SBE-SES 0820318: PI Shin (U of Wisconsin); Co-PI Buera (NBER, subaward)
Understanding the sources of cross-country differences in economic development is a central question in the social sciences. Recent empirical research has provided some answers: Cross-country income differences are mainly explained by the low total factor productivity in developing countries, particularly in producing investment/tradable goods. Misallocation of resources across production units is an important source of their low productivity. Well-functioning financial markets are an important institution missing in these countries. This project constructs a unified framework where financial frictions and resource misallocation are explicitly modeled and their impact on economic development is quantitatively evaluated.
This project first analyzes how financial frictions lead to resource misallocation, and how some industrial sectors are more vulnerable to financial frictions than others. It is shown that a model incorporating sectoral differences in the scale of establishments explains why developing countries are particularly unproductive in producing investment/tradable goods. This model has implications on the patterns of establishment size distribution across countries and across sectors. Such model predictions are tested against establishment-level data. As part of this project, a comprehensive data set on the size distribution of establishments in developing (e.g. Mexico and India) and developed countries (e.g. the US) is put together, to be shared with other researchers.
The project also studies dynamic effects of an economic reform that partially eliminates distortions in the economy. It is shown that the interaction between financial frictions and resource misallocation is crucial in understanding growth experiences of developing countries that are incompatible with standard theories. Consistent with the data, the model generates a slow transition to a higher state of economic development, low interest and investment rates in the early stages of development, and endogenous productivity dynamics.
Finally, this project studies how the interaction between international and domestic financial markets determines economic development. The model is used for studying the transition dynamics following liberalizations of cross-border production factor flows, which are an important part of growth-enhancing reform packages in many developing countries. In particular, it addresses the puzzling observation that countries going through a period of output and productivity growth tend to export capital, contradicting the standard theory. In addition, other dimensions of factor flows are explained, such as foreign direct investment flowing from developed to developing countries while entrepreneurial talent moves in the opposite direction (brain drain) at the same time.
More broadly, this project is related to the literature that places institutions at the center of economic development: Financial frictions in this project are modeled as arising from imperfect enforcement of contracts, an important topic in the broader institutions literature. In this context, this project sets an example of how to quantitatively analyze the mechanisms through which institutions determine economic development. This project is also useful for the design and execution of public policies. By applying its quantitative framework, one can answer important questions on economic reforms: How soon will reforms start to pay off? How fast will economic growth trickle down to the poor? What are the optimal policies on international factor mobility?
In our funded research, we study the impact of finance on economic development. Our distinct contribution is that we build models that are founded microeconomically---capturing the rich heterogeneity across households and firms---and oriented toward serious quantitative analysis. Our approach helps identify the exact mechanism through which financial markets influence economic outcomes. Here we highlight two strands of our research. The first explores the long-run effects of finance on economic development. The second explains many salient patterns in the rapid growth of emerging economies that contradict the conventional models. Obviously, financial markets are an integral part of our explanation. Long-Run Impact of Financial Development In ``Finance and Development: A Tale of Two Sectors,'' we start by documenting the systematic relationship between countries' financial development and their output, aggregate productivity, and sector-level productivity. Financial frictions distort the allocation of capital and entrepreneurial talent across production units, adversely affecting measured productivity. In our model, sectors with larger scales of operation (e.g., manufacturing) have more financing needs, and are hence disproportionately vulnerable to financial frictions. Our analysis shows that the observed cross-country differences in financial development account for a substantial part of their differences in output per worker, aggregate productivity, sector-level relative productivity, and capital-to-output ratios. Given the importance of financial development, it is natural to ask about economic policies that can alleviate financial market imperfections. One popular policy intervention in recent years has been microfinance. In ``The Macroeconomics of Microfinance,'' we provide a quantitative evaluation of the impact of economy-wide microfinance. Using our model, we can evaluate large-scale long-term interventions that are difficult to implement in reality. Making the typical microfinance program more widely available has only a small impact on per-capita income, since an increase in aggregate productivity is offset by lower capital accumulation that stems from the redistribution of income from high-saving individuals to low-saving ones. However, the vast majority of the population is positively affected by microfinance, but only through the equilibrium increase in wages. In other words, extrapolating from the small-scale microfinance interventions, one will overestimate the positive impact on aggregate output, but will underestimate the overall welfare gains through the redistributive general equilibrium effects. Finance and Growth Dynamics We start out by identifying episodes of ``growth accelerations,'' or upward structural breaks in growth rates, and discover that the macroeconomic dynamics during such episodes are not explained by the standard models. In ``Financial Frictions and the Persistence of History,'' we quantify the role of financial frictions and the misallocation of resources in explaining development dynamics. The main features of the dynamics are: slower transition than is predicted by the standard model, investment rates that rise over time and then fall eventually, and aggregate productivity that rises over time. The standard neoclassical model predicts, by contrast, much faster transitions and monotonically-declining investment rates. In addition, the standard model takes aggregate productivity as exogenously given, and is hence silent about its dynamics. We note that the onset of many growth accelerations coincides with large-scale economic reforms aimed at removing distortions in the economy. We construct an initial steady state characterized by rampant idiosyncratic distortions. A reform is implemented to remove such distortions, which triggers efficient reallocation of resources. Our model economy with financial frictions replicates the observed growth dynamics. The model dynamics reflect the unwinding of resource misallocation, a process drawn out by the imperfections in financial markets. We present new data from post-war miracle economies, which support the aggregate and micro-level implications of our theory. In ``Productivity Growth and Capital Flows: The Dynamics of Reforms,'' we examine the international movement of capital during growth accelerations. We discover that, contrary to the standard model predictions, while saving surges, investment falters initially and rebounds only slowly, resulting in capital outflows. When a reform eliminates idiosyncratic distortions in our small open economy model, the aggregate productivity rises gradually and capital flows out of it. The rise in productivity reflects efficient reallocation of capital and entrepreneurial talent, a process drawn out by frictions in local financial markets. The capital outflows reflect a surge in saving and a stagnation in investment. Saving increases for two reasons. First, constrained entrepreneurs have strong self-financing motives. Second, as resource misallocation is unwound, factor prices rise over time along with aggregate productivity. For an entrepreneur, this implies that his profits are dwindling over time, prompting him to save a large fraction of his temporarily-high profits. The stagnation in investment is an effect of the underdeveloped local financial markets: While entrepreneurs losing subsidy downsizes, newly-productive entrepreneurs scale up production only slowly because of financial constraints. This model also explains the allocation puzzle, a broadly-documented correlation between aggregate productivity growth and capital outflows. This second line of work provides a laboratory for policymakers looking for the optimal sequencing of large-scale reforms designed to promote economic growth.
