A Tale of Two Islands
Differences in macroeconomic policy choices, not differences in institutions, account for the differing growth experiences of Barbados and Jamaica.
Economists have long believed that there is a correlation between institutions and economic performance. Rich countries, they argue, have laws that provide incentives to engage in productive economic activity. Investors rely on secure property rights, facilitating investment in human and physical capital. Government power is balanced and restricted by an independent judiciary. Contracts are enforced effectively, supporting private economic transactions. Yet these institutional factors are not the only determinants of economic growth, even over horizons of several decades.
Barbados and Jamaica provide a striking counter-example to the institution-focused long-run view of income determination. In Institutions vs. Policies: a Tale of Two Islands (NBER Working Paper No. 14604), authors Peter Blair Henry and Conrad Miller remind us that both countries inherited property rights and legal institutions from their English colonial masters, yet experienced starkly different growth trajectories in the aftermath of independence. From 1960 to 2002, Barbados' GDP per capita grew roughly three times as fast as Jamaica's. Consequently, the income gap between Barbados and Jamaica is now almost five times larger than at the time of independence. Since their property rights and legal systems are virtually identical, recent theories of development cannot explain the divergence between Barbados and Jamaica. The authors show that differences in macroeconomic policy choices, not differences in institutions, account for the differing growth experiences of these two Caribbean nations.
Barbados and Jamaica are both former British colonies, small island economies, predominantly inhabited by the descendants of Africans who were brought to the Caribbean to cultivate sugar. The two islands inherited almost identical political, economic, and legal institutions: Westminster Parliamentary democracy, constitutional protection of property rights, and legal systems rooted in English Common Law. Yet the standard of living in the two countries diverged widely in the roughly forty-year period following their independence.
The authors argue that the explanation for the divergence lies in differences in macroeconomic policy. They lay out the qualitative and quantitative data that make their case. When Jamaica gained independence in 1962, the Jamaican Labor Party (JLP) held a parliamentary majority. For the next ten years the JLP remained in power and GDP per capita grew at a rate of 5.4 percent per year. However, for a variety of reasons, that strong growth was accompanied by rising unemployment. The unemployment rate was 13 percent in 1962 and 23.2 percent in 1972. Rising unemployment, income inequality, and the attendant societal tensions proved too much for the JLP. In 1972 the People's National Party (PNP) rose to power with the promise of "democratic socialism," which translated as extensive state-intervention in the economy. The PNP nationalized companies, erected import barriers in the form of higher tariffs and outright bans, and imposed strict exchange controls. Social justice meant income redistribution through job-creation programs, housing development plans, and subsidies on basic food items.
Government spending subsequently rose in Jamaica from 23 percent of GDP in 1972 to 45 percent of GDP in 1978. Revenue did not keep pace with the rise in expenditure. From 1962 through 1972 Jamaica's average fiscal deficit was 2.3 percent of GDP, but from 1973 to 1980 the average fiscal deficit was 15.5 percent of GDP. Much of the deficit was financed through direct borrowing from the Bank of Jamaica. Predictably, inflation also rose. From 1962 to 1972 the average rate of inflation was 4.4 percent per year. By 1980 inflation was 27 percent per year and investment had collapsed to 14 percent of GDP, down from 26 percent in 1972.
Because Jamaica's reversal of fortune coincided with the Oil Price Shock of 1973 and the onset of worldwide stagflation, it is tempting to blame the country's downward spiral on external events. However, even a cursory comparison with Barbados makes it difficult to do so. The inflation rate in Barbados also spiked in the early 1970s, hitting a peak of 39 percent in 1975, but Barbados's policy response to the external shocks that precipitated the spike was radically different than Jamaica's.
First, Barbados avoided nationalization, kept state ownership to a minimum, and adopted an outward-looking growth strategy. Second, instead of delaying the inevitable retrenchment needed to adjust to higher energy prices, policymakers in Barbados kept government spending under control. While the fiscal deficit in Barbados did climb to 7.7 percent of GDP in 1973, that number was down to 2.9 percent by 1978. Since much of deficit financing comes from the central bank, by extension, Barbados also ran a tighter monetary ship than Jamaica.
The authors attribute the divergence of the two nations' growth rates over the last four decades to differences in macroeconomic policy. They observe that for small open economies, the response of policy to macroeconomic shocks, such as a fall in the terms of trade, is particularly important. Changes in macroeconomic policy, even those that do not have a permanent effect on growth rates of GDP per capita, can have a significant impact on a country's standard of living within a single generation.
-- Lester Picker