How Deregulation Spurs Growth

Summary of working paper 9560
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Regulatory reforms - in particular those that liberalize entry - are very likely to spur investment; tight regulation of product markets restricts investment.

The U.S. economy grew at an annual average rate of 4.3 percent in the second half of the 1990s, while Germany, France, and Italy grew at an average annual rate of 2 percent. A common view is that greater regulation in continental markets has retarded investment and economic growth - and that this was particularly important in the late 1990s, a period of significant technological innovation. However, the impact of product market regulation on investment has received little attention from economic researchers.

In a new paper, Regulation and Investment (NBER Working Paper No. 9560), NBER Research Associate Alberto Alesina and co-authors Silvia Ardagna, Giuseppe Nicoletti, and Fabio Schiantarelli examine the relationship between product market regulation and capital spending. Their study is based on differences in regulation among OECD countries. Alesina et al exploit the fact that while most OECD countries have deregulated product markets over the past three decades, they differ in terms of their starting points and the timing, nature, and intensity of reforms. For example, the United States started deregulating in the 1970s. In 1977, 17 percent of U.S. gross national product was produced by fully regulated industries, and by 1988 this total had fallen to below 9 percent of GNP. The United Kingdom was another early reformer, while the laggards include Germany, France, and Italy.

The researchers demonstrate that a number of measures of regulation - in particular barriers to entry - are negatively related to investment. The implications of the analysis are clear: regulatory reforms - in particular those that liberalize entry - are very likely to spur investment; tight regulation of product markets restricts investment.

The study focuses on the sectors that, traditionally, have been the most sheltered from competition: airlines, road freight and railways, telecommunications and postal services, and electricity and gas utilities. The authors measure regulation using a number of indicators -- including barriers to entry and the extent of public ownership. They use a dataset based on the OECD International Regulation Database, for 21 OECD countries over the period 1975-98, and data on investment and the capital stock from the OECD Industrial Analysis database.

The analysis demonstrates a significantly positive impact of deregulation on investment in the transport, communications, and utility industries; it is robust to various controls for sector or country-specific shocks and for labor market liberalization. The most important component of reform is liberalization of entry into markets. A reduction in entry barriers leads to a reduction in the markup of prices over marginal costs, and hence to a reduction in the penalty for expanding the capital stock and production. However, privatization doesn't appear to affect investment significantly. Privatization may lead to more profitable opportunities for private companies, but nationalized companies may over-invest, either reflecting the pressure of politicians, or because managers of public enterprises are not constrained by the discipline imposed by financial markets.

The researchers show that the effect of deregulation on investment depends on the extent of the deregulatory effort and on the initial level of regulation. A more decisive reform is associated with a greater marginal increase in investment. Moreover, liberalization in a more deregulated industry has a bigger impact on investment than liberalization in a highly regulated industry.

-- Andrew Balls