Country-Level Growth Analytics
February 3, 2014
- Policymakers often look to the World Bank for advice on how to improve economic growth.
- World Bank economists strive to understand the constraints to growth in a country and the reasons the poor may not be benefiting from country-wide increases in GDP.
- A number of tools help economists break down growth into components, helping them better understand growth drivers and trends.
A country’s economic growth is usually measured in terms of a change in gross domestic product, or GDP. This is a measure of everything a country produces in a year, and GDP estimates are calculated by a number of organizations, including the World Bank, the International Monetary Fund, and the United Nations. When a country’s production increases year-over-year, it is said to be experiencing economic growth.
Why a country experiences economic growth is a question economists have been trying to answer for decades. What makes factories and workers in a particular country more productive? Why does one country produce more from one year to the next when its neighbor produces less? The answers to these questions could help lift millions of people out of poverty.
World Bank economists, based in country offices and in the Washington, DC, headquarters, follow certain methods to examine the sources of economic growth within a country and better understand its drivers. Often their inquiries are guided by questions that come directly from countries. That is, leaders in developing nations might want to fix specific aspects of their economy or grow in a particular way. They might ask a World Bank team:
- How can we industrialize?
- How can we boost exports or diversify trade?
- How can we create jobs?
- What skills should our country invest in to maximize employment opportunities?
- Where should we target public investments to grow faster and create jobs?
- How can we help create jobs in parts of our country that are economically depressed?
World Bank economists create country-specific reports – such as Country Economic Memoranda, Economic Updates, and Growth Reports – to address these and other questions related to economic growth. Below are descriptions of some of the techniques used in these reports.
Finding out what is wrong
An over-arching methodology often used by World Bank economists to examine growth was developed at Harvard by economists Ricardo Hausmann, Dani Rodrik, and Andrés Velasco and is laid out in a paper called "Growth Diagnostics." This methodology, often referred to as "HRV," sets up a decision-tree that helps investigators systematically evaluate constraints to economic growth in any given country.
This rubric helps policymakers identify the most important hurdles, or “binding constraints,” that need to be overcome for a country to grow faster. For example, the first question might be: What is hindering investment in country X? That might lead to subsequent questions: Is it that investors don’t see profits, but have to spread their gains across taxes, bribes and other costs? Do entrepreneurs have poor access to technology from abroad? Is the government not investing in public infrastructure or education?
A Country Economic Memorandum prepared for Benin, for example, used the HRV framework to examine growth trends and identify constraints to Benin’s private investment and economic development. Working down the HRV “Growth Diagnostic Tree,” it became evident that although Benin’s economy was not constrained by liquidity, private investment was weak because of low returns to economic activity–a result of (1) costly and unreliable infrastructure services, including electricity, domestic rail and road transport, and communications; (2) weak “innovation” efforts; and (3) failures related to a poorly designed and administered tax system. Problems extended to customs and trade procedures, and included corruption and weak contract enforcement. While these are no easy problems to fix, with this information, the government knew where to start on solutions that would make the biggest impact.
The strategy is aimed at identifying the most binding constraints on economic activity, and hence the set of policies that, once targeted on these constraints at any point in time, is likely to provide the biggest bang for the reform buck.
Is growth benefitting the poor?
Importantly, a main mission of the World Bank Group is to promote “inclusive growth,” or growth that helps the poor as well as the middle class and wealthy. Accordingly, one strain of diagnostics, described in a World Bank Working Paper, “Inclusive growth analytics: Framework and application,” focuses on the patterns – not pace – of growth. It looks at how broad-based the growth is: Does it touch a wide variety of sectors, such as agriculture, manufacturing and services, and does it reach people from all parts of the country’s labor force?
The intuition behind much of this work is that the benefits of GDP growth will accrue to either capital (owners of factories, farms, etc.) through profits and rent or to labor (workers) through wages. The owners of capital are understood to be wealthier than workers, and prosperity in a growing economy can be shared across socioeconomic classes in a number of ways: the under-employed can find employment; real wages can increase at least as fast as profits; wages in the low-wage sector can rise as fast as wages in the high-wage sector; or, finally, people in low-wage sectors can move to jobs in higher-wage sectors. Each of these dynamics implies a sharing of prosperity and a growth that is more inclusive than one driven purely by increases in profits.
Country analysis in this vein might assess whether the incomes of some segments of the population are growing, and if not, why they are unable to grow sufficiently through more productive employment at higher real wages. World Bank economists might then try to determine the underlying causes behind the growth or distribution problems. Finally, they might draw on analytical techniques, practical global experiences, theory to propose some viable policy changes that could help a broader segment of the population benefit from economic growth.
Finally, and very importantly, World Bank economists want to know who is benefitting from growth in the country. A main mission of the Bank is to promote “inclusive growth,” or growth that benefits the poor as well as the middle class and wealthy.
[Draw on “Inclusive Growth Analytics,” (Ianchovichina and Lundstrom, 2009) here, with country examples.]
Rapid and sustained poverty reduction requires inclusive growth that allows people to contribute to and benefit from economic growth. Rapid pace of growth is unquestionably necessary for substantial poverty reduction, but for this growth to be sustainable in the long run, it should be broad-based across sectors, and inclusive of the large part of the country’s labor force.
Examining the components of growth
Beyond the over-arching evaluation of constraints to growth and the evaluations of which socioeconomic groups are benefitting from growth, World Bank economists use a number of theory-based methodologies to better understand economic progress. One method is called growth accounting. The classic approach to growth accounting is based on a theory developed by American economist Robert Solow (and independently by Trevor Swan) in the 1950s and follows this equation:
Yt = AtKtαLt1-α
Yt = GDP in year t
At = Total Factor Productivity (TFP) in year t
Kt = Capital stock in year t
α = The income share of capital
Lt = Labor force (population 15+) in year t
A World Bank economist working in a client country might use this framework to structure an inquiry: Why is “Y” changing? Are new factories, office buildings, and other types of capital investment (K) driving it? Or is the labor force (L) simply getting bigger?
The most prized type of growth comes from something called “total factor productivity” or TFP – “A” in the equation above. That is something that is not an independent measurement, but rather a calculation of what is left over in the Solow equation after accounting for capital and labor. In the long term, an increase in TFP suggests that the economy is getting more productive through innovation and technology -- more sustainable contributions to economic growth than increases in capital stock or the workforce. This is the path to long-run growth. Deteriorations in productivity, on the other hand, may suggest problems that require further investigation.
Within the Solow model, World Bank economists can look at the specific components of an economy in more detail. For example, they can find out how much growth results from investment in capital infrastructure. This “rate of return to capital” can shed light on how efficiently a country uses its capital stock, including privately held capital, such as factory machinery, or public infrastructure, such as roads and railways.
The Solow model also can be expanded to incorporate "human capital," or an approximation of the sophistication of the labor force that is determined by taking into account the education level in a country. Below is an example of Brazil's growth decomposed into capital, labor, human capital, and TFP. The graph is designed by the LAC Equity Lab, a group at the World Bank that uses data to look at economic progress in Latin America.
Drilling down even more, World Bank economists might want to know what the growth trends are within sectors. This kind of analysis can show how different parts of the economy have become more important over time. Is agriculture boosting GDP, or is manufacturing getting stronger? In the example below, the services sector is contributing less to Brazil's growth than it was in the 1970s, and the country's growth overall has slowed.
Economists also might want to know what sectors are creating new jobs. Is mining the main source of jobs growth in the economy? Is agriculture? The answers to these questions might show that an economy is depending on a single sector for growth or job-creation. This information might, in turn, help guide government policy in a country that is trying to boost a certain sector’s productivity, support the production of new jobs, or diversify its economy.
For more short-term analysis, economists might want to look at a country's aggregate demand, or how the population is using money. This method breaks GDP into the following components: private consumption, government consumption, investment, imports and exports. It helps structure questions about whether consumer spending is driving growth or whether investment is contributing in a major way. This line of inquiry might show that a country’s income is reduced because its imports outnumber its exports. Or it might show that government spending is propping up the economy, and private investment is not as substantial as it should be.
In summary, there are many tools and frameworks that World Bank economists use to study growth and answer the questions that come from government policymakers. While we still don't know a recipe for economic growth, we can use these tools to learn information that is useful in crafting growth-promoting policies and encouraging long-term, inclusive growth.
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