18 May 2009  Research & Ideas

The Unseen Link Between Savings and National Growth

Professor Diego Comin and fellow researchers find a little observed link between private savings and country growth. The work may offer a simple interpretation for the East Asia "miracle" and for failures in Latin America. Q&A. Key concepts include:

  • Companies in poor countries must attract FDI to gain access to "frontier technologies" that drive productivity and growth.
  • Savings become key to attracting these investors, who expect the local company to have colateral in the deal.
  • A 10 percent increase in the savings rate over the previous 10 years leads to an increase in the average growth rate over the next 10 years of 1.3 percent.
  • Developing countries should consider policies that foster domestic savings.

 

It is commonly accepted in economic circles that a country can grow faster by making key investments in sectors such as technology and in R&D and human or physical capital.

But can a country also grow by saving more?

A recent working paper finds a strong relationship between the two, particularly in developing, technology-poor countries. Harvard Business School professor Diego Comin teamed with Harvard University's Philippe Aghion and Brown University's Peter Howitt to research the issue and write the working paper "When Does Domestic Savings Matter for Economic Growth?".

The paper concludes that savings contributes to growth in locations where entrepreneurs and companies lack access to necessary technological advances, in countries far away from the "technological frontier." To overcome this obstacle companies must lure foreign investors who posses the technology expertise they need. And thus the link to savings—to attract an investor, companies must put collateral into the project: money from savings. With access to technology, the company improves its productivity and contributes to growth of the developing country.

The research group's study of far-from-frontier countries shows that a 10 percent increase in the savings rate over the previous 10 years leads to an increase in the average growth rate over the next 10 years of 1.3 percent.

We asked Comin to discuss the research and its implications.

Sarah Jane Gilbert: Why do you think the role of domestic savings in economic growth has been discounted in the past? How has your research advanced knowledge in this area?

Diego Comin: There are several literatures that have studied the relationship between savings and growth. At least since Robert M. Solow (1956), we know of a theoretical link between savings and growth through investment. This link, however, disappears in open economy models, which is surely the relevant scenario in reality.

An alternative interpretation of the relationship between savings and growth is that future growth prospects lead agents to higher current savings because they want to smooth consumption growth due to the presence of "habits" that made very costly declines in consumption growth. These forces, however, are not a significant explanation for the observed relationship between past savings and subsequent growth we uncover in the paper.

Our research has evaluated this alternative view and developed a theory based on the effect of past savings on growth through the adoption of new technologies (mostly through foreign direct investment: FDI).

Q: What is the technological frontier? What does it mean for foreign and domestic savings and growth?

A: The technological frontier is a theoretical construction useful to build models of technology adoption. Basically, it captures the state-of-the-art technology. We assume it evolves exogenously, typically in a deterministic way.

Countries (or more precisely, companies in these countries) must spend resources to adopt some of the state-of-the-art technologies. Rich countries are sufficiently close for companies to be able to adopt these technologies by themselves. Poor countries are very far from the frontier, so it is extremely costly for their companies to adopt frontier technology. In order to do so, they need the help of foreign "investors" that are familiar with the frontier.

Of course, these foreign partners will not do all the work. Domestic companies need to provide certain inputs and exert effort. However, these companies will not have incentives to do so without being co-financiers of the projects.

This is where private savings become relevant. Countries with sufficient private savings have the resources necessary so that their companies become co-financiers of adoption projects with foreign investors. As a result, they are able to adopt frontier technology much faster than other poor countries with less private savings.

Q: You studied Korea as one place where savings led growth. What actions contributed to the evolution of their Total Factor Productivity during the post-war period?

A: TFP started to grow very fast after 1964. This coincided with an increase in the flow of FDI. In support of our theory, private savings increased very rapidly beginning around 1960. This seems a good example of the dynamics emphasized by the model where private savings is helpful in attracting FDI, which improves the technology and productivity of the developing country.

Q: What are the practical policy or other implications from your work for public or private decision makers? Where do you see the research making a difference?

A: Our paper provides a simple interpretation for the East Asian miracles and for the failures in Latin America. The policy implication is that policies that foster domestic savings are important in developing countries because private savings is an important input in attracting foreign investment in frontier technology that raises the country's TFP. If governments learn this lesson, the paper can make an important difference since the effects we find on growth over the medium term are very significant.

Q: Do you think the recent commitment of the G-20 to contribute $1 trillion into the global economy will have an effect on a country's ability to more readily adopt such frontier technology?

A: Not directly. Typically, governments are not very effective in accelerating technological change or in fostering technology adoption. If a government's deficit leads to higher aggregate demand, companies may find it more attractive to adopt and develop new technologies. However, it is not clear that increasing government expending is the best way to foster aggregate demand.

Q: Given that there are more challenges for entrepreneurs in developing countries, what can they learn from your research to help them seek funding and support for their businesses?

A: I think they probably have figured out the nature of problem they face. Without frontier technology, they are not competitive. But they cannot adopt frontier technology by themselves. They need a partner that is familiar with the frontier, but this partner will not come for free. She will demand an equity stake and also that the domestic entrepreneur becomes a co-financier.

So in the end, being able to raise the co-financing capital is critical. Raising capital depends on specific factors such as social networks the entrepreneur has access to, or the level of development of credit markets—but also on aggregate conditions such as the private savings rate in the recent past.

Q: What are you working on now?

A: On a variety of projects related to building models to analyze economic fluctuations in environments where technology is endogenous. By taking seriously technology, my models generate much more persistent responses to shocks (very much as we see in the data) and generate realistic theories of the stock market and of the co-movement across countries at different horizons. I am using this to explore the macro consequences of the current crisis in the United States, Mexico, and Europe.

About the author

Sarah Jane Gilbert is a product manager for Harvard Business School's Knowledge and Library Services.