An Arab Framework for Growth Diagnostics

Wednesday, August 1, 2012
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Most policymakers and economists would agree that corrective policies and measures countries can take to promote economic growth are heavily dependent on national context and economic environment. Across the Arab World, we see an emphasis on a similar global economic development narrative based on the transition to knowledge-based economies and accompanying high wage, high skill jobs which was perpetuated by the engagement of the World Bank and UN with the Arab World in the early Nineties. This has resulted in rather identical growth strategies which fail to adequately take into account domestic opportunities and constraints for many of the countries in the region. For example, our research (see for example http://tahseen.ae/blog/?p=35) shows that seventeen of the twenty-two countries in the Arab World have adopted development of a knowledge-based economy as a medium to long-term economic policy objective.

While there are certainly some fundamental development principles, such as property rights, rule of law, market-oriented incentives, sound fiscal policy, and responsible public sector spending, it has become clear that many of the economic development strategies in the region are not helpful because they are laundry lists of reforms without targeting or adequately assessing in a systematic way the most binding constraints to growth. The risk of such an approach is potentially pursuing a reform process that addresses too many things at once without prioritization, valuing, for example, infrastructure development as equivalent to improving human capital, or reforming capital markets. Growth in Arab countries may not require ticking all the boxes on the extensive to do lists of current economic development strategies which are based on consensus development “best practices” rather than individual country opportunities.  More emphasis must be placed on prioritizing the most binding growth constraints rather than tackling everything at once or prioritizing reforms based on institutional self-interests that undermine national welfare.

Reform Strategies and the Theory of the Second Best

Lipsey and Lancaster’s theory of the second best suggests that efforts to remove distortions in one market may not have intended effects if distortions are concurrently present in other markets. This suggests that Arab policymakers need to understand their country’s context before jumping to the theory-based, best practice conclusions. We see two approaches that Arab countries can take to jumpstart growth:

Comprehensive Reform: The focus of such development strategies is on eliminating all problems at once, a prescription that is technically correct but difficult, if not impossible, to implement since complete knowledge of all problems is impossible.

Pragmatic and Ex-Ante Pragmatic Reform: This is the sort of reform suggested by most Arab national development strategies. Such strategies advocate pursuing reforms that are feasible and politically possible; that all reforms are equally additive and good; the more sectoral reforms the better; the more adherence and convergence towards international standards and benchmarks the better. A corollary of the pragmatic approach is ex ante pragmatism, which is an attempt to look at second order conditions that may impact the effectiveness of reforms. However, it is incredibly difficult if not impossible to determine ex ante potential behavioral policy effects of a particular market or institutional reform.

Given the events of the Arab Spring, it seems that pragmatic reform strategies also have their weaknesses. For example, in many of the countries most affected by the Arab Spring, the promise of high skill, high wage jobs purported to be one of the benefits of economic convergence towards knowledge-based economies has not emerged after over a decade of economic reform. The Arab Spring is also a reminder that it isn’t always the reforms with the largest economic impact or welfare maximizing effects that are pursued. This is evidenced by a clear gap between polices and social welfare that led to widespread complaints about a lack of economic opportunity by large segments of the population in the countries most affected by the Arab Spring. The reform process can be coopted by internal power politics or suboptimal processes such as government budgeting. For example, one way of assessing relative importance of a particular reform might be the value of the budget devoted to the implementing ministry. However, the rampant use of cost based budgeting in the region places an emphasis on control over expenditures rather than results, producing a disconnect between budgetary allocation and public policymaking. From this perspective, pragmatic reform strategies cannot assure that any one reform in particular will have welfare generating effects in an environment of many socio-economic challenges and external factors that may limit the effectiveness of reform efforts. Such approaches also tend to lose sight of larger macroeconomic processes such as globalization and widespread global increases in human capital which serve as forces of creative destruction that can undermine the effectiveness of exclusively inward looking economic reform.

How Should Arab Countries Determine What Reforms to Focus On?

Given that comprehensive reform is infeasible and determining ex ante effects of particular policy reforms is very difficult, prioritization and addressing economic challenges based on the magnitude of their negative effects on growth is critical. Our argument is not that policy pragmaticism is a bad approach but that prioritization should focus on eliminating the most severe constraints on growth rather than light-touch approaches in a number of areas.

For example, we view the approach similar to that taken in the Qatar National Development Strategy, which prioritizes “programs” and “projects” according to nondescript criteria to measure the need for change and the urgency of a particular intervention or the likely speed of impact, as a poor way to prioritize potential reforms based on the likelihood to remove impediments to growth.  We view such imprecise prioritization criteria as appropriate to temporary, discrete projects but not appropriate to altering the growth trajectory of Arab countries. Rather than focusing at the aggregate country level  to consider binding constraints on the growth of the nation, such project management-like criteria shift the level of analysis to discrete projects which emphasizes implementation and delivery and shows partiality towards more powerful ministries rather than aggregate economic impact. This form of prioritization myopia heavily biases Arab countries towards quick fix policies that are more pragmatic than impactful. We argue that this sort of prioritization sets Arab countries up to eliminate some minor problems but not large, more economically binding challenges.

In Kaldorian manner, our growth diagnostic to help Arab Countries determine what reforms to focus on starts with five “stylized facts” as a starting point:

  • Sufficient empirical evidence supports the conclusion that  economic growth depends on the accumulation of capital through investments that realize a financial return affecting both income per capita and long-run growth consistent with endogenous growth models;
  • Differences in policies, institutions, ideas, population, and human capital and the incentives they create have an large effect on economic growth;
  • Globalization has substantially increased the market for and mobility of goods, capital, and people, and Arab economies have not satisfactorily considered the impact of high skill, low wage economies in their economic development strategies;
  • While human capital per worker is rising globally, there is no guarantee that higher levels of education always guarantees high skill, high wage employment and wage premia. In situations where growth is constrained by a multitude of factors, more education can lead often lead to lower returns to human capital;
  • One area of particular weakness in Arab countries is the articulation of social determinants of growth with the generation of firm-based intangible capital critical to compete effectively with other knowledge-based economies. Schwalje (http://ssrn.com/abstract=1809224) finds that gaps, particularly around skills in national labor markets influences Arab businesses to contest lower-skilled, non-knowledge intensive industries.

We advocate a two-step funnel approach to identifying the most binding constraints on economic activity to prioritize policy reform. The initial stage of our diagnostic process probes the reasons why public and private investment and entrepreneurship might be low. We view two primary reasons for low levels of investment: Suboptimal financial returns accruing to economic actors and high costs or lack of finance. We then move on to determine and prioritize root causes of these challenges based on the magnitude of their impediment to economic growth with the ancillary goal of identifying and solving institutional problems that affect the viability of new and important industries to increase their rate of return and facilitate investment. We believe that as these sectors grow, they will create employment and state revenues to address second order economic constraints, but caution must be observed so that high potential industries do not outgrow the institutions that support them.

While this approach is complicated because it requires knowledge of all particular economic challenges as well as market and institutional failures, empirical economic research sheds some light on areas where socio economic challenges can affect growth which can be further refined to fit national contexts to remove growth obstacles. Our growth diagnostic approach resolves two major issues with the current applicability of generalized growth models to Arab countries which we view as critical to knowledge-based development in the Arab world: the articulation of human capital with developing firm level knowledge in the form of intangible capital and addressing the forces of creative destruction due to globalization which influence the competitiveness and viability of knowledge-based industries in the Arab World. In this way the missing link between the national vision and economic development strategies and institutional priority setting and budget allocation found in many Arab countries can be resolved.

 

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