To assess whether the level of financial development in low-income countries plays a role in determining the effects of capital account liberalization on income inequality, we first estimated Eq. (2) with EFW’s credit market indicator. The IRFs obtained from the estimated coefficients of the two different levels of financial development are illustrated in Fig.6, together with the baseline IRFs. The figure shows that in economies with high level of credit market openness, a capital account reform is only associated with 1.3% medium-term increase in Gini index in contrast to 9.6%
increase in countries with low level of credit market openness. The results confirm
-2 0 2 4 6 8 10 12
0 1 2 3 4 5
Gini (Percent)
Baseline Low Financial Deepening High Financial Deepening
Fig. 6 The effect of capital account liberalization on inequality in LICs, financial depth
-5 0 5 10 15 20
0 1 2 3 4 5
Gini (Percent)
Baseline Low Financial Inclusion High Financial Inclusion
Fig. 7 The effect of capital account liberalization on inequality in LICs, financial inclusion
that the effects of capital account liberalization depend on the level of credit market development in low-income countries since for countries with low financial depth, the impact of capital account liberalization in the medium term is much larger than that of countries with high financial deepening.
We also re-estimate Eq. (2) with financial inclusion indicator and find that financial inclusion is crucial in determining the response of inequality to capital account liberalization episode in low-income countries. The respective IRFs of the high financial inclusion and low financial inclusion are displayed in Fig.7. As
-25 -20 -15 -10 -5 0
0 1 2 3 4 5
Percent
Baseline Low Financial Inclusion High Financial Inclusion
Fig. 8 The effect of capital account liberalization on poverty rates in LICs: the role of financial inclusion
demonstrated in the figure, in countries with low financial inclusion, Gini index typically experiences 15.7% increase in the medium term after a capital account reform, whereas in countries with high financial inclusion, inequality measured by Gini actually is decreased by 3.6%. In other words, for low-income countries, capital account liberalization helps to reduce the income inequality if the country has given people relatively more equal access to formal financial services.
In addition, we find that countries with high financial inclusion are likely to experience much larger reduction in poverty rates measured by poverty headcount ratio at $3.10 (2011 PPP) in short term, compared to countries with low financial inclusion, even though the effects tend to converge in the medium term after a capital account liberalization episode. The impacts of capital account reform on poverty are exhibited in Fig.8.
6 Conclusion
Even though most of the literature has supported the idea that opening up capital account could bring considerable economic benefits, particularly on growth, to a country, the trend in inequality has casted doubt on whether these benefits can be distributed equally among the people, especially in low-income countries. This paper, using an unbalanced panel of 29 low-income countries over the period from 1970 to 2010, empirically examines the effects of capital account liberalization episode on income inequality and finds that capital account reform may lead to a long-lasting and statistically significant increase in inequality. Specifically, we
estimate that a capital account liberalization reform could increase the Gini index by 6.5% in the medium term (that is, 5 years after the reform) in low-income countries.
In addition, our research provides evidence that the appropriate degree of capital account liberalization for a country depends on its financial and institutional development. For low-income countries, where the level of financial development and inclusion is relatively low, our results imply that a capital account liberalization reform is most likely to increase income inequality even more, up to 16% in medium term. When deciding to liberalize the capital account following the footsteps of high-income countries, policymakers in low-income countries should take into consideration these distributional effects and ensure that the supporting conditions are in place so that all segments of society can reap the benefits of opening up.
Appendix: Data Appendix
This appendix provides details on other variables used in this paper.
Current Account Openness Index
De jure index of current account openness is taken from Quinn and Toyoda (2008) dataset which is based on IMF’s AREAER and is mostly available from 1980 to 2009 for 125 countries. The index measures a country’s degree of compliance under IMF’s Article VIII to free government restrictions in regard to international trade of goods and services. The higher the index, the more open the current account is.
Using the same method outlined in the paper to identify capital account liberalization, we assume current account liberalization reform occurs when, for a low-income country at a given time, the annual change in current account openness index exceeds by two standard deviations the average annual change of all observations covering 125 countries. As a result, with our low-income country sample, we are able to identify 10 current account liberalization episodes in 1980s, 21 in 1990s and 3 in 2000s.
Regulation Reform
The regulation index is from Fraser Institute’s EFW (Economic Freedom of the World) database developed by Gwartney et al. (2016). It assesses the regulatory restraints of credit market, labor market and business regulations together for about 160 countries from 1970 to 2014, with lower number indicating more restrictions in these areas.
We identify an episode of regulatory reform if, for a given country at a given time, the annual change in the composite regulation index exceeds by two standard deviations the average annual change of all observations included in the EFW dataset. Following this methods, we find 8 regulatory reforms in 1980s, 21 in 1990s and 17 in 2000s for our low-income country sample.
Macroeconomic Variables
Macroeconomic variables: Gross domestic Product (GDP), GDP Growth Rate, Log GDP per Capita, Industry Value Added over GDP, Agriculture Value Added over GDP, Government Expenditure, Imports, Exports and Dependency Ratio are from World Bank’s World Development Indicators (WDI), with annual data covering from 1970 to 2010. We calculated Trade Openness as the sum of exports and imports over GDP.
Redistributive Policies
To measure the redistributive policies of a government, we used the difference between market Gini indices, which measures the pre-tax and pre-transfer income inequality and net Gini indices, which measures inequality in post-tax and post- transfer income, as a proxy. Both measures of Gini indices are taken from Standardized World Income Inequality Database (SWIID) from 1970 to 2010.
Credit Market Freedom Indicator
Credit market freedom indictor (ownership of banks), based on the percentage of bank deposits held in privately owned banks, is from Fraser Institute’s EFW as well, which measures conditions in the domestic credit market. The indicator is consisted of numeric variables between 0 and 10, covering around 160 countries from 1970 to 2014. When private held deposits ranges from 95 to 100% of total deposits, countries were given a score of 10 that indicates high financial depth and high level of credit market openness. When the private deposits were 10% or less of the total deposits, countries were assigned a rating of 0 to indicate low financial depth and low level of credit market openness.
Financial Inclusion
The financial inclusion indictor was taken from The Global Financial Inclusion database (Global Findex) developed by Demirguc-Kunt et al. (2015) at World Bank, covering around 140 economies. The inclusion indicator is defined as ratio of adults who borrowed from a formal financial institution in the past years to the number of total adults.
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Economies
Alfred Greiner
Abstract In this paper we analyze effects of public debt on the long-run allocation of resources in a basic endogenous growth model with infinitely lived households.
The government levies an income tax and issues government bonds to finance unproductive public spending. We demonstrate that in the case of flexible wages and elastic labour supply the balanced growth rate is the higher the smaller the ratio of public debt to GDP for a given income tax rate. When wages are rigid public debt is neutral in the sense that it does not affect the allocation of resources along the balanced growth path. Finally, in both cases the economy is stable only if the government puts a sufficiently high weight on stabilizing public debt.
1 Introduction
The financial and economic crises of 2008 that began as a sub-prime crisis in the USA in 2007 had plunged a great many economies throughout the world in deep recession. It seemed that the slump had been overcome by 2010 when some countries had reached their pre-crisis level of production. However, meanwhile the sub-prime crisis has turned into a public debt crisis because the bail-out of private financial institutions by governments led to an in part drastic increase of national debt ratios. In particular, in the Euro area some countries face severe problems and must be supported by others. This evolution drastically shows that public debt does affect real economies and with this paper we intend to contribute to the question of how public debt may affect the growth process of market economies in the long-run.
When one looks at the economics literature that studies the relationship between endogenous growth and public deficits and debt, one realizes that the way public spending is modelled plays an important role. For example, in an OLG model of endogenous growth Yakita (2008) demonstrates that there exists an upper bound for the level of public debt beyond which a sustainable debt policy is excluded that is the larger the higher the stock of productive public capital. Brọuninger (2005) also
A. Greiner
Department of Business Administration and Economics, Bielefeld University, P.O. Box 100131, 33501 Bielefeld, Germany
e-mail:agreiner@wiwi.uni-bielefeld.de
© Springer International Publishing AG 2017
B. Bửkemeier, A. Greiner (eds.),Inequality and Finance in Macrodynamics, Dynamic Modeling and Econometrics in Economics and Finance 23, DOI 10.1007/978-3-319-54690-2_5
97
finds that public debt policy is unsustainable once a critical value of public debt is crossed which, however, in his model only depends on the stock of private capital since he does not consider productive public spending. In the approach by Greiner (2008), who considers an endogenous growth model with infinitely lived agents and productive public capital, it is demonstrated that a higher ratio of public debt to GDP requires resources that reduce public spending so that higher debt leads to lower growth. But, once unemployment is allowed for, this result changes as has been pointed out by Greiner and Flaschel (2010). Then, an increase in deficit financed public spending may generate a higher long-run growth rate. In Greiner (2011) public spending is incorporated into the utility function and yields utility for the household sector. With this assumption it is shown that a debt policy that leads to higher long-run growth does not necessarily also imply higher welfare.
Finally, Futagami et al. (2008) show that public debt policy may not only affect economic growth but can also be decisive as regards transition dynamics to the balanced growth path and the emergence of multiple growth paths.
With this paper we want to contribute to the research that analyzes how public debt affects economic growth in the long-run. We are interested in effects that come from public debt by itself so that we assume that public spending is a mere waste of resources. That means government spending is neither productive nor does it yield any utility. Further, we keep the income tax rate fixed so that any growth effects must indeed be attributed to variations of public debt.
When the government raises the stock of public debt, it has to run higher primary surpluses in the future to repay the higher debt. Then, the crucial question is which fiscal parameter the government uses to increase the primary surplus. When a distortionary tax is levied, the higher public debt will reduce future investment and growth. When the government raises a lump-sum tax or reduces non-distortionary transfers to the private sector, public debt will be neutral giving the Ricardo equivalence theorem. When the government reduces productive public spending as a result of higher debt, economic growth will also decline. However, when public spending is non-productive the effects of a decline in government spending with respect to economic growth are less obvious and it is this latter case that is analyzed in this contribution.1
Often endogenous growth models do not take into consideration unemployment when they are used to get insight into real world phenomena. The reason is that those models adopt a medium- to long-term perspective and markets, in particular labour markets, that are rigid in the short-run may become flexible in a longer-run perspective. But, if one looks at real world economies, one can see that unemployment in many European countries seems to present a persistent phenomenon. In the economics literature one can find different approaches that integrate unemployment in models of economic growth (Arico 2003, gives a survey of how unemployment can be integrated into endogenous growth models).
1We abstract from monetary aspects. A model showing how monetary and fiscal policy determine growth and inflation can be found in Greiner and Fincke (2015), Chap. 3.
Pissarides (1990), for example, identifies a link between economic growth and the labour market through a capitalization effect that states that firms are more willing to create new jobs in times of high growth. A different approach has been proposed by Aghion and Howitt (1994) who model the Schumpeterian idea of creative destruction meaning that innovations render existing technologies obsolete which then leads to reallocations of labour across firms. If specific skills are needed that not any job searcher disposes of, persistent unemployment may occur. Yet a different mechanism has been elaborated in the contribution by Acemoglu (1997). There, strategic interactions between firms affect their investment in new technologies and in human capital accumulation. This model can give rise to multiple equilibria where the equilibria with little employment is interpreted as an unemployment trap.
These considerations suggest that unemployment may indeed be relevant when one analyzes models of economic growth. Therefore, we distinguish between two cases in our analysis of growth effects of public debt. First, we consider the model with full employment and, then, we allow for wage rigidities that give rise to unemployment.
In the rest of the paper we proceed as follows. In the next section we present the structure of our growth model where we assume that wages are flexible and analyze the resulting model. Section3, then, posits that the economy is characterized by wage rigidity and studies implications of that assumption with respect to long-run growth effects of public debt and deficit policies. Section4, finally, summarizes the main results and concludes the paper.
2 The Growth Model with Flexible Wages and Elastic Labour Supply
To start with we describe the structure of our model for the case of flexible wages and elastic labour supply.