Academic journal article Seoul Journal of Economics

Why We Learn Nothing from Regressing Economic Growth on Policies*

Academic journal article Seoul Journal of Economics

Why We Learn Nothing from Regressing Economic Growth on Policies*

Article excerpt

Government use policy to achieve certain outcomes. Sometimes the desired ends are worthwhile, and sometimes they are pernicious. Cross-country regressions have been the tool of choice in assessing the effectiveness of policies and the empirical relevance of these two diametrically opposite views of government behavior. When government policy responds systematically to economic or political objectives, the standard growth regression in which economic growth (or any other performance indicator) is regressed on policy tells us nothing about the effectiveness of policy and whether government motives are good or bad.

Keywords: Economic growth

JEL Classification: O4

I. Introduction

Government use policy to achieve certain outcomes. Sometimes the desired ends are worthwhile, as is the case when policy is targeted on removing market failures. At other times, they are pernicious, as in the case when policies aim to create and distribute rents. Cross-country regressions have been the tool of choice to date in assessing die effectiveness of policies and die empirical relevance of these two diametrically opposite views of government behavior. This paper argues that such regressions are uninformative about die questions that motivate the analysis. The standard growth regression in which economic growtii (or any other performance Indicator) is regressed on policy tells us nothing about the effectiveness of policy and whether government motives are good or bad.

There is a voluminous empirical literature which attempts to estimate the effects of economic policy on growth. The typical cross-country growth regression takes the form

g^sub t^= αln y^sub 10^+Z^sub t^' β+ γs^sub t^ + ε^sub t^

where s^sub t^ is a policy variable for country i, y^sub i0^ is initial income and Z^sub t^ is a vector of other covariates. Such growth regressions are sometimes specified in panel form, with growth and all left-hand side variables averaged over 5- or 10-year subperiods. The object of the exercise is to obtain an estimate of γ, the impact of policy intervention on growth. Regressions of this type are ubiquitous in academic research, as well as in policy work carried out by development agencies, where they are used to predict the effect of policy reforms.

The list of economic policies that have been included in cross-national regressions includes:

* fiscal policy (Easterly and Rebelo 1993)

* government consumption (Barro 1991)

* inflation (Fischer 1993)

* black market premia on foreign exchange (Sachs and Warner 1995)

* overvaluation of the exchange rate (Dollar 1992)

* financial liberalization (Eichengreen 2001)

* trade policy (Lee 1993)

* state ownership in industry or banking (La Porta, Lopez-de-Silanes, and Shleifer 2002)

* industrial policy (Ades and di Telia 1997)

While economic growth is the most frequently used measure of economic performance, sometimes other performance indicators such as productivity and investment are used as the dependent variable. Djankov et cd. (2002) regress a variety of public goods (ranging from health outcomes to product quality standards) on regulations that restrict firm entry. Similar regressions are run also across industries or states/regions, regressing a performance variable on policies that apply at the relevant level. Besley and Burgess (2002), for example, analyze the impact of labor regulations on differential growth rates across Indian states.

As the empirical growth literature has grown, so has the critical evaluation of it. There is by now a wide-ranging discussion of die shortcomings of growth regressions, which focuses on problems relating to:

* parameter heterogeneity

* outliers

* omitted variables

* model uncertainty

* measurement error

* endogeneity

Temple (1999), Durlauf, Jonhson, and Temple (2005), and Easterly (2004) provide very useful recent critical surveys of the empirical growtti literature. …

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