NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Capital and Institutions Stimulate Growth

"...the best single predictor of the growth of an economy remains its investment rate."

"The four key issues for defining institutional quality are: the quality of the bureaucracy; rule of law; risk of expropriation; and repudiation of contracts by government."

What explains the stellar economic performance of the East Asian nations since World War ll? How critical a role did government interventions and industrial policy play? And perhaps most importantly, what policy insights can be gleaned from East Asia that might spur faster economic growth in the former East Bloc and developing nations of the world?

"Most economists would agree that there are major lessons to be drawn for other countries from East Asia's growth experience," begins a wide-ranging paper by NBER Research Associate Dani Rodrik. "But what these lessons are remains subject to considerable controversy." In TFPG[total factor productivity growth] Controversies, Institutions, and Economic Performance in East Asia (NBER Working Paper No. 5914), Rodrik concludes that high-quality institutions are critical for growth, and that "making the transition from a low-investment economy to a high-investment economy requires a hands-on government."

Rodrik emphasizes the fundamental role of strong capital accumulation in generating rapid growth in East Asia. He believes the "best single predictor of the growth of an economy remains its investment rate." It is also likely, he adds, that labor-saving technological change takes place where there is plenty of investment.

The East Asian region often is compared favorably to other parts of the developing world, but economists seem to pay less attention to the divergent economic experiences of the various East Asian countries. For instance, average annual growth rates per worker in Indonesia and Malaysia lagged Korea and Taiwan by about 2 percentage points from 1960 to 1994. And the Philippines had a growth rate comparable to Latin American nations during the same time period.

The key to understanding accumulation and growth trends among the East Asian countries is the quality of their institutions. Rodrik uses an index of "institutional quality" for eight East Asian nations:Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Thailand, and Taiwan. The index was created by other scholars from surveys compiled by the International Country Risk Guide. The four key issues for defining institutional quality are: the quality of the bureaucracy; rule of law; risk of expropriation; and repudiation of contracts by government. The raw figures show a wide range of institutional quality, with Japan, Singapore, and Taiwan receiving very high grades and the Philippines ranking quite low. Even more striking, Rodrik finds that combining three economically meaningful variables--institutional quality, initial income, and initial education-- is enough to explain all of the differences in growth performance among the East Asian countries.

An intriguing test of his point of view is Hong Kong. A bastion of laissez faire economics, Hong Kong is the only East Asian country where investment as a percentage of gross domestic product has remained flat since the early 1960s. Yet Hong Kong grew rapidly. A triumph of laissez faire? Not necessarily, since Hong Kong was already a relatively rich country in the 1960s. Hong Kong made its transition to a high-investment economy during the 1950s as capital poured into a safe harbor from the region's political and economic turmoil. In other words, Hong Kong did not face the same overriding challenge of economic development: how to convert a low-savings and low-investment economy into a high-savings and high-investment economy--in quite the same way as the rest of East Asia.


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