RDP 9507: Macroeconomic Policies and Growth 2. An Overview of Long-run Growth Trends

To gain a preliminary impression of the potential role of macroeconomic policies, Table 1 presents long-run trends in per capita income growth over the period 1870–1989. Four features are worth noting:

• growth does not evolve along a smooth constant trend – there is clear evidence of ‘epochs’ of growth, raising important questions as to the causes of trend breaks;
• the period 1951–73 clearly stands out as a period of exceptionally strong growth and, seen in a longer perspective, post-1973 developments are relatively favourable;
• the growth performance of Australia is rather poor compared with that of other industrial countries, especially during 1951–73 when the growth differential exceeded one percentage point; and
• among the developing countries, the extraordinary growth performance of the Asian countries is of relatively recent origin as, prior to 1950, growth in Asia was well below that of other regions. By contrast, Latin America grew relatively fast before 1950, while growth was rather slow during 1950–73 and almost came to a complete halt in the post-1973 period. The same pattern is even more evident in Africa, following a somewhat better growth performance during the pre-war period.

The 1951–73 era is clearly the most interesting one, especially given the macro-policy activism during the period. To what extent did ‘good’ policies contribute to the high growth? It is generally recognised that once-off factors such as post-war reconstruction and catch-ups with the technological leader (the United States) had a large part in explaining the favourable growth performance. Thus excluding the United States, average per capita growth in the industrial countries exceeded 4 per cent (compared with less than 1 per cent over 1914–50) while the United States grew by only 2.2 per cent (1.6 per cent). These unique factors also implied that high growth was unlikely to continue; once the catch-ups had been completed, growth would return to a slower pace.

The catch-ups did not, however, occur automatically. They were no doubt facilitated by the move towards free trade and currency convertibility and within each country they were helped by higher investment in both education and physical capital. Indeed, by 1973 the investment/GDP ratio for the industrial countries had increased to over 25 per cent, compared with 22 per cent in 1960 and for the 1960–73 period on average (Table 2). In some countries with restrictions on capital movements, the rise in investment may have been helped by low-interest-rate policies. A favourable social environment, resulting in stable factor-income shares, probably also stimulated investment. In a few countries, ‘social contracts’ were instrumental in generating stable factor shares (see Crafts and Toniolo (1995)) but more generally, the stability was probably the result of the high rate of productivity growth. With most prices set as a mark-up on unit labour costs, high labour-productivity growth meant that moderately rising nominal wages translated into growing real wages and low price inflation. Distributional pressures and disputes could thus be resolved in a relatively non-inflationary way and without large short-term changes in factor income shares.

The role of demand-management policies is more difficult to evaluate (and will be discussed further in Section 3). Attempts to ‘fine tune’ the economy may have been instrumental in generating relatively stable growth rates during 1950–73, with a variability about one-third lower than in the inter-war period (Romer 1988) and also substantially lower than in the post-1973 period (see Table 3). This is likely to have reduced uncertainty and spurred investment.^[1] On the other hand, it also appears that either policy makers went too far in ‘smoothing the cycle’, stimulating output to a level that, in retrospect, was too high relative to potential output, or they did not take sufficient account of shocks and other external changes that reduced potential output. Thus, while inflation was low on average, it accelerated significantly during the period (Table 2).

Moreover, the labour share of income rose in the late 1960s and into the 1970s, pointing to strains in the social fabric. One tentative conclusion emerging from this episode is, therefore, that macro-policies aimed at smoothing the cycle may increase the level as well as the average rate of output growth. However, such changes are only sustainable if the target level of output does not lead to rising inflation.

Because the productivity slowdown in the early 1970s^[2] coincided with the breakdown of the Bretton Woods system and the rise in oil prices, it is tempting to associate floating exchange rates and higher oil prices with lower output and productivity growth. With the perspective of two decades, however, there is little evidence to support these hypotheses. The share of oil and other energy products in overall output costs is only around 5 per cent and while some early studies identified higher energy prices as the principal reason for the growth slowdown, most recent analyses do not find changes in relative oil and energy prices to be significant. The terms-of-trade losses suffered by many industrial countries combined with real wage rigidities have also figured prominently in explanations of the slower growth after 1973, especially for European countries. If, however, ‘real wage gaps’ were a major cause, the terms-of-trade gain following the decline in oil prices in the mid 1980s should have boosted growth and reduced unemployment, which it failed to do. The evidence is also weak regarding the growth effects of the rise in the variability of exchange rates: some have found that high variability has an adverse effect on trade but most have found no significant effects.^[3] It seems more likely that these two events were themselves the results of the previous developments and policies and that the slowdown would have occurred in their absence, though it might have been less abrupt.

Some have also associated the productivity slowdown with the change in the consensus view of economic policies from a Keynesian paradigm based on fine-tuning economies at close to full employment to a neoclassical paradigm stressing market forces and giving high priority to low inflation. However, the change in policy regimes did not take place overnight (though by the early 1980s most industrial countries had accepted this new view) and was thus less sharp than the 1973 trend-shift would suggest. A more plausible interpretation would seem to be that part of the high growth rate generated during the Keynesian regime was unsustainable and part of the slowdown during the neoclassical regime reflects the ‘costs of repairing the damage’ caused by the earlier policies.

This combination of over-expansionary policies followed by a period of re-establishing macroeconomic balance is even more striking for Latin America (Adams and Davis 1994). Although there was some slowdown between 1960–73 and 1974–82, growth in the latter period was still relatively high but, as it turned out, mainly based on fiscal and monetary policies aimed at expanding domestic demand. These policies did succeed in raising output growth, but they also resulted in widening fiscal imbalances, accelerating inflation and, above all, in steeply rising external deficits and levels of foreign debt. The unsustainability of the situation became evident in 1982, when world real interest rates rose and the measures required to correct the past mistakes resulted in the ‘lost decade’ of the 1980s. In Sub-Saharan Africa, too, short-term policies – to a large extent in the form of expanding the public sector – helped to maintain relatively high growth in the 1970s. However, since the earlier 1980s, aggregate growth has averaged less than 2 per cent, partly because of a 30 per cent fall in the terms of trade and other external shocks, but also as a result of correcting unsustainable fiscal imbalances and over-expansionary policies, reinforced by a large burden of foreign debt and limited access to international capital markets.

Footnotes

Kormendi and Meguire (1985), however, find a positive coefficient for the variability of income growth in a cross-country regression of per capita income growth. [1]

A slowdown in trend growth occurred in most industrial countries around 1973, while in many developing countries, the break seems to have coincided with the second oil price rise and the debt crisis (see Crafts and Mills (1995) and Ben-David and Pappell (1995)). [2]

On the other hand, maintaining exchange rates at levels that are not consistent with ‘fundamentals’ can have adverse output effects (see Section 3). Such policies are more likely under fixed than under flexible exchange rate regimes. [3]