IN OPEN ECONOMIES: EXPORT-LED CUMULATIVE CAUSATION OR A BALANCE-OF-PAYMENTS CONSTRAINT?

Prof. Robert A. BleckerDepartment of EconomicsAmerican UniversityWashington, DC 20016 USAblecker@american.edu

2nd Summer School on “Keynesian Macroeconomics and European Economic Policies,” Research Network Macroeconomics and Macroeconomic Policies, 2-9 August, 2009, Berlin, Germany.

Overview

Two alternative types of long-run open economy models in the post-Keynesian tradition:

Export-led cumulative causation (ELCC)

N. Kaldor, J. Cornwall, M. Setterfield, etc.

Balance-of-payments-constrained growth (BPCG)

(R. Harrod), A.P. Thirlwall, J.S.L. McCombie, etc.

Some common foundations

But very different assumptions and implications

How can they be reconciled?

ELCC: intellectual origins

Adam Smith’s idea of the international division of labour increasing the “wealth of nations” (1776)

Expanding the size of the market enables greater specialization and higher productivity

Gunnar Myrdal’s cumulative causation (1950s)

virtuous or vicious circles of causality

stressed positive feedbacks in growth (or stagnation)

Nicholas Kaldor’s growth models and anti-equilibrium views (1960s-70s)

explaining why the UK lagged relative to W. Germany etc.

based on increasing returns to scale

export-led growth formalized by Dixon & Thirlwall (1975)

John Cornwall, Modern Capitalism: Its Growth and Transformation (1977)

synthesized the literature to date

Four of Kaldor’s growth laws (according to Thirlwall, 1983)

“The faster the rate of growth of the manufacturing sector, the faster will be the rate of growth of Gross Domestic Product (GDP)....”

“The faster the rate of growth of manufacturing output, the faster will be the rate of growth of labor productivity in manufacturing owing to static and dynamic economies of scale, or increasing returns in the widest sense....”

Called Verdoorn’s Law (after Verdoorn, 1949)

“The growth of manufacturing output is not constrained by labor supply but is fundamentally determined by demand from agriculture in the early stage of devel-opment and exports in the later stages....”

“A fast rate of growth of exports and output will tend to set up a cumulative process, or virtuous circle of

th th h th li k b t t t th d

More rapid export growth , x

Faster output growth, y

Faster labor productivity growth, q

Increased external competitiveness or real currency depreciation,

(e + p* – p)

Keynesian multiplier effects, increased

utilization rates, stimulus to investment

Increasing returns to scale, induced technological

innovation, R&D (“Verdoorn’s Law”)

Based on mark-up pricing over unit labor costs, taking nominal

wage increases as given

Export demand function with a high relative price elasticity

Figure 1: The Basic Export-Led Growth Model

Some Comments

Often this is model disaggregated and the focus is on the manufacturing sector

The Verdoorn relationship between output growth and productivity growth is thought to apply mainly in manufacturing

This leads to analyses of uneven sectoral growth between manufacturing, agriculture, and services

Labor supply is assumed to be endogenous and not a binding constraint on output growth

Because productivity growth releases labor that can be reemployed in other activities

This includes transfers of labor from agriculture to manufacturing and manufacturing to services

Also migration, guest workers, and/or changes in gender and age relations can relax labor supply constraints

ELCC Model: Setterfield & Cornwall (2002) version

1) Export demand: x = x (e + p*

p) + x y*

2) Mark-up pricing:

3) Verdoorn’s Law:

4) Output growth:

yqq 0Labor productivity growth is an increasing function of output growth (dynamic increasing returns)

qwp Price inflation = wage inflation – productivity growth(assuming no change in the mark-up rate, = 0)

Export growth depends positively on changes in relative foreign prices and foreign income growth

)( axy ax Where is the Keynesian multiplier, A = C+I+G is domestic demand (a is its growth rate), and the ’s are weights on export and domestic shares of aggregate demand

Note: all variables in growth rate form.

Model solution (slightly modified from S&C)

The model boils down to 2 equations in 2 endogenous variables, q and y:

(3) The Verdoorn equation: “Productivity Regime” (PR)

(5) The other 3 equations solved for:where

“Demand Regime” (DR)

With equilibrium solution

(6)

yqq 0

qy xx

** )( ywpea xxxa

xx

xxE

qy

1

0

There is a stable long-run equilibrium as long as the slopes are as shown, i.e.,

orin other words, not too much cumulative causation!

xx 1 1xx

Figure 2: Graphical Solution of ELCC Model

Labor productivity growth rate (q)

Output growth

rate (y)

(5) Demand Regime (DR)

yqq 0

(3) Productivity Regime (PR)

q0

q0 /

qy xxyE

$

Theoretical and policy implications:

In spite of the disequilibrium motivations of the theory, there can be a stable equilibrium as long as the forces of cumulative causation are not too strong

Either supply-side policies to boost productivity growth (q0 ) or demand-side policies to stimulate output (a) can increase both output and productivity growth in the long run

But there are still too many positive self-reinforcing effects, and not enough offsetting effects, to be realistic

For example, wage increases, currency appreciation, or spillovers of technology to other countries can

Shifting the focus to the “traverse” or convergence process

Setterfield (2002, ch. 12) argues that there has been too much focus on the long-run equilibrium

Real economies spend most of their time in transition or the “traverse” between the equilibria described by these models

Roberts (2007) shows that this same type of model implies “conditional convergence,” empirically similar to what is implied by the neoclassical Solow model

This is shown by introducing time lags into the equations for exports and/or productivity

Economies that are below (above) their equilibrium growth rate grow faster (more slowly)

The further an economy’s initial growth rate is below its long-run equilibrium, the faster it grows

The main difference from Solow’s predictions is what variables the convergence is conditional on (e.g., elasticities of export demand rather than saving rates)

Empirical Evidence: León-Ledesma (2002)

A Critique and an Alternative: Balance-of-payments-constrained growth

The ELCC growth model could imply persistent trade imbalances (surpluses or deficits) in the long-run “equilibrium”

This may not be sustainable

In the long run, a country must either keep its trade balanced (on average) or else maintain a sustainable level of financial inflows or outflows

See Thirlwall & Dixon (1979), who assumed balanced trade

In his original model, Thirlwall (1979) ignored capital (“financial”) flows

These were introduced by Thirlwall and Hussain (1982), who assumed that financial inflows grow at a steady rate

Alternatively Moreno-Brid (1998) postulated that a country should have a stable (constant) ratio of the current account balance to GDP in the long run

Extended (most general) BPCG model (combining Dixon & Thirlwall with Moreno-Brid)

Export demand: x = x (e + p*

p) + x y*

Import demand: m =

m (e + p*

p) + m y

Balance of payments equilibrium

Moreno-Brid’s approach, assuming CA/Y ratio is constant (where = PX/EP*M):

(x – y) = e + p* – p + m – y

Assuming also that Verdoorn’s Law and markup pricing apply, the general solution is:

)1(1))(1( *

0*

mxm

xmxB

yqwpey

Special cases

Elasticity pessimism: x + m

1

if also there are no financial flows (balanced trade), then

Relative purchasing power parity (PPP): e + p* – p = 0

if also there are no financial flows (balanced trade), then we have “Thirlwall’s Law” (simplest version):

1

*

m

xB

yy

m

xB

yy *

1m

Bxy

mB

xy

Theoretical implications

There are many different solutions for the BP- constrained growth rate, depending on assumptions about

price elasticities

real exchange rates

financial (capital) flows

Which assumptions are realistic may depend on the time frame and historical situation

PPP does not hold except in very long run (25+ years?) and only for some countries/currencies

Elasticity pessimism is more likely to be valid in the short run

None of these solutions is equivalent to ELCC

But the most general solution does allow for cumulative causation to affect BP-constrained growth

This requires that PPP and elasticity pessimism do NOT h ld

Policy implications

In any of the BPCG models, domestic stimulus policies cannot raise the long-run BP-constrained growth rate

Only policies that promote exports or restrain imports can raise the BP-constrained growth rate

The policies must increase export growth (or the income elasticity of export demand) and reduce the income elasticity of import demand

In the stronger versions (with PPP or elasticity pessimism), there is no long-run advantage from more price-competitive exports

However, the basic Kaldorian idea that success in exports is essential to long-run growth is preserved.

Empirical test by Alonso & Garcimartín (1998-99)

They estimate a more complicated model with two alternative systems of equations:

Post-Keynesian (output adjustment) Neoclassical (price adjustment)

taking into account simultaneity issues, different price indexes, and gradual adjustment of export and import quantities.

Results for post-Keynesian model

Outputadjustmen t

Price elasticities

Income elasticities

Results for neoclassical model

Price elasticities

Income elasticitiesPrice

adjustments

Reconciling the Two Growth Rates?

Figure 3:

Labor productivity growth rate (q)

Output growth rate (y) (5) Demand Regime (DR)

(3) Productivity Regime (PR)

q0

q0/

yE (12) Balance of Payments Constraint (BP)

yB

Figure 4:

Labor productivity growth rate (q)

Output growth rate (y)

(5) Demand Regime (DR)

(3) Productivity Regime (PR)

q0

q0/

yE

(12) Balance of Payments Constraint (BP)

yB

Explanation of graphs

To get the BP constraint (12), we solve the extended BPCG model for yB as a function of q

omitting the Verdoorn’s Law equation which is shown separately as the PR curve (3)

this yields

which is upward-sloping under plausible assumptions

If either PPP or elasticity pessimism holds, this becomes horizontal

1

))(1( **

m

xmxB

yqwpey

Can financial (capital) flows relax the BP constraint and make yB yE ?

No!

Not if we model financial flows à la Moreno-Brid (1998)

A higher or lower (but sustainable) CA/Y ratio will not generally move the BP constraint toward the ELCC solution

On the contrary the changes in may move BP the wrong way

Assuming PPP or elasticity pessimism, BP does not shift at all

Points above or below BP are not just higher or lower CA balances, but continuously increasing or decreasing ratios of CA/Y (which are not

l ibl / t i bl )

So the ELCC relationship must shift toward the BP constraint

Domestic expenditure adjustments

Endogenous fiscal or monetary policies (restraint in Fig. 3, expansion in Fig. 4)

Do governments have targets for CA/Y? (Bayoumi, Epstein, Summers)

Private sector expenditure restraint or expansion

Perhaps Stock-Flow dynamics would force this to happen?

Or would they exacerbate the disequilibrium?

Relative price adjustment?

E.g. in Fig. 3, a rise in w or fall in e (appreciation) would offset the competitive gains and lower DR toward BP

This could establish PPP, as Thirlwall perhaps assumed

But such changes in relative prices are not automatic

See Alonso & Garcimartín (1998-99)

Unless PPP is reached, the adjustment could be unstable

Another possibility for relaxing BP

If we model financial (capital) flows à la Thirlwall and Hussain (1982), the BP constraint becomes

(1)(x + p) + f = e + p* + mwhere = F/(PX + F) is financial inflows as a percentage of total BP “receipts” and f is the growth rate of financial inflows

The BP constraints in Figs. 3 and 4 are described by:

The meaning of being above or below BP now changes

It only requires a higher or lower f

m

mxxmxB

qwfywpey

)1)1()()1()()1)1( **

Now can financial (capital) flows relax the BP constraint and make yB yE ?

Yes – maybe!

Now the BP-constrained growth rate solution is

If f can increase or decrease, yB will rise or fall

This depends partly on the degree of financial liberalization (“capital mobility”), also on confidence factors

But this cannot be sustained in the long run if CA/Y would grow too large or too small (negative)

If f > y + p, then the CA/Y ratio would fall continuously

This would be implausible

)1)1(

)()1()()1)1( 0*

0*

mxm

xmxB

qwfyqwpey

Conclusions

The ELCC model makes more sense as a “medium-run” model, where MR is defined as a period in which

PPP does not hold

price elasticities are high enough (J-curve has turned up)

Recent empirical studies find evidence for real exchange rate effects on growth (Blecker & Razmi, 2008a &b; various others)

countries can borrow or lend amounts that might not be sustainable in the long run

This requires the Thirlwall-Hussain approach to financial flows

But this can lead to financial crises (debt, currency, etc.)

In the longer run, CA/Y ratios must stabilize and the Moreno-Brid approach makes more sense

Which BP constraint?

The longer the time horizon, the more likely it is that PPP holds and the original Thirlwall’s Law holds

Or a modified version with financial flows but not relative price effects

Razmi’s (2005) estimates for India using cointegration suggest 25-50 years

Over shorter periods, cumulative causation effects could be at work

But do we ever get to the long run?

Setterfield suggests we are normally in a “traverse” between shifting ELCC medium-run equilibria

This has to be reconciled with why the long-run data do seem to support BPCG!

Directions for future research

Levels vs. growth rates:

Can there be lasting gains (or losses) in the levels of income due to cumulative causation even if growth rates can’t permanently increase?

Roberts’ (2007) work on convergence suggests the answer is “yes”!

Econometric tests:

More powerful methods are required to distinguish between these alternative hypotheses

Existing empirical estimates are consistent with both but don’t enable us to tell which one is more valid or under what conditions

Reconciling with other branches of post-Keynesian theory

Monetary production economy/role of finance