contribution smart choices for growth · contribution smart choices for growth georg zachmann...

ISSUE 2012/21NOVEMBER 2012 SMART CHOICES

FOR GROWTH

GEORG ZACHMANN

Highlights

• Recovery in Greece, Italy, Portugal and Spain is held back in part by structuralbarriers. Overcoming these requires structural reform and public investment.Given the limited availability of political and financial capital, prioritising reformefforts and spending is important, but difficult. The different success factorsfor individual sectors are complementary. Using the example of the high-techindustry, we make the case that only investing in one success factor (eg broad-band infrastructure) without having a sufficient endowment of others (eg edu-cation) is unlikely to make the sector successful.

• One consequence of the complementarity of the different success factors isthat public investment and reform efforts should be fine-tuned in order to matchthe endowment of other factors. This might imply an increase in efforts to tackleseveral structural barriers at the same time, but it might also imply reducinginvestment in less promising fields. This in turn requires strategic thinking aboutwhether it is worthwhile pursuing development strategies that require invest-ment in many success factors but that do not promise much success. Such astrategic approach to public investment and reform efforts might make the allo-cation of scarce public financial and political capital more efficient.

Georg Zachmann ([email protected]) is a Research Fellow at Bruegel.The author acknowledges excellent research assistance from Philine Schuseil andAmma Serwaah.

Telephone+32 2 227 4210 [email protected]

www.bruegel.org

BRU EGE LPOLICYCONTRIBUTION

SMART CHOICES FOR GROWTH

GEORG ZACHMANN, NOVEMBER 2012

02

BR U EGE LPOLICYCONTRIBUTION

1. See Darvas and Pisani-Ferry (2011).

2. This includes legislation,formal institutions and

actual governance. A dis-cussion of the institutional

deficits can be found inPisani- Ferry, Jean (2010)

‘Euro-area governance:what went wrong? How torepair it?’ Policy Contribu-

tion 2010/05, Bruegel.

3. See for example Barroand Sala-i-Marin (1995).

4. For example, according toDarvas (2012b) ‘Composi-tional effects on productiv-ity, labour cost and exportadjustment’, Policy Contri-bution 2012/11, Bruegel,

the unit labour cost inGreece, Italy and Spain

increased by more than 30percent between 2000Q1

and 2008Q1.

TOGETHER WITH OTHER EUROPEAN UNIONCOUNTRIES, Greece, Italy, Portugal and Spain sawnegative average annual growth rates in 2008-11(see Map 1). In contrast to most EU economies,however, they expect no or even negative growthto continue in 2013 (Figure 1). Restoring growthis essential for these countries to achieve thesustainable budgets that are necessary tomaintain the integrity of the euro area in a mannerthat is both socially bearable and politicallysupportable1. Their economic decline isintrinsically tied to the European sovereign bondand banking crisis, which has affected various

drivers of growth, by for example reducingaggregate demand. However, the crisis is itselfpartly caused by structural barriers to growth.Overcoming the crisis and restoring growthrequires two strands of action: reforms targeted atthe macro-economic and institutional dimensionof the European sovereign bond and bankingcrisis2, and the resolution of structural barriers toeconomic development. In this Policy Contributionwe focus on the structural reform aspect.

Countries’ long-term growth prospects arefundamentally determined by structural factorssuch as infrastructure, human capital, financialsector development and the quality of regulation3.Table 1 on page 3 shows that the southern EUcountries and those that joined the bloc in 2004and afterwards continue to lag behind in severalof these factors. The southern countriesexperienced pre-crisis growth for a number ofreasons (eg convergence, cheap capital fuellinginternal demand); however, their competitivenesssubstantially deteriorated4 not least because thelong-term structural determinants of their growthdid not improve. In addition, structural barriersprevented quick adjustments in those countriesto the changing economic environment during thecrisis. This has proved particularly detrimental for

SMART CHOICES FOR GROWTH Georg Zachmann

>2.5%1% to 2%0% to 1%-1% to 0%-6% to -1%

Map 1: Annual average GDP growth rate 2008-11

Source: Eurostat.

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Figure 1: Expected growth rates for 2013 (%)

Source: IMF World Economic Outlook, October 2012.

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BR U EGE LPOLICYCONTRIBUTIONGeorg Zachmann SMART CHOICES FOR GROWTH

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04

BR U EGE LPOLICYCONTRIBUTION SMART CHOICES FOR GROWTH Georg Zachmann

euro-area countries that were unable to devalue toimprove their competitive positions5.

The different structural factors behind sectoralsuccess are inter-related, and this should be takeninto account when addressing structural weak-nesses. Figure 2 illustrates that in some cases,where there are complementary relationshipsbetween success factors, shifting efforts betweendifferent policies might simultaneously reducecosts and increase benefits. This holds not onlyfor public investment, but also for reforms thatcomplement public investment, such as cuttingred tape for innovative young companies.

General structural factors such as education,infrastructure and regulation encompass a widerange of sub-divisions. Infrastructure, for example,entails access to water, electricity, material andimmaterial communication. Each of these sub-divisions features different dimensions that policymakers might influence, for example the speed,price and reliability of data connections. Individualsectors require different sets of structuralstrengths to be successful. Consequently,unleashing sectoral growth potentials requiresaddressing structural factors relevant for theindividual sector. Thereby, the individual structuralstrengths are complimentary. To illustrate thispoint we will in the following focus on the high-tech sector. The motivation for this choice is thatthis sector is a typical target for sectoraldevelopment policies because, as Eurostat putsit, “high-tech sectors and enterprises are key

drivers of economic growth, productivity andsocial protection, and generally a source of highvalue-added and well-paid employment”.

In this Policy Contribution we will describe thecomplementary relationship between differenttypes of reforms and public investment forsuccess in the high-tech sector. Subsequently, wediscuss the implications of this complementarityfor the mix of public investments and reformpolicies in times of scarce fiscal resources andlimited political capital.

COMPLEMENTARITY OF REFORMS AND PUBLICINVESTMENT

Success in high-tech industries builds on variousfactors including specialised education, thepresence of communication infrastructure, andgood regulation. Map 2 indicates that theperipheral countries of the south and east are lessequipped in terms of an educated workforce (iePISA scores6). Maps 3 and 4 illustrate weaknessesin modern communication infrastructure andnetwork regulation (ie broadband connections inhouseholds,) relative to other countries in the EU.Map 5 demonstrates that these countries alsospend relatively little on R&D. These indicatorscorrespond to these countries' below averageemployment in high-tech sectors and belowaverage high-tech exports, as shown by Maps 6and 7.

Table 2 on page 6 highlights the structurallydifferent developments in northern and southernEurope by comparing the performances of Italy,Greece, Spain and Portugal to those of Finland andSweden. The four southern countries have higheducation drop-out rates. In most of their regionsmore than 15 percent of students leave educationor formal training early. In some Spanish andPortuguese regions, this figure is greater than 20percent. In contrast, fewer than 5 percent ofFinnish and Swedish students are consideredearly leavers. In terms of the scholasticperformance of 15-year-olds as measured by PISA(see footnote 6), results are more balanced. WhileFinland (>525) and Greece (<475) are thepositive and negative outliers, Italy, Spain,Sweden and Portugal are close to the Europeanaverage (scores between 475 and 500).

5. Note that for example theCzech Koruna, the Hungar-

ian Forint and the PolishZloty significantly depreci-ated compared to the eurocompared to their peak in

summer 2008.

6. The Programme forInternational Student

Assessment (PISA) is aworldwide study by the

Organisation for EconomicCo-operation and

Development (OECD) inmember and non-member

nations, of 15-year-oldschool pupils' mathematics,

science and readingattainment.

Public investment in infrastructure

Priv

ate

inve

stm

ent i

n ed

ucat

ion

Potentialgrowth, high

Potential growth, low

Figure 2: Complementarity of public policies forpotential growth of the high-tech sector

Source: Bruegel.

05


broadband connections. The contrast is evenstarker when comparing country scores given bythe World Economic Forum’s political andregulatory environment index (for networkregulation)7. Greece's score is in the lowestcategory; Portugal ranks slightly better, but stillperforms poorly compared to other nations,

7. World Economic Forum(2012).

Similarly, in terms of modern communicationnetwork infrastructure measured by broadbandconnections in households as a percentage oftotal households, Portugal and Greece arenegative outliers, with less than 45 percentconnectivity, while more than 75 percent ofFinnish and Swedish households have access to

525-600510-525490-510450-4900-450

Map 2: PISA average scale including reading,mathematics and science, 2009

Source: Eurostat.

85-9575-8565-7545-650-45

Map 3: Broadband connections in households as %of households, 2011

Source: Eurostat.

5.5-65-5.54.5-54-4.50-4

Map 4: Political and regulatory environment (net-work regulation), scale of 1-7 (7=best), 2012

Source: Network Readiness Index 2012 of the WorldEconomic Forum.

2.5 - 52 - 2.51.5 - 21 - 1.50 - 1

Map 5: Total R&D intramural expenditure as % ofGDP, 2010

Source: Eurostat.

5 - 124 - 53 - 42 - 30 - 2

Map 6: High-tech Employment as % of totalemployment, 2011

Source: Eurostat.

24 - 3116 - 248 - 165 - 81 - 5

Map 7: High-tech exports as % of total exports,2009

Source: Eurostat.

6


whereas Spain achieves the EU median. Again,Finland and Sweden achieve the highest ranks inthe index.

In line with the low network connectivity indicator,Greece has the largest percentage of populationwho have never used a computer. By contrast,fewer than 20 percent of the Finnish and Swedishpopulations have never used a computer. We finda corresponding distribution when comparing totalR&D intramural expenditure. This figure isbetween 3 percent and 4 percent for Finland andSweden. It is less than 0.5 percent for Greece, andbetween 0.5 percent and 2 percent for variousregions of Spain and Portugal.

The disparities described above are reflected inthe final statistics which consider high-techemployment as a percentage of total employmentand high-tech exports as a percentage of totalexports. High-tech industries account for less than2 percent of total employment in Greece, between2 and 4 percent for parts of Spain, Portugal andItaly, and more than 7 percent in Finland. Swedenis not a top performer in this instance, butnonetheless scores above the EU median.

The contrast is less pronounced when consider-ing high-tech exports. Here, both Finland andSweden are closer to the EU median.

This comparison indicates that Italy, Greece, Spainand Portugal on one hand and Finland and Swedenon the other are experiencing contrastingdevelopments. At least four hypotheses attemptto explain the origin of such divergent patterns: (1)

the countries are at different stages of economicdevelopment, (2) the pattern is the natural resultof specialisation, (3) the differences are due tolocational or cultural factors, (4) the countries arelocked into different varieties of capitalism (Halland Soskice, 2001).

It is impossible to determine which effect is themain cause of the divergent patterns, though evi-dence suggests that the southern economicmodel has failed to generate the foundations forsustainable growth. Thus the question is whethersome of the north European success factors canbe transposed to the south European countries inorder to reproduce north European success. In thefollowing, we argue that reproducing success isdifficult because it hinges not only on the averagelevel of structural factors but also on their interac-tion. In particular, sectoral success cannot bequickly engineered by just improving some easy-to-fix structural factors.

The interaction of different factors is confirmed atthe country level by the correlation exerciseshown in Table 3 (page 7). Even after controllingfor different levels of GDP per capita, countrieswith better education, broadband access, networkregulation, higher penetration of computers orhigher R&D intensity, have a higher share of high-tech employment and exports. Causality is unde-termined, yet sectoral strength appears to beconditional on the interaction of these factors.

When looking at specialisation in high-techindustries (as measured by high-tech exports) wefind that several factors are complementary. As

Structural factors SpecialisationEarly leaversfrom schooland training,

as % ofcorresponding

population

PISA averagescale

Broadbandconnections

in householdsas % of

households

Political andregulatory

environment

Individualswho have

never used acomputer as %of population

Total R&Dintramural

expenditureas % of GDP

High-techemploymentas % of total

employment

High-techexports as %

of totalexports

ItalyPortugalSpainGreeceFinlandSweden

Table 2: Indicators linked to success in high-tech industries

Source: Bruegel based on: Eurostat, World Economic Forum, OECD. Note: time period: 2008 - 2012. Colours indicate performancein comparison to other European countries: dark green (top performer) – light green – yellow – orange – red (bottom performer).

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the regression results below demonstrate, scoringin the lowest 30 percent in terms of PISA score,broadband connections and R&D expenditureshas some power to explain low levels of exportspecialisation. That is, a high score in any one ortwo of the factors can be entirely offset by beingamong the under-performers when it comes to thethird factor.

Hence, resolving infrastructure, education or reg-ulatory issues individually might have limitedimpact on the growth potential of high-tech indus-tries. For example, the net benefit of additionalinfrastructure spending might be negative if regu-latory issues prevent infrastructure prices fromdropping. Other sectors illustrate further thesecomplementarities: opening markets without cre-ating a framework that accommodates domesticinvestment might risk shifting activity to more pro-ductive offshore locations. To give a specific exam-ple, improving access to the Greek electricitymarket, while at the same time maintaining theinefficient de-facto state monopoly, might resultin higher electricity imports.

Furthermore, the potential (feedback-) effect ofsectoral success on the factors that underlie thesector's success is likely to reinforcespecialisation patterns. If a successful sectorpromises better job prospects and higher wages,it attracts more students into correspondingeducation. Similarly, governments will morewillingly invest in sector-specific education,infrastructure, regulatory reform or research if asuccessful sector can translate these efforts intoinstantaneous economic growth and jobs.

This leads to the timing issue. Most publicinvestment and reform has a substantial upfrontcost that only pays off in the long term.Sometimes the public has to invest for a long timein specific factors before a level is reached thatallows a new sector to flourish – educationsystems being a classic example.

As a consequence of the above-described effects,a large number of reforms and public investmentsin structural factors might appear to offer littlebenefit for a policymaker faced with the urgentrequirements of the economic and fiscal crisis.

DISCUSSION

The example of the high-tech sector demonstratesthat sectoral success and the presence ofcorresponding structural factors coincide. It is, infact, sensible to assume that structural factorsform the basis for sectoral success. In thefollowing we will discuss what it would take forgovernments to engineer sectoral success. Westart by discussing the implications of thecomplementarity of different public investments.

High-techexports

High-techemployment

NetworkReadiness

R&D expenditure

PISA score BroadbandNon-usage

of computerHigh-tech employment 0.23*Network readiness 0.53***R&D expenditure 0.24** 0.50*** 0.50***Pisa score 0.23** 0.19* 0.58* 0.27*Broadband connectivity 0.58*** 0.17* 0.88*** 0.44*** 0.73***Non-usage of computer -0.58*** -0.38*** -0.84* -0.49*** -0.67* -0.91***Early leavers from education -0.317*** -0.29*** -0.22** -0.21** -0.36*** 0.39*

Table 3: Are there significant correlations between structural factors?

Source: Bruegel based on Eurostat, Network Readiness Index. The factors are made orthogonal to the level of economic devel-opment by using the residuals of a regression on per capita GDP. The variables are the same as used in maps 2-7. Green indi-cates a significant (* 10%, ** 5%, ***1%) positive correlation, red a significant negative correlation, all others are not significantat the 5% level.

Share of high-techexports as % of total

exportsConstant -2.21***Broadband access 0.321***Pisa score -0.117***Intramural R&D as % of GDP -1.16**Being among the last 30% in oneof the categories

-5.42***

Table 4: The importance of complementarity

Source: Bruegel. Note: We control the variables for per capitaGDP, *** at the 1 % confidence level, ** at the 5% confidencelevel, N=93, R²=47%.

8


Then we address the interaction between reformsand public investment. Finally, we discuss thethorny issue of targeting sectors.

Dealing with complementarities

To engineer sectoral success, public investmentis obviously best employed when it is targeted toindividual shortcomings that are holding back theentire sector. As discussed, the factorsunderpinning the success of a specific sector areoften complementary. Hence, addressingindividual shortcomings might not be beneficial ifother barriers persist. In the high-tech example, itmight for example not be enough to improve thebroadband communication infrastructure. Withoutinvestment in the quality and length of education,in addition to targeted support to R&D, the cost ofa massive broadband infrastructure deploymentmight surpass its economic benefits.Consequently, a holistic view needs to be taken ofpublic investment8. At the same time, the conceptof complementarity suggests that public fundsused for investment in programmes that cannotbecome beneficial because of a lack ofcomplementary factors might be employed morebeneficially elsewhere.

Interaction of reforms and public investments

Deep structural reforms are necessary to restorethe foundations for growth in Greece, as well as inSpain, Portugal, and Italy (see Table 1). But, themost important structural reforms are charac-terised by upfront costs that only pay dividendsin the medium to long term (eg education system,pension system, labour market). Implementingsuch reforms without a commitment to conductthe necessary upfront public investment signifi-cantly challenges their prospects of success. Inaddition, some essential structural reforms mightonly become politically feasible if losers can becompensated to some degree. Consequently, akey criterion for public investment is if it supportsnecessary structural reforms. This entails two con-sequences. First, even the most cash-strappedpublic administrations might consider prioritisingsome funds for supporting reforms. This would notonly hold for regional or national budgets. The EUmight also focus its structural and regional fundson supporting reform efforts.

Second, certain public investment cannot deliverbecause the institutional framework is insufficientand corresponding reforms might not be easilyimplemented (ie if the first consequence isunfeasible). Expenditures in correspondingsectors – even though they are often highlypolitically contagious such as spending ondeclining incumbent industries – should beassiduously scrutinised.

Targeting sectors?

The costs and benefits of resolving such barriersdiffer between sectors and regions. To follow-upon the high-tech example, it might well be thatcertain countries lack so many of theunderpinnings for a high-tech driven growthmodel, that the financial and political capitalrequired to remove the shortcomings in the high-tech sector would be better employed in anotherarea. This leaves policymakers with the toughchoice of which sectors (and sometimes alsoregions) to support with the scarce availablefunds. Implementing the simple economic rulethat the sectors should be supported whereadditional funding has the highest benefit isdifficult to implement, as these benefits arecontingent on many factors: becomingcompetitive in sectors with fierce internationalcompetition is difficult (eg photovoltaic panels),supporting sectors with limited growth potentialmight be a dead-end (eg rotary printing presses),supporting sectors that feature a concentratedmarket structure and focus on the domesticmarket risks translating into higher rents forproducers instead of higher competitiveness ofthe sector (eg retail) and focusing on existingsectors risks exposing the country even more tosectoral shocks (eg the forestry industry inFinland in the 1990s). The cost of engendering thesuccess of a specific sector is contingent on howdifficult it is for a country to develop competitivestrength in that sector. This again depends on thepresence of complementary factors and howcostly it is to address the identified shortcomings.

Hidalgo et al (2007) provide an interestingapproximation to the cost of making a sectorcompetitive. They use the correlation of exportcompetitiveness between different sectors as oneindicator to identify which sectors in a country

8. Thereby, it might provehelpful that public invest-

ment can be very narrowlytargeted to different themes

(eg R&D, infrastructure oreducation), regions and sec-tors (eg high-tech, services,

industry). Consequently,comprehensive packages

for regional and sectoraldevelopment that built onexisting strength could be

engineered.

9


might become competitive. They claim thatcountries might become competitive in sectorsthat are under-developed but ‘close’ to sectorsalready present in the country underconsideration. To measure the ‘closeness’ of thesectors, they analyse on a global scale the co-location of sectors in countries. For example,countries exporting semi-conductors are typicallyfound to be also exporting photovoltaic cells (seeHuberty and Zachmann, 2011). Hence, a countrythat is successful in exporting semi-conductors,but not yet in exporting photovoltaic cells, mightbe more easily able to generate exportcompetitiveness in the latter than other countries.For Greece, for example, Hausmann (2011)identifies the main product markets, which areagriculture (milk products, dried fruits, vegetables,tobacco, wheat, cotton, olive oil); metals(aluminium, copper, ferro-alloys, cutlery); textilesand garments; construction materials (cements,bars, pipes); and chemicals (medicines,

cosmetics, petrochemicals). Hausmann (2011)suggests moving towards 'nearby' products thatfulfil four criteria: First, how easy would it be tobecome 'good' at the product; second, what is thepotential gain from producing it; third, howsophisticated is the product; and last, howstrategic is the product – namely, how will itimprove the firm’s (or country's) position?

This indicates that targeting sectors to overcomebarriers by implementing reforms and publicinvestments is a complex strategic exercise9. Butskipping the strategic choice step and returning toa disbursement of public investment based onhistoric sector strength and lobbying power is nooption. Without strategic direction it might makesense to completely omit public ‘investment ingrowth’ programmes. Finally, independent ex-postevaluation of the choice is essential to learn forthe future and to decide on the continuation ofexisting programmes.

REFERENCES

Allard, Celine, Anthony Annet, Ajai Chopra, Luc Everaert, Julio Escolano, Daniel Hardy, MartinMühleisen, and Boriana Yontcheva (2010) ‘Lifting Euro area growth: priorities for structural reformsand governance’, Staff Position Note SPN/10/19, International Monetary Fund

Barabasi, Albert-László, César Hidalgo, Ricardo Hausman and Bailey Klinger (2007) ‘The productspace conditions the development of nations’, Science 317: 482-487

Barro, Robert and Xavier Sala-i-Martin (2003) Economic Growth, 2nd Edition, The MIT PressBecker, Torbjörn and Daniel Daianu, Zsolt Darvas, Vladimir Gligorov, Michael Landesmann, Pavle

Petrovic, Jean Pisani-Ferry, Dariusz Rosarti, André Sapir and Beatrice Weder Mauro (2010) ‘Whithergrowth in Central and Eastern Europe? Policy lessons for an integrated Europe’, Blueprint 11,Bruegel

Darvas, Zsolt and Jean Pisani-Ferry (2010) ‘The threat of currency wars: a European perspective’,Policy Contribution 2010/12, Bruegel

Bustos, Sebastián, Michele Coscia, Sarah Chung, Juan Jimenez, Ricardo Hausmann, César A. Hidalgo,Alexander Simoes and Muhammed A. Yildirim (2011) The Atlas of economic prosperity, Centre forInternational Development at Harvard University

Darvas, Zsolt and Jean Pisani-Ferry (2011) ‘Europe’s growth emergency’, Policy Contribution2011/13, Bruegel

Darvas, Zsolt (2012) ‘Compositional effects on productivity, labour cost and export adjustments’,Policy Contribution 2012/11, Bruegel

Hall, Peter and David Soskice (2001) Varieties of capitalism: the institutional foundations ofcomparative advantage, Oxford University Press

Huberty, Mark and Georg Zachmann (2011) ‘Green exports and the global product space: prospectsfor EU industrial policy’, Working Paper 2011/07, Bruegel

Pisani-Ferry, Jean (2010) ‘Euro area governance: What went wrong? How to repair it?’, PolicyContribution 2010/05, Bruegel

9. Furthermore, the sectoraladvantages might change

over time. The highlypraised Finnish exports in

‘electronics –telecommunication’, for

example, dropped by about75 percent from €9.3 billion

in 2007 to €2.5 billion in2011.

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