Growth Diagnostics

Most well-trained economists would agree that the standard policy reforms included in the Washington Consensus have the potential to be growth-promoting. What the experience of the last 15 years has shown, however, is that the impact of these reforms is heavily dependent on circumstances. Policies that work wonders in some places may have weak, unintended, or negative effects in others. We argue in this paper that this calls for an approach to reform that is much more contingent on the economic environment, but one that also avoids an anything goes attitude of nihilism. We show it is possible to develop a unified framework for analyzing and formulating growth strategies that is both operational and based on solid economic reasoning. The key step is to develop a better understanding of how the binding constraints on economic activity differ from setting to setting. This understanding can then be used to derive policy priorities, in a way that uses efficiently the scarce political capital of reformers. Our approach is motivated by three considerations. First, while development is a broad concept entailing the raising of human capabilities in general,we believe increasing economic growth rates is the central challenge that developing nations face. Higher levels of living standards are the most direct route to achieving improvements in social and human indicators. Reform strategies should be principally targeted at raising rates of growth that is, they should be growth strategies. Second, trying to come up with an identical growth strategy for all countries, regardless of their circumstances, is unlikely to prove productive. Growth strategies are likely to differ according to domestic opportunities and constraints. There are of course some general, abstract principles such as property rights, the rule of law, market-oriented incentives, sound money, and sustainable public finances which are desirable everywhere. But turning these general principles into operational policies requires considerable knowledge of local specific cities. Third, it is seldom helpful to provide governments with a long list of reforms, many of which may not be targeted at the most binding constraints on economic growth. Governments face administrative and political limitations, and their policy-making capital is better deployed in alleviating binding constraints than in going after too many targets all at once. So growth strategies require a sense of priorities. What we propose to do in this paper is to develop a framework for growth diagnostics that is, a strategy for figuring out the policy priorities. The strategy is aimed at identifying the most binding constraints on economic activity, and hence the set of policies that, once targeted on these constraints at any point in time, is likely to provide the biggest bang for the reform buck. The methodology that we propose for this can be conceptualized as a decision tree (see Figure 1, discussed below). We start by asking what keeps growth low. Is it inadequate returns to investment, inadequate private appropriability of the returns, or inadequate access to finance? If it is a case of low returns, is that due to insufficient investment in complementary factors of production (such as human capital or infrastructure)? Or is it due to poor access to imported technologies? If it is a case of poor appropriability, is it due to high taxation, poor property rights and contract enforcement, labor-capital conflicts, or learning and coordination externalities? If it is a case of poor finance, are the problems with domestic financial markets or external ones? And so on. Then we discuss the kind of evidence that would help answer these question one way or another. We also illustrate the practical implications of this approach by drawing on examples from specific countries. Aside from providing a useful manual for policymakers, our approach has the advantage that it is broad enough to embed all existing development strategies as special cases. It can therefore unify the literature and help settle prevailing controversies. For example, our framework will clarify that doctrinal differences on development policy between proponents of the Washington Consensus and of state-led strategies, or between pro-globalizers and cautious globalizers are grounded in divergent evaluations about the nature of the binding constraints on growth. Making these differences explicit, and clarifying the nature of the evidence that can resolve them, can move us forward to a more productive policy agenda. The outline of the paper is as follows. We first lay out the conceptual framework, linking our terminology of binding constraints to standard economic models. In particular, we relate our framework to theories of second-best and partial reform and of endogenous growth. We next cast the framework in the form of a decision tree, and discuss the nature of the evidence that is required to move along the nodes of the tree. In the final section we carry out an analysis of several "archetypal" cases, each representing a different syndrome or combination of binding constraints.