2 The macroeconomics of convergence

The fundamental political and economic goal of national economies is to create and increase social welfare, which requires stable economic growth. One important question is what the main driving forces of development are. Economies that have already had successful growth periods in the past can serve as empirical examples for emerging economies. Development is important not only in terms of economic considerations, but also for the individual. Development, rising standards of living and ‘living as well as possible’ are basic human needs and goals. Comparison with developed economies is important as they are the real examples of an attainable high standard of living.

In the history of economics, various growth models were created to examine growth. The common goal of these tools is to describe convergence processes and help understand them. As with any model, these growth models also have strengths and weaknesses. At the same time, the models have often provided a consistent conceptual framework for economists to answer a specific question. The objective of all models is to examine the growth of economies and to explore, analyse and understand the underlying driving forces.

Following World War II, by the 1950s, stable economic growth was observed in the world in general and a wealth of data was available for the wider analysis of growth. This period saw the creation and spread of the neoclassical growth theory, which primarily concentrated on the relationship between the factors of production and output of economies, focusing on how much a certain economy was able to potentially produce. This, in turn, depended on the factors of production, without being influenced by aggregate demand. Their main relationship is the so-called production function, which was applied as a general production function for the economy, and which described how much output was achievable from the various combinations of the different factors. As time passed, the models continuously expanded along various concepts. One of them was that, in addition to the traditional capital and labour as factors of production, human capital was also directly included in the production function. The importance of human capital is unquestionable nowadays; most economic progress, innovation and development is ultimately provided by knowledge, and increasing knowledge means sustained economic growth.

One key question of growth theory is whether the differences between poor, middle-income and rich countries will ever cease to exist. Based on this approach, two basic types of convergence (absolute and conditional) are distinguished. According to absolute convergence, income disparities between countries will disappear sooner or later. Irrespective of any other factors (e.g. production possibilities, economic policy), economies are heading towards the same level of development in the long run. Based on data from past decades, this theoretical approach cannot be corroborated at all. According to conditional convergence, not every economy is automatically heading towards the same level of development, only ones with similar characteristics. This is exactly what neoclassical growth models claim: over the long term, economies with identical fundamentals will reach the same level of development, irrespective of where they started from. It is important to note here that at the same time the so-called endogenous models do not contain convergence to the developed economies, as there is no mechanism in the model that would decelerate a developed economy. This means that the ceasing of initial income disparities is not guaranteed on the basis of these models.

According to our opinion, a more balanced approach describes the convergence characteristics. In this case, not only consider the basic fundamentals of the economy, but also the current level of development. In this type of path dependency, different stable situations arise at different levels of development. If an economy starts from a lower level of GDP per capita, but its growth gradually cools off, it becomes trapped. What state it arrives at also depends strongly on the initial income level. In the case of lower-income economies, it may even mean getting stuck in the poverty trap. In their case, it is important to set up an adequate institutional system, integrate into global trade and adopt more developed foreign technologies. In the case of Hungary, it is more important to compare the middle-income trap and the state of equilibrium of developed economies, which is discussed in more detail in this chapter. A middle-income economy can transition over to another convergence path towards developed economies with significant technological advances, innovation and substantial human capital development.

Introduction

For an economy that is not yet in a developed status, it is extremely important how – if at all – convergence with the standard of living of developed economies takes place. This is essential not only in terms of economic considerations, but also for the individual.

Development, rising standards of living and ‘living as well as possible’ are basic human needs and goals.

Comparison with developed economies is important as they are the real examples of an attainable high standard of living. In our report, the level of development is analysed in comparison to Austria, which is one of the most developed and geographically closest countries to Hungary. Our macroeconomic projection is detailed in the next chapter, while this section provides an overview of the theoretical and empirical results of growth models and convergence.

For economists, it is important to continuously deal with the above aspects and monitor economic developments. How is it possible and expedient to do so? There are various ways of measuring welfare. One is to examine per capita consumption and compare it with the corresponding indicator in developed economies. This is important and useful, but paints a different picture of the economy as a whole, as it only takes consumption into account and disregards, for example, the export sector or the investment performance of economic agents. A wider

indicator that takes into account the comprehensive situation of the economy as well as the performance and state of all sectors is the

change in GDP per capita. 10 Accordingly, this statistic is considered the main indicator in our analyses. 11

The macroeconomic path of developing national economies can be divided into four basic groups in certain periods

(Chart 2-1). One group consists of the economies that achieve persistent, continuous economic development with unbroken real economy convergence. Another path is where convergence takes place for a while, but fails to continue after a certain level and gets stuck. The third and fourth ones constitute the non-converging group. Although the level of development of the former does not rise, it does not worsen significantly either, while in the case of the latter group the relative GDP per capita declines. A country’s membership of a group may even change over longer periods of time, 12 and thus the grouping represents the countries’ convergence path, rather than the countries themselves.

Chart 2-1: Stylised chart of possible developments in catching up

1

Relative development

2

3

4

Time

Note: 1: Increasing level of development, 2: Increasing level of development with stopping, 3: Unchanged relative development, 4: Declining relative development. Source: prepared by the MNB.

Over its history, Hungary has belonged to different groups. Perhaps one of the most important economic policy questions is whether Hungary’s convergence, which has restarted in a balanced manner in recent years, will be able to persistently remain in group 1. The main subject of the Growth Report is the macroeconomic goals that are needed to achieve this.

The fundamental political and economic goal of national

economies is to create and increase social welfare. This requires stable economic growth. In growth theory, an important question is what factors growth stems from and what the main driving forces of convergence are. Economies that have already had successful growth periods in the past serve as empirical examples for emerging economies.

The analysis of growth is a priority area of economics; accordingly, numerous growth models have been created in the history of economics. 13 The common goal of these tools is to describe convergence processes and help understand them. Another common feature is that unfortunately none of the models is able to provide a set recipe for economic policy for the implementation of successful convergence. Nevertheless, the conclusion that can be drawn from empirical experiences is that the economies that achieved

successful convergence were characterised by the appli

cation of developed technology and by high productivity. Accordingly, the ultimate economic policy recommendation is to focus on these factors.

10 It should be mentioned, however, that the methodology of measuring GDP has been a subject of debate among economists and statisticians for a long time. We dealt with the difficulties in more detail in Chapter 4 of last year’s Growth Report. 11 There are also many other alternative indicators to measure welfare (e.g. Human Development Index, Happy Planet Index, Environmental Performance

Index, Ecological Footprint; see Szigeti, 2011), but in economics, GDP per capita is the generally used indicator, so this is what we also use. 12 A good example for this is Chile. In the 1900s it mostly belonged to group 4, while in the past 25–30 years it tends to show a path belonging to group 1. 13 Below is a concise summary of the individual models; concerning other models and for a more detailed description see e.g. Bessenyei (1995).