Michael Spence

Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, Academic Board Chairman of the Asia Global Institute in Hong … read more

In Search of Growth Strategies

MILAN – In 2008, the Commission on Growth and Development, which I had the privilege of chairing, produced a report updating our knowledge about sustainable growth patterns. Then, as now, one thing is clear: the policies that underpin multi-decade periods of high growth, structural transformation, rising employment and incomes, and dramatic reductions in poverty are mutually reinforcing. The impact of each is amplified by the others. They are ingredients in recipes that work – and, as with recipes, missing items can substantially undermine the outcome.

To understand the weak, deteriorating, and fragile growth patterns seen today in many countries and in the global economy as a whole, one should compare what is actually happening with what reasonably comprehensive growth strategies might look like. Of course, there are many policies that sustain high growth, and to some extent they are country-specific. But a few key ingredients are common to all known successful cases. 

The first is high levels of public and private investment. In successful developing countries, investment is at or above 30% of GDP. The public-sector component (infrastructure, human capital, and the economy’s knowledge and technology base) is in the 5-7% range. And the public- and private-sector investments are complementary: The former raises the rate of return to the latter, and hence its level.

Private domestic and foreign investment is influenced by a host of other factors that affect risks and returns. These include the skills of the workforce, the security of property rights and related legal institutions, ease of doing business (for example, the process and time required for starting a business), and the absence of rigidities in its product and factor markets (those for labor, capital, and raw materials).

Above all, the investment climate is positively influenced by stability – both competent and alert macroeconomic management and political effectiveness and continuity. Conversely, uncertainty about growth, or the commitment to a reasonably coherent reform agenda, will produce adverse impacts on investment.

A second common ingredient of sustainable growth strategies is that financing these relatively high levels of investment comes from domestic savings. Substantial reliance on external savings (as reflected in persistent high current-account deficits) seems to end badly – in debt crises and major growth setbacks.

Openness to the global economy with respect to trade and investment is critical as well. Foreign direct investment, for example, is a key channel for transmitting and adapting the accumulated stock of global technology and knowhow. And export competitiveness is raised as investment pours into the construction of links in global supply chains.

The capital account is a more complicated story. Generally, successful developing economies have managed it to prevent excessive volatility, including volatility resulting from external shocks or imbalances and from excessive reliance on external financing. In addition, most successful countries manage the exchange rate to keep it in line with productivity growth, using a combination of capital controls, monetary policy, and reserve accumulation or decumulation. Both over- and undervalued currencies have different adverse effects, though persistent overvaluation is more problematic for stability and growth.

Finally, inclusiveness is also a key component of successful development strategies. Growth patterns that systematically exclude subgroups founder on the loss of political and social cohesion and, ultimately, on the loss of support for the strategy. By contrast, income inequality that is not too extreme, and that does not arise from corruption or privileged access to markets, is understood and accepted. The provision of high-quality basic services like education and health care is viewed as crucial for equality of opportunity and intergenerational mobility.

Against that backdrop, one can assess current growth patterns in the global economy and its various parts.

For starters, public-sector investment is broadly below levels needed to restore and sustain growth, partly owing to fiscal constraints in overly indebted countries. Absent defaults, the normal way to reduce sovereign-debt overhangs is with nominal growth. But growth-oriented policies have been absent, beyond whatever monetary policy can contribute, and inflation is broadly below targets. And large pools of savings in sovereign wealth funds, pension funds, and insurance companies have not yet been successfully deployed at scale on the public-sector side, presumably because of blockages in the intermediation channels related to risk and incentives.

Private-sector investment (in tangible and intangible assets) is also below growth-sustaining levels (though there are contrary trends in some high-growth technology sectors). Contributing factors include a shortage of aggregate demand, high levels of uncertainty about policies and regulatory agendas, and growing doubts about key drivers of global growth like China. In addition, depending on the economy in question, stalled tax reform and policy-induced structural rigidities in product and factor markets are having adverse effects.

With respect to inclusiveness, much useful recent analysis focuses on technology-driven shifts in economic structure and labor markets on the demand side, and globalization, which has left education and skills mismatches on the slower-moving supply side. Job polarization and rising patterns of income inequality are in part the result of these forces, with adverse effects on final demand and, more important, on the resources that individuals and families have to invest in their own human capital.

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In short, a reasonably comprehensive strategy for restoring country-level and global growth would include measures to elevate and remove obstacles to public and private investment, thereby contributing to aggregate demand. It would also include a variety of reforms to strengthen private investment incentives. And it would include an inclusiveness agenda directed at structural disequilibrium in labor markets and potentially destructive income inequality. Thus far, with few exceptions, such comprehensive growth strategies have been missing.

If those strategies were not just implemented, but also synchronized across major economies, each would be amplified through positive international spillovers via trade – a clear role for the G-20. In the absence of such an approach, one can foresee an extended period of low and fragile growth, at best, with downside risks stemming from increased leverage in a prolonged low-interest-rate and deflationary environment. A worse outcome – and all too plausible – is further deterioration in the political and social cohesion that forms the foundation for vigorous policy responses. At that point, stagnation becomes a trap.