.5) Figure A2.5. Satellite Picture of Hunchun-Rajin Road

Other GTI Projects under Promotion There are seven other projects in five sectors under the framework of GTI, which are as follows: 1. In the transportation sector, the Comprehensive Infrastructure Development Research Project is underway. This is to analyze bottlenecks in expanding physical interchange in GTI region and to suggest ways to overcome those bottlenecks on the basis of cost/benefit analysis. 2. In energy sector, two projects are being undertaken.  The GTI Energy Capacity Development Project: This is to minimize technical and institutional barriers that interfere with energy trade, to construct institutional structures for strengthening energy cooperation, and to provide training programs for bureaucrats of less developed countries.  The Construction of Energy DB in Northeast Asia Region and Publication of Statistics: This is to collect and provide basic data for energy cooperation in the region.

Okyu Kwon

3. In the tourism sector, the Construction of Tourism Capacity Project is ongoing. This is to study standardization of the issuance of tourism visas, to produce tourist guidebooks, and to develop diversified Mt. Baekdu tourism. 4. In the trade sector, the Training Program for Trade Facilitation is ongoing. This is to provide training programs for bureaucrats to advance customs clearance procedures. 5. In the Environmental sector, two projects are ongoing.  The Cross‐Border Environment Effects Analysis and Standardization of Environmental Standard: This is to evaluate environmental effects on the Tumen River border region and to standardize environmental standard in the Northeast Asia region.  The Feasibility Study on the Tumen River Water Resource Protection: This is to construct multilateral cooperation framework for environmental protection of the Tumen River region. Northeast Asia Undersea Connection Initiative Motivation The twenty‐first century is often referred to as the Era of Asia. Particularly, three countries in Northeast Asia, the Republic of Korea, China, and Japan, are at the center of global attention and make up one of the most dynamic regions of the world. It is estimated that as of 2010, the three countries account for one‐fourth of the world’s population, and for one‐fourth of the world’s economy with China ranking 2nd, Japan 3rd, and Korea 13th in terms of GDP. Some economic forecasts indicate that the three economies may even account for one‐third of the global economy in less than next two decades. While China has continued to see fast growth of around 9 percent per annum since 1990s, the division of labor in Northeast Asia centered on Japan is also facing a new phase. Major cities in the region are competing with each other to dominate finance, distribution, and other knowledge‐based services; therefore among these cities competitive as well as cooperative relations will be intensified. Considering rapidly increasing demand for transportation of passengers and freight in the region, it is an appropriate time to review the diversified comprehensive transportation network connecting China, Japan, and the Korean peninsula. In this regard, the Korean government is considering building undersea tunnels with China and Japan, as a key component of an envisioned integrated Northeast Asia transportation network. The Ministry of Land, Transportation, and Maritime Affairs of Korea commissioned the state‐sponsored Korea Transport Institute in 2009 to review the technical and economical feasibility of the projects. The results will be available soon. According to the proposal, three undersea tunnels for high‐speed trains and automobiles are currently being

The Republic of Korea’s Infrastructure Development

considered; the Mokpo‐Jeju (167 kilometers) section, Incheon‐Weihai (341 kilometers) section, and Busan‐Fukuoka (222.6 kilometers) section (Figure A2.6). Figure A2.6. Undersea Tunnels

Such projects were also mentioned in a plan prepared by the Korea’s Ministry of Land, Transportation, and Maritime Affairs to expand the country’s bullet train network by 2020, due to the increasing importance of so‐called mega‐ regions in the global economy. If three high‐speed trains—Korea’s KTX, China’s Hexiehao, and Japan’s Shinkansen—are connected to each other to form a Northeast Asia high‐speed train network, economic integration of the region could be accelerated. However, two major obstacles remain. The first is that the undersea tunnel projects should take at least 10–15 years to launch because such a project needs agreement with neighboring countries. (Discussions between local governments of the three countries have already started.) The other obstacle is the enormous cost of the projects. Each tunnel is likely to cost up to US$80 billion, which should be shared by relevant parties. Despite these obstacles, the undersea tunnels will be needed to handle future demands, and therefore they should be carried out as mid‐ to long‐term projects.

Okyu Kwon

Undersea Tunnel Connecting the Republic of Korea and China Considering uncertainty regarding the Democratic People’s Republic of Korea and the need to directly connect highly populated areas of the Republic Korea and China, it was proposed by Kyunggi Province to build an undersea tunnel connecting 374 kilometers between Weihai, China and Pyongtaek, the Republic of Korea. Currently China’s share in Korea’s export destination recorded around 25 percent and Korea’s share in China’s export destination 18 percent as of 2009. Within a decade, GDP size of China and the Republic of Korea is expected to be No. 1 and No. 10 respectively in the global economy. If the undersea tunnel is built, a high‐speed train will take 1 hour and 15 minutes from Seoul to Weihai, 4 hours to Beijing, and 5 hours to Shanghi, which will be competitive compared to travelling by air. Undersea Tunnel Connecting the Republic of Korea and Japan Compared to the recently evolved Korea‐China Undersea tunnel project, this project idea was conceived long ago during the Japanese occupation at the turn of the twentieth century. Studies on the tunnel have been initiated mostly by private sector organizations such as the Korea‐Japan Tunnel Project Association in Busan and the Japan‐Korea Tunnel Research Institute in Tokyo, both of which are nonprofit organizations. Now, government support seems to be gaining pace, particularly in light of the role the tunnel is expected to play in accelerating travel and business exchanges. At the Summit meeting held in April 2008, the leaders of Korea and Japan agreed to undertake a joint study to prepare for vision of a new era of cooperation between their countries, which includes this undersea tunnel project. According to the study, if constructed, the Korea‐Japan undersea tunnel would be 235 kilometers in length, linking Busan to Geoje Island to Japan’s Tsushima Island to Ikido and then to Kyushu. This tunnel would be four times longer than the 50 kilometer Channel Tunnel linking England and France and the 53.9 kilometer Seikan Tunnel in northern Japan. That means it would be the longest undersea tunnel in the world. The tunnel will stimulate business, ease tensions, and promote political stability in East Asia. For example, Busan and its sister city Fukuoka could promote various projects to create a common economic zone. However, the project also faces many hurdles before it can become a reality. Engineering and cost concerns are major hindrances. Construction costs are projected at around US$60–80 billion and the project would take 7 to 10 years to construct.

The Republic of Korea’s Infrastructure Development

Infrastructure Cooperation Projects between the Republic of Korea and the Democratic People’s Republic of Korea Road and Railroad Connection Projects Two projects across the DMZ to connect the Republic of Korea and the Democratic People’s Republic of Korea were completed based on the Basic Agreement on Motor Vehicle and Train Operation between South and North effective as of August 1, 2005. One project is on the western part of Korean peninsula to connect 27.3 kilometers of railroad between Munsan and Gaesung and 12.1 kilometers of road between Tongil Bridge and Gaesung Industrial Site, both of which are to support factories in Gaesung Industrial Site. The other project is on the East Sea coast to connect 25.5 kilometers of railroad and 24.2 kilometers of road, both of which are to support tourists visiting Diamond Mountain. All the costs were borne by the Republic of Korea, except labor cost for the construction in of the part in the Democratic People’s Republic of Korea. The future of infrastructure cooperation projects across the DMZ is so dim because the military of the Democratic People’s Republic of Korea is strongly resist to developing any infrastructure behind their back at DMZ. In addition, the infrastructure of the North is so rugged that it will require tremendous amounts of money to modernize. Uncertainty is preventing investment the Republic of Korea, since any additional investment in the North may become a hostage in case tension increases with the South. A very cautious approach is inevitable. As a result, despite the 2008 Korea‐Russia Summit meeting, which agreed to cooperate on railroad connections between the Korean peninsula and TKR and TSR, nothing has been achieved up to now. Gaesung Industrial Site Construction Plans have been made to develop 6.6 million square meters at Gaesung. The first phase of construction—3.3 million square meters—was completed in 2007. Currently, more than 200 firms from the Democratic People’s Republic of Korea are operating their businesses and total investment has reached US$0.9 billion. The number of Northern workers at the site is around 45 thousand. However, this project also faces difficulties in future expansion due to recent, increasing uncertainties.

Okyu Kwon

Concluding Remarks Potential for regional cooperation in Northeast Asia is vast considering the fact that the region’s weight in the global economy is rapidly increasing. To this purpose, geopolitical stability should be regained first to materialize such a huge potential.

The Republic of Korea’s Infrastructure Development

nfrastructure development plays a crucial role in economic growth, poverty alleviation, and enhancing the competitiveness of developing countries. However, existing infrastructure in many developing countries is inadequate, and more infrastructure investment is urgently needed. The problem is particularly acute in Africaâ&#x20AC;&#x2122;s developing economies, which continue to lag far behind in areas such as telecommunications, electricity, roads, and sanitation. As a result, potential growth as well as the delivery of basic services has been substantially limited. This paper introduces the Republic of Koreaâ&#x20AC;&#x2122;s experiences in infrastructure development, which have successfully supported economic development. Lessons learned from Koreaâ&#x20AC;&#x2122;s experiences during the second half of the twentieth century can be shared with the developing economies of Africa. Okyu Kwon is Visiting Professor, the Graduate School of Finance and Accounting, KAIST, Seoul, the Republic of Korea. Previously Dr. Kwon held the posts of the Deputy Prime Minister and Minister of Finance and Economy, the Republic of Korea. The Growth Dialogue is a network of senior policy makers, advisors, and academics. The participants aim to generate a sustained stream of views and advice on policies that complements existing, established sources of opinion; to be an independent voice on economic growth; and to be a platform for policy dialogue among those entrusted with producing growth in developing and emerging market economies.

http://www.growthdialogue.org/ info@growthdialogue.org

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ÂŠ 2012 The Growth Dialogue 2201 G Street NW Washington, DC 20052 Telephone: (202) 994 8122 Internet: www.growthdialogue.org E mail: info@growthdialogue.org All rights reserved 1 2 3 4 15 14 13 12 The Growth Dialogue is sponsored by the following organizations: Canadian International Development Agency (CIDA) UK Department for International Development (DFID) Korea Development Institute (KDI) Government of Sweden The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the sponsoring organizations or the governments they represent. The sponsoring organizations do not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the sponsoring organizations concerning the legal status of any territory or the endorsement or acceptance of such boundaries. All queries on rights and licenses, including subsidiary rights, should be addressed to The Growth Dialogue, 2201 G Street NW, Washington, DC 20052 USA; phone: (202) 994 8122; e mail: info@growthdialogue.org; fax: (202) 994 8289. Cover design: Michael Alwan

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

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About the Author Shahid Yusuf is Chief Economist, the Growth Dialogue. Dr. Yusuf brings many decades of economic development experience to the Dialogue, having been intensively involved with the growth policies of many of the most successful East Asian economies during key periods of their histories. Dr. Yusuf has written extensively on development issues, with a special focus on East Asia and has also published widely in various academic journals. He has authored or edited 24 books on industrial and urban development, innovation systems, and tertiary education. His five most recent books are: Development Economics through the Decades (2009); Tiger Economies under Threat (co authored with Kaoru Nabeshima, 2009); Two Dragonheads: Contrasting Development Paths for Beijing and Shanghai (co authored with Kaoru Nabeshima, 2010); Changing the Industrial Geography in Asia: The Impact of China and India (co authored with Kaoru Nabeshima, 2010); and China Urbanizes (co edited with Tony Saich, 2008). Dr. Yusuf holds a PhD in Economics from Harvard University and a BA in Economics from Cambridge University. He joined the World Bank in 1974 as a Young Professional and while at the Bank spent more than 35 years tackling issues confronting developing countries. During his tenure at the World Bank, Dr. Yusuf was the team leader for the World Bank Japan project on East Asia’s Future Economy from 2000–09. He was the Director of the World Development Report 1999/2000: Entering the 21st Century. Prior to that, he was Economic Adviser to the Senior Vice President and Chief Economist (1997–98), Lead Economist for the East Africa Department (1995–97), and Lead Economist for the China and Mongolia Department (1989– 1993). Dr. Yusuf lives in Washington, DC and consults with the World Bank and with other organizations.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

Abstract A scientific and industrial revolution accelerated growth rates in a handful of Western countries starting in the nineteenth century. By the early twentieth century, growth rates had begun rising in Asian, Latin American, and Eastern European economies as well. With the end of WWII and the subsequent decolonization, rapid growth spread to late starting developing nations. As a result of this history, a growth ideology has become firmly entrenched. Initially it was buttressed by the contest between capitalist and socialist systems during the Cold War era. Since the 1980s, the quest for growth has been reinforced by globalization, by the â&#x20AC;&#x153;war on povertyâ&#x20AC;? as championed by the international financial institutions, and by a wealth of theorizing and empirical research. The latter effort has singled out productivity as the primary source of long term growth and advances in technology, broadly defined, as the driver of productivity. Now, policy makers are demanding more from growth than a mere increase in GDP, even as the potential contribution of industrialization is diminishing. Growth economics is struggling to expand the toolkit and enlarge the menu of practical policy options. Capital investment embodying advances in technology remains crucial, albeit difficult to manipulate. Investment in high quality human capital promises large dividends via innovation and efficiency gains, but raising the quality of education and the volume of commercial innovation by dint of policy is a struggle. Institutional reforms that harness the full power of market forces, tempered by regulation, continue to offer somewhat elusive hope. Growth economics remains a vital subdiscipline and the concepts of sustainability, inclusiveness, and greening are challenging researchers. But with the refinement of theory and practice proceeding at a homeopathic pace, relevance is at risk. There is an urgent need for disruptive innovation to give new direction to theorizing and policy.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

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Growth Economics and Policies: A Fifty Year Verdict and a Look Ahead Shahid Yusuf Our forefathers struggled to maintain living standards from one generation to the next. Only the privileged or lucky few saw their incomes rise steadily year after year. Constructing a time series for worldwide per capita incomes going far back in time is a stretch. However, Angus Maddison (2008) did undertake this herculean task and we are fortunate to have his educated guesstimates extending back to the dawn of the Common Era. At the time when the Roman and Han Empires were in full flower, per capita GDP of a population numbering about 226 million was US$467 in 1990 dollars. A thousand years later, the world’s population had risen by a few tens of millions (to 267 million) but per capita incomes were almost unchanged. By 1500, incomes had crept to US$567 for a population numbering 378 million and after another 300 years, with numbers having more than doubled, per capita GDP had inched up by only US$100. China and India, the two largest economies at the beginning of the nineteenth century, had per capita incomes close to the world average while people in Western Europe enjoyed incomes of over US$1,200. It is around this time that the Great Divergence begins to emerge, with the industrial revolution ushering in “modern economic growth” in some West European countries and later the United States. By the mid nineteenth century, the tempo of growth was quickened by the embrace of industrialization by Western countries, continuing advances in scientific knowledge and a broad spectrum of technologies, and institutional changes. On the eve of the Great War, Western Europe and its “offshoots” had far outpaced the rest of the world with per capita incomes of US$3,500 and US$5,200 respectively as against US$658 in Asia (excluding Japan). The unending economic growth we now take for granted1 surfaced in the latter half of the nineteenth century and although economic progress was interrupted by cyclical downswings,2 it was around this time that Europe and the Americas 1

Classical economics (that of Smith, Malthus, Marx, Mill, and Ricardo) concluded that growth, if it occurred, would be temporary, with economies tending to revert to a stationary/steady state if perturbed. 2 The National Bureau of Economic Research has tracked business cycles in the United States dating back to 1854 (see http://www.nber.org/cycles.html). Many downswings were severe and painful but they came to be viewed as the inevitable lot of capitalist economic systems. Such tolerance is much less in evidence in the post WWII period.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

decisively broke with the relative economic stagnation of past centuries and established new benchmarks. Between 1870 and 1939, the United States and the United Kingdom averaged unprecedented growth rates of 3.3 percent and 1.9 percent respectively. Several European countries achieved comparable rates of growth and late in the nineteenth century, Argentina and Brazil were also beginning to catch up.3 Starting in the early 1950s, something even more remarkable happened. Not only did the United States and the United Kingdom maintain their earlier momentum,4 but also, within a decade, economic growth had emerged as a key objective of the vast majority of nations. With Germany leading the way in Europe and Japan in East Asia, economies recovering from the devastation caused by war accelerated to growth rates of 5 percent and higher in the 1950s and these were joined by a number of newly independent colonies in the 1960s.5 Very soon, an extended past during which growth was slow if it occurred at all became a distant memory and a “new normal” took root. It could hardly be otherwise in the light of the vertiginous growth of per capita incomes worldwide: incomes that had grown just 18 percent between 1500 and 1820 increased by 750 percent from the beginning of the nineteenth century to the start of the twenty first century.6 The impact of accelerating economic growth on poverty in the face of a spiraling global population has been nothing short of dramatic: between 1981 and 2008, the number of people living on less than US$1.25 a day declined from 1.94 billion to 1.29 billion and the decline continued through 2010, with the reduction being greatest in Asia because of the performance of the Chinese and Indian economies.7 As the global economy recovers from the financial crisis of 2007–08 and struggles with the smoldering eurozone crisis, two questions are uppermost for policy makers: (i) whether and how industrialized and industrializing countries might be able to restore the robust performance of the 1993–2007 period (minus the bubbles),8 and (ii) the contribution that growth economics could make to the 3

Maddison (2010). In fact, the mobilization of resources for the war effort was tonic for economies recovering from lasting effects of the Great Depression and subsequent, somewhat ill considered, fiscal actions (in the United States) to narrow public sector deficits. 5 One of the earliest accounts of the recovery of the European economies is by Kindelberger (1967). 6 See Ventura (2005). According to Zilibotti (2007), the population weighted growth rate in the second half of the twentieth century alone was 2.9 percent per year. This growth has been paralleled by a lengthening (and an international convergence) of life expectancy and, at least in the advanced countries, an increase in the fraction of individual lifetimes devoted to learning, together with a decline in the fraction devoted to working. 7 World Bank (2012). 8 This period is viewed as a second golden age (the 1960s was the first), even though it was punctuated by the East Asian economic crisis of 1997–98, which severely imperiled some of the highest fliers, and by the dot com bust of 2000–01, which punctured visions of a high growth, low inflation “new economy” propelled by IT based innovations. 4

Shahid Yusuf

policy agenda. Most developing and middle income countries continue to envisage growth rates averaging 6–8 percent. They are convinced that the extraordinary performance of a handful of countries9 during the past quarter century can be replicated by the many in the decades ahead.10 The purpose of this paper is to study how thinking on growth has evolved since the 1950s11 through the interplay of international politics, country level experience, and theorizing almost exclusively conducted in Western countries. The paper reflects on how this body of thinking has diffused through a variety of channels and influenced policies in virtually all developing countries. Finally, the paper considers whether—following the financial crisis and the unsettled circumstances in the first decade of the twenty first century—economic research based on the experience of a few countries, over a limited period of time, can provide relevant and effective policy guidance. The paper is divided into three parts. Part 1 examines the experience of the early postwar decades and the worldwide spread of a “growth ideology” that marked a shift from the prewar beliefs and experiences of the majority of nations. Part 2 discusses economic theory and empirical findings underlying the new growth ideology from the 1960s onwards. Part 3 reflects on the policy prescriptions to be garnered from growth economics. It also briefly examines how thinking on development is responding to the financial crisis, worries about an income trap in middle income countries, notes a resurgent interest in industrial policies, and asks questions regarding the future contribution of innovation to growth and its greening.

1. Industrialization and Growth: The New Normal Western Europe and North America were long the center of economic growth. However, Jeffrey Williamson (2011) notes that economic change was accelerating in a number of countries on the periphery starting in the last quarter of the nineteenth century. Russia, Japan, Mexico, Argentina, and Chile all began building industrial capacity at a pace exceeding that of countries at the core; industrial growth in these countries averaged between 4 and 6 percent as against the 3.5 percent average of the United States, the United Kingdom, and Germany. After 1920, these early developers from the periphery were joined by several 9

The Commission on Growth and Development (2010) identified 13 countries that averaged growth rates of 7 percent or more per year between 1960 and 2002. 10 Hope springs eternal; however, Acemoglu (2012, p. 5) points out that the gap between countries in the 90th percentile and the 10th percentile as well as those in the 75th and the 25th percentile has widened. The ratio between the 90th and the 10th percentile was less than 9 early in the twentieth century and over 30 towards the end of the century. 11 Seminal papers on growth by Roy Harrod and Evsey Domar were written in 1939 and 1946, respectively. These were in the Keynesian vein and compared the stability of growth paths.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

Southern European countries such as Italy and Greece, by Brazil and Peru, by Poland and Turkey, and by colonial Korea; Taiwan, China; and Manchuria. Countries enjoying political autonomy followed the lead of the pioneers and industrialized faster with some of the colonized East Asian nations close behind. Starting in the 1950s, with postwar recovery and decolonization in full swing, industrialization moved into higher gear. Williamson (2011) estimates that industrial growth in the periphery rose to 7.9 percent between 1950 and 1975. “Industrialization in the poor periphery was ubiquitous. In every region, many others joined the previous, precocious industrial leaders. In short, the rate of industrial catching up surged in the post war quarter century and it also spread from the emerging leaders to regional followers” (Williamson 2011, pp. 11–12). Many factors contributed to this surge. For example, the transport revolution and cheap energy lowered costs, which stimulated trade and helped diffuse industrial production to the periphery. In addition, changing terms of trade favoring manufactures encouraged local production, and greater readiness to use tariff and exchange rate policies to protect domestic production boosted import substituting industrialization.12 Perhaps most significant was the germination of a growth ideology among national elites, who had become increasingly aware of enhanced economic opportunities and eager to secure material prosperity comparable to what they saw in the West. In the grip of this new fervor, developing countries began planning for rapid growth. They took their cues from the leading Western economies and also drew lessons from “compressed development”13 achieved by the former Soviet Union, Japan, and China. These three relatively late starting countries were rebuilding their economies with remarkable speed and reentering an arc of development predating WWII. Developing countries could benefit—as Alexander Gerschenkron (1962) showed—from the advantages of backwardness by introducing institutional innovations that could ease or unlock key constraints. There were huge productivity gains to be realized from adopting new and codified agricultural and industrial technologies and from the transfer of resources from the rural sector to industry and services in urban centers.14 The nascent growth ideology of national elites was powerfully reinforced by the ideologies of the great powers that defined the political economy of international development throughout the more than three decade long Cold 12

The use of tariff protection to promote domestic industrialization mirrored the policies adopted by the United States and Germany in the nineteenth and the first half of the twentieth centuries. Chang (2002) observes that the United States was the most protectionist nation from the time of the Civil War until the eve of WWII. 13 This is a term used by Whitaker and others (2008) to describe development in East Asia bringing out the role of the state and of links with global value chains. 14 Gerschenkron’s ideas are echoed in Justin Lin’s analysis of the emerging economies—and China in particular—over the past 30 years (Lin, 2011). See also Mathews (2006) on the potential advantages enjoyed by latecomers.

Shahid Yusuf

War.15 Michael Latham (2003, p. 9) observes “though American visions of the true and only heaven differed from Soviet visions of the ‘end of history’, both models stressed the ability of enlightened elites to accelerate an inevitable, universal movement through historical stages and posited that technological diffusion would engender a new consciousness and a new society.” Both sides worked tirelessly using every instrument and channel they could mobilize to create, through the agency of local technocratic elites, a new economic order in their often contested spheres of influence. America and its allies attempted to promote modernization and material prosperity within a capitalist framework, sometimes with the trappings of democracy,16 whereas the countries of the communist bloc pursued broadly similar international policy objectives within a Leninist framework. And both sides used virtually identical means to achieve desired geopolitical and economic outcomes: foreign aid, power projection and arm twisting, technical assistance, training programs, arming of militaries, soft power, and, not infrequently, proxy wars to prop up favored regimes (some of which persisted for years, making life nastier and more brutish for millions).17 Econometrically sharpened hindsight shows that aid in pursuit of geopolitical objectives contributed little to investment, growth, or poverty reduction.18 However, it cemented alliances with ruling elites19 and trained the focus on modernization and development and through technology transfers hard as well as soft, kept growth at the center of policy attention and the preferred yardstick for measuring economic progress. Post war thinking was influenced by the efficacy of state economic control during WWII and the embracing of Keynesian policies following the Great Depression to help smooth business cycle fluctuations or at least reduce their amplitude. These policies reinforced other trends and measures contributing to the acceleration in growth rates. However, they also slowly gave rise to a perception that the business cycle had been largely tamed (some argued by a deepening of market institutions and increasing market/price flexibility). The belief was that policy makers had the tools to sustain economic activity at high 15 The term was coined by George Orwell and first used in 1947 by Bernard Baruch to describe the tensions that erupted between the Soviet Union and the Western powers shortly after the end of WWII. 16 America supported European integration starting in the 1950s because it believed that this would raise growth rates, strengthen democracy, and neutralize communist influence. 17 Hironaka (2005) describes some of these never ending wars in postcolonial states. 18 A large literature on the relationship between aid and growth comes to at best inconclusive findings. Aid (including military assistance) did not cause growth and may on balance have supported predatory elites who through their rent seeking activities were (and are) a brake on growth. See Doucouliagos and Paldam (2006, 2009); Easterly (2006); Roodman (2007). Nevertheless, the more than US$16 billion of aid provided to the Republic of Korea by the United States and its allies contributed to technology transfer, as well as to the stabilization and development of that country, and helped ward of the threat from the Democratic People’s Republic of Korea. 19 In the process, aid seems to have increased inequality in recipient countries. See Herzer and Nunnenkamp (2012).

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

levels or, in other words, to minimize the threat of prolonged downturns that eroded past gains. As result of these policies and beliefs, the role of the state, already greatly enlarged during the course of the long war, was steadily augmented, and the state acquired the responsibility to strive after and maintain rapid growth. The emergence of a large and initially economically successful Communist Bloc (and active economic proselytizing by the countries of the Bloc) contributed to a widespread belief in the augmented role of the state. Fiscal policy, including direct public sector intervention, was seen as a way to promote private initiative and industrialization. State guided capitalism received a strong endorsement from the performance of the Republic of Korea; Taiwan, China; Singapore; Malaysia; and Thailand and it provided other developing economies with both inspiration and a proven model at least through the early 1990s.20 The performance of the Chinese economy, once market oriented reforms were introduced in the early 1980s, further underscored the advantages of market institutions tempered by state control and an outward orientation to harness the power of globalization. The growth expectations that took root during the halcyon 1960s proved to be remarkably durable. Europe endured a long spell of stagnation during the 1970s and growth was slow also in the United States through the early 1980s. Latin America, after an initial surge, lost ground starting in the 1980s and suffered from “lost decades.” China was hobbled first by the havoc caused by the Great Leap in 1958–60 and, after a short spell of recovery in the first half of the 1960s, by more than 10 years of disruption resulting from the Cultural Revolution that Mao choreographed in 1966. By the mid 1970s, Africa had entered a long economic twilight that persisted for over two decades, and India remained on the treadmill of the “Hindu growth rate” until the onset of reforms in the early 1990s.21 Only the “tiger economies” in East Asia defied gravity and exploited international market opportunities to grow their economies at high speed with the help of investment in industry and buoyant exports. The gloom lifted in the 1990s, arguably because of four main developments: (i) accelerating globalization assisted by the lowering of trade barriers;22 (ii) the stripping away of capital controls and declining transport costs; (iii) the tonic effects of general purpose technologies (GPTs)23 that released a flood of innovations; and (iv) the spread of regulatory reforms to weed out market 20

State guided capitalism in the Republic of Korea and Taiwan, China was the subject of two well known publications by Wade (1990) and Amsden (1989). A sampling of the voluminous literature on industrial policy is summarized in Yusuf (2011). 21 In the Indian case, the first steps towards deregulation in the 1980s had already begun raising growth rates, but the release from the prolonged stagnation took place in the 1990s. 22 The landmark Uruguay Round of trade negotiations was successfully concluded in 1994. 23 Semiconductors (and microprocessors), which are key components of information and communication technologies, and the Internet are two GPTs that have served as the drivers of innovation since the mid 1980s. See Bresnahan and Trajtenberg (1995); Jorgenson, Ho, and Stiroh (2011).

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distortions that stifled competition,24 caused inefficiency, and promoted rent seeking. The neoliberal argument for enlarging the role of markets and reining in the activities of the state25 received a boost first from the collapse of the former Soviet Union and the discrediting of the socialist planned approach to development, and then, more convincingly, from the surge in global economic activity. Could the growth ideology have become so all pervasive absent the parallel rise of growth economics? This is difficult to answer because growth and development have become inextricably linked and growth is widely accepted as the touchstone of performance. However, it is fair to say that the rise and teaching of neoclassical growth economics in leading Western universities from the mid 1950s did much to build the analytic and empirical scaffolding to support the idea that a steady state growth path26 was theoretically feasible and was being demonstrated in practice by a number of countries. After a slow start, growth modeling exploded in the 1960s as economists became more accustomed to using mathematics and began elaborating the “science of growth” in conscious imitation of the methodologies of the hard sciences.27 As national income data accumulated, especially on the United States, theoretical models were put to the test and the growth industry was born providing much needed intellectual underpinnings for the growth ideology and a few conceptual tools for policy makers wanting to translate political promises into tangible economic results. Sections 2 and 3 of this paper discuss how economics accounts for growth, but before getting to that it is worth listing a number of other reasons for the popularity of the growth ideology and why it has survived and will continue to survive setbacks and disappointments. Growth as a Belief System The growth “ideology” has permeated the discourse on development and proven compelling for good and bad performers alike for several reasons. First, the growth rate for the global economy between 1950 and 1999 averaged 4 percent per year, well in excess of pre 1850 levels. Moreover, there is the demonstration effect generated by highly successful performers, however small they might be— and Singapore; Hong Kong SAR, China; Taiwan, China; and the Republic of 24

This was a time when concerns about state failure were making deep inroads into thinking in the United States, spurred by the ideas emanating from the Chicago School and the activities of increasingly influential neoliberal and libertarian think tanks (Backhouse 2010). 25 This was enshrined in the “Washington Consensus,” first tabled by John Williamson in 1989. 26 An early collection of essays by Nobel Prize winner Edmund Phelps (1967) offered a foretaste of the esoterica to come. Another example is Chakravarty (1969), lavishly praised in a Foreword by Paul Samuelson, who urged countries to stay “indefinitely near the turnpike (path)” when embarked “on a sufficiently long journey” (p. xii) See also the work of Bardhan (1970) and Arrow and Kurz (1970). 27 The calculus of variations and optimal control theory became a favorite tool of some instructors teaching courses in development economics in leading American universities.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

Korea were small economies in the 1970s and 1980s. These resource poor countries on the periphery showed that steady progress from the lowest rung to near the top of the income ladder was possible in as little as four decades through technological catching up and the patient building of human and physical capital largely from internal resources. Growth was achieved not through the virtuosity of policy but through macroeconomic and political stability, successful efforts at resource mobilization, learning and absorbing technologies from abroad, and the exploiting of market opportunities opened up by globalization. The early and later “tigers” served as a beacon of hope for the majority of economies that have struggled with low or negative growth rates. Had the tigers not materialized, it is doubtful that the growth ideology could have acquired such a loyal following. No amount of modeling can substitute for 7 percent rates of growth sustained for three decades. Second, perhaps one can claim with little exaggeration (witness the concerns expressed in the United States circa 2012) that in democracies and autocracies alike, political legitimacy of governments has come to hinge on the delivery of good economic results over the medium term. If incomes stagnate and become more unequal or employment is hard to come by, democracies will show governments the door. The Arab Spring uprisings have demonstrated that populations can eventually become restive even in tightly policed autocracies. Rightly or wrongly, the notion that governments must deliver growth (or steady gains in welfare that in time come to be widely shared28) has acquired worldwide currency29—and politicians have had a large hand in embedding it more firmly through the promises they make as they seek office. Rightly or wrongly, it is becoming conventional wisdom that some degree of international convergence of consumption standards is a viable objective, given the relative performance of developed and developing countries during the past decade.30 Third, a number of developments over the past 50 years have rendered growth more urgent and made it harder to think of a world without growth. Population increase is a critical concern for a number of countries and, even as it slows, they will still have to convert a youth bulge into a youth dividend. Slow growth will have enormous economic and consequences (already apparent in the Middle East and South Asia) not only for countries saddled with high rates of unemployment but also for others if mass unemployment leads to an upsurge in international migrations. A related factor is the promises many governments— 28

Worsening inequality can be politically corrosive and a threat to democratic and capitalist institutions. However, in many countries, advanced and others, inequality continues rising inexorably. See the discussion below. 29 GDP growth as measure of welfare gain is frequently challenged but has yet to be dethroned by an equally compact, easy to compute, and compelling indicator. See Stiglitz, Sen, and Fitoussi (2010). 30 Rodrik (2011) doubts that such convergence will easily materialize except in the case of a few countries.

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and the international community—have made (and will continue to make) to reduce if not eliminate poverty and more guardedly, inequality. The evidence suggests that countries (such as China) that have successfully tackled poverty have relied upon high rates of growth, which generate jobs, finance social safety nets, and enable governments to provide the poor with services that will equip them with capabilities.31 The commitment to reduce poverty, staunchly backed by international financial institutions (IFIs) and nongovernmental organizations (NGOs), is supported by vast, international, bureaucratic machinery; but to deliver results, foreign assistance alone will not do. Countries saddled with large poverty burdens must grow. A return to nineteenth century rates of growth would be intolerable. Hence out of necessity, all parties must hold tight to the growth ideology and hope for the best. Increasing resource and energy scarcities, climate change, and environmental degradation demand an urgent greening of growth. Although debate continues on the advantages of early and precautionary action, the weight of evidence points increasingly to net growth benefits of green policies and green technologies.32 The evidence also suggests that 2–3 degrees of warming is becoming unavoidable, a development that will entail costly mitigating efforts in the future, in particular to increase the resilience of cities. In anticipation of a harsher environment, countries need to build their resource bases, because it is the wealthier countries that are far better able to weather shocks and to repair the damage. These three developments increase the pressure on governments to assign priority to growth because there can be no doubt that each will require large investments of capital and advances in technological capabilities—all associated with success at growing GDP. Fourth—and there are other factors I will not list—industrialized and industrializing countries are ageing and faced with a shrinkage of the workforce a decade or two into the future. A number of economies are weighed down with large debts and even larger contingent liabilities, which will be difficult to pay down or accommodate without fairly robust growth.33 Therefore, for fiscal and welfare reason at the very least, a resumption of “adequate” growth rates in these countries is vital if they are to maintain or improve on their current living standards. Stagnating economies will face enormous difficulties. In fact, there is no alternative but to aim for the highest rates of growth a country can potentially achieve. The above sketches the emergence and 60 year dominance of the growth ideology. But while average growth rates are handily above the levels reached prior to the mid nineteenth century for many countries, sustaining growth rates 31

The capabilities approach is associated with Amartya Sen (1985) and his co authors—for example, Martha Nussbaum. See http://www.iep.utm.edu/sen cap/; http://plato.stanford.edu/entries/capability approach/; http://ndpr.nd.edu/news/26146 creating capabilities the human development approach 2/. 32 See Hallegatte and others (2012). 33 Unless of course, the long term healthcare, pension, and social benefits can be pared or revoked.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

of 7 percent or more has proven difficult and this confronts growth economics with a severe challenge: to convincingly explain sustained growth accelerations34 and with the benefit of such analyses arrive at policy recommendations tailored to individual country circumstances that will enable others to replicate what thus far has been the lot of a favored few. Economists have responded to the social and political demand for policy measures—and the need to build professional reputations by constructing sophisticated models and testing myriad hypotheses. However, as indicated below, analytic complexity and empirical rigor, while admirable, have yielded meager results by way of policies that are both specific to country needs and effective. As Arrow (1962) observed, “the math has taken on a life of its own,” and the furious productivity of growth economists has still to yield convincing evidence of its policy relevance.

2. Growth: Supply Push and Demand Pulled The literature on growth is forbiddingly large and the expanding international army of researchers guarantees an endless stream of additions. The two volumes of the Handbook of Economic Growth provide a sense of the scope and richness of the research.35 These were published in 2005 and much new material has appeared since then. Capturing the many sidedness of this literature in a few pages is impossible. However, mercifully, the central threads and stylized facts are few and they have changed little over time—and there is nothing to suggest that the next 10,000 papers will add or subtract much from what we already know. Growth can be viewed from two angles and because this is economics, they are supply and demand. In a contribution to the debate on capital theory that raged between the two Cambridge schools,36 Paul Samuelson (1966, p. 444) ringingly announced that “until the laws of thermodynamics are repealed, I will continue to relate outputs to inputs—i.e. to believe in production functions.” And factor inputs have remained the drivers of growth in the supply side version of growth economics. Demand provides a complementary perspective. Whether or not supply materializes is a function of demand for outputs. If demand is weak, as it is in recessions, investment diminishes, production slackens, workers are not hired, and some of those employed are laid off. The unemployed cut back their consumption, which further sours the expectations of 34

Empirically tracked by Hausmann, Pritchett, and Rodrik (2005). See Aghion and Durlauf (2005). These are volumes 1A and 1B. Volume 2 is to come. 36 The controversy swirled around the aggregation of goods and services into a factor of production to be plugged into a production function yielding a marginal product that determines the distribution of income. The controversy was captained by Joan Robinson and Paul Samuelson from Cambridge University, United Kingdom and Cambridge University, United States, respectively. See Harcourt (1972) and, more recently, Cohen and Harcourt (2003). 35

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investors. In the absence of reflationary, state initiated macro policies (as Keynesians advocate), this leads to a tightening vicious spiral. Economic growth slows with potentially long lasting consequences. Market fundamentalists, unlike Keynesians,37 are of the view that business cycles caused by market forces leave trend rates of growth mostly unchanged. They suggest that so long as markets are left to do their work (that is, the state stays on the sidelines), the demand side of growth can be ignored. But not all agree that demand management is irrelevant from the standpoint of long run growth or that a “night watchman” state should be the twenty first century ideal. The Reign of Capital followed by Total Factor Productivity In the beginning, when the Harrod Domar model was the workhorse of growth economics, only capital and labor mattered. These were the two basic factors whose entry into the production function caused growth, depending on a combination determined by technological relationships. In a Harrod Domar world, if the supply of labor was elastic, then growth was paced by the supply of capital. Countries mobilizing a large volume of capital through domestic savings, supplemented by investible resources from abroad, could grow faster. This relationship helped to explain the performance of the communist countries that sacrificed consumption in order to build productive capacity. The dominance of capital lasted until the middle of the 1950s, when papers by Trevor Swan (1956) and more famously by Solow (1956, 1957), revolutionized thinking on the sources of growth. These papers showed that as much as 70 percent of the growth in the United States could not be traced to factor inputs but instead was caused by a residual, including technology and other intangibles.38 By singling out technological change as a key factor, Solow (and others such as Abramovitz39) highlighted the role that knowledge had come to play since the dawn of the Industrial Revolution. Prior to that, “even the best and the brightest mechanics, farmers and chemists—to pick three examples—knew relatively little about the fields of knowledge they sought to apply. The pre 1750 world … made many path breaking inventions. But it was a world of engineering without mechanics, iron making without metallurgy, farming without soil science, mining without geology, water power without hydraulics, dye making without organic chemistry and medical practice without microbiology and immunology. Not 37

Sometimes the two opposing groups are divided into the “freshwater” school of market fundamentalists and believers in real business cycles (such as Robert Lucas from Chicago and Thomas Sargent, formerly from Minnesota) and the “saltwater” school of neo and post Keynesian theory (including most notably, Paul Krugman and Larry Summers), many from the East coast and some from the West coast. See http://seekingalpha.com/article/306991 paul krugman and the saltwater economists predictions. 38 Kuznets (1966) recognized the importance of capital saving innovations and investment in education and the development of skills. 39 For Abramovitz (1993), technology accounted for only a part of the coefficient of ignorance or the residual.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

enough was known to generate sustained growth based on technological change (Mokyr 2005, p. 1,119). Solow’s findings were subsequently validated by others, and triggered theoretical and empirical research to track down the “quarks” that inhabit the residual—or total factor productivity (TFP) as it has come to be known.40 This quest is now in its sixth decade and although a multitude of suspects have been identified, a theory that convincingly accounts for the residual/TFP, lays bare its dynamics, and points unequivocally to effective policies has proven elusive. Researchers attempting to explain the differences in performance among countries have marshaled scores of so called fundamental variables including geography, entrepreneurship, financial deepening, religion, ethnic fractionalization, and natural resources.41 But after examining the explanatory robustness of the leading candidate growth theories, Durlauf, Kourtellos, and Tan (2008, p. 344)42 are forced to conclude that there is a lack of “strong evidence that any of the new growth theories are robust direct determinants of growth when we account for model uncertainty…. [However,] variation in growth rates across countries are more robustly explained by differences in macroeconomic polices and unknown heterogeneity associated with regional groupings.” Recent attempts at estimating TFP for a large number of countries range from a quarter of growth to over two thirds, with the average falling somewhere in the 50 percent range.43 Over the longer term, the consensus is that growth of GDP and divergences in per capita GDP will be closely tied to individual country performance with regard to productivity. Moreover, Solow’s initial intuition that the explanation for the residual was to be found in technology grounded in the accretion of knowledge has come to be widely accepted. Technological change and innovation (some embodied in new equipment) are seen as the mainsprings of productivity growth. Underlying these is a learning and innovation system that produces human capital and determines its quality; helps to absorb technology and refines it through incremental innovations; generates ideas, some of which are translated into commercial innovations; and through the agency of greater technical, vocational, managerial, and organizational skills, brings about gains in efficiency. Physical capital is still very much in the picture by creating productive capacity and serving as a vehicle for research and technology transfer. In addition, since 1995, information technology (IT) capital has acquired

Earlier work by Denison (1962), Jorgenson and Griliches (1967), and Maddison (1987) suggested ways of decomposing the residual, including through human capital inputs. 41 One compact source of cross country growth analysis is Barro (1997). 42 See also the detailed weighing of approaches to modeling growth and econometrically tracing its causes in Durlauf, Johnson, and Temple (2005). Kenny and Williams (2001) also observe that the empirical evidence does not enable one to select among competing explanatory factors. 43 Among a legion of TFP enumerators, see Bosworth and Collins (2003), Crafts (2010), Jorgenson and Vu (2010), and Allen (2012).

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a substantial role, especially in the United States and Europe.44 IT is complemented by technology that is at the heart of what Baumol (2002) describes as the â&#x20AC;&#x153;capitalist growth machine.â&#x20AC;? As Parente and Prescott (2000), Comin and Hobijn (2010), Allen (2012), and many others note, the main reason why some countries are so far down on the income scale and convergence is so halting is because these economies have difficulty borrowing technologies from more advanced countries and tailoring it for their own purposes. A number of reasons have been put forward to explain why frontier technologies have been slow to diffuse. Bad institutions that place limits on absorptive capacity, regulatory constraints, vested interests, and poor governance must take some of the blame. They have discouraged technology adoption through their affects on the business climate and entrepreneurship. The poor quality of human capital and associated deficiencies in technological capacity has thrown up additional hurdles. But the nature of technologies closer to the frontier may also slow diffusion. These technologies tend to be capital intensive because they were developed in countries where labor is relatively expensive and skills are abundant. They are less cost effective in countries where labor costs are low relative to those of capital. Lower and middle income countries, all in East Asia, that have managed to narrow technology gaps in two or three decades have done so through rapid deepening of capital. This was made possible by intensive resource mobilization and the provision of capital at low rates of interest to industry through state controlled financial channels. This process, which mimics the approach adopted by Germany and Italy during their catch up stage in the late nineteenth century, has been backstopped by investment in learning and innovation systems that have built up the technical, research, and soft skills to absorb and effectively utilize advanced methods of production. A country such as China offers a good illustration of how technology gaps can be narrowed and productivity raised. China has invested massively in state of the art production equipment, financed by equally massive domestic savings channeled to enterprises through state owned banks at state controlled rates of interest that substantially depress the cost of capital.45 At the same time, China has successfully enlarged its pool of skills, thus facilitating absorption of technology from overseas. This brings us back to the refinements and advances in growth theory, as expounded in work by Paul Romer46 that modeled endogenous growth and explicitly accounted for the role of knowledge. 44

Jorgenson, Ho and Stiroh (2005) note that a decline in IT prices have induced firms to substitute IT for non IT capital and since 1995, Jorgenson and Vu estimate (2010) that IT capitalâ&#x20AC;&#x2122;s contribution worldwide rose from less than a quarter to more than a third of the total contribution of capital. 45 Financial repression is a notable accompaniment of capital intensive development in several of the East Asian economies. 46 Romer (1986, 1994).

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

From Solow to Endogenous Growth The Solow model, by clarifying the relationship between capital accumulation and growth, helped to partially dislodge the orthodoxy that saw capital as the key to growth and focused growth augmenting policies exclusively on measures to raise the rate of investment. For example, in Rostow’s analysis (1960), a takeoff into sustained growth was explicitly a function of a prior increase in capital investment from 5–6 percent to 15 percent or more.47 Solow showed that increasing capital accumulation eventually runs into diminishing returns48 as an economy shifts from extensive to intensive growth, but in avoiding the problem the model assumed exogenous technological change that limited its explanatory power. This deficiency was remedied by explicitly incorporating (endogenizing) knowledge into the growth model. Endogenous growth theory assumes that learning by doing49 and investment in education creates knowledge and knowledge spillovers. Thus, externalities reverse the diminishing returns to capital, allowing growth to be sustained. In other words, the continuous production of knowledge through a variety of avenues staves of what would otherwise be an inevitable onset of diminishing returns that would negate the deepening of capital.50 It is arguable whether endogenous growth theory constitutes a significant advance, however, as Solow (2007, p. 6) remarks, “the most valuable contribution of endogenous growth theory has not been the theory itself, but rather the stimulus it has provided to thinking about the actual production of human capital and useful technological knowledge.” The literature is replete with an immensity of small variations and minor extensions, including the role played by institutions (whether viewed as rules or as organizations with specific governance mechanisms),51 but the action revolves 47

Rostow’s rules of thumb were appealing to American policy makers because they distributed countries along a continuum of stages and imposed a semblance of order on a complex and at times chaotic world situation. This in turn simplified the decision rules for foreign assistance and put a ceiling on how much foreign assistance would be needed to realize America’s development objectives for the international community. See Haefele (2003, p. 87). 48 This became spectacularly evident in the case of the former Soviet Union, which by 1975 was investing 38 percent of GDP but saw its growth taper through the 1970s to almost zero in the 1980s. See Allen (2011, p. 134). 49 The endogenizing of technological change as a profit making activity in its own right was foreshadowed by Arrow in a landmark 1962 paper where he used capital investment as the vehicle through which learning/technological change occurs endogenously rather than being introduced exogenously. See also Solow (1997). But Solow (2007, p. 5) wonders whether endogenizing was as much of a breakthrough as it is touted to be, because to endogenize the growth rate of a variable requires a linear differential equation: “the plausibility of the model depends upon the robustness of that assumption: it amounts to the firm assumption that the growth rate of output (or some determinant of output) is independent of the level of the output itself.” 50 Aghion and Howitt (2009) nicely elucidate the workings of all and sundry models of growth and track the twists and turns in the development of theory. See also Howitt (2004). 51 According to some researchers, institutions (represented by a proxy for which data can be found) are the keys to growth. Institutions such as property rights and intellectual property surely matter,

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around capital and TFP and ways of parsing TFP. The contribution of TFP appears to be rising, according to a recent study by Arezki and Cherif (2010) of 94 countries covering the period 1970–2000. The question that refuses to go away is whether all the fuss over TFP is increasing the stock of effective policy instruments and institutions, and helping us understand why growth is so persistently uneven and all too often unresponsive to the moving of conventional policy levers. Policy instruments and institutions are discussed in the next section. Introducing Demand Much of the attention of growth theory has been on the supply side, with demand attracting sporadic attention during business downturns, as has been the case since 2008. Such is the trajectory of international growth after WWII that a prolonged shortfall in demand was not perceived as a significant problem until recently. This explains the surprise and alarm52 that greeted both the severity of the financial crisis (unexpected by the legion of believers in the efficiency and stability of Western financial markets and disinclined to harbor bearish sentiments) and the Great Recession that followed. During the extended period of calm prior to 2008,53 the majority of macroeconomists were content to track the movements of the economy using variants of dynamic stochastic general equilibrium (DSGE) models that incorporated consumption smoothing and rational expectations, which papered over the differences between the Keynesian54 and new classical models. From the perspective of growth economics, this neglect of demand management (including the demand generated by net exports) and the risk of crises are hard to explain, given crises’ frequency (though mainly in developing countries). A literature going back several decades has established that poor demand management—by injecting macroeconomic volatility,55 inflationary pressures, or adverse expectations—has been responsible for depressing investment and growth in many countries.56 One reason why the East Asian tiger but how and how much they impinge on TFP is difficult to determine. As policy instruments, institutional variables are tricky to define and manipulate and the returns can accrue non linearly over a long period of time. 52 And the initial silence and the subsequent defensive response to Queen Elizabeth’s question: “Why did no one see the crisis coming?” http://www.ft.com/intl/cms/s/0/1c1d5a9e bb29 11dd bc6c 0000779fd18c.html#axzz1rNHjoBif. 53 Between the mid 1980s and 2007, there was a relative lull in financial crises and defaults, which, according to Reinhart and Rogoff (2008), set the stage for the “big one.” 54 New Keynesian models assume (difficult to measure) sticky prices. 55 Burnside and Tabova (2009) find that a country’s average growth rate is correlated with its exposure to risk factors and the greater its exposure to shocks, the lower its average growth. In other words, riskier countries depress domestic investment and attract less capital from abroad. 56 See Sirimaneetham and Temple (2009) for a reexamination of the evidence using a new index of instability and for references to a large earlier literature.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

economies performed at such a high level is because, for the most part, they were able to create stable macroeconomic environments conducive to investment and to risk taking. A second reason of equal importance was the emphasis that East Asian economies placed on trade (and foreign direct investment) policies aimed at maximizing the growth impetus from exports. Thus, growth was supported both in the form of demand and through gains in productivity, technology transfer, and the encouragement that an open trading environment offered to foreign investors. It was the relative neglect of such policies at the very time when globalization was widening opportunities for growth through trade that stifled growth in many developing economies and enabled the East Asians to pluck the low hanging fruit. The experience of Japan also shows how poor macroeconomic management can undermine efforts at accumulating knowledge and inducing innovation. Japan is home to some of the most innovative multinational corporations, spends in excess of 3 percent of GDP on research and development (R&D), is second only to the United States in the number of patents it registers each year, and is not short of science and technology skills. Nevertheless, following the bursting of the real estate bubble in 1989 and the ensuing financial crisis, Japan’s growth slowed to a crawl, with TFP growing by just 0.6 percent per year between 1990 and 2003.57 In other words, investment in knowledge to augment science, technology, and innovation (ST&I) activities cannot boost growth if demand is persistently weak. Moreover, experience suggests that the private sector is quick to pare R&D spending when the economy enters a downturn and the immediate future demand for innovation weakens. The more astute companies are careful not to cut their research activities, as they provide the ideas and products for future growth, but the majority does in fact take the axe to R&D. Following the 2007–08 financial crisis, companies reacted by curtailing expenditures on research, as did some governments beset with fiscal problems—the result of past macroeconomic mismanagement. As Keynes58 observed, deficient demand tilts the odds against the entrepreneur and can stifle innovation and eat into the growth of productivity. Amazingly, after so much research on macroeconomic policy, the financial crisis and the problems of the eurozone have uncovered a singular lack of consensus regarding the efficacy of demand management and how it can be most effectively conducted, once monetary policy is reduced to near impotence when 57

Jorgenson and Motohashi (2005). “If effective demand is deficient … the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him. The game of hazard, which he plays, is furnished with many zeros, so that the players as a whole will lose if they have the energy and hope to deal all the cards. Hitherto the increment of the world’s wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. But if effective demand is adequate, average skill and average good fortune will be enough” (Keynes 1936). 58

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interest rates are at the zero bound. In the United States, for example, the leading economists are unable to agree as to whether the multiplier effect of fiscal spending by the Federal government is greater or less than one. The reason appears to be that the new classical “freshwater” school never embraced a role for fiscal policy as a stimulus. Instead, it assumed that monetary and exchange rate polices would be sufficient and its members are virulently opposed to government intervention of the sort associated with fiscal activism. What we see playing out on the macroeconomic front is not a debating of policy options grounded in rigorous empirical analysis but a contest between two belief systems unable to convincingly establish a position with reference to preceding research. Perhaps most disconcerting is that the debate is being conducted exclusively among participants drawn from a handful of schools (with strong ideological leanings) in North America and Western Europe. Other countries and other academics have a stake in the outcome of the debate and future directions of macroeconomic policies but their contribution is barely visible. On demand management as on the supply related aspects of growth, a few Western universities continue to call the shots by training and indoctrinating the majority of those who worldwide conduct influential research and advise policy makers. The epicenter of growth economics remains highly localized, and more than 60 years after the birth of growth economics, Western ideas, fashions, and methodologies continue to determine what is researched, how it is researched, and what gets translated into policies. Indices of Performance In this context there remains one additional substrand of the demand side approach that deserves consideration because it figures so prominently in the assessment of growth prospects and the making of policies. This strand comprises the numerous indices of competitiveness, business climate, corruption, innovation, logistics, and entrepreneurship. These are just a few of the indicators that seek to gauge a country’s attractiveness for investors, its potential for innovation, and its production competitiveness relative to other countries.59 Because of their apparent simplicity and due to intensive marketing, these indicators have emerged as the yardsticks with which countries measure performance and they provide some of the more monitorable policy handles. Macroeconomic stability and demand management through monetary, fiscal, and exchange rate polices are the key determinants of investment, consumption, and exports. However, some research confirms that the “investment climate” (the competitiveness of the economy as measured by a number of indicators) and innovative capacity (also measured from several different angles) affect investment decisions and innovativeness, and that these feed through into growth via capital accumulation and gains in productivity. Undoubtedly, the 59

See, for instance, World Bank (2004); WEF (2012).

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

various elements that enter into these indices matter. How much each counts, and which ones should be singled out to yield the maximum productivity gains, is unlikely to be settled because there are far too many indices. Many are built up through subjective assessments, and it is difficult to say which combination of factors, in conjunction with a host of other determinants, will be appropriate for a specific country. Inevitably, as with most things, one size does not fit all. The safe conclusion is that conventional demand management dominates all other types of management. Insufficient demand, demand volatility, excess demand, and the distortions, bubbles, and crises they can cause, are likely to negatively affect growth prospects. The first step to a good business climate and a competitive economy is macroeconomic stability. Looking at the fragile state of many Western economies following the official start of recovery, the importance of demand management is self evident but not apparently to a sizable segment of the economics profession and to the policy makers whose ear they have. Brad DeLong (2012, p. 2) captures the Keynesian mood well when he remarks: â&#x20AC;&#x153;For 62 years, from 1945â&#x20AC;&#x201C;2007, with some sharp but temporary and regionalized interruptions, entrepreneurs and enterprises could bet that the demand would be there if they created the supply. This played a significant role in setting the stage for the two fastest generations of global economic growth the world has ever seen. Now the stage has been emptied.â&#x20AC;? Clearly Keynesians are on the defensive. The case for reflationary fiscal policies to restore growth is receiving a frosty political reception and the case for restoring long term growth, once recovery is well and truly launched in Western countries, is not being made in a manner that convinces the politician or the median voter. In middle income countries that must drive global growth if the advanced countries do not, the situation is satisfactory in the short term but much less so over the longer haul.60 Countries such as Brazil, the Russian Federation, South Africa, India, Malaysia, the Arab Republic of Egypt, Indonesia, and China are by no means primed for sustained growth of the kind the high flyers enjoyed in the 1980s and the 1990s. Future growth in these countries is vulnerable to a number of factors, including dysfunctional domestic governance and political turbulence, low rates of saving and investment (in certain cases), an unwelcoming business climate, major sectoral imbalances and inefficiencies, limited or declining manufacturing capabilities, and weak innovation systems. In addition, all of these countries would be affected by the inability of their Western trading partners to return to earlier growth paths, or, worse, by a reversal of trade liberalization.

Some of these countries worry about becoming caught in a middle income trap and being unable to upgrade industry and close technology gaps because of human and research capital constraints.

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Increasing income inequality, especially in advanced English speaking countries and many middle and low income ones, including some in East Asia, is adding to the uncertainty regarding future growth prospects. The Kuznets curve has proven unreliable. Kuznets (1955) forecast a period of increasing income inequality as labor migrated from rural to higher paying urban jobs in developing countries (and income from land declined), followed by a return to greater equality once societies urbanized, industrialized, raised average levels of education, and introduced equalizing tax and transfer programs.61 In fact, inequality declined in Western countries until about 1980, but has been rising since.62 In continental European countries, the Nordic countries, and Japan, inequality was flat and is now increasing slowly. In developing countries, inequality first declined and leveled off and in many it is now on the riseâ&#x20AC;&#x201D; including in the East Asian economies, which demonstrated, with the help of land reforms and rapid industrialization,63 that countries could achieve high rates of income growth and maintain income inequality. Income inequality is edging upward in the United States, Singapore, China, Japan, some of Europe, and remains high in South America and Sub Saharan Africa. Conventional wisdom would suggest that growth could suffer if political tensions arise and boil over, affecting policy making and investor risk perception. However, research reported in the Oxford Handbook of Economic Inequality64 does not point to a clear relationship running from inequality to economic performance. A meta analysis by de Dominicis, de Groot, and Florax (2006) adds some valuable detail, which shows that the influence of inequality on growth is stronger in less developed countries and when the duration of a spell of growth is shorterâ&#x20AC;&#x201D;the long term impact is different from the impact in the short run. Although past experience partially allays fears regarding growth, recent trends in inequality and levels reached are nevertheless disquieting and these could prove to be problematic if growth is weak because of the lingering aftermath of the Great Recession. Inequality could be become politically unacceptable in democracies if economic performance remains sluggish, and could unleash demands and policy actions that further curb growth, at least over the medium term. The search for policy recipes to achieve or restore rapid growth, and to distribute the gains more equitably, is urgent, as countries wrestle with 61

Acemoglu and Robinson (2002) explain the shape of the Kuznets curve in Western European countries as follows: by increasing inequality, capitalist industrialization either brings about a change in the political regime or forces the ruling political elites to redistribute income in the interests of stability. 62 Goldin and Katz (2009); Atkinson, Picketty and Saez (2011); Acemoglu (2012). The increasing equality is explained by the spread of education resulting from the shifts in the distribution of political power, mediated by democratic institutions and change in ideological beliefs. 63 Acemoglu and Robinson (2002) maintain that the land reforms in East Asia fundamentally altered the relationship between growth and inequality. 64 Salverda, Nolan, and Smeeding (2009).

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

unemployment, expectations and contingent liabilities. However, arithmetic65 suggests that serious economic and environmental strains could ensue if a few of the largest countries, such as China, converged towards the living standards of the West and the majority of the others start to narrow technology and income gaps. The tax that such growth would impose on global public goods, and the resource depletion it would entail, would imperil the growth project that has been the centerpiece of development for so many decades. Even a substantial greening of growth, were it to occur in the next two to three decades, might be too little and too late. Does growth economics have a convincing riposte for the doom mongers? What are the stylized policy recommendations of continuing significance that have come out of 60 years of research and its application? The next section discusses these questions.

3. Policies for Growth: A Small Pot of Gold Long immersion in the literature on growth leaves one with the feeling that pearls never stop pouring in: so much is being written on such a staggering multitude of topics. There is a sense that a lot of incremental innovation is afoot wherever economics is being taught or practicedâ&#x20AC;&#x201D;and not just in a few Western hotspots. But then one stops to remember the last 1,000 papers read and the 4 million regressions66 scrutinized. That is when the sense of moving in circles becomes apparent and the impossible task of summarizing a few stylized policies begins to seem manageable. King Capital Although the spotlight might have shifted to TFP, capital is the driver of growth for most low and lower middle income countries67 far from the technological frontier, with low capital labor ratios and still on the extensive margin of development. For these countries, the first order of business is to put in place the infrastructure that undergirds development and to build the productive capacity. Capital investment does this and it also serves as the avenue through which technology is transferred from more advanced to developing countries. China is the foremost exemplar of this approach. It telescoped decades of development into years by pulling out the stops on capital investment and in the process transferring technology at a much faster pace than would ordinarily have been possible. How can a country raise investment to upwards of 25 percent of GDP? 65

See Cohen (2012); Sachs (2008). Only Sala i Martin (1997a, b) has confessed to having run 4 million regressions (www.nber.org/papers/w6252.pdf), later reduced to 2 million (www.jstor.org/stable/2950909). 67 The United States could also use a sizable dose of capital investment to restore its ailing infrastructure and perhaps even partially reverse the hollowing of its manufacturing activities. In 2009, U.S. gross investment was a paltry 15 percent. 66

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Only a few have managed this through a combination of resource mobilization through the fiscal system and public sector entities; by harnessing publicly owned and controlled banks; by exerting financial repression, which depresses interest rates over long periods; through state capitalism in combination with industrial policy vigorously implemented through fiscal and organizational incentives; and with the help of an exchange rate policy that undervalues the domestic currency relative to that of major trading partners. This is a tall order, beyond the capacity of most countries, and some of the incentives utilized in the past are now disallowed by the World Trade Organization (WTO). In fact, even countries that once achieved high rates of investment, such as Malaysia, have fallen far below earlier levels. Other countries such as Brazil and South Africa have been unable to approach East Asian levels in spite of introducing generous fiscal incentives for investment and a deepening of the financial sector to mobilize and allocate savings. Improving the business climate can in principle increase investment, but it is difficult to identify countries that have moved to a high growth path by working on the indicators that affect transaction costs. In the 1980s and a part of the 1990s, low rates of saving and investment in Latin American and Sub Saharan countries was blamed on macroeconomic mismanagement. However, better macro management has increased investment modestly if at all. Between 1995 and 2009, gross investment was unchanged in Latin America and rose from an average of 18 percent to an average of 21 percent in Sub Saharan Africa. Low levels of private investment in productive capacity and limited investment in physical infrastructure constrain growth, both directly and by dampening the gains in TFP from embodied technological progress and learning. Horizontal and matrix based approaches (as distinct from the earlier vertical ones) to industrial policy that were pushed aside by market fundamentalism in the 1990s are back in favor,68 as countries struggle to raise the level of investment and orient it more towards the productive sectors rather than housing or real estate. The jury is still out on whether such policies or others will make a tangible difference in primarily market based economies operating with reference to WTO rules. Human Capital the Knowledge Producer Endogenous growth theory and the research on human capital has brought out the vital role of education and ST&I skills. They serve both as drivers of (inclusive) growth in themselves and as complements to increasingly more sophisticated capital/IT equipment based on technologies introduced in the advanced countries. Research by Hanushek and others69 has demonstrated that the quality of human capital (based on standardized tests) counts for more than 68

See Van Reenen (2012), Aiginger (2007, 2011), and Aiginger and Sieber (2006). Hanushek and Woessman (2008, 2012); Pritchett and Viarengo (2008).

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

quantity, especially in the race to narrow technological gaps and to raise factor productivity by improving management, soft skills, allocative efficiency, and policy implementation. Learning from countries that are high on the quality ladder has become a growth industry in its own right, even as some of these countries (for example, Singapore and Finland) begin to worry about the emphasis on rote learning and on the inability to instill sufficient creativity and problem solving skills. It is clear from Western experience that greater spending on education does not by itself suffice, once it is over some threshold of adequacy. Teacher qualifications, incentives, status, and autonomy can make a difference but each success story has tight and unreplicable cultural correlates. Human capital has emerged as an axis of growth economics, and many of the answers countries are seeking must be found in the swampland of education â&#x20AC;&#x153;science,â&#x20AC;? itself full of interesting papers and dead ends. Innovation Systems Human capital development and the learning economy it represents is inseparable from the ST&I system that uses human capital to generate ideas and commercial innovations facilitated by legal and regulatory institutions to move the TFP needle. The architecture of innovation systems in the leading economies has been exhaustively mapped to the following conditions: the role of the government, universities, and the financial system (including venture capital providers); legal institutions supporting intellectual property and the trading of ideas; industrial composition; the entrepreneurial dynamics of the business community, both domestic and foreign; and the contribution of a competitive market environment. A series of OECD reports70 elucidates country experiences and offer policy advice. Lundvall (2007) provides a historical perspective and Martin (2012) nicely summarizes the state of the field and notes the challenge of coordinating the actions of several participants in the innovation game. The idea and innovation generating machine must function smoothly to extract the maximum TFP from capital investment and the accumulation of human capital. This is very much in the spirit of endogenous growth theory, but it should be noted that endogenous growth policies and innovation activities are not really separable. They are carried out more or less in tandem, given the fast moving nature of the technological environment. A universal roadmap exists only as a broad sketch. With the U.S. and Finnish innovation systems showing signs of strain, two of the global icons are tottering on their pedestals. Demand Management Demand management is linked to economic openness and the role of trade in creating opportunities for firms (especially in small countries). Through demand management, firms can realize economies of scale and connect with international value chains. This creates avenues for technology transfer and subjects domestic 70

See http://www.oecd.org/document/62/0,3746,en_2649_34273_38848318_1_1_1_1,00.html.

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firms to competitive pressures. Whether or not trade enhances productivity through these channels remains undecided. Bernard and his co authors71 show that the firms that enter export markets are already the productive ones. Others find that trade does cause productivity to rise.72 As with macroeconomic policy, the answer seems to boil down to a matter of belief, because there are an equal number of papers arguing both sides of the case. I tend to go with the ayes. But this expression of belief only begs the larger question: How does a country become a successful exporter? If one takes China as a model, then the answer appears to lie in making massive investments in physical and human capital to build manufacturing capability; creating an innovation system to enhance absorptivity; exploiting foreign direct investment to increase access to technology; maximizing fiscal, financial, and exchange incentives; and applying pressure from the party organization to achieve state mandated export targets.

4. Concluding Remarks The economics profession has been hard hit by the inability to warn of the recent financial crisis and to contribute coherent policy directions to aid recovery and to restore growth. After a few months of soul searching and the occasional mea culpa, the response, inevitably, is denial, and a return to business as usual.73 Perhaps it cannot be otherwise. For its part, growth economics seems resigned to circling around the coefficient of ignorance and stirring in new variables, even though the policy value added from these efforts is perilously close to zero. There is no denying the scale of the economic research conducted over the past half century, but growth economics is struggling to provide detailed and meaningful answers to policy concerns. If TFP is indeed the driver of growth, its measurement is becoming something of an art,74 appreciated by practitioners (there are scores of estimates, no two alike) but contributing little to the content and precision of policies for raising TFP. There is no consensus on how growth that is evenly shared might be accelerated in advanced countries and sustained by middle income ones fearing the onset of sclerosis. In the absence of fresh ideas, the professional and public debate mindlessly regurgitates well worn nostrums on investment in education and science and technology; on stimulating innovation; and on creating an institutionally well stocked, regulation lite, 71

Bernard (2006). Iacovone and Javorcik (2012) added also find that potential exporters upgrade quality prior to entering the export market. 72 See Lopez (2005). 73 Specialization, ideological predispositions, and an absence of alternative models makes people return to the same coalface. Dislodging neoclassical/neo Keynesian macroeconomics will require the mother of all disruptive theories. 74 A survey of the econometrics of TFP by Van Beveren (2012) indicates how many tools and tests the modeler can now marshal to enhance the joys of estimation.

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead

market friendly, enabling business environment. The one apparent innovation is the greening of several of the latest offerings on growth. Since the early 1970s, leading economists have periodically warned that their profession would be marginalized by the trend towards technical specialization, mathematical modeling, and a focus on the testing of narrow hypotheses using increasingly more abstruse econometrics. These warnings have gone unheeded. As a consequence, in the face of a crying need for rapid and effective policy action on many fronts, growth economics is not forthcoming with convincing analysis, plus the kind of fine grained policy suggestions informed by political realities, that determine whether and how policies are implemented and the nature of outcomes. Policy makers often have short time horizons, are looking for practical proposals, and must constantly weigh the political and distributional implications of economic policies. Therefore, they have little time for recommendations to “strengthen institutions,” or move from the periphery to the “core of the product space,” or invest more in R&D, or improve the quality of education, or, most dishearteningly, raise TFP. These are all suitable grist for articles and blogs. But after 60 years, growth economics should be able to offer more varied, politically informed, specific, and operationally relevant fare, and policy makers and others who ultimately finance the uncountable regressions deserve better. Maybe in the next 60 years they will receive their due.

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Keynes, John M. 1936. The General Theory of Employment, Interest and Money. New York: Harcourt and Co. Kindelberger, Charles P. 1967. Europe’s Postwar Growth: The Role of Labor Supply. Cambridge, MA: Harvard University Press. Kuznets, Simon. 1955. “Economic Growth and Income Inequality.” American Economic Review 45(1): 1–28. ———. 1966. Modern Economic Growth: Rate Structure and Spread. New Haven: Yale University Press. Lacovone, Leonardo, and Beata S. Javorcik. 2012. “Getting Ready: Preparation for Exporting.” CEPR Discussion Paper No. 8926. The Center for Economic and Policy Research, London. Latham, Michael E. 2003. “Introduction.” In D.C. Engerman, N. Gilman, M. H. Haefele, and M. E. Latham, eds., Staging Growth. Amherst: University of Massachusetts Press. Lin, Justin Yifu. 2011. “From Flying Geese to Leading Dragons.” World Bank Policy Research Working Paper No. 5702. World Bank, Washington, DC. Lopez, Ricardo A. 2005. “Trade and Growth: Reconciling the Macroeconomic and Microeconomic Evidence.” Journal of Economic Surveys 19(4): 623–48. Lundvall, Bengt Ake. 2007. “Innovation System Research: Where It Came From and Where It Might Go.” GLOBELICS Working Paper Series No. 2007 01. Global Network for Economics of Learning, Innovation, and Competence Building Systems (GLOBELICS), Aalborg University, Denmark. Maddison, Angus. 1987. “Growth and Slowdown in Advanced Capitalist Economies: Techniques of Quantitative Assessment.” Journal of Economic Literature 25(2): 649–98. Maddison, Angus. 2005. Growth and Interaction in the World Economy. Washington, DC: The AEI Press. ———. 2008. “The West and the Rest and the World Economy: 1000–2030.” World Economics 9(4): 75–99. ———. 2010. The World Economy. Paris: OECD. Martin, Ben R. 2012. “Innovations Studies: Challenging the Boundaries.” Unpublished paper. Science and Technology Policy Research (SPRU), University of Sussex, UK. Mathews, John A. 2006. “The Intellectual Roots of Latecomer Industrial Development.” Journal of Technology and Globalization 1(3 4): 433–50. Mokyr, Joel. 2005. “Log Term Economic Growth and the History of Technology.” In Handbook of Economic Growth, Volume 1A, Philippe Aghion and Steven Durlauf, eds., pp. 679–741. New York: North Holland. Parente, Stephen L., and Edward C. Prescott. 2000. Barriers to Riches. Cambridge, MA: MIT Press.

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Phelps, Edmund S. 1967. Golden Rules of Economic Growth. Amsterdam: North Holland. Pritchett, Lant, and Martina Viarengo. 2008. “Producing Superstars for the Economic Mundial.” Unpublished paper. JFK School, Harvard University, Cambridge MA. Reinhart, Carmen, and Kenneth S. Rogoff. 2008. “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.” NBER Working Paper No. 13882. National Bureau of Economic Research, Cambridge, MA. Rodrik, Dani. 2011. “The Future of Economic Convergence.” Unpublished paper. Harvard University. Roodman, David. 2007. “The Anarchy of Numbers: Aid, Development, and Cross Country Empires.” World Bank Economic Review 21(2): 255–77. Romer, Paul M. 1986. “Increasing Returns and Long Run Growth.” Journal of Political Economy 94(5): 1002–37. ———. 1994. “The Origins of Endogenous Growth.” The Journal of Economic Perspectives 8(1): 3–22. Rostow, Walt W. 1960. The Stages of Economic Growth: A Non Communist Manifesto. Cambridge, UK: Cambridge University Press. Sachs, Jeffrey. 2008. Commonwealth. New York: Penguin Press. Sala I Martin, Xavier X. 1997a. “I Just Ran Four Million Regressions.” NBER Working Paper No. 6252. National Bureau of Economic Research, Cambridge, MA. www.nber.org/papers/w6252.pdf. ———. 1997b. “I Just Ran Two Million Regressions.” The American Economic Review 87(2): 178–83. www.jstor.org/stable/2950909. Salverda, Wiemar, Brian Nolan, and Tim Smeeding, eds. 2009. The Oxford Handbook of Economic Inequality. New York: Oxford University Press. Samuelson, Paul A. 1966. “Rejoinder: Agreements, Disagreements, Doubts, and the Case of Induced Harrod Neutral Technical Change.” Review of Economics and Statistics 48(4): 444–48. Sen, Amartya K. 1985. Commodities and Capabilities. Oxford: Oxford University Press. Sirimaneetham, Vatcharin, and Jonathan Temple. 2009. “Macroeconomic Stability and the Distribution of Growth Rates.” World Bank Economic Review 23(3): 443–79. Solow, Robert M. 1956. “A Contribution to the Theory of Economic Growth.” Quarterly Journal of Economics 70(1): 65–94. ———. 1957. “Technical Change and Aggregate Production Function.” Review of Economic Statistics 47: 312–20. ———. 1997. Learning from Learning by Doing. Stanford, CA: Stanford University Press.

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———. 2007. “The Last 50 Years of Growth Theory and the Next 10.” Oxford Review of Economic Policy 23(1): 3–14. Stiglitz, Joseph E., Amartya Sen, and Jean Paul Fitoussi. 2010. Mis measuring Our Lives. New York: The New Press. Swan, Trevor W. 1956. “Economic Growth and Capital Accumulation.” Economic Record 32(2): 334–61. Van Beveren, Ilke. 2012. “Total Factor Productivity Estimation: A Practical Review.” Journal of Economic Surveys 26(1): 98–128. Van Reenen, John. 2012. “Industrial Policy Works for Smaller Firms.” VoxEU.org, February 17. http://www.voxeu.org/index.php?q=node/7633. Ventura, Jaume. 2005. “A Global View of Economic Growth.” In Handbook of Economic Growth, Volume 1A, Philippe Aghion and Steven Durlauf, eds., pp. 679–741. New York: North Holland. Wade, Robert. 1990. Governing the Market. Princeton, NJ: Princeton University Press. Whittaker, D. Hugh, Tianbiao Zhu, Timothy J. Sturgeon, Mon Han Tsai, and Toshie Okita. 2008. “Compressed Development.” MIT IPC Working Paper 08 005. MIT, Cambridge, MA. Williamson, Jeffrey G. 2011. “Industrial Catching up in the Poor Periphery 1870– 1975.” Discussion Paper No. 8335. CEPR, London. World Bank. 2004. World Development Report 2005: A Better Investment Climate for Everyone. Washington, DC: World Bank. ———. 2012. “An Update to the World Bank Estimate of Consumption Poverty in the Developing World.” World Bank, Washington, DC. World Economic Forum. 2012. Global Competitiveness Report 2011–2012. Geneva. Yusuf, Shahid. 2011. East Asian Experience with Industrial Policy and its Implications for South Africa. Washington, DC: World Bank. Zilibotti, Fabrizio. 2007. “Economic Possibilities for Our Grandchildren 75 Years After: A Global Perspective.” Working Paper No. 344. Institute for Empirical Research in Economics, University of Zurich, Zurich.

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© 2012 The Growth Dialogue 2201 G Street NW Washington, DC 20052 Telephone: (202) 994‐8122 Internet: www.growthdialogue.org E‐mail: info@growthdialogue.org All rights reserved 1 2 3 4 15 14 13 12 The Growth Dialogue is sponsored by the following organizations: Canadian International Development Agency (CIDA) UK Department for International Development (DFID) Korea Development Institute (KDI) Government of Sweden The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the sponsoring organizations or the governments they represent. The sponsoring organizations do not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the sponsoring organizations concerning the legal status of any territory or the endorsement or acceptance of such boundaries. All queries on rights and licenses, including subsidiary rights, should be addressed to The Growth Dialogue, 2201 G Street NW, Washington, DC 20052 USA; phone: (202) 994‐8122; e‐mail: info@growthdialogue.org; fax: (202) 994‐8289. Cover design: Michael Alwan

Contents About the Author ............................................................................................................. v Abstract .......................................................................................................................... vii Introduction ...................................................................................................................... 1 The Schumpeterian Growth Paradigm ......................................................................... 2 A Remark on Growth Policy and a Country’s Stage of Development ..................... 3 Growth‐Enhancing (Supply‐Side) Policy in Developed Economies ......................... 4 Investing in Growth while Reducing Public Deficits: The Strategic State ............... 5 Industrial Policy ............................................................................................................... 6 Taxation ............................................................................................................................. 7 Demand versus Supply Side .......................................................................................... 8 Macroeconomic Policy .................................................................................................... 8 Climate ............................................................................................................................... 9 The State and the Social Contract ................................................................................ 10 Democracy ...................................................................................................................... 11 Implications for the Design of a European Growth Package ................................... 11 Conclusion ...................................................................................................................... 15 References ....................................................................................................................... 15

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iii

About the Author Philippe Aghion is Robert C. Waggoner Professor of Economics at Harvard University, Programme Director in Industrial Organization at the Centre for Economic and Policy Research (CEPR), and Fellow at the National Bureau of Economic Research (NBER) and the Institute for Fiscal Studies (IFS). Professor Aghion is one of the most prolific and influential economists of his generation. He focuses much of his attention on the relationship between economic growth and policy, particularly innovations as a main source of economic growth. Professor Aghion’s approach is to examine how various factors interact with local entrepreneurs’ incentives to either innovate or to imitate frontier technologies. With Peter Howitt, Philippe Aghion developed the so‐called ‘Schumpeterian paradigm’, and extended the paradigm in several directions. Much of the resulting work is summarised in the book he co‐authored with Howitt entitled Endogenous Growth Theory. In the process of trying to link growth and organisations, Professor Aghion has also contributed to the field of contract theory and corporate governance. His work concentrates on the question of how to allocate authority and control rights within a firm, or between entrepreneurs and investors. In addition to his academic research, Professor Aghion has been associated with the European Bank for Reconstruction and Development (EBRD) since 1990. He is also managing editor of the journal The Economics of Transition, which he launched in 1992, and is co‐editor of the Review of Economics and Statistics. Philippe Aghion holds a PhD from Harvard University (1987). He was elected a Fellow of the American Academy of Arts and Sciences in 2009 and of the Economic Society in 1992. In 2001, he received the Yrjö Jahnsson Award of the European Economic Association, which rewards a European economist under the age of 45. He was associated with the Commission on Growth and Development and is active in the work of the Growth Dialogue.

Growth Policy and the State

Abstract The importance of investing in research and development (R&D) and knowledge for innovation and growth is now commonly acknowledged. So is the role for structural reforms aimed at making product and labor markets more flexible. More controversial, however, is the role that the state should play in the growth process. The debate on the role of the state has been revived by the financial crisis to the extent that this crisis has turned into a public debt crisis. One response to the public debt crisis is the neo‐conservative approach of a minimal state. Public spending and taxes should be minimized, so that private firms would face low interest rates and low tax rates, which in turn would encourage them to hire and expand, thereby generating prosperity for the whole economy. However, this approach is not working too well in the United Kingdom, where it has been implemented. Conversely, in Scandinavian countries, where governments remain big, innovation and productivity growth rates remain high. In this paper we argue for a strategic or “smart” state, rather than a reduced state. The strategic state would target its investments to maximize growth in the face of hard budget constraints. This departs both from the Keynesian view of a state sustaining growth through demand‐driven policies, and from the neo‐ liberal view of a minimal state confined to its regalian functions.

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vii

Growth Policy and the State Philippe Aghion

Introduction The importance of investing in research and development (R&D) and knowledge for innovation and growth is now commonly acknowledged. So is the role for structural reforms aimed at making product and labor markets more flexible. More controversial however is the role that the state should play in the growth process. The debate on the role of the state has been revived by the financial crisis to the extent that this crisis has turned into a public debt crisis, thereby forcing governments to make difficult choices between the need to quickly reduce public debt and deficits on the one hand, and the need to support growth on the other hand. One response to the public debt crisis is the neo‐conservative approach of a minimal state. To reduce public deficits while stimulating growth and employment, governments should focus attention on the so‐called “regalian” functions of the state, namely, to maintain law and order. Public spending and taxes should be minimized, so that private firms would face low interest rates and low tax rates, which in turn would encourage them to hire and expand, thereby generating prosperity for the whole economy. However, this approach is not working too well in the United Kingdom, where it has been implemented. Conversely, in Scandinavian countries, where governments remain big, innovation and productivity growth rates remain high. In this paper we argue that it is not so much the size of the state that is at stake, but rather its governance. In other words, it is not so much a reduced state that we need to foster economic growth in our countries, but a strategic state. The strategic state would target its investments to maximize growth in the face of hard budget constraints. This course departs both from the Keynesian view of a state sustaining growth through demand‐driven policies and from the neo‐liberal view of a minimal state confined to its regalian functions. We spell out our view of the “smart state” and apply it to European growth policy.

Growth Policy and the State

The Schumpeterian Growth Paradigm A useful framework within which to think about the role of the state in the growth process is the so‐called Schumpeterian paradigm (see Aghion and Howitt 1992, 1998). It grew out of modern industrial organization theory and put firms and entrepreneurs at the heart of the growth process. The paradigm relies on two main ideas. First idea: long‐run growth relies on innovations. These can be process innovations, namely to increase the productivity of production factors (for example, labor or capital); product innovations (introducing new products); or organizational innovations (to make the combination of production factors more efficient). These innovations result from investments like R&D, firms’ investments in skills, the search for new markets, and so forth that are motivated by the prospect of monopoly rents for successful innovators. When thinking about the role for public intervention in the growth process, an important consideration is that innovations generate positive knowledge spillovers (on future research and innovation activity) that private firms do not fully internalize. Thus private firms under laissez faire conditions tend to underinvest in R&D, training, and other knowledge‐supporting activities. This propensity to underinvest is reinforced by the existence of credit market imperfections that become particularly tight in recessions. Hence an important role for the state is as a co‐investor in the knowledge economy. Second idea: creative destruction. Namely, new innovations tend to make old innovations, technologies, and skills obsolete. Thus, growth involves a conflict between the old and the new: the innovators of yesterday resist new innovations that render their activities obsolete. This also explains why innovation‐led growth in OECD countries is associated with a higher rate of firm and labor turnover. And it suggests a second role for the state, namely as an insurer against the turnover risk and to help workers move from one job to another. More fundamentally, governments need to strike the right balance between preserving innovation rents and at the same time not deterring future entry and innovation. This approach offers a natural framework for thinking about growth policy. For example, policies that have a potential effect on innovation incentives and therefore on long‐run growth include new patent laws (like the Bayh‐Dole Act in the United States), the introduction of a single market for goods and services in Europe (which affects the degree of product market competition), trade liberalization (which also affects competition), macroeconomic policy (which affects interest rates and firms’ access to credit over the business cycle), and education policy (which affects the cost of R&D and training).

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A Remark on Growth Policy and a Country’s Stage of Development Innovations may be either “frontier innovations,” which push the frontier technology forward in a particular sector, or “imitations,” which allow the firm or sector to catch up with the existing technological frontier. The more technologically advanced a country is, the higher the fraction of sectors that are already close to the existing technology frontier, and therefore require frontier innovation to develop further. On the other hand, growth in less‐advanced countries, where most sectors lie farther behind the current frontier, will rely more on imitation. This dichotomy first explains why countries like China grow faster than all OECD countries. Growth in China is driven by technological imitation, and when one starts far below the frontier, catching up with the frontier means a big leap forward. Second, it explains why growth policy design should not be exactly the same in developed and less‐developed economies. In particular, an imitative economy does not require labor and product market flexibility as much as a country where growth relies more on frontier innovation. Also, bank finance is well adapted to the needs of imitative firms, whereas equity financing (such as venture capital) is better suited to the needs of an innovative firm at the frontier. Similarly, good primary, secondary, and undergraduate education is well suited to the needs of a catching‐up economy whereas graduate schools focusing on research education are more indispensable in a country where growth relies more on frontier innovations. This in turn suggests that beyond universal growth‐enhancing policies such as good property rights protection (and more generally the avoidance of expropriating institutions) and stabilizing macroeconomic policy (to reduce interest rates and inflation), the design of growth policy should be tailored to the stage of development of each individual country or region. This in turn offers responses to the view of Easterly (2005) that policy does not matter for growth once controlling for institutions; to the Washington Consensus view; and to the Growth diagnostic approach of Hausmann, Rodrik, and Velasco (2002) whereby observed prices can help identify the binding constraint on growth. To Easterly, an answer is that he looked at the effect of policies independently from the countries’ stage of development. However, the positive effects of a particular policy in some countries (for example, in more advanced countries) may well be counteracted by its negative effects in other countries. Instead, our approach calls for growth regression exercises where policy is interacted with other variables such as the degree of technological or institutional development in the country. To the advocates of the Washington Consensus, our answer is that while macroeconomic stability and property right protections appear to be universally growth‐enhancing factors, there are other

Growth Policy and the State

factors to consider. When we go further and assess the growth impact of competition policy, of various ways of designing education systems, of the choice of exchange rate systems, or of the design of labor or credit markets, knowing a country’s level of technological or institutional development appears to be key. To Hausmann, Rodrik, and Velasco, our answer is that growth regressions (particularly when also performed at more disaggregated levels, like industry or firm levels, or at the regional level) appear to do a better job than observed prices at encompassing possible intertemporal knowledge externalities involved in the various types of investments.

Growth‐Enhancing (Supply‐Side) Policy in Developed Economies The above discussion suggests that supply‐side policies aimed at increasing growth potential are appropriate in developed economies where growth is primarily driven by frontier innovation. A first lever of growth in developed economies is investment in the knowledge economy, particularly in in higher education and research. Innovation‐driven growth requires the development of high‐performing universities, particularly at the graduate school level (university performance is measured both in terms of the volume and quality of publications and in terms of students’ subsequent labor market success); it also requires firms to invest more in R&D. A second lever is increasing product market competition and labor market flexibility: the idea is that innovation‐based growth goes along with a higher degree of firm and job turnover. This in turn results directly from creative destruction as discussed above. Product market competition ensures that entry by new innovators will not be deterred by incumbent firms. Whereas labor market flexibility reduces the hiring and firing costs faced on the labor market by new entrants, and it also helps existing firms to start new activities while closing some old activities. Some of these policies—for example, the enhancement of higher education or the provision of subsidies and other inducements to R&D investment by private firms—appear to require public support on a long‐term basis. Examples of such policies include the excellence initiatives for universities in Germany or France, the small business acts in the United States and other OECD countries, and sectoral policies aimed at fostering innovation in selected sectors. Other policies, such as the liberalization of product and labor markets, seem to require more targeted and transitional support from governments. Examples of such policy actions include setting up flexsecurity systems or partial employment schemes and the transition to new labor or product market rules.

Philippe Aghion

Investing in Growth while Reducing Public Deficits: The Strategic State A main issue facing countries in the euro area, particularly in its southern part, is how to reconcile the need to invest in the long‐run growth levers mentioned above with the need to reduce public debt and deficits. To address the challenge of reconciling growth with greater budgetary discipline, governments and states must become strategic. This first means to adopt a new approach to public spending: in particular, they must depart from the Keynesian policies aimed at fostering growth though indiscriminate public spending, and instead become selective as to where public funds should be invested. They must look for all possible areas where public spending can be reduced without damaging effects on growth and social cohesion. A good example is potential savings on administrative costs. Technical progress in information and communication makes it possible to decentralize and thereby reduce the number of government layers, for similar reasons as those that allowed large firms to reduce the number of hierarchical layers over the past decades. Decentralization makes it also easier to operate a high‐quality health system at lower cost, as shown by the Swedish example. Second, governments must focus public investments and policies on a limited number of growth‐enhancing areas and sectors. This state support could include investment in education, universities, and innovative small and medium enterprises (SMEs); policy support for labor and product market flexibility; and investment in industrial sectors with high growth potential and externalities. Third, governments must link public financing to changes in the governance of sectors they invest in: how can one make sure that government funds will be appropriately used? For example, public investments in education must be conditional upon schools taking concrete steps to improve pedagogical methods and to provide individual support to students. Similarly, the necessary increases in higher education investments must be conditional upon universities going for excellence and adopting the required governance rules. For example, Aghion et al. (2010) show that investments in higher education are more effective the more autonomous universities are and the more competitive the overall university system is (in particular, the more funding relies on competitive grants). Another area where governance matters is that of sectoral investments (“industrial policy”). Such investments must preserve if not improve competition within the targeted sectors, and not reduce it (see Aghion et al. 2012). We discuss this industrial policy issue in more detail in the next section.

Growth Policy and the State

Industrial Policy Since the early 1980s industrial policy has come under disrepute among academics and policy advisers. In particular, it has been attacked for preventing competition and for allowing governments to pick winners and losers—and, consequently, for increasing the scope for capture of governments by local vested interests. However, three new considerations have gained importance over the recent period, which invite rethinking the issue. First, there is increasing awareness of climate change and of the fact that without government intervention aimed at encouraging clean production and clean innovation, global warming will intensify and generate all kinds of negative externalities (droughts, deforestations, migrations, conflicts) worldwide. Second, the recent financial crisis has revealed the extent to which laissez faire policies in several countries (particularly in southern Europe) promoted uncontrolled development of nontradable sectors (in particular real estate) at the expense of tradable sectors that are more conducive to long‐term convergence and innovation. Third, China has become prominent on the world economic stage, thanks in large part to its constant pursuit of industrial policy. The existence of knowledge spillovers supports a major theoretical argument for growth‐enhancing sectoral policies. For example, firms that choose to innovate in dirty technologies do not internalize the fact that current advances in such technologies tend to make future innovations in dirty technologies also more profitable. More generally, when choosing where to produce and innovate, firms do not internalize the positive or negative externalities this might have on other firms and sectors. A reinforcing factor is the existence of credit constraints which may further limit or slow down the reallocation of firms towards new (more growth‐enhancing) sectors. Now, one can argue that the existence of market failures on its own is not sufficient to justify sectoral intervention. On the other hand, there are activities—typically high‐tech sectors—that generate knowledge spillovers on the rest of the economy, and where assets are highly intangible. Such intangibility makes it more difficult for firms to borrow from private capital markets to finance their growth. In such cases there might indeed be a case for subsidizing entry and innovation in the corresponding sectors, and to do so in a way that guarantees fair competition within the sector. Note that the sectors that always come to mind are always the same four or five sectors, including energy, biotech, information and communication technology (ICT), and transportation. To our knowledge, the most convincing empirical study in support of properly designed industrial policy is by Nunn and Trefler (2009). These authors use microdata on a set of countries to analyze whether, as suggested by the “infant industry” argument, the growth of productivity in a country is positively affected by tariff protections biased in favor of activities and sectors that are

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“skill intensive”—that is, using highly skilled workers. They find a significant positive correlation between productivity growth and the “skill bias” due to tariff protection. Of course, such a correlation does not necessarily mean there is causality between skill bias due to protection and productivity growth: the two variables may themselves be the result of a third factor, such as the quality of institutions in countries considered. However, Nunn and Trefler show that at least 25 percent of the correlation corresponds to a causal effect. Overall, their analysis suggests that adequately designed (here, skill‐intensive) targeting may actually enhance growth, not only in the sector being subsidized but also the country as a whole. Below we will stress the importance of sectoral policies that are not only adequately targeted but also properly governed.1 Thus, using Chinese firm‐level panel data, Aghion et al. (2012) show that sectoral subsidies tend to enhance total factor production (TFP), TFP growth, and new product creation, more if they are both implemented in sectors that are already more competitive and also distributed in each sector over a more dispersed set of firms. In particular, sectoral investments should target sectors, not particular firms (or “national champions”).

Taxation Targeting investments may not be enough to square the circle of reconciling growth investments with budgetary discipline and additional funding may have to be found. Some countries can use the fiscal capacity they already have to raise additional taxes to finance growth investments. Other countries may have to try and increase their fiscal capacity (although in this case the effects on growth will be more long term). There is a whole theoretical literature on how capital and labor income should be optimally taxed. However, somewhat surprisingly, very little work has been done on taxation and growth, and almost nothing in the context of an economy where growth is driven by innovation.2 Absent growth considerations, the traditional argument against taxing capital is that this discourages savings and capital accumulation, and amounts to taxing individuals twice: once when they receive their labor income, and a second time when they collect revenues from saving their net labor income. Introducing endogenous growth may either reinforce this result (when the flow of innovation An adequately targeted policy is, in principle, one that targets a particular market failure (such as knowledge externalities and financial market imperfections). A particularly interesting case arises in markets that suffer from imperfect competition. By subsidizing its domestic industries, a government may give a strategic advantage to domestic firms, and allow them to gain market shares over foreign competitors. This approach, suggested by Brander and Spencer (1985), suffers from serious limitations, but could in principle be used to target “key” industries by looking at their structure. See Brander and Spencer (1985) for a seminal contribution and Brander (1995) for further insights. 2 See Aghion, Akcigit and Fernandez‐Villaverde (2012) for a first attempt. 1

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is mainly driven by the capital stock) or dampen it (when innovation is mainly driven by market size which itself revolves around employees’ net labor income). Excessive redistribution may deter innovation and thus growth. However, some redistribution can help enhance competition by preventing the emergence of an income‐based fractionalization of society with exclusion of individuals at the bottom and the top of the wealth‐income distribution. This in turn relates to the notion of “inclusive growth.”

Demand versus Supply Side While governments should focus primarily on the supply side when deciding how to target their investments in the growth process, they should not completely disregard the demand side. Indeed, firms’ innovation incentives depend upon the size of the market they serve. The large fraction of the market is European—even for Germany, half of whose exports are to other EU countries. Thus, if all EU countries were to embark on austerity policies, the resulting effect on aggregate demand within the EU might end up deterring innovative activities by firms across member states. This underscores the important role of automatic stabilizers aimed at sustaining consumption demand across EU countries over the business cycle. These stabilizers are implemented by EU countries as countercyclical fiscal policies, and the ability to pursue such policies is enhanced if countries can reduce their public debt. Hence also the importance of subsidizing credit access for households wishing to purchase innovative manufactured products: recent work by Mian (2012) shows that the tightening of U.S. credit markets affected economic activity mainly by reducing households’ access to credit, which in turn had a negative impact on firms’ market size.

Macroeconomic Policy Recent studies (see Aghion, Hemous, and Kharroubi, 2009; Aghion, Farhi, and Kharroubi, 2012), performed at cross‐country and cross‐industry levels, show that more countercyclical fiscal and monetary policies enhance growth. Fiscal policy countercyclicality refers to countries increasing their public deficits and debt in recessions but reducing them in upturns. Monetary policy countercyclicality refers to central banks letting real short‐term interest rates go down in recessions while having them increase again during upturns. Such policies can help credit‐constrained or liquidity‐constrained firms pursue innovative investments (such as R&D, skills development, and other training) over the cycle in spite of credit tightening during recessions, and it also helps maintain aggregate consumption and therefore firms’ market share over the cycle as argued in the previous section (see Aghion and Howitt, 2009, ch. 13).

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Both countercyclical fiscal and monetary policies encourage firms to invest more in R&D and innovation. Once again, this view of the role and design of macroeconomic policy departs both from the Keynesian approach of advocating untargeted public spending to foster demand in recessions, and from the neo‐ liberal policy of just minimizing tax and public spending in recessions.

Climate A laissez faire economy may tend to innovate in “the wrong direction.” This insight is supported by Aghion et al. (2010), who explore a cross‐country, panel‐ data set of patents in the automotive industry. They distinguish between “dirty innovations,” which affect internal combustion engines, and clean innovations, such as those on electric cars. Then they show that the larger the stock of past “dirty” innovations by a given entrepreneur, the “dirtier” current innovations by the same entrepreneur. This observation, together with the fact that innovations have been mostly dirty so far, implies that in the absence of government intervention our economies would generate too many dirty innovations. Hence, there is a role for government intervention to “redirect technical change” towards clean innovations. Delaying such directed intervention not only leads to further deterioration of the environment. In addition, the dirty innovation machine continues to strengthen its lead, making the dirty technologies more productive and widening the productivity gap between dirty and clean technologies even further. This widened gap in turn requires a longer period for clean technologies to catch up and replace the dirty ones. As this catching‐up period is characterized by slower growth, the cost of delaying intervention, in terms of foregone growth, will be higher. In other words, delaying action is costly. Not surprisingly, the shorter the delay and the higher the discount rate (that is, the lower the value put on the future), the lower the cost will be. This is because the gains from delaying intervention are realized at the start in the form of higher consumption, while losses occur in the future through more environmental degradation and lower future consumption. Moreover, because there are basically two problems to deal with (the environmental one and the innovation one), using two instruments proves to be better than using one. The optimal policy involves using (i) a carbon price to deal with the environmental externality and, at the same time, (ii) direct subsidies to clean R&D (or a profit tax on dirty technologies) to deal with the knowledge externality. Of course, one could always argue that a carbon price on its own could deal with both the environmental and the knowledge externalities at the same time (discouraging the use of dirty technologies also discourages innovation in dirty technologies). However, relying on the carbon price alone leads to excessive reduction in consumption in the short run. And because the two‐instrument

Growth Policy and the State

policy reduces the short‐run cost in terms of foregone short‐run consumption, it reinforces the case for immediate implementation, even for values of the discount rate under which standard models would suggest delaying implementation.

The State and the Social Contract One of the main roles of the state is as the guarantor of the social contract—that is, an economical and social pact on which all the citizens and their government agree. This pact has to allow the state to control public deficits in a post‐crisis context while maintaining social peace and avoiding strikes and social protests. Indeed, the current economic context can be characterized by a weakening of public finances, a tightening of credit constraints, and a need to correct global imbalances. While government debts increased a lot during and after the crisis, it now appears necessary to reduce public deficits while investing in growth at the same time. Such a reduction effort won’t be easy, and for it to be accepted by everybody, it will have to be fairly shared in order to maintain a peaceful social climate. This supposes that the state will choose to (i) invest in trust, (ii) promote redistributive policies while reducing deficits, and (iii) fight against corruption. To understand why it is necessary for the state to invest in trust, one could remember the following statement made by the Nobel Prize Kenneth Arrow in 1972: “Virtually every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time. It can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence.”3 This speech has given rise to a recent literature that studies the links between trust and various economic outcomes.4 Trust appears positively correlated with all these outcomes. Moreover, trust is also closely linked to institutions.5 We want to underscore here the fact that trust is particularly important for economic growth and innovation. Closely linked to the trust question is the redistributive nature of the social contract. Reducing public deficits involves increasing taxes and reducing public spending in various sectors as discussed above. However, to make this pain acceptable (and to avoid violent social movements of protestation), the effort will have to be shared equally. Taxes will have to be increased in a fair (that is, progressive) way and social expenditures targeted towards the poorest not cut too much. Moreover, citizens will be more willing to accept tax increases if they http://www.nobelprize.org/nobel_prizes/economics/laureates/1972/arrow‐lecture.html. See, for example, Guiso et al. (2004) on financial development, Guiso et al. (2006) on entrepreneurship, and Guiso et al. (2009) on economic exchanges. 5 See Aghion et al. (2010, 2011). 3 4

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know that the fiscal resources will be used in an efficient way by the government (hence the importance of democracy). Consider the relevant example of Sweden. Over only four years in the 1990s, Sweden was able to reduce its public deficit from 16 percent to less than 3 percent of GDP. This was done without reducing the level of public education and health services provided to the Swedish population (indeed, these services are still higher today in Sweden than in a lot of other European countries). This success was mainly the result of Sweden’s efficient and progressive tax system.

Democracy Our view of the state as a strategic growth investor, with priority sectors and a concern about governance of those sectors, calls for a reexamination of how states organize their own governance. In particular, once subsidies become targeted to particular sectors or activities, then checks and balances on governments become even more indispensable. First, checks and balances are needed to make sure that the selection of sectors or activities is not driven by interest groups activism and lobbying. Second, they are needed to make sure than sectoral state investments that turn out to be unsuccessful will not continue to be pursued. Third, they are needed to guarantee that state intervention does not deter competition and entry of new firms. To this end, it is importance that media producers and the judiciary system remain truly independent from the government. Equally important it is to have good and well‐funded institutions to evaluate the effects of government policies and legislations. In this respect, a country like France still lies too far behind its counterparts in northern Europe (see Aghion and Roulet 2011). Free media minimize the scope for corruption as shown by recent studies. This in turn reduces entry barriers for new businesses and increases trust in society, both of which enhance innovation and growth in modern societies

Implications for the Design of a European Growth Package The above discussion suggests at least three complementary directions for a new growth package for the EU and in particular eurozone countries: First, structural reforms can be implemented, starting with the liberalization of product and labor markets. Here we will argue that an important role can be played by structural funds provided the targeting and governance of these funds is suitably modified. Second, industrial investments can be made along the lines suggested by our above discussion on the role and design of industrial policy. Here, a recapitalized European Investment Bank (EIB) together with the project bonds suggested by

Growth Policy and the State

the European Commission should play a leading role. Third, a more countercyclical macroeconomic policy can be implemented within the eurozone, in particular by always relying on structural (that is, corrected for cyclical variations) measures of public debts and deficits. 1. Structural Reforms and the Role of Structural Funds There is a broad consensus among European leaders regarding the importance of structural reforms, in particular product and labor market liberalization and higher education reform, to foster long‐run growth in Europe. In this section we first assess the potential increase in growth potential from having all eurozone countries converge fully or partly to the best standards with regard to product or labor market liberalization, and also with regard to higher education. Then we discuss the role that structural funds might play in encouraging such reforms. Assessing the Growth Effects of Structural Reforms Using the data from Aghion, Hemous, and Kharroubi (2009), we look at the effect of structural policies using cross‐country panel regressions across 21 European countries. Our structural indicators are the following:  For higher education system: the share of population 25–64 years old having completed tertiary education (SUP)  For the product market: an OECD index assessing product market regulation (PMR)  For the labor market: an OECD index assessing the strictness of employment protection (LPE). In fact we focus on the interaction between these two rigidities, namely the variable PMR*LPE, in the analysis of labor market and product market reforms. We can look at the short‐ and long‐run growth effects of converging towards the performance levels of “target countries.” The target groups include those countries that are found to be the best performers in terms of education, product market, and labor market regulations. In order to determine these groups, we rank countries according to the variables SUP and PMR*LPE and we come up with two target groups: (i) Non‐European target group: United States and Canada; (ii) European target group: United Kingdom, Ireland, and Denmark. The advantage of these two target groups is that they allow comparisons between countries within the EU as well as with non‐European counterparties. Interestingly, we found the same target groups both for the higher education and the labor and product market regulation. We could then assess the average effect of converging towards best practice for the eurozone (European Monetary Union) as a whole. Our results show that converging towards the best practice in terms of product and labor market liberalization generates a growth gain of between 0.3 and 0.4 percent in the short run. Converging towards the best

Philippe Aghion

practice in terms of higher education enrollment generates a growth gain that is initially smaller (if we take the United Kingdom, Ireland, and Denmark as the reference countries), but grows up to 0.6 percent by 2050. Altogether, a full percentage point in growth can be gained through structural convergence towards those three countries. Rethinking the Role and Design of Structural Funds Here we argue that structural funds can be partly reoriented towards facilitating the implementation of structural reforms. So far, these funds have been used mainly to finance medium‐term investment projects and to foster socioeconomic cohesion within the EU. Moreover, these funds are allocated ex ante based on recipient countries’ GDP relative to the EU average, population, and surface area. We argue in favor of an alternative approach to the goals, targeting, and governance of structural funds. On the goals of structural funds: these funds should become transformative. In other words, they should help achieve structural reforms in the sectors they are targeted to. In our above discussion, we identified some main areas and sectors where structural reforms are needed: labor markets, product markets, and education. Structural funds should aim at facilitating changes in the functioning of these sectors in the various countries. The allocation of funds should generally be made on an individual basis: in other words, they should mainly target schools, employment agencies, individual workers, but not so much countries. The funds would help finance transition costs. The allocation of funds should be to well‐specified deliverables, such as provision of better tutorship in education, improvements in the organization of employment agencies, transition to portable pensions rights across two or more countries, and setting up of diploma equivalence for service jobs. Allocation should be also conditional upon the country or region not having put in place a general policy that contradicts the purpose of the fund allocation. Regarding the governance of structural funds, the allocation of funds should be made by European agencies on the model of the European Research Council: a bottom‐up approach with peer evaluation ex ante and ex post. 2. A New European Investment Policy Growth also requires more European investments in growth‐enhancing activities. Aghion, Boulanger, and Cohen (2011) survey recent studies suggesting that sectoral aid is more likely to be growth‐enhancing if (i) it targets sectors with higher growth potential, one measure of it being the extent to which various industries are skill‐biased; and (ii) it targets more competitive sectors and enhances competition within the sector. In that research, we first compare various sectors/activities in terms of their degree of skill‐biasness and also according to the relative importance of SMEs in these sectors (a larger fraction of SMEs can in turn be interpreted as reflecting the scope for increasing competition in the sector). A main finding is that the energy

Growth Policy and the State

sector is particularly skill‐biased. Then, we look at the EIB’s investment portfolio, and conclude that growth‐maximization considerations should lead the EIB to invest more in the energy sector compared to the less skill‐intensive construction/infrastructure sectors. Finally, we look in more detail at the energy sector. The argument for unregulated market operation seems nowadays less convincing than it might have been in the 1980s, for a number of reasons. First, the European single market has been associated with a reallocation of production from the tradable to the nontradable sector, depressing growth prospects. This may not be related to laissez faire as such but to the fact that the single market is in fact incomplete and that other important rigidities remain on both product and labor markets. However, it is still necessary to support adjustment in the transition and until the single market will be truly complete. Second, climate change will come with important negative externalities if the costs of the transition are not at least partly supported from outside. As we argued above, the new investment policy should not pick individual winners, but rather should target sectors, in particular those that are more skill‐ intensive (Nunn and Trifler 2010) and/or those that are more competitive (Aghion et al. 2012). As it turns out, within the EU skill intensity is particularly low in the manufacturing and wholesale and retail sectors. An industrial policy picking these sectors would be ill‐advised, for example, if not accompanied by effective liberalizing measures. By contrast, as suggested by Nunn and Trefler (2010), an effective industrial policy should focus on the “electricity” sector of the International Standard Industrial Classification (ISIC) listings, mainly composed of energy production, processing, and transport activities. However, if we look at the composition of the EIB’s investment portfolio within the European Union, we find that the EIB invests about twice as much in the Transport sector as it does in the Energy sector. This suggests that EU countries should not only increase the scope of EIB activities, both by recapitalizing it and by using the European budget as a leveraging device mobilize additional co‐financing, but also they should make sure that the EIB and the EU agencies in charge of investment policy, target sectors like energy with higher growth potential. 3. More Countercyclical Macroeconomic Policies In previous sections we argued that more countercyclical macroeconomic policies can help (credit constrained) firms maintain R&D and other types of innovation‐enhancing investments over the business cycle. One implication of this for European growth policy design is that all the debt and deficit targets (both in the short and in the long term) should be corrected for cyclical variations; in other words, they should always be stated in structural terms. For example, if a country’s current growth rate is significantly below trend, then the short‐run budgetary targets should be relaxed so as to allow this country to

Philippe Aghion

maintain its growth‐enhancing investments. However, while the fiscal compact specifies long‐term objectives that are stated in structural terms, the short‐ and medium‐term targets agreed between the European Commission and member states last year are in nominal terms. This inconsistency is can be damaging to growth.

Conclusion A successful innovation‐led economy requires a combination of policies, including investment in the knowledge economy, liberalization of markets, and governance reform to make the state more strategic. Although the old welfare states are not well suited to the needs of an economy where growth is driven by frontier innovation, the minimal state advocated by neo‐liberals may not be the solution either. Between these two extreme solutions is what we refer to as the strategic state. It acts primarily on the supply side of the economy and targets its investments on the sectors or activities with higher expected growth potential. It is a state that tries to reconcile the need to invest in growth with the need to achieve budget balance. And it is a state that looks carefully at governance, both of the sectors it invests in and of itself as investor. Germany or Scandinavian countries are noteworthy signposts to the strategic state. They reacted to past crises by implementing structural reforms, both in labor and product markets and in the organization of the state, and they now have unemployment rates lower than many other OECD countries and growth rates close to 3 percent. These lessons should not be lost on us.

References Acemoglu, D., P. Aghion, and F. Zilibotti. 2006. “Distance to Frontier, Selection, and Economic Growth.” Journal of the European Economic Association 4(1): 37–74. Aghion, P., J. Boulanger, and E. Cohen. 2011. “Rethinking Industrial Policy.” Bruegel Policy Brief, 04/2011. Aghion, P., and P. Howitt. 1992. “A Model of Growth through Creative Destruction.” Econometrica 60: 323–51. ———. 2006. “Appropriate Growth Policy.” Journal of the European Economic Association 4(2‐3): 269–314. ———. 2009. The Economics of Growth. Cambridge, MA: MIT Press

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Aghion, P., D. Hemous, and E. Kharroubi. 2009. “Countercyclical Fiscal Policy, Credit Constraints, and Productivity Growth.” Forthcoming in the Journal of Monetary Economics. Aghion, P., M. Dewatripont, C. Hoxby, A. Mas‐Colell, and A. Sapir. 2010. “The Governance and Performance of Universities: Evidence from Europe and the US.” Economic Policy 25(61): 7–59. Aghion, P., Y.Algan, P. Cahuc, and A. Shleifer. 2010. “Regulation and Distrust.” The Quarterly Journal of Economics 125: 1015–49. Aghion, P., Y. Algan, and P. Cahuc. 2011. “Civil Society and the State: The Interplay between Cooperation and Minimum Wage Regulation.” Journal of the European Economic Association 9: 3–42. Aghion, P., and A. Roulet. 2011. Repenser l’Etat. Editions du Seuil, Paris. Aghion, P., M. Dewatripont, L. Du, A. Harrison, and P. Legros. 2012. “Industrial Policy and Competition.” Mimeo, Harvard University. Aghion, P., E. Farhi, and E. Kharroubi. 2012. “Monetary Policy, Liquidity and Growth.” Mimeo, Harvard University. Aghiony, P., U. Akcigit, and J. Fernández‐Villaverde. 2012. “Optimal Capital versus Labor Taxation with Innovation‐Led Growth.” JEL No. O31, H21. First draft presented at the 26th Annual Meeting of the Canadian Macroeconomics Study Group: Recent Advances in Macroeconomics, November 2–3, 2012. http://hp.gredeg.cnrs.fr/maurizio_iacopetta/workshop% 20growth%202012/AAFV_NBER_SI.pdf. Brander, J. 1995. “Strategic Trade Policy.” In G. Grossman and K. Rogoff, eds., Handbook of International Economics, Volume 3, pp. 1295–1455. Amsterdam, North Holland: Elsevier. Brander, J., and B. Spencer. 1985. “Export Subsidies and International Market Share Rivalry.” Journal of International Economics 18: 83–100. Easterly, W. 2005. “National Policies and Economic Growth.” In P. Aghion and S. Durlauf, eds., Handbook of Economic Growth. Amsterdam, Elsevier. Guiso, L., P. Sapienza, and L. Zingales. 2004. “Does Local Financial Development Matter?” Quarterly Journal of Economics 119(3): 929–69. ———. 2006. “Does Culture Affect Economic Outcomes?” Journal of Economic Perspectives 20(2): 23–48. ———. 2009. “Cultural Biases in Economic Exchange.” The Quarterly Journal of Economics 124(3): 1095–1131. Hausmann, R., D. Rodrik, and A. Velasco. 2005. “Growth Diagnostics.” Mimeo, Harvard University.

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Mian, A. 2012. “The Case for a Credit Registry.” Paper delivered at NBER conference on Systemic Risk in New York. Forthcoming in Systemic Risk and Macro Modeling, Markus K. Brunnermeier and Arvind Krishnamurthy, eds. University of Chicago Press. Nunn, N., and D. Trefler. 2010. “The Structure of Tariffs and Long‐Term Growth.” American Economic Journal: Macroeconomics 2(4): 158–94. Romer, P. 1990. “Endogenous Technical Change.” Journal of Political Economy 98: 71–102. Solow, R. 1956. “A Contribution to the Theory of Economic Growth.” Quarterly Journal of Economics 70(1): 65–94. Spence, M. 2009. “The Growth Report: Strategies for Sustained Growth and Inclusive Development.” World Bank, Washington, DC.

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