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2019-05-17Macro `n Cheese

At the Intersection of Exogenous and Endogenous Growth

This week, Roger has been quite unbearable at the office, reverting to his old sins of name-dropping a bunch of (wise, old,) dead, white guys almost all the time. It’s Kaldor here and Verdoorn there. The silver lining is that it resulted in quite an interesting discussion about how to respond when the R-word (recession) is communicated by the NBER's business cycle dating committee. (Btw, shouldn’t every country have one of those?)

In the aftermath of the global financial crisis, we have enjoyed one of the longest growth streaks in modern history. Currently, however, both the global economy and financial markets seem to be caught in a seesaw. And stakes are high. While labor markets have, to a large degree, recuperated the losses seen in conjunction with the crisis, productivity has never posted its usual post-recession growth spurt leaving it well below any conceivable pre-crisis trend.

To mainstream economics, this constitutes something of a fundamental problem as productivity has long been expected to grow more or less exogenously and, almost irrespective of cyclical ups and downs, increase incomes and welfare for the masses in the long run. However, and just from looking at the graph above, we can conclude that the exogenous (productivity) growth theory has struggled to explain actual developments after the global financial crisis.

Of course, exogenous and endogenous (dynamic) growth theories have co-existed for decades, and while the endogenous kind has led a healthy life on the fringes of mainstream economics, it had almost completely disappeared from economic policy discussions. Nonetheless, the post-crisis period has seen numerous prominent researchers making forays into the endogenous camp advocating secular stagnation, employment hysteresis, and other cyclical-structural feedback phenomena as well as a return of fiscal policy in general and public investments/financing in particular to stabilize economic developments.

Suffice to say, developments after the crisis question the traditional view of productivity being exogenous to the business cycle and – importantly – to stabilization policy. I have already referred to the work of Blanchard, Farmer and others (here and elsewhere) touching on this subject, but today I wanted to find something more hands-on and came to think of the good old empirical relationship sometimes called Kaldor-Verdoorn’s law. In its very simplest form: p = a + b*q; where ‘p’ is productivity growth, ‘a’ is trend/exogenous growth and ‘b’ is the “Verdoorn coefficient” – measuring how strongly productivity growth is endogenous to output growth, ‘q’. Momentarily leaving statistical issues emanating from the definition of productivity[1] aside, it might (hopefully) provide a way to capture both exogenous productivity growth (where incentives, schooling, etc. are important drivers) and an endogenous, self-reinforcing growth stemming from growth in profits and wages.

In most studies, it seems the Verdoorn-coefficient stays close to 0.5, but I thought it could be quite interesting to see how this coefficient interacts with the intercept over time, and perhaps also shed some anecdotal light on steady technological progress vs. technological “leapfrogging” in the process. In all the graphs below, I have therefore used rolling regressions (over 60 quarters) to study the size of the intercept and the Verdoorn-coefficient.

The intercept is perhaps the hardest one to dissect as it will probably capture a lot of heterogenous productivity effects, with true exogenous productivity growth being only one. That said, in the OECD countries the intercept has stayed quite close to zero, but the period from (around) 1980 and up until (around) 2005 nonetheless suggested an exogenous productivity growth of up to ½ p.p. per annum (~0.1 % q/q). That was a period strongly characterized by high IT-investments and increased globalization (international specialization), and the intercept probably captures some of those developments.

Stretching the perspective further, and especially when incorporating developments after the global financial crisis (GFC), an on-trend weaker exogenous growth factor appears. This might be interpreted in a number of ways; globalization and digitalization losing steam and production gradually shifting abroad or to less productive sectors, i.e., some kind of Baumol effect. But it might also be, plain and simple, a testament to the demographic challenges of most OECD economies.

[1] You guessed it, productivity and output being parts of an accounting identity this specification raises all sorts of statistical problems, but it has still proved a decent empirical description of productivity developments over time.

 

From a stabilization policy perspective, the most intriguing part is that the Verdoorn-coefficient is quite high and has risen over the past couple of decades. Now, the Verdoorn coefficient does indeed suggest some sort of behavioral effect where, e.g., increased public investments would raise productivity not only by capital deepening and (hopefully) improved total factor productivity, but also by simply increasing demand.

The underlying idea is straight-forward. Companies refrain from investing during a recession, because they anticipate that the returns from these investments will be low. Hence, future productivity growth and potential output fall. This way, temporary recessions can give rise to persistent adverse developments in long-run output. Simultaneously, households noticing/perceiving a deteriorating outlook for future income growth will probably respond by current consumption (and increase savings), creating fertile ground for a negative feedback loop.

This also explains how, when the shock to income expectations is sufficiently large, the economy can get liquidity trapped.

The good news is that it also provides a way out of almost any cyclical hole we have dug for ourselves. If monetary policy can be effectively complemented by fiscal policy interventions lifting future productivity and income expectations, there is room to counter even the deepest of recessions. That’s what the high Verdoorn-coefficient demonstrates.

Here, Nota Bene, is also where we have to be very careful (and not only due to statistical challenges). We don’t want to use up fiscal space on Japan-like, non-productive, public investments of building bridges to inhabited islands, but rather on big innovation projects, education, infra-structure (of the right kind), etc. Not only that, there is the non-negligible question of timing such projects and coordinating them with monetary policy (to lock in cheap financing).

Failing to take this into consideration will probably end in a return to the failed policies of the 70’s and 80’s, or – even more probable – speed up the Japanification-process we are currently in the midst of.

 

As can be seen, most countries currently demonstrate a Verdoorn-coefficient above 0.5 and also above historical median values. Notably, Germany and France, the anchors of the Euro Area, would be especially well-situated to explore the endogenous nature of productivity growth and literally underline how unproductive German fiscal policy has been over the past decade.

On that note, quite a few, and predominantly small countries (more countries are available if you download and open the graph below) demonstrate the same intriguing pattern as my homeland, Sweden.

 

When exogenous growth is improving, endogenous growth is less prominent. (For larger economies, these patterns are less easy to detect, which is probably a natural consequence of more diversified business sectors.) A speculation is that this has to do with technological leaps where a country is well-positioned to explore or develop new industries. In Sweden’s case it is well known that Ericsson – an offspring of the public Swedish phone company, Televerket, i.a., – was able to explore the increased interest in mobile communication during the IT-boom, developments that were seemingly unrelated to the business cycle.

And the Sweden case hopefully offers a telling moral of this story. Agreeing very much with Mariana Mazzucato’s collected works, I believe that a structured governmental innovation policy is symbiotic and even necessary, to induce increased private investments and also raise “exogenous” productivity growth. Utilizing cheap financing and creating a strict public innovation framework is the epitome of a win-win situation. It could also help us evade the next run-in with the effective lower bound of nominal interest rates. What’s not to like?

 

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