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December 11, 2014

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'Growth slowdowns: Middle-Income Trap vs. Regression to the Mean'

Posted: 11 Dec 2014 12:24 AM PST

Lant Pritchett and Lawrence H. Summers:

Growth slowdowns: Middle-income trap vs. regression to the mean, by Lant Pritchett, Lawrence H. Summers, Vox EU: Dozens of nations think they are in the 'middle-income trap'. Lant Pritchett and Larry Summers present new evidence that this trap is actually just growth reverting to its mean. This matters since belief in the 'trap' can lead governments to misinterpret current challenges. For lower-middle-income nations the 21st century beckons, but there are still 19th century problems to address. Moreover, sustaining rapid growth requires both parts of creative destruction, but only one is popular with governments and economic elites.

No question is more important for the living standards of billions of people or for the evolution of the global system than the question of how rapidly differently economies will grow over the next generation. We believe that conventional wisdom makes two important errors in assessing future growth prospects.

  • First, it succumbs to the extrapolative temptation and supposes that, absent major new developments, countries that have been growing rapidly will continue to grow rapidly, and countries that have been stagnating will continue to stagnate.

In fact, when it comes to growth, our research (Pritchett and Summers 2014 [5]) suggests that the past is much less the prologue than is commonly supposed.

  • Second, conventional wisdom subscribes to the notion of a 'middle-income trap' – the idea that when countries reach some intermediate income threshold, growth becomes much more difficult.

Our work suggests that any tendency of this type is very weak, and that what is often ascribed to the middle-income trap is better thought of as growth rates reverting to their means.

Sportswriters refer often to the phenomenon of the 'sophomore slump' – the tendency for outstanding rookies to perform less well in their second seasons. In that same vein, reference is often made to the 'cover of Time magazine curse' – the observation that public figures or celebrities seem to be on the cover of Time at the peak of their careers, and that it is downhill from there. Both of these phenomena reflect the statistical principle of mean reversion. In any process where there are transitory random fluctuations, there will be a tendency for increases to be followed by decreases, and above-average levels to be followed by declines.

In Pritchett and Summers (2014), we apply this frame to the analysis of national growth rates and find that regression to the mean is a robust regularity. We corroborate earlier findings (e.g. Easterly et al. 1993) that find the correlation across decades in national growth rates is surprisingly low, typically in the range of 0.2 to 0.3. This is in sharp contrast to typical forecasts, which assume much more persistence in growth rates – with both success and failure expected to continue. It is also inconsistent with many prevailing theories of growth that seek to explain growth performance in terms of highly stable national features like culture, institutional quality, or the degree of openness. We suggest that the prevailing pattern of regression to the mean in growth rates should create substantial doubt about extrapolative forecasts of China's growth, and we believe that there is a significant risk of a major growth slowdown in China at some point over the next decade.

It is natural to ask whether there is any content to the idea of a 'middle-income trap' over and above regression to the mean. Since countries that have recently entered into any classification of 'middle-income' are, almost by definition, countries that have had recent rapid growth, it is obviously difficult to distinguish between these two phenomena. We think there are three ways in which 'middle-income trap' is overstated as a concern relative to regression to the mean.

Which countries should count as 'middle-income'?

First, we find it difficult to understand the meaning of the 'middle-income trap' when it is used to discuss countries that range from Latin American countries to Russia to China to Indonesia to India to Vietnam to Ethiopia. We agree that all of these (and other) rapidly growing countries should be greatly concerned about the risk of a growth deceleration. But, it is not at all clear what the 'middle-income trap' means – outside of some arbitrary threshold the World Bank set decades ago for concessional lending – if countries at less than 11% of US GDP per capita (Indonesia 10.2, India 8.5, Vietnam 8.0 and Ethiopia 1.8) qualify and are considered at risk. The 2011 world average GDP per capita was $14,467 and the median was $8,491. Countries like Mexico (average GDP $12,709), Malaysia ($13,468), and Turkey ($14,437) are clearly 'middle-income' countries, and having reached these levels of economic sophistication might make continued progress more difficult. But, India could grow for 20 more years at 6% per capita before reaching Mexico's 2011 level of $12,709, and for Ethiopia it would take 47 years. It is impossible to disentangle the 'middle-income trap' from regression-to-the-mean growth dynamics if all growing countries – regardless of their current level of income – are considered at risk of a 'middle-income trap'.

Income level is a poor predictor of growth slowdowns

Second, if we run an empirical horse race of the correlates of growth decelerations (discrete transitions to lower growth), we find rapid growth a much more powerful predictor of the likelihood of a deceleration than level of income. In our recent paper, Pritchett and Summers (2014), we the use the timing of growth episodes from Kar et al. (2013) to estimate a dummy for a growth deceleration, and regress that on current growth and a quartic in the level of per capita income.

There are three points, all visibly detectable in Figure 1, that plot the predicted values for a country at the average growth rate, at India's growth rate of 6.3% per annum, and at China's growth rate of 8.6% per annum.

First, we take an F-test of whether the income terms are jointly significant at the 0.037 level. We find significance, but this is entirely driven by the difference between the very highest income countries and the rest of the sample – the tapering risk for high-income countries. If one estimates the same regression for just those under $25,000 (or any lower threshold), the income terms are not jointly significant.

Second, while the quartic has some 'middle-income trap' features – particularly, that decelerations are more likely at higher income ranges up to a point, and less likely above that point – the peak to trough difference is small. For a country at the average growth rate, the smallest likelihood of a deceleration is 4.3% at an income level of roughly $5,500, which then increases, but only to 5.7% at income of roughly $19,000. Going from the range of incomes of Mongolia or Jamaica all the way to the upper middle-income range of Hungary or Bahrain would increase the predicted deceleration in any given year by only 1.4%. Not surprisingly, given the low value of the F-test, this is much smaller than the standard error of the prediction, so within this range, the highest and lowest risks of the 'middle-income trap' are not significantly different.

Rapid growth is a strong predictor of future slowdowns

Third, in contrast to the very weak impact of level of income, the impact of the current growth rate on the likelihood of deceleration is large, significant, and important. A 1% higher growth rate leads to a 1.46% higher risk of deceleration – equal to the trough to peak rise due to moving into the 'middle-income' range. The T-statistic on past growth is 13.3. As Figure 1 shows, the predicted likelihood of a slowdown in China is 14.4% at its current growth rate of 8.63%, and at the country sample growth rate of 1.84%, but the same income level it is only 4.5% – a 10 percentage point difference.

So, by these predictions of the correlates of growth slowdowns, there is a substantial risk of slowdown for countries that are growing rapidly, but it is almost entirely due to regression to the mean; whereas, the effect of the 'middle-income trap' is small, and even moves to the peak 'middle-income trap' risk on these estimates empirically add little value.

Figure 1. Risk of growth slowdown from 'middle-income trap' is small compared to risk from regression to the mean

Voxeu1
Source: Pritchett and Summers 2014.

These three findings – low statistical significance, small empirical magnitudes, much larger differences in predicted change in growth – also hold true for simple panel regressions of growth acceleration rates on lagged growth rates and a quartic in level of income at five-year frequencies. There is some increase in the likelihood of acceleration up to a point, and then a decline above that point – but the magnitude of pure 'middle-income' decreasing acceleration in growth at income levels above $11,000 is small compared to the regression-to-the-mean effect. The coefficient on lagged growth is 0.83 – consistent with strong mean reversion.

Why do we care whether the impetus for adopting policies to sustain growth is based on a narrative of regression to the mean as opposed to the 'middle-income trap'? Both emphasise that sustaining rapid growth is hard and that the quickest way to slow growth is complacency during rapid growth. However, we think there are three important differences.

Three important differences for policy thinking

First, the cause of the sophomore slump cannot be found by asking, "What went wrong in athletes' second years?" The cause of sophomore slumps may just be exceptionally good luck in their first years. It was not that success was qualitatively harder in their second year or that they got worse, just that things tend to even out. As we have learned excruciatingly from experience with the financial crisis in the US, the time when things seem to be going well is the time it is most important to be prudent about the future. Labelling the problem of sustaining growth as the 'middle-income trap' might suggest that the risk of a growth slowdown is much more controllable by policy than it actually is.

We have had a number of people suggest that China will not have a growth slowdown because a slowdown would be politically costly and hence Chinese policymakers have every incentive to avoid that. Thus, they will act to prevent it – and a known 'trap' should be easily avoidable. But acting to sustain an unsustainably high growth rate may lead subsequent adjustment to be much harsher. As our friend Ricardo Hausmann puts it, "the path from 8 percent growth to 4 percent growth often goes through negative 2 percent."

Second, labelling the generic risk of growth slowdowns a 'middle-income trap' risks posing current challenges in the wrong light – of how to handle the final stages of the transition from middle-income into developed economy, with the accompanying 'bright lights' temptations of picking cutting-edge industries to attract, for example, biotech and software engineering firms. But, the complexity for most countries in the World Bank 'lower-middle-income' band is that the 21st century beckons, but there are still 19th century problems to address. Sixty percent of Indians still practice open defecation – because the urban water and sanitation is so inadequate. The average food share in Vietnam in 2010 was still 50% – and so core agriculture issues must remain on the agenda.

Third, one of the factors that makes sustaining rapid growth so difficult is that growth depends on both parts of creative destruction, but only one is popular with governments and economic elites. Everyone loves the 'creative', as it brings new investments, new industries, and new profits. But sustained economic growth typically relies on continued structural transformation in which new industries arise, but also old industries shrink – sometimes just relatively, but sometimes absolutely. While essential to sustained economic growth, neither governments nor existing firms like destruction – with its geographic shifts, employment shifts, and firm exits that are a necessary part of weeding out uncompetitive industries. This makes it much harder to sustain rapid growth (which few do) than to get it going (which many do). While this happens at 'middle-income' levels, it is also a part of economic transformation at every stage – from the challenges posed by the threat of new industrialists to the landed aristocracy in the Industrial Revolution to the difficulties facing the most advanced countries today. Sustaining growth is not a 'middle-income' problem – it is the fundamental challenge of progress at all stages.

At the end of the day, our reading of the statistical evidence is that rapid growth is not something that can be taken for granted, even for those who have enjoyed for a long time. Its continuation requires the constant renewal of good policy along with good luck. This is the challenging reality for all countries, not just those who have been deemed to have middle incomes.

References

Easterly W, M Kremer, L Pritchett and L Summers (1993), "Good Policy or Good Luck: Country Growth Performance and Temporary Shocks", Journal of Monetary Economics 32(3): 459–483.

Kar S, L Pritchett, S Raihan and K Sen (2013), "Looking for a Break: Identifying Transitions in Growth Regimes", Journal of Macroeconomics 38(B): 151–166.

Pritchett, L and L H Summers (2014), "Asiaphoria Meets Regression to the Mean [5]", NBER Working Paper 20573. 

Fed Watch: Challenging the Fed

Posted: 11 Dec 2014 12:15 AM PST

Tim Duy:

Challenging the Fed, by Tim Duy: Both Paul Krugman and Ryan Avent are pushing back on the Federal Reserve's apparent intent to raise rates in the middle of next year. Why is the Fed heading in this direction? Krugman offers this explanation:

My guess — and it's only that — is that they have, maybe without knowing it, been bludgeoned into submission by the constant attacks on easy money. Every day the financial press, many of the blogs, cable financial news, etc, are full of people warning that the Fed's low-rate policy is distorting markets, building up inflationary pressure, endangering financials stability. Hard-money arguments, no matter how ludicrous, get respectful attention; condemnations of the Fed are constant. If I were a Fed official, I suspect that I would often find myself wishing that the bludgeoning would just stop, at least for a while — and perhaps begin looking for an opportunity to prove that I'm not an inflationary money-printer, that I can take away punchbowls too.

I don't think that the Fed is reacting to external criticism. What I think is that there are two basic views of the world. In one view, the post-2007 malaise is simply the hangover from a severe financial crisis. Time heals all wounds, including this one, and the recent data suggests such healing is underway. The alternative view is that the economy is suffering from secular secular stagnation similar although not to the same extreme as Japan. The latter view suggests the need for a very low or negative real interest rates to maintain full employment, the former view suggests a fairly significant normalization of monetary policy.

I believe that the consensus view on the Fed is the former, that the malaise is simply temporary ("a temporary inconvenience") and now ending. I think this is evident from the Summary of Economic Projections - the implied equilibrium Federal Funds rate is around 3.75%. Perhaps this is below what might have been perceived as normal ten years ago, but the difference could be attributed to slower potential growth rather than secluar stagnation.

If you don't like that argument, then take the more explicit route. Gavin Davies did the intellectual legwork here so we don't have to, and catches Vice Chair Stanley Fischer saying that he doesn't believe the situation calls for protracted negative interest rates. In other words, he rejects the main monetary policy implication of the secular stagnation hypothesis.

And, I don't know if Krugman agrees, but I find it hard to believe that Fischer carries anything but extreme intellectual weight within the Fed. So I would hardly be surprised that the Fed would be moving in a direction he defined. One wonders where Fed Chair Janet Yellen's leadership is on this point? That was always a risk of adding Fischer to the Board - that what might have seemed to be a dream team turned into a power struggle.

This is not to say that I do not share Krugman's and Avent's concerns. I most certainly do. Fischer claims that markets do not believe the secular stagnation story either, but in my mind the flattening of the yield curve is a red flag that the Fed has less room to maneuver than implied by the SEP. But maybe once the Fed actually starts hiking rates, market participants get the clue and the yield curve shifts up. I am not sure I am interested in taking that risk at this point, but no one is asking me to serve on the Federal Reserve Board.

One quibble with Krugman regarding his interpretation of the Phillips Curve:

Suppose the Fed waits too long. Well, inflation ticks up — probably not much, since the short-run Phillips curve looks very flat. And the Fed has the tools to rein the economy in. It would be annoying, unpleasant, and no doubt there would be Congressional hearings berating the Fed for debasing the dollar etc.. But not a really big problem.

Maybe two quibbles. First is that if you asked policymakers why the Phillips Curve was flat, I think they would say that nominal wages rigidities hold up the back end, while tighter policy holds down the front. In other words, the reason inflation does not accelerate at low unemployment rates is that the Fed tightens policy accordingly. Second, I think they equate "reigning the economy in" as triggering a recession. I think they find this more than unpleasant.

Bottom Line: If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week's press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?

Links for 12-11-14

Posted: 11 Dec 2014 12:06 AM PST

'What is Congress Trying to Secretly Deregulate in Dodd-Frank?'

Posted: 10 Dec 2014 12:03 PM PST

And so it begins:

What is Congress Trying to Secretly Deregulate in Dodd-Frank?, by Mike Konczal: There are concerns that the budget bill under debate in Congress will eliminate Section 716 of Dodd-Frank, using language previously drafted by Citigroup. So what is this all about?
Section 716 of Dodd-Frank says that institutions that receive federal insurance through FDIC and the Federal Reserve can't be dealers in the specialized derivatives market. Banks must instead "push out" these dealers into separate subsidiaries that don't benefit from the government backstop. They can still trade in many standardized derivatives and hedge their own risks, however. This was done because having banks act as swap dealers put taxpayers at risk in the event of a sudden collapse. That's it.
Why would you want a regulation like this? The first is that it acts as a complement to the Volcker Rule. ...
A second reason is 716 will also prevent exotic derivatives from being subsidized by the government's safety net. ...
The third reason is for the sake of financial stability. ...
Stiglitz reiterated this point today, saying "Section 716 facilitates the ability of markets to provide the kind of discipline without which a market economy cannot effectively function. I was concerned in 2010 that Congress would weaken 716, but what is proposed now is worse than anything contemplated back then."
Now many on Wall Street would argue that this rule is unnecessary. However, their arguments are not persuasive. ...
We should be strengthening, not weakening, financial reform. And removing this piece of the law will not benefit this project.

See also Barney Frank Criticizes Planned Roll-Back of Namesake Financial Law.

'Labor Union Membership and Life Satisfaction'

Posted: 10 Dec 2014 10:45 AM PST

Via a tweet from Bruce Bartlett:

Labor Union Membership and Life Satisfaction in the United States, by Patrick Flavin and Gregory Shufeldt: Abstract While a voluminous literature examines the effects of organized labor on workers' wage and benefit levels in the United States, there has been little investigation into whether membership in a labor union directly contributes to a higher quality of life. Using data from the World Values Survey, we uncover evidence that union members are more satisfied with their lives than those who are not members and that the substantive effect of union membership on life satisfaction rivals other common predictors of quality of life. Moreover, we find that union membership boosts life satisfaction across demographic groups regardle ss if someone is rich or poor, male or female, young or old, or has a high or low level of education. These results suggest that organized labor in the United States can have significant implications for the quality of life that citizens experience.

'For Worker Control'

Posted: 10 Dec 2014 09:50 AM PST

Chris Dillow:

For worker control: ... Social democrats used to think that they did not need to challenge the fundamental power structures of capitalism because, with a few good top-down economic and social policies, capitalism could be made to deliver increased benefits for workers and the poor in terms both of rising real wages and better public services. ...

The "golden era" in which this was true has vanished. Instead, we face harsher times... Times have changed. So the left must change. ...

There's one context in which this is especially necessary - the workplace. ... If firms cannot or will not offer rising wages, they should at least offer non-pecuniary benefits: more control over working conditions and the assurance of good rewards if the business thrives in future. There are ... big benefits to doing so...

Of course, there are countless types and degrees of worker ownership and control, some compatible with capitalism and some not. But this is a strength, not a weakness.

My point here is a simple one. The days when the leftist politics could ignore the "hidden abode of production" because lightly modified capitalism would deliver the goods have gone. Our new times require new politics. ...

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