Growth policy for dummies

A recent working paper by Nicholas Crafts – Creating Competitive Advantage: Policy Lessons from History – should be compulsory reading for any South African politician, bureaucrat, journalist, student, trade unionist or anyone vaguely affiliated with policy-making in South Africa. Let me rephrase that: at least the first four pages of this paper should be compulsory reading for anyone working for South Africa’s Department of Trade and Industry, Treasury and the Department of Economic Development.

Why? Because it gets to the heart of what a government can do to help grow an economy (and, consequently, improve the lives of its citizens). And also why – even if we know what to do and how to do it – it probably won’t happen. I’ll quote liberally.

The main lesson, as I’ve mentioned before, is that long-run growth happens on the supply-side, i.e. by improving productivity:

Economic growth, and especially productivity growth, is at the heart of the matter. In turn, longrun productivity performance depends upon decisions to invest, innovate, and adopt new technology which in a market economy will be sensitive to incentive structures. This means that a wide range of government actions which comprise ‘supply-side policy’ can potentially have an impact on productivity growth.

So what can governments do?

The main thrust is that growth depends on investment in tangible and intangible capital, in education and training, and on innovation. Decisions to invest and innovate respond to economic incentives such that well-designed policy which addresses market failures can raise the growth rate a bit. This implies governments need to pay attention to making investments that complement private sector capital accumulation, for example in infrastructure, to supporting activities like R & D where social returns exceed private returns, to avoiding the imposition of high marginal direct tax rates and to fostering competitive pressure on management to develop and adopt cost-effective innovations.

Technology – foreign and domestic – is important:

In the long-run, the key to sustained growth in labour productivity (and growth in living standards) is technological progress. In this context, however, it is important to recognize that better technology can be the result of domestic invention or technology transfer from abroad which is implemented by means of appropriate investments in physical and organizational capital. In fact, most new technology comes from abroad and TFP growth depends much more on foreign than domestic R & D. Nevertheless, the contribution of new technology to growth comes from its use. The key to good growth performance is prompt and effective diffusion of foreign technology rather than domestic invention.

I like that last point. It’s not about flashy, new technologies being developed in the domestic industry (think: Rooivalk, or the Joule?), but about adopting technologies that will permeate several, large industries (think: mobile technology). Crafts, for example, finds the distribution industry to have made the largest contribution to the gains in labour productivity between 1995 and 2007. What explains this?

First, a sector’s contribution depends not only on its productivity growth rate but its weight in the economy. (Distribution is large.) Second, distribution is a sector which does (virtually) no R & D but is big and has benefited greatly from the opportunity to improve productivity using ICT. In sum, policymakers should be aware of the basic arithmetic of growth and realize that diffusion matters much more than invention and that productivity improvement in big service sectors is central.

But growth is neither smooth, nor linear:

Economic growth is an unbalanced process – over time, some sectors expand and others contract. This reflects relative productivity growth, differences in income elasticities of demand, and, in an open economy, comparative advantage which reflects relative production costs between (South Africa) and the rest of the world based on differences in productivity and payments to factors of production. Comparative advantage evolves reflecting developments both in (South Africa) and our trading partners in terms of relative wage rates, technological capabilities, labour force skills, agglomeration benefits and this implies the need for sectoral and spatial adjustment as workers are redeployed, especially away from activities which have become importables in the face of competition from emerging Asia. A key requirement fully to realize the benefits from increased trade in a globalizing world is flexibility of labour and product markets.

Of course, this isn’t easy to achieve because politicians have different goals than a benevolent dictator – they need to win votes:

Although higher productivity may seem attractive, the politics of achieving it may be quite challenging. A central aspect of technological progress is ‘creative destruction’, i.e., the exit of the old replaced by entry of the new. The pursuit of higher productivity through policies such as trade liberalization creates losers as well as gainers; realizing the potential productivity gains from privatization involves job losses. The common theme here is that, while there are gains for the economy as a whole, these do not translate into votes whereas the losses of the downsized producer groups are highly visible, matter a lot to the individuals involved, and have adverse implications for vote-seeking politicians.

So is there no way government can help? Well, there is industrial policy, a tricky topic. But what is industrial policy really?

Industrial policy encompasses public sector intervention aimed at changing the distribution of resources across economic sectors and activities. Thus, it includes both ‘horizontal’ policies which focus on activities such as innovation, provision of infrastructure and so on, while ‘selective’ policies aim to increase the size of particular sectors.

Why do we need industrial policy?

The classic justification for industrial policy is that it remedies market failures, for example, by providing public goods, solving coordination problems, or subsidizing activities with positive externalities. More generally, the development of endogenous-growth theory suggests that horizontal policies which raise the appropriable rate of return to innovation and/or investment can have positive effects on the rate of growth. Quite a wide range of government policies might be relevant here including the structure of taxation, extent and type of regulation, quality of state education and supply of infrastructure capital which raises private sector profitability.

So it seems like horizontal industrial policy, where no industry benefits absolutely, is beneficial. What about selective industrial policy?

The case for selective industrial policies has always been more controversial. However, the modern literature highlights three arguments in their favour, namely: infant-industry related capital market failures, agglomeration externalities, and rent-switching under imperfect competition. It should also be acknowledged that there are important potential downsides to the use of selective industrial policy. In particular, it has been widely remarked that, in practice, support is disproportionately given to sunset rather than sunrise industries and some economists argue that this ‘government failure’ is an inherent aspect of the political economy of industrial policy.

(Consider the South African clothing and textiles industry.)

An important issue is whether industrial policy reduces competition. Ideally, industrial policy should be used in a competition-friendly way and not through aiming to create ‘national champions’.

There is much more to read in the paper, including a discussion of UK industrial policies and their failure to deliver the desired results. I guess the take-away is that governments should tread lightly whenever support for a certain industry weights more heavily than another. The focus should be on improving the productivity of the large sectors and industries (in South Africa, as in most middle-income countries, services and manufacturing). How to do this? Investment in infrastructure and education that will allow firms in these industries to become more productive by adopting more efficient technologies and hiring more efficient workers. That is, building a fast and reliable telecommunications and transport network, and delivering graduate students that are able to work in these industries. This is not only difficult, it’s also unsexy. Which means dummies politicians will continue their search for national champions that do more harm than good.

Turkish delights

I recently spent four wonderful days in Istanbul. Here’s a few notes on five unexpected delights of this great city:

1. Dried fruit. While this is probably not the first reason most people visit Turkey, you have to try the dried strawberries, pineapples, figs, peaches and several others that’s available in the Spice Bazaar. I don’t know why I’ve never had (or seen) dried strawberries before, but this should be a compulsory ingredient in any dessert. It comes with a warning though: dried fruit is not cheap. While we’re at fruit, also try the amazing watermelon (served in a bowl with a plastic fork) sold in the Sultan Ahmet park between the Hagia Sophia and Blue Mosque for about 5 lira (roughly R25) every evening.
2. Treat yourself. There’s the famous Turkish Baths (I went to the more touristy Cemberlitas Hamami) which is certainly something to experience (it will set you back about R330 for an hour of steaming, washing and, well, bathing). Each patron gets his/her own washer, and after about 20 minutes in the sauna, you are rubbed, then washed and then washed again in another room. I don’t think I’ve ever been so thoroughly clean. But while Turkish Baths are well known, Turkish barbers are perhaps even more entertaining. I had a cut and shave for about R150 – and it’s a great way to relax and listen to the comings and goings of the locals. If you want, some barbers also use something like a Bunsen burner on your, well, sideburns. (I decided not to for the very obvious reason that I don’t have sideburns.)
3. Read. I hadn’t known much about Orhan Pamuk before visiting Turkey, but his books are excellent ways to understand the history and culture of its people. I would recommend his ‘My Name is Red’, a murder mystery about miniaturists (book illuminators) set in the Ottoman Empire at the end of the sixteenth century. If you’ve loved ‘The Name of the Rose’ by Umberto Eco, ‘My Name is Red’ should be on your next reading list. I also started reading Pamuk’s latest – ‘The Museum of Innocence’ – set in 1970s Istanbul. Be warned though: it’s a tragic tale of love lost and won’t do much to brighten your mood.
4. Mosques. For someone that’s never been in a mosque (like me), there is no better place than Istanbul to experience some of the most impressive Islamic architecture and traditions. While the Blue Mosque is open to non-Muslims (except during prayer hours and religious events) and should be a compulsory visit, what makes Istanbul unique is the plethora of mosques all across the city; taking a cruise on the Bosporus is perhaps the best way to see this city of spires. Istanbul is not only a city of vivid colours and tastes, but also of sounds, and the morning and evening prayers that envelop the city is a constant reminder that religion is an essential part of Turkish life. And for that reason, even though traffic can be terrifying and thousands of people populate the streets, there is an incredible sense of calm about Istanbul that I’ve not experienced anywhere else. One piece of advice, though: if you’re a late sleeper, make sure your hotel room is not situated next to a mosque spire…
5. Turkish delight. Don’t wait. Don’t think that you’ll try it later. The more, the earlier, the better. Don’t try just one variety (the pistachio ones are my favourite). Don’t think they’re too expensive (they’re not). And don’t hold back; as with Istanbul, you won’t be disappointed.

Fire, don’t hire

What should strike any visitor to Switzerland, as I realised on a recent trip, is the extremely high capital-labour ratio of the country. Road sweepers don’t use brooms (as they do in South Africa), they use sweeper cars (think of golf carts on steroids), allowing those workers to be far more productive and, consequently, the government to employ fewer of them. This is true throughout the economy: there are fewer service staff in shops; fewer waiters in restaurants; fewer workers in factories. (But, importantly, more shops, restaurants and factories because these firms are competitive.)

Contrast this with the focus in South Africa on employment. Everyone from politicians and academics, to journalists and even trade unionists emphasise the need to create more jobs. But while job creation is an obvious necessity given South Africa’s highly unequal income distribution, the irony is that it is not achieved through focusing on job creation. No. Development is about producing more stuff with the same number of inputs, or using fewer inputs to produce the same amount of output (stuff). In short: it’s about improving productivity. And labour (i.e. jobs) is an input into producing the various outputs of the country: food on farms, clothing in small factory ships, vehicles in large assembly plants, and services in the financial, tourism or construction industries. So, in truth, if we want to develop, we need to focus on producing more stuff with fewer people, and should spend less time on thinking of creative ways to increase our inputs.

Instead of focusing on jobs, we should be focusing on adding more capital to people. Giving workers skills (human capital) adds to their ability to produce more with less. That is where an adequate education system is crucial, an issue which has received a lot of attention in South Africa. My take is that the particularly poor supply of education is only half the story. Perhaps South Africans don’t want a good education, because there is little need for it. Why would you want to learn anything if you believe that the best you can become is an unskilled labourer on a mine? Or maybe education is not even that important. (I can see Nic Spaull choking in his morning coffee.) Huge investments in education in several African countries after independence did little to accelerate economic growth.

When labour is scarce, it not only increases the price paid for labour, but also the incentive to innovate. This is something even Adam Smith noted when he said that no slave society has ever invented anything, simply because there was no need to: slaves were always available to do the job. But invention is the key to making a sustained improvement in productivity levels (i.e. to continuously do more with less): the Geneva road sweeper could never be so productive without the improvements in road sweeper technology that has eventually created the sweeper car. If South African firms are so focused on employing more people, there will be little incentive to innovate (both in technology and processes) which will allow the workers that already work there to be more productive. Our firms will not be competitive if they simply hire more workers when production increases.

So what about the 40% unemployed? Firstly, shedding jobs in one industry will make that industry more productive, which will also make it more competitive in international markets. This will allow the industry to grow, and more workers will be needed. But job shedding in one industry should also reduce the wage rate in other industries as those workers move. This would reduce wages in the rest of the economy, which will allow the rest of the economy to be more productive and competitive, creating a virtuous cycle. But, of course, wages don’t really fall where trade unions can collectively bargain against it. So, instead, some workers go unemployed, 40% of the South African labour force, to be exact.

Development is about making people better off. This is done by producing more stuff per worker than before. But if all of society’s focus is on creating jobs, rather than improving productivity, we will see this ratio of stuff per worker declining, which will only harm South Africa’s competitiveness and long-run development potential. If we’d like to be as rich as Switzerland, we should shift our focus from employing more people, to making those that are employed more productive.

Dragonomics

China is often the scapegoat for South Africa’s economic ills. A recent Briefing Paper by Rhys Jenkins of the University of East Anglia and Laurence Edwards of the University of Cape Town does much to reinforce this view (the authors kindly sent me the paper, read a newspaper report here). In short, the paper argues that Chinese imports of manufactures has harmed the domestic manufacturing industry and particularly employment. While industrial production in South Africa grew by 14% between 2001 and 2010, “this increase would have been around 5% higher in the absence of increased Chinese import penetration.” The paper finds that at least 77,751 jobs were lost since 2001 to China, while only 4,080 jobs were created by South African firms finding new markets in China. The authors also argue that on average South African exports to the top ten exports markets in sub-Saharan Africa “would have been almost 10% higher ($900 million more) had it not lost market share to China between 2001 and 2010”. The message: China is the evil dragon that is destroying South African manufacturing jobs and especially hurting the poor.

Nothing of this is new, of course. South African trade unions and clothing and textile firms have lobbied government for protection in the form of tariffs and quotas for nearly a century (yes, the first tariffs were introduced during the Great Depression in the 1930s). As the authors’ own numbers show, most of the job losses in the clothing and textiles industry occurred before 2001 when China officially joined the World Trade Organisation (170 000 vs 139 000). China’s imports, therefore, are only the final nail in the coffin of an industry that was on life support for too long.

The main focus of the paper is on counting job losses, but little is said of the benefits of trading with the Chinese. (While they do mention that “there are positive benefits to consumers from the availability of cheaper consumer goods”, they conclude that “as far as industrial employment is concerned, the effects are clearly negative”.) As any trade economist should know, the main benefit of international trade is a fall in prices: consumers are able to buy things more cheaply than they could before, allowing them to purchase more of the same things, or more of different things, or even save more. Did China’s imports of clothing and textiles reduce prices? The figure below, using published South African CPI data, suggests an unequivocal yes.

Consumer price indices for food and clothing goods in South Africa. Courtesy of Johann van Eeden (see reference below).

What does this mean? It means that, while food prices increased by more than 50% between 2001 and 2007, clothing and footwear prices fell by 30%. The poorest South Africans, which spend the highest proportion of their budget on food and clothing, were thus able to substitute the higher food prices with the lower clothing prices. Look at what happened at the end of 2007. After successful lobbying by trade unions, the government decided to increase protection in the clothing and textiles industry: they negotiated with China a quota on clothing and textiles imports (which is, incidentally, illegal under WTO rules). The consequence? A rapid increase in the price of clothes. Even now, South Africans pay between 35% and 45% on imported clothes. Imagine paying R200 less for that Levi jean of R600. Imagine adding all those R200’s and spending it somewhere else in the economy: buying healthier food, going on holiday, or even paying off the home loan quicker. Add all those R200’s together and you will create far more jobs elsewhere in the economy than trying to protect those clothing and textile workers who will anyway be undercut by low-cost producers (even if it’s not China).

That is not to deny that some people have not lost their jobs. But the knee-jerk response is that, because unemployment is a major social issue in South Africa, we must do our best to protect as many jobs as possible. Economists, better than anyone, should know that there is not a fixed number of jobs available globally. That notion died in 1776. If China is growing, employing more people, it is to the benefit of the South African economy: we not only get more stuff cheaper, but we also have a growing market to export to. And this is happening, our exports to China has grown by 33% annually to China between 2007 and 2011 (and, remember, there was the small matter of a global recession). Just ask the cotton farmers (exports to China increased by 44% annually), polystyrene producers (by 146% annually) or lobster fishermen (by 469% annually). And, by the way, these are actually also labour-intensive industries. Given this evidence (which I retrieved from Trademap.org), the 4,080 jobs claimed by the authors seem absurdly low.

More importantly, the authors fail to think about the underlying reasons why China’s imports are so cheap. No, it’s not only because of bare-bones wages; it’s because their workers are more productive at that wage level. But this is also a static picture: China is growing at unprecedented rates, which also means their wages are increasing. In fact, I suspect China won’t be the main exporters (and competitors) of cheap clothing soon; it will be countries like Bangladesh and Tanzania that will compete in this market. In fact, when South Africa imposed quotas on Chinese exports in 2008, it wasn’t as if our domestic industry benefited: imports simply switched from China to these countries (imports from Pakistan increased by 55%, Bangladesh by 660%, Myanmar 197%, Sri Lanka by 728% and even Italy by 120%) (see Johann van Eeden and Taku Fundira’s paper on this). Given our relatively high wages, no protection will allow us to compete in this market.

China has grown rapidly over the last two decades causing significant changes in most countries of the world, creative destruction which have evidently caused some industries (like the clothing and textiles industry in South Africa) to contract and suffer job losses. But the benefits have also been monumental: even with higher tariffs, the average price of a clothing item is actually lower in 2010 than it was in 2000. This is remarkable considering that the prices of all other goods have increased by more than 50%. This has yielded significant (but less publicly proclaimed) benefits for the poorest of South Africa’s poor. South African producers have also been able to exploit the growing Chinese market, which will allow us to pay for the cheap imports from China. Moreover, China’s growth has also allowed it to invest more in South Africa, and Africa, when many had thought it too risky.

Rather than fearing the evil dragon, we need to realise, the sooner the better, that this dragon’s our friend.