Two Different Meanings for the Economic Convergence - Assignment Example

?Introduction Economic convergence is the concept that poor economies will eventually catch up with the developed countries. Under this hypothesis, the GDP Growth rates of the poorer economies will be higher than the growth rates of the rich countries and as a result of this poor and rich economies will finally converge with each other. This concept is based upon the assumption that the diminishing returns in developed countries are not as strong. It is also important to note that economic literature, especially on the growth economics, indicates two different meanings for the economic convergence. Chile is one of the smaller countries in South American region with one of the most vibrant economies in the region. It is termed as an upper middle income country as per the standards of World Bank. It is also considered as most stable and prosperous nations in the region due to its sustained economic performance. It has been argued that the Chile’s government has kept constant policies sustained over the period of almost three decades witnessing reduction in poverty to almost half. This impressive economic performance of the country has resulted into the narrowing of the gap between Chile and other developed countries as accelerated rate of growth has provided Chile much needed convergence to be part of the fastest growing countries. This literature review will provide a review of existing literature on the subject of economic convergence, growth and financial development in Chile. By reviewing the current literature, this review will offer insight into economic convergence of Chile. Macroeconomic Convergence- Theoretical Framework As mentioned above, there are two different concepts of macroeconomic convergence i.e. beta and sigma convergence. Beta convergence signifies convergence through the per capita income and the later is through convergence of cross sectional dispersion of per capita income. In economic growth literature, word convergence is often used to define the initial economic and subsequent growth. (Jones) Two countries exhibit convergence if the poor country with lower levels of income grows faster than the other. This type of convergence is called beta convergence where absolute convergence can be achieved when the per capita incomes actually converge to a steady level of state. Conditional convergence however occurs when the countries have different level of per capita income and it is also experiencing convergence. This also means that each country is actually converging at its own rate and that in the long run all countries will converge and growth rates will be equalized. Absolute convergence also suggests the conversion of the growth rates of all the economies over the period of time. The convergence debate is mostly based upon two important models of economic growth i.e. Solow’s growth model as well as the endogenous growth theory. Neo-classical literature suggests that an economy starts to converge when the output is constant and the growth rate is zero. When both these variables are witnessed, a country is believed to be entering into an steady state where it starts to achieve convergence with other countries depending upon the fact that with whom country wants to correlate itself. (Papageorgiou and Perez-Sebastian) Economists have actually attempted to explain this concept by assuming two types of economies i.e. if two countries with same rates of investment, savings, depreciation, population growth rates and technological progress, poorer countries will tend to grow faster than the developed or rich country. There is however a controversy over the growth models regarding the unconditional convergence especially endogenous growth models are believed to be based upon providing decreasing returns or constant returns to per capita capital. This controversy therefore makes it relatively difficult as growth theories predict convergence however; empirical studies do not tend to support this assertion with the data. Neo-classical models have also failed to find any correlation between the initial GDP and the GDP growth rate. This has also been due to the fact that neo-classical growth models assume that in the long run, all the economic growth is subject to the technological change. Economies can grow in long run if the rate of technological change is relatively higher and consistent over the period of time. Technological change is also assumed to be exogenous under the neo-classical growth models therefore empirical validity of the convergence claim is not well supported through data. Studies have also outlined that there is also an international convergence of technological progress especially among the developed countries specially those countries which have been able to dominate the world production and trade during last few decades. (Francesco Caselli, Esquivel and Lefort) Chile’s Economic History Chile’s economy is considered as an exception and all those who either support free market economies or not tend to agree to the fact that over the period of time, Chile has been able to achieve tremendous economic growth. Over the period of time, it has been able to witness sustainable level of growth and have proved that free market economic policies can actually provide the desired results if properly implemented and carried out. What is also important to understand that recent economic history of Chile also suggests as to how the protectionist policies can actually help the stabilization of economy and ensure its sustainable development. One of the keys to the economic success of Chile was its ability to enforce rule of law and open its markets for foreign companies persistently. This persistence has actually made it possible for Chile to actually experience such economic growth. Over the period of time, it has been able to demonstrate as to how a country can actually get off from economic aid and can create economic opportunities which can experience sustained growth over the period of time. The overall reform process in Chile started during 1970s under the dictatorship of Pinochet. These policies are still continued and Chile is following a unique model of State intervention along with the free market economic policies allowing it have sufficient control over the economic policy making process within the country. Chile’s economic progress and its rapid rise started with the reforms of its trade policy during 1970s. Chile dismantled the quotas and other non-tariff related barriers which allowed it to put in place a uniform tariff structure under which it only implemented a flat 10% tariff on all imports except for agriculture products. This rate was though increased during the crisis however, it was again rationalized in order to achieve consistency in its economic policies. Lowering of tariffs have actually reduced the corruption and the margin of manipulating the rules and thus international businesses were easily able to trade with local businesses in the country. (Montecinos) Another important change was witnessed in the reforming of the tax code of the country with introduction of new reforms. It went through a systematic reduction of the corporate tax rates thus giving industry much needed boast in terms of improving their productivity and increase capital formation. (Bergman). Apart from reforming the taxes, government also initiated the process of curtailing its expenditure and brought up much needed fiscal discipline. This was initiated in order to reduce the budget deficit. Fiscal discipline was specially achieved in public wages, public expenditure as well as the elimination of subsidies in order to ensure that government expenditures remain within the control. Government was also instrumental behind this rise it systematically introduced various rounds of privatization. Privatization process of industries and banks which were initially nationalized or acquired by the State ensured that private parties run the affairs of these institutions in order to improve their efficiency. Chile’s government also increased the autonomy of its Central Bank and empowered an independent Board to oversee the affairs of the monetary policy. Ministry of Finance was disallowed to have any voting power on the Board thus giving central bank a virtual authority to actually ensure that monetary policy of the country is carried out independently. It is important to understand that Chile historically experienced high rates of inflation however, with better monetary policy management, inflation rates reduced to a great deal. This was associated with the ability of Central Bank to actually control the economy. (Boylan) Banking sector during 1970s were liberalized too with many banks being privatized and the financial liberalization policies started to pay dividends. Privatization of banks actually allowed banks to become more competitive at the domestic and regional level. Liberalization of interest rates as well as the reduction in reserve requirements actually created much stronger growth for the credit. This has allowed for accelerated capital formation as firms started to borrow at lower lending rates in order to expand their capacity. Liberalization of banking sector and effective supervision from the central bank also actually increased the penetration of banks within the economy. Over the period of time, deposits and loans of the banks started to increase thus providing economic much needed liquidity for the future expansion. (Ffrech-davis.) As a result of the liberalization policies adapted, capital flows and foreign direct investment also increased and thus Chile became one of the better managed economies in the region. Macroeconomic convergence Though the real reform process started during 1970s in Chile however, steps taken after 1990s witnessed an additional growth in the economy. During 1990s, policies were made with more social emphasis- a condition necessary to increase the social capabilities to achieve the economic convergence within the country. Literature on economic convergence indicates that building up of social capabilities is one of the basic and most important elements of the of the convergence and Chilean government started to practice policies which were typical social in nature. (Temple and Johnson) 1990s reforms in the country opened it to world trade, expansion of domestic capital markets and reforms and tax and labor markets resulted into an economic growth of 6% consistently. Increase in government expenditure and redistributive policies have reduced the gap between top 20 and bottom 20% population by nearly one-half. This drastic reduction in the income disparity means income per capita increased consistently in Chile with the growth rates of 6% suggesting that increase in per capita income has been higher. It has also been argued that much of the poverty reduction and the increase in the per capita income in country is to be attributed to the higher growth rates. Though poverty reduced because of the social policies of the regime too but the major contribution came from the higher growth rates suggesting that Chile might have experienced economic convergence with other countries in the region. Some studies on convergence suggested that convergence in Chile actually swung over the period of time. Technological Progress Studies indicate that more than 60% of the divergence differences between the rich and poor countries are due to technology. The variations across cross country per capita divergence suggests that higher differences in the technology can effectively result into the much of the difference between the rich and the poor countries and that if poor countries can actually increase their technology growth, they can actually achieve the so called catch-up effect. Some studies even suggest that almost 90% of the variations between the nations is owing to the technological variations between them and thus convergence may not take place unless technology gap is reduced. Various empirical studies have suggested dynamic increasing returns due to changes and shifting in its economic structure. Over the period of time, its openness has resulted into technological transfer that has ultimately culminated into the increase in returns on the technology. Technological progress therefore has been relatively higher due to diversification of the economy. During the initial years of reforms, most of the technological progress was driven by the copper mining sector of the economy however, during recent times, it has been observed that the technological progress have been mostly dominated by the trade and investment. The higher technological progress being driven by the investment and trade suggests that the economy has developed itself to a point where its reliance on one particular sector may not sufficient enough to propel economic and technological progress within the country. A comparative study between convergence in Chile and US indicated that convergence was largely in favor of US during 1960s and 1970s however, due to rapid technological progress, it has also swung into the favor of Chile especially after 1970s. This indicates that the reforms which have been undertaken after 1970s have actually resulted into better marginal productivity of the technology as measured through output levels. These figures therefore clearly identify that Chilean economy witnessed higher level of growth and per capita income as compared to developed countries mostly due to its technological progress which it witnessed as a result of liberal economic policies and inflow of foreign direct investment. Financial Development in Chile Theory suggests that financial development has a positive impact on the convergence of a country however; its effect may vanish in the longer run. Its impact on the steady state growth rate may therefore be positive in the initial phase however, it may gradually vanish over the longer run. (Rioja and Valev) Chilean financial development started to take its roots during 1975 and afterwards as it shifted from financial repression to financial liberalization. Literature on the convergence suggests that a country’s ability to achieve the technological development is restricted due to the financial constraints and that in order to achieve the much needed technological progress to achieve the convergence effect, it is critical to liberalize the financial sector. Chile therefore started to liberalize its financial sector to deepen its financial development in order to allow domestic banks and financial markets as whole more adaptive and flexible to support technological progress. (Hernandez and Parro) Financial development of the country is also considered as essential because technological progress cannot be achieved without the financial development. Literature indicates that changing technology requires increase in investment to keep pace with the technology and master it in order to use for the domestic purposes. Until and unless financial development of a country is lagging, it may not be able to achieve the technological progress necessary to achieve convergence and reduce the gap between per capita GDP of rich and poor countries. (Levine) Financial development is also important for the innovators to actually finance their innovations and increase the technological capability of the economy. Reforms in the Chilean banking sector has actually increased the depth of the financial sector thus giving much needed access to the innovators to tap into the sources of finance for their technological innovation. By increasing access to the external finance, Chilean Central Bank actually increased the penetration of the financial institutions within the country and allowed domestic innovators and entrepreneurs to have access to local finance. Available literature on the financial development and convergence also indicates the existence of perfect credit markets. The achievement of growth and convergence in the longer run through financial deepening and development can only be associated if the credit markets are perfect. Though credit markets in Chile are far from being perfect however, move towards liberalization kick started the process of removing the imperfections in the credit markets which could have created restrictions on the technological development. Reforms process in Chile has also been attributed to the pension reforms which increased the domestic base of savings for the country and reduced its reliance on the external or foreign savings. Higher increase in domestic savings gave financial institutions much needed depth in terms of liquidity and access to the funds. (Agosin.) Another and probably one of the most important reasons behind the financial development and deepening of Chile were the better institutional reforms at the central bank. The absence of prudential regulations for the banks during 1970s and early 1980s created financial crisis for the country however, later reforms ensured that the supervisory control is increased and that the financial institutions actually witnessed control growth. Financial development of the country also resulted into better monetary controls and thus reduction in the inflation. Chile has been experiencing low rates of inflation indicating that its convergence in terms of low levels of inflation rates has also helped to improve its standing into the world economy. Control over inflation has been mostly associated with the better monetary policy management within the country. As a result of the policies of Chile, it has now been suggested that Chile closed its convergence Gap with developed countries by almost 30% since 1980s suggesting that strong reforms, technological improvement as well as financial development can result into convergence. The increase in per capita income per GDP and the reduction of the convergence gap speaks volumes about the economic performance of Chile. Conclusion Latin American countries have historically shown varied economic performance with some countries like Brazil and Argentine showing occasionally better economic performance. Brazil is the only country which is witnessing higher growth rates during the current decade. However, Chile is the only country in the region which has been able to reduce its convergence gap with the developed countries by almost 30%. Over the period of time, Chile has been able to post consistent economic performance because of its important institutional reforms. Institutional reforms in Chile started during 1970s whereas its second round of reforms started during 1980s in the wake of serious financial crisis which it witnessed. As a result of the financial liberalization, opening up of the trade as well as pension reforms, Chile has been able to register important economic growth in terms of both its GDP growth and increase in the per capita income. Chile has been able to achieve its economic convergence due to advance technological progress achieved as a result of the reforms. Reforms in Chile have been well directed with more control and autonomy given to various institutions. Under the reforms, central bank of the country was made independent which invariably strengthened the banks and increased their depth in the local economy. This increase in the depth of the financial institutions coupled with the higher levels of domestic savings has resulted into enough liquidity where technological progress within the country could be financed through the domestic savings thus reducing the reliance of country on external sources of finance. Works Cited Agosin., M. "What accounts for the chilean saving miracle." Cambridge Journal of Economics 25 (2001): 503{516,. Bergman, Marcelo S. "Tax Reforms and Tax Compliance: The Divergent Paths of Chile and Argentina." Journal of Latin American Studies 35.3 (2003): 593-624. Boylan, Delia M. "Preemptive Strike: Central Bank Reform in Chile's Transition from Authoritarian Rule." Comparative Politics 30.4 (1998): 443-462. Ffrech-davis. Economic reform in Chile: From dictatorship to democracy. 2nd. New York: Palgrave Macmillan, 2010. Francesco Caselli, Gerardo Esquivel and Fernando Lefort. "Reopening the Convergence Debate: A New Look at Cross-Country Growth Empirics." Journal of Economic Growth, 1.3 (1996): 363-389. Hernandez, Leonardo and Fernando Parro. "Economic Reforms, Financial Development and Growth: Lessons from the Chilean Experience." Cuadernos de Economia 45 (2008): 59-103. Jones, Charles I. "Convergence Revisited." Journal of Economic Growth 2.2 (1997): 131-153. Levine, Ross. "Financial Development and Economic Growth: Views and Agenda." Journal of Economic Literature 35 (1995): 688-726. Montecinos, Veronica. "Economic Reforms, Social Policy, and the Family Economy in Chile." Review of Social Economy 55.2 (1997): 224-234. Papageorgiou, Chris and Fidel Perez-Sebastian. "Is the Asymptotic Speed of Convergence a Good Proxy for the Transitional Growth Path?" Journal of Money, Credit and Banking, 39.1 (2007): 1-24. Rioja, Felix and Neven Valev. "Finance and the Sources of Growth at Various Stages of Economic Development." Economic Inquiry (2003): 50-62. Temple, Jonathan and Paul A. Johnson. "Social Capability and Economic Growth." Quarterly Journal of Economics 113 (1998): 965-90. Read More