The Role of Six Capital Types in Economic Growth: Real, Human, Financial, Foreign, Social,, Study notes of Business Administration

Download The Role of Six Capital Types in Economic Growth: Real, Human, Financial, Foreign, Social, and more Study notes Business Administration in PDF only on Docsity! Mother Earth:? Abstract Economic growth requires capital. This article reviews the relationship between economic growth around the world and six different kinds of capital: (a) real capital, (b) human capital, (c) financial capital, (d) foreign capital, (e) social capital, and (f) natural capital. Economic theory and empirical evidence suggest that domestic and foreign investment, education, financial maturity, and reasonable equality in the distribution of income are all good for growth. However, recent theory and evidence also seem to suggest that natural capital – i.e., abundant natural resources – may crowd out or impair other types of capital and thus impede economic growth over long periods. Docsity.com All models of growth, after all, stress the necessity and power of capital. The accumulation of capital is a crucial engine of economic growth around the world. The two main competing economic philosophies of the 20th century were both centered on capital: one was derived from a book called Das Kapital, the other was widely referred to as ‘capitalism’ – and still is. The traditional concept of capital, however, is too narrow to fully serve the purposes of the modern theory of economic growth. The concept of capital must be enlarged to comprise at least six different types of capital: 1) real capital in the traditional sense, i.e., machinery, equipment, and so on; 2) human capital which is embodied in the education, know-how, and training of the labor force, in addition to health care; 3) financial capital which serves as a lubricant of economic transactions, trade, and production; 4) foreign capital which differs from other real or financial capital – or human capital, for that matter! – solely by its origins abroad; 5) social capital, by which is meant the infrastructure and institutions of society in a broad sense: its culture, law, system of justice, rules and customs and so on; and finally 6) natural capital, in the form of vegetation, fishing banks, minerals, energy in the form of fossil fuels, thermal and hydroelectric power potential, and so forth. There is a need, in other words, to distinguish between extensive economic growth that results from the accumulation of produced capital as time passes and intensive growth that results from more efficient utilization of existing capital. The build-up of human, financial, foreign, and social capital promotes intensive growth for given real capital. An abundance of natural capital, on the other hand, raises different concerns for reasons to be discussed below. This article is intended to highlight the relationship between economic growth over long periods and the six different kinds of capital listed above, with special emphasis on natural capital. Figure 1 describes the ways in which the different types of capital dictate economic growth according to recent growth theory and the rapidly expanding empirical literature on the subject. The quantitative studies in question typically apply multiple regression analysis to cross-sectional data or panel data that reflect developments within countries as well as differences across countries. In Figure 1, 2 Docsity.com fits the data slightly better than a straight line because there are diminishing returns to education: increased education makes the greatest difference for growth when the standard of education is low to start with. A similar pattern of education and growth across countries emerges when the flow of human capital formation is measured by public expenditure on education rather than focusing on the stock of human capital as measured by school enrolment as in Figure 3. As far as economic growth is concerned, however, the supply of education may matter less than demand. This is relevant here because public expenditure on education tends to be supply-determined and of mediocre quality, and may thus fail to foster efficiency, equality and growth, in contrast to private expenditure on education, which is generally demand-led and thus, perhaps, likely to be of a higher quality and more conducive to growth. 3. Financial capital Arrow 3 in Figure 1 describes the contribution of financial capital to economic growth. The extent of liquidity represented by the ratio of money, broadly defined, to GDP reflects the financial maturity of a country, or financial depth: the more mature a country’s financial markets – that is, the better the markets can serve their core function of channeling household saving into high-quality investment – the higher will be the rate of economic growth, other things being the same. Without enough money to grease the wheels of production, the economic system begins to stall like engine without oil. Herein lies the importance of money as a medium of exchange. This key role of money helps explain why high inflation hinders financial development and economic growth as well. Consider a farmer: she needs cash in order to be able to keep her tractors running, to buy fuel, to replace spare parts that wear out, and so on. Thus, cash can be viewed as an input into production; this is sometimes called “working capital.” If high inflation makes it too expensive for the farmer to hold cash, it also increases the number of broken tractors, and thereby disrupts production. High inflation makes real capital crowd out financial capital. The result, as a rule, is impaired efficiency and slow growth. Recent empirical evidence indicates that high inflation hurts economic growth through a number of channels, including financial depth. It is worth emphasizing that this is a recent discovery. After all, not long ago only technological progress was 5 Docsity.com considered capable of influencing long-run growth (Solow, 1970). Further, inflation was widely regarded as being solely a monetary phenomenon, so that the possibility that inflation could have something to do with real growth was by many considered remote. The crux of the matter is, however, that inflation is a relative price – the price of money and other nominal assets in terms of real assets – and it is, therefore, fully capable of having real effects. In particular, high inflation punishes people and firms for holding cash, and thus deprives the economy of essential lubrication. Figure 4 shows the relationship between per capita economic growth and the ratio of money and quasi-money and GDP from 1965 to 1998 in the same 85 countries as before. The figure shows that an increase in money and quasi-money relative to GDP by 20 percentage points from one country to another is associated with an increase in annual per capita growth by 1 percentage point. The Spearman rank correlation is 0.73 and significant. There is, however, no clear evidence of a two-dimensional correlation between inflation and growth around the world. The reason is that the relationship between inflation and growth is a complicated one, and involves several factors – among them, real interest rates, saving, and probably also political stability – other than financial maturity. As before, the causation can run both ways. Slow growth may hinder financial development just as financial maturity may spur growth. Even so, the policy implication is clear: keeping inflation low and liquidity reasonably high is most likely to be good for growth. 4. Foreign capital One of the oldest lessons of economics is the one about the gains from trade and investment. Economic specialization through trade enables nations to do what they do best, and leave the rest to others. This makes, or at least has the potential to make, every participating nation better off, provided the gains are distributed so as to compensate those nationals who lose from trade. True, this may be easier said than done, but when a nation becomes better off, it is, in principle at least, possible if not always practical to ensure that no one is left worse off than before. The chief challenge of globalization in the modern world is to put this fundamental principle into viable practice. 6 Docsity.com Arrow 4 in Figure 1 describes the effect of the influx of foreign capital on economic growth. What is the empirical evidence? Figure 5 shows the relationship between economic growth as measured before and the ratio of gross foreign direct investment (FDI, adjusted for country size3) to GDP (converted to international dollars using purchasing power parity rates) from 1975 to 1998 in the same 85 countries as before. The regression line drawn through the scatterplot indicates that an increase in the FDI ratio by 2 percentage points from place to place is associated with an increase in per capita growth by 1 per cent per year. The Spearman rank correlation is 0.62 and significant. A similar pattern emerges when openness is measured by the ratio of exports and imports of goods and services to GDP (adjusted for country size, not shown) rather than by the FDI ratio as in Figure 5. This stands to reason: openness is a matter of exporting and importing goods and services as well as financial capital. We saw before, in Figure 2, that investment is good for growth. Figure 5 indicates that this applies to foreign as well as domestic investment. Foreign investment is particularly good for growth because foreign capital is often accompanied by foreign expertise and ideas: fresh winds, in short. 5. Social capital Arrow 5 in Figure 1 refers to the contribution of social capital to economic growth. Social capital can mean different things to different people (Woolcock, 1998). For our purposes, it is most useful to think of social capital in terms of those aspects of a country’s political and social infrastructure that matter most for economic growth. For example, corruption in government and business, rampant rent seeking by pressure groups, and a lack of democracy all tend to distort the allocation of resources, impair efficiency, and reduce economic growth (Bardhan, 1997). Such activity can be viewed as corrosion of social capital. Similarly, a lack of social cohesion bred by excessive inequalities may create animosities and conflicts among social groups that impede economic efficiency and growth by corroding social capital. If so, too much inequality in the distribution of income is unlikely to be good for growth. But how much is too much? 7 Docsity.com tariff protection or other favors to producers at public expense, creating competition for such favors among the rent seekers. Extensive rent seeking – that is, seeking to make money from market distortions – can breed corruption in business and government, thus distorting the allocation of resources and reducing both economic efficiency and social equity. Insofar as natural resource abundance involves public allocation of access to scarce common-property resources to private parties without payment, thereby essentially leaving the resource rent up for grabs, it is only to be expected that resource-rich countries may be more susceptible to corruption than others. Empirical evidence and economic theory suggest that import protection, which is often extended to foreign capital as well as goods and services, tends to impede economic efficiency and growth (recall Figure 5). Further, natural resource abundance may fill people with a false sense of security and lead governments to lose sight of the need for good and growth-friendly economic management, including free trade, bureaucratic efficiency, and institutional quality. Incentives to create wealth through good policies and institutions may wane because of the relatively effortless ability to extract wealth from the soil or the sea. Manna from heaven can thus be a mixed blessing. Furthermore, natural capital may crowd out social capital by increasing income inequality. The idea here is that natural resource rents tend to be less equally distributed than labor income among the population. Indeed, if this is not so at the time of the resource discovery, then the chief purpose of the ensuing rent-seeking activity is precisely to produce such an outcome. Some of the most resource-rich countries in the world are also among the least egalitarian. Arrow 7 describes the effects of natural resources on economic growth through rent seeking, corruption, and excessive inequality all of which tend to corrode social capital and reduce growth. Third, natural capital may crowd out human capital as well as social capital by hurting education, as suggested by arrow 8. Specifically, natural resource abundance or intensity may reduce private and public incentives to accumulate human capital. Awash in cash, natural-resource-rich nations may be tempted to underestimate the long-run value of education. Of course, the rent stream from abundant natural resources may enable nations to give a high priority to education – as in Botswana, for instance, where government expenditure on education relative to national income is among the highest in the world. Even so, empirical evidence shows that, across countries, school enrolment at all levels is inversely related to natural resource abundance or intensity. There is also evidence that, across countries, public 10 Docsity.com expenditures on education relative to national income, expected years of schooling, and school enrolment are all inversely related to natural resource abundance (Gylfason, 2001). This matters because more and better education is good for growth. Fourth, abundant natural resources may blunt private and public incentives to save and invest and thereby impede economic growth (arrow 9). Specifically, when the share of output that accrues to the owners of natural resources rises, the demand for capital falls, and this leads to lower real interest rates and less rapid growth (Gylfason and Zoega, 2001). In other words, natural capital may thus crowd out real capital as well as human and social capital. As in the case of education, it is not solely the volume of investment that counts because its quality – i.e., efficiency – is also of great importance. Unproductive investments – white elephants! – may seem unproblematic to governments or individuals who are flush with cash thanks to nature’s bounty. For example, most of the oil-rich OPEC countries have grown remarkably slowly since the 1960s despite a large volume of investment relative to GDP. Fifth, when a large part of national wealth is stored in a natural resource, there may be less need for financial intermediation to conduct day-to-day transactions (arrow 10). Dissaving can take place through more rapid depletion of the resource and saving can take the place through less rapid depletion, or of more rapid renewal if the resources are renewable. In some countries, such as the OPEC states, saving also takes the form of foreign bank deposits. In this case, domestic financial intermediation becomes even less important. In contrast, when saving is piled up at home in the form of physical capital, domestic banks and financial markets assume paramount importance. By linking up domestic savers and investors, the domestic financial system contributes to a more efficient allocation of capital across sectors and firms. So, if an abundance of natural resources tends to hamper the development of the financial system and hence to distort the allocation of capital, economic growth may slow down due to a detrimental effect of financial backwardness on saving and investment (recall Figure 4). Hence, resource dependence tends to retard the development of financial institutions and hence discourage saving, investment, and economic growth. Put differently, natural capital can crowd out financial capital. Sixth and last, arrow 11 in Figure 1 suggests that natural resource abundance may reduce openness by discouraging foreign capital inflows as well as exports. This point follows directly from the first two points above. The Dutch disease manifests itself through reduced incentives to produce nonprimary goods and services for export 11 Docsity.com which the overvalued currency of the resource abundant country renders uncompetitive at world market prices. Hence the reduction in trade. Rent seeking appears in many guises, including demands by domestic producers for protection against foreign competition, for example in the form of restrictions against foreign direct investment. Natural capital may thus crowd out foreign capital. This form of the Dutch disease – from natural resource riches to foreign capital controls – needs closer scrutiny in future empirical research. This matters because openness is good for growth (recall Figure 5). Let us now look at the empirical evidence on natural resources and economic growth. Several measures of natural resource intensity can be used, some referring to the flow of services from natural capital while others refer to the underlying stock of such capital: (a) the share of primary exports in total exports of goods and services or GDP; (b) the share of primary production in employment or the labor force; and (c) the share of natural capital (i.e., oil reserves, mineral deposits, forests, agricultural land, etc.) in national wealth, defined as the sum of natural capital as described above, real capital accumulated through investment in machinery and equipment, and human capital built up through education and training. No attempt is made here to distinguish nonrenewable resources such as oil fields from nonrenewable ones such as fisheries or forests in view of the somewhat paradoxical, but apparently real, possibility that renewable resources may be almost as susceptible to depletion as nonrenewable resources. It is also possible to use the share of agriculture in GDP as a proxy for natural resource intensity. A small or at least declining share of agriculture in GDP is a sign of successful economic diversification, industrialization, and the development of services. Moreover, agriculture in developing countries is generally less high-skill labor intensive than industry and services. As a result, agriculture contributes less than other industries to growth through education. Here we use the share of natural capital in national wealth as a proxy for natural resource intensity; any one of the other three measures would produce similar results. Figure 7 shows the relationship between average annual per capita growth from 1965 to 1998 as measured above and the share of natural capital in national wealth in the same 85 countries as before. A decrease in the natural capital share by 8 per cent of national wealth is associated with an increase in per capita growth by 1 per cent per year. The correlation is significant; the Spearman rank correlation is -0.64. This result accords with the linkages expressed through arrows 6-11 in Figure 1. 12 Docsity.com Figure 1. Capital and Growth Foreign capital Financial capital Human capital Social capital Growth Real capital 7 11 3 1 4 5 2 9 8 10 + + + + + – – 6 Natural capital – – – – Figure 2. Real Capital and Growth Niger Nicaragua China Botswana -8 -6 -4 -2 0 2 4 6 0 5 10 15 20 25 30 35 Gross domestic investment 1965-98 (per cent of GDP) G ro w th o f G N P pe r c ap ita 1 96 5- 98 , a dj us te d fo r i ni tia l i nc om e (p er c en t p er y ea r) 16 Docsity.com Figure 3. Human Capital and Growth Thailand New Zealand Finland Jamaica -8 -6 -4 -2 0 2 4 6 0 20 40 60 80 100 120 Gross secondary-school enrolment 1980-97 (per cent) G ro w th o f G N P pe r c ap ita 1 96 5- 98 , a dj us te d fo r in iti al in co m e (p er c en t p er y ea r) Figure 4. Financial Capital and Growth Jordan Indonesia Switzerland Japan -8 -6 -4 -2 0 2 4 6 0 20 40 60 80 100 120 Money and quasi-money 1965-98 (per cent of GDP) G ro w th o f G N P pe r c ap ita 1 96 5- 98 , a dj us te d fo r i ni tia l in co m e (p er c en t p er y ea r) 17 Docsity.com Figure 5. Foreign Capital and Growth Papua New Guinea NetherlandsNorway Madagascar -8 -6 -4 -2 0 2 4 6 -4 -2 0 2 4 6 8 Actual less predicted FDI 1975-98 (per cent of GDP) G ro w th o f G N P pe r c ap ita 1 96 5- 98 , a dj us te d fo r in tia l i nc om e (p er c en t p er y ea r) Figure 6. Social Capital and Growth Sierra Leone Japan China Korea -6 -4 -2 0 2 4 6 0 10 20 30 40 50 60 70 Gini index of inequality (various years) G ro w th o f G N P pe r c ap ita 1 96 5- 98 , a dj us te d fo r in iti al in co m e (p er c en t p er y ea r) 18 Docsity.com