Can Malta copy the Four Tigers?

It is now widely accepted that in the past generation many countries in East Asia achieved a remarkable record of high and sustained economic growth. Many economists describe the growth performance of Hong Kong, Korea, Taiwan and Singapore - the Four Tigers - as "miraculous".

Ironically, the explanations offered by them for this performance vastly exceed the number of miracles that have to be explained. Many of our economists and politicians have frequently pointed to East Asia's success and suggested that Malta should replicate this success. Can we?

There seem to be four main dimensions to the analysis of East Asia's performance: whether growth in the fastest-growing Asian economies was driven by productivity growth or massive factor accumulation; the role of public policy in general and, in particular, the role of selective interventions in promoting growth; the role of high investment rates and a strong export orientation as possible engines that drive rapid economic growth; and the importance of the initial conditions in economic growth and their relevance for policy.

In economic theory most discussions about growth take as their departure point the so-called Cobb-Douglas production function which, simply put, established a relationship between the amount of output, a technological constant, the amount of capital used as input, and the amount of labour used as input, over a period of time.

The function is useful in that it points out that a significant and sustained rate of technological progress is the only possible way, in the long run, for an economy to achieve a sustained rate of growth of output per person. The intuition for this result is that the labour participation rate can only increase for a while, but obviously cannot increase without bounds in the long run.

Furthermore, higher growth in capital than in labour will lead to diminishing returns to capital with output growth falling over time, even if capital growth is maintained.

Therefore, in order to achieve permanent growth, an economy must continuously improve its technology. This kind of growth is called "intensive growth". In contrast to intensive growth, increasing output by increasing inputs ("extensive growth") can work only for a limited period, but it cannot last too long.

In a famous study, R.M. Solow (Quarterly Journal of Economics, 1956) conducted a growth accounting exercise and found that technological progress accounts for most of the growth of output per person, while accumulation of capital and changes in the participation rate play only a minor role.

Since then, many other studies confirmed again and again that technological progress plays the major role in long-run economic growth.

The collapse of the Soviet economy around 1990, after its apparent success in the previous decades, caught most people by surprise.

Among many economists, the favourite explanation of this economic collapse is the Extensive Growth Hypothesis. This holds that the Soviet economy ran into inevitable diminishing returns after many decades of extensive growth caused by massive accumulation of capital not accompanied by technological progress, just as predicted by the growth-accounting framework.

This extensive growth hypothesis raises serious concerns about other economies that invested heavily during the past decades. Research led some authors to convey a very pessimistic message: that the process of economic growth in the most successful economies in East Asia is not at all miraculous: it is just the expected outcome of massive accumulation of inputs; the path of growth that these economies followed in the past 30 years is not sustainable: sooner or later, they will experience a dramatic decrease in their growth rates; and societies in these countries paid a huge price for achieving these impressive growth rates: they sacrificed a large amount of consumption and of leisure.

Therefore, even if their so-called success can be replicated in other countries, it is probably not wise to do so. The conclusion that emerges is that although the Four Tigers accumulated capital and increased labour participation much faster than other economies, the increase in these two factors far from fully explains their exceptional growth rates; productivity growth also accounts for a significant fraction. In the case of Hong Kong, Korea and Taiwan, their productivity growth rates are as outstanding as their growth rates.

Among the many suggested determinants of growth in East Asia, the investment rate and export orientation, in particular, are held in very high esteem. Frequently, they are called the "engines of growth", meaning that these activities are considered not only to contribute directly to growth, but also to generate spill-over effects to the rest of the economy.

The policy implication of these views is obvious: if some sectors in the economy contribute to economic growth, while others do not, then the government should increase the growth rate by promoting these 'good' sectors. Therefore, it should promote investment and exports, using policy instruments such as direct subsidies or preferential allocation of credit.

The view of investment and/or exports as the engines of growth is based mainly on one empirical argument and on one theoretical argument. The empirical argument is simple: most East Asian countries that experienced phenomenal growth rates also experienced impressive exports (and imports) and investment rates.

The theoretical argument in the case of investment is that a high investment rate increases the capital stock, and some growth theories predict that this can permanently increase the growth rate.

In the case of exports, the theoretical argument is that export orientation increases the openness of the economy and exposes it to foreign technology (and, perhaps more importantly, to foreign competition), thus provoking a rapid rate of technological progress.

Unfortunately, evidence from the Four Tigers does not offer much support for the views of export orientation or high investment rate as engines of growth. High investment rates and a large degree of openness were certainly not a general feature of the Four Tigers in 1960.

The high investment rates (in the case of Korea, Taiwan and Singapore) and the high degree of openness (in the case of Korea and Taiwan) were economic features that evolved in these economies only gradually, accompanying rather than preceding the process of economic growth. The view that these activities are 'engines' of growth does not find much support in the data.

Michael Sarel shows that a small set of initial conditions can 'explain' a large fraction of the growth rates in quite a few countries. He found that countries that were poorer had good primary education, and had less inequality of income and land distribution around 1960, enjoyed significantly higher rates of growth in the period 1960-85.

While there have been highly disparate growth performances in the post-war period, it has been observed that groups of countries exhibit similar growth patterns so that they form convergence clubs. Initial levels of income appear to be a major determinant of this. However, a more important question than the process of convergence is what causes initial conditions to differ across countries.

For this reason it has been argued that it may be more useful to define convergence clubs in terms of policy choices. For example, policy choices with respect to institutional arrangements (such as systems of property rights) or macroeconomic objectives (such as inflation performance or trade exposure), can be expected to influence growth performance.

Given that initial conditions vary across regions, another theme for discussion is why some countries, such as those in Latin America, failed to exploit their promising initial conditions. This raises a debate about the role for policy. Policy is considered by some to be of fundamental importance.

Others consider it to be less important than the "natural" growth dynamic, although it is generally agreed that some role for policy exists in "getting the basics right" in terms of macroeconomic stability, a good system of property rights and integrity of the financial system.

Disagreement relates to the efficacy of specific growth-promoting policies, such as strategic industry policy and whether it has played a role in East Asia's success. Even where this is believed to be the case, it is acknowledged that there is great difficulty in identifying the causal effect of policy.

Discussion of economic performance in cities and the hinterland has raised debate about other influences of geography on economic performance. Are there 'coat-tail effects' of living next door to a high performing economic region? Is there the possibility of catch-up and convergence between regions within a country?

The issue of why we have a new era of highly disparate growth performance remained unresolved. The surge of productivity that permitted the advanced economies to take off in the 1950s may have reflected the arrival of a wave of invention and ideas. It may have also reflected the focus of business on maximising market share and a tendency to be geared for upswings.

Now it can be argued that firms are focused on surviving downswings, and that there has been a depletion of ideas and innovation that awaits a new wave.

The reality, though, is that the leadership of economic performance changes hands only infrequently. Despite the acceleration of per capita income growth in the newly industrialising countries, for most income levels still remain significantly behind those of the post-war leaders.

There are three views on public policy and selective interventions by a government which may play a role in growth. The first view emphasises the positive role of free markets; it requires the government only to "get the basics right", but opposes any kind of selective government intervention. The second emphasises the problems associated with free markets, especially in developing countries; it fully embraces the idea that the government should get the basics right, but, in addition to that, it also advocates selective interventionist policies.

The third questions the legitimacy of any conclusions about effects of public policy and selective interventions on economic growth.

The 'Good'. The advocates of this view see the success of East Asia as the natural outcome of conservative policies. A World Bank report on the East Asian miracle (1993), for example, points out: "Macroeconomic management was unusually good, providing the stable environment essential for private investment. Policies to increase the integrity of the banking system, and to make it more accessible to nontraditional savers, increased the levels of financial savings.

"Education policies that focused on primary and secondary schooling generated rapid increases in labour force skills. Agricultural policies stressed productivity change and did not tax the rural economy excessively. Governments either actively encouraged family planning or, at the minimum, did not restrict family planning choices.

"Finally, all the high-performing East Asian economies kept price distortions within reasonable bounds and were open to foreign ideas and technology, policies that, along with other fundamentals, facilitated efficient allocation and helped to set the stage for high productivity growth."

The 'Bad'. The revisionist view does not share the belief in the efficiency of the markets. It asserts that, especially in poorer countries, there are many market imperfections (such as externalities in production, credit constraints, monopolies, unfair trade practices by multinationals and foreign firms, and a general lack of access to many markets).

Accordingly, the government should play a central role in helping to acquire technology, allocate funds for key projects and guide the development of the economy. Not surprisingly, the advocates of this view also see the success of East Asia as confirming their conviction.

Even the World Bank report, after emphasising the "getting the basics right" policies in East Asia, concedes that "...these fundamental policies do not tell the entire story. In each of these economies the government also intervened to foster development, often systematically and through multiple channels."

Policy interventions took many forms: targeted and subsidised credit to selected industries, low deposit rates and ceilings on borrowing rates to increase profits and retain earnings, protection of domestic import substitutes, subsidies to declining industries, the establishment and financial support of government banks, public investment in applied research, firm- and industry-specific export targets, development of export marketing institutions, and wide sharing of information between the public and private sectors.

The 'Ugly'. This third position essentially claims that we cannot say anything meaningful about selective interventions because we cannot properly identify the role that such policies play in the determination of economic growth.

This is not to say that policies are not important. Rather, the modest point is that we still understand very little about the relationship between public policy and the miraculous growth rates of the East Asian economies.

Other countries should be careful in trying to imitate East Asian policies. Not understanding the causality between growth and industrialisation, in particular, proved to be a very costly mistake for many poor countries that pushed for a rapid industrialisation in a futile effort to boost economic growth.

Since the principal determinants of growth are factor accumulation and technological progress, the impact of macro-policies is probably at the margin. Nevertheless, on balance, macro-policies do make some difference to long-run growth. Palle Andersen and David Gruen (RBA Conference, 1995) draw the following five broad conclusions from their study.

First, although most growth models assign a major role to capital accumulation, policy measures to boost aggregate investment through special incentives do not seem to be called for. They argue that the main tasks of policy makers in this area are to remove existing distortions (especially those favouring investment in property) and to abstain from reducing public investment in infrastructure merely as a means of restoring fiscal balance.

Second, in a world of liberalised capital flows, saving acts as a constraint on investment and growth for the world as a whole but less so for an individual country, as capital flows from countries with excess saving to those where profitable investment exceeds domestic saving.

Yet, reliance on foreign saving is not costless since a country with growing external liabilities will face higher real interest rates, a depreciating real exchange rate, and perhaps, a higher degree of economic uncertainty.

Third, in many industrial countries, declining national saving rates are primarily a consequence of lower government saving, suggesting the need for reduced fiscal imbalances. There is also some evidence that the causation between higher national saving and faster growth may run both ways.

While many cross-country regressions identify the saving rate as one of the principal growth determinants, several recent studies suggest that faster growth also leads, with some lag, to a higher saving rate.

Fourth, recent evidence suggests that, provided inflation is kept close to its target in the medium term, policy which tolerates some short-term deviations of inflation from its target can reduce fluctuations in real output and thereby generate a higher long-run output level than a policy with the sole goal of keeping inflation close to its target.

Fifth, because monetary policy determines inflation in the long run, a key role of monetary policy in influencing growth depends on the relationship between inflation and growth. Although most economists believe even moderate rates of inflation adversely affect growth, unambiguous evidence has been difficult to come by.

While there is still professional disagreement on the robustness of the empirical evidence, it does appear that higher inflation, and the associated increased uncertainty about future inflation, adversely affects growth.

Is there some action the government of Malta could take that would lead the Maltese economy to grow like Taiwan's or Singapore's? If so, what, exactly? The importance of this question could hardly be exaggerated. A positive answer would be the academic equivalent of possessing a magic ability to transform everything into pure gold. Much like many naïve people expect EU membership to transform Malta's economy almost overnight.

My conclusion is that nobody really has or knows what the right formula for fast economic growth is. Copying successful countries might help, but could in certain circumstances be counter-productive. Alas, there is no guarantee that what works in other countries will work in Malta.

We can only work it out for ourselves or stumble on it accidentally. Forget the magic wand from the EU or anywhere else.