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Abstract:
Legal and accounting reform that strengthens creditor rights, contract enforcement, and accounting practices boosts financial development and accelerates economic growth.

Levine, Loayza, and Beck evaluate:

Whether the level of development of financial intermediaries exerts a casual influence on economic growth.

Whether cross-country differences in legal and accounting systems (such as creditor rights, contract enforcement, and accounting standards) explain differences in the level of financial development.

Using both traditional cross-section, instrumental-variable procedures and recent dynamic panel techniques, they find that development of financial intermediaries exerts a large causal impact on growth.

The data also show that cross-country differences in legal and accounting systems help determine differences in financial development.

Together, these findings suggest that legal and accounting reform that strengthens creditor rights, contract enforcement, and accounting practices boosts financial development and accelerates economic growth.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand the links between the financial system and economic growth. Thorsten Beck may be contacted at tbeck@worldbank.org.

Abstract:
This paper evaluates (1) whether the exogenous component of financial intermediary development influences economic growth and (2) whether cross-country differences in legal and accounting systems (e.g., creditor rights, contract enforcement, and accounting standards) explain differences in the level of financial development. Using both traditional cross-section, instrumental variable procedures and recent dynamic panel techniques, we find that the exogenous component of financial intermediary development is positively associated with economic growth. Also, the data show that cross-country differences in legal and accounting systems help account for differences in financial development. Together, these findings suggest that legal and accounting reforms that strengthen creditor rights, contract enforcement, and accounting practices can boost development and accelerate economic growth.

Financial development, economic growth, legal system

Abstract:
This study uses a cross-country panel to examine the determinants of corruption, paying particular attention to political institutions that increase accountability. Even though the theoretical literature has stressed the importance of political institutions in determining corruption, the empirical literature is relatively scarce. Our results confirm the role of political institutions in determining the prevalence of corruption. Democracies, parliamentary systems, political stability, and freedom of press are all associated with lower corruption. Additionally, common results of the previous empirical literature, related to openness and legal tradition, do not hold once political variables are taken into account.

Abstract:
The results of a cross-country empirical analysis suggest that political institutions are extremely important in determining the prevalence of corruption: democracy, parliamentary systems, political stability, and freedom of the press are all associated with lower corruption.

Using a cross-country panel, Lederman, Loayza, and Soares examine the determinants of corruption, paying particular attention to political institutions that increase political accountability. Previous empirical studies have not analyzed the role of political institutions, even though both the political science and the theoretical economics literature have indicated their importance in determining corruption.

The main theoretical hypothesis guiding the authorsi empirical investigation is that political institutions affect corruption through two channels: political accountability and the structure of the provision of public goods.

The results suggest that political institutions are extremely important in determining the prevalence of corruption: democracy, parliamentary systems, political stability, and freedom of the press are all associated with lower corruption. In addition, the authors show that common findings of the earlier empirical literature on the determinants of corruption related to openness and legal traditionódo not hold once political variables are taken into account.

This paper - a product of the Office of the Chief Economist, Latin America and the Caribbean Region - is part of a larger effort to conduct research on pressing policy issues in the region. The authors may be contacted at dlederman@worldbank.org or nloayza@worldbank.org.

Abstract:
This paper studies the apparent contradictions between two strands of the literature on the effects of financial intermediation on economic activity. On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities. On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns. This paper accounts for these contrasting effects based on the distinction between the short- and long-run effects of financial intermediation.

Growth empirics, banking crisis, pooled mean group estimation

Abstract:
This paper studies the apparent contradiction between two strands of the literature on the effects of financial intermediation on economic activity. On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities (e.g.,Levine, Loayza, and Beck 2000). On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns (e.g., Kaminski and Reinhart 1999). The paper accounts for these contrasting effects based on the distinction between the short- and long-run impacts of financial intermediation. Working with a panel of cross-country and time-series observations, the paper estimates an encompassing model of short- and long-run effects using the Pooled Mean Group estimator developed by Pesaran, Shin, and Smith (1999). The conclusion from this analysis is that a positive long-run relationship between financial intermediation and output growth co-exists with a, mostly, negative short-run relationship. The paper further develops an explanation for these contrasting effects by relating them to recent theoretical models, by linking the estimated short-run effects to measures of financial fragility (namely, banking crises and financial volatility), and by jointly analyzing the effects of financial depth and fragility in classic panel growth regressions.

Financial development

Abstract:
This paper attempts to reconcile the apparent contradiction between two strands of the literature on the effects of financial intermediation on economic activity. On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities (e.g., Levine, Loayza, and Beck 2000). On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns (e.g., Kaminski and Reinhart 1999). This paper starts by illustrating these opposing effects by, first, analyzing the dynamics of output growth and financial intermediation around systemic banking crises and, second, showing that the growth enhancing effects of financial depth are weaker in countries that experienced such crises. After these illustrative exercises, the paper attempts an empirical explanation of the apparently opposing effects of financial intermediation. This explanation is based on a distinction between transitory and trend effects of domestic credit aggregates on economic growth. Working with a panel of cross-country and time-series observations, the paper estimates an encompassing model of long- and short-run effects, following Pesaran, Shin, and Smith (1999), Pooled Mean Group Estimator. The main result of the paper is that a positive long-run relationship between financial intermediation and output growth co-exists with a, mostly, negative short-run relationship.

Abstract:
Development of the banking sector exerts a large, causal impact on total factor productivity growth, which in turn causes GDP to grow. Whether banking development has a long-run effect on capital growth or private saving remains to be seen.

Beck, Levine, and Loayza evaluate whether the level of development in the banking sector exerts a causal impact on economic growth and its sources- total factor productivity growth, physical capital accumulation, and private saving.

They use (1) a pure cross-country instrumental variable estimator to extract the exogenous component of banking development and (2) a new panel technique that controls for country-specific effects and endogeneity. They find that:

- Banks do exert a large, causal impact on total factor productivity growth, which feeds through to overall GDP growth.
- The long-run links between banking development and both capital growth and private savings are more tenuous.

This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to understand the links between the financial system and economic growth.

Abstract:
Foreign direct investment (FDI) flows to developing countries surged in the 1990s to become their leading source of external financing. This rise in FDI volume was accompanied by a marked change in its composition: investment taking the form of acquisition of existing assets (mergers and acquisitions) grew much more rapidly than investment in new assets ("greenfield" FDI), particularly in countries undertaking extensive privatization of public enterprises. This raises two issues. First, is the mergers and acquisitions boom a one-time effect of privatization, or is it likely to be followed by a rise in greenfield investment? Second, do these two types of FDI have different macroeconomic causes and consequences in relation to aggregate investment and growth? Calderon, Loayza, and Serven focus on establishing the stylized facts in terms of time precedence between both types of FDI, investment, and growth, using annual data for the period 1987-2001 and a large sample of industrial and developing countries. The authors find that in all samples higher mergers and acquisitions is typically followed by higher greenfield investment, while the reverse is true only for developing countries. In industrial and developing countries alike, both types of FDI lead domestic investment, but not the reverse. Finally, neither type of FDI appears to precede economic growth in developing or industrial countries, but FDI does respond positively to increases in the growth rate.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand international capital flows.

Abstract:
Although conventional wisdom suggests that reducing military spending may improve a country`s economic growth performance, empirical studies have produced ambiguous results. This paper extends a standard growth model and estimates it using techniques that exploit both cross-section and time-series dimensions of available data to obtain consistent estimates of the growth-retarding effects of military spending via its adverse impact on capital formation and resource allocation. Model simulations suggest that a substantial long-run "Peace Dividend"--in the form of higher capacity output--may result from: (i) markedly lower military expenditure levels achieved in most regions during the late 1980s; and (ii) further military spending cuts that would be possible in the future if a global peace could be secured.

Abstract:
Empirical results suggest that lower military spending in the late 1980s - plus further cuts in military spending should global peace be secured - could produce a substantial long-term peace dividend in higher capacity output.

Conventional wisdom suggests that reducing military spending may improve a country's economic growth, but empirical studies have produced ambiguous results on this point.

Extending a standard growth model, Knight, Loayza, and Villanueva exploit both cross-section and time-series dimensions of available data to get consistent estimates of the growth-retarding effects of military spending. Military spending is growth-retarding because of its adverse impact on capital formation and resource allocation.

Model simulation results suggest a substantial long-term peace dividend - in the form of higher capacity output per capita - that may result from (1) markedly lower military spending in most regions in the late 1980s and (2) future cuts in military spending if global peace is secured.

This paper - a joint product of the Macroeconomics and Growth Division, Policy Research Department, and the International Monetary Fund - is part of a larger effort to understand the link between policies and growth.

Abstract:
An increase in the size of the informal sector hurts growth by reducing the availability for public services for everyone in the economy and increasing the number of activities that use some existing public services less efficiently or not at all.

Loayza presents the view that informal economies arise when governments impose excessive taxes and regulations that they are unable to enforce. Loayza studies the determinants and effects of the informal sector using an endogenous growth model whose production technology depends essentially on congestable public services. In this model, changes (in both policy parameters and the quality of government institutions) that promote an increase in the relative size of the informal economy will also generate a reduction in the rate of economic growth.

Using data from Latin American countries in the early 1990s, Loayza tests some of the model's implications and estimates the size of the informal sector in these countries - identifying the size of the informal sector to latent variable for which multiple causes and indicators exist. The results suggest that:

The size of the informal sector depends positively on proxies for tax burden and restrictions on the labor market.

It depends negatively on a proxy for the quality of government institutions.

An increase in the size of the informal sector hurts growth by reducing the availability of public services for everyone in the economy and by increasing the number of activities that use some existing public services less efficiently or not at all.

This paper - a product of the Macroeconomics and Growth Division, Policy Research Department - is part of a larger effort in the department to examine the determinants of economic growth.

Abstract:
Hnatkovska and Loayza study the empirical, cross-country relationship between macroeconomic volatility and long-run economic growth. They address four central questions:

- Does the volatility-growth link depend on country and policy characteristics, such as the level of development or trade openness?

- Does this link reflect a statistically and economically significant causal effect from volatility to growth?

- Has this relationship been stable over time and has it become stronger in recent decades?

- Does the volatility-growth connection actually reveal the impact of crises rather than the overall effect of cyclical fluctuations?

The authors find that macroeconomic volatility and long-run economic growth are indeed negatively related. This negative link is exacerbated in countries that are poor, institutionally underdeveloped, undergoing intermediate stages of financial development, or unable to conduct countercyclical fiscal policies. They find evidence that this negative relationship actually reflects the harmful effect from volatility to growth. Furthermore, the authors find that the negative effect of volatility on growth has become considerably larger in the past two decades and that it is mostly due to large recessions rather than normal cyclical fluctuations.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand the effects of volatility.

Abstract:
This paper studies the effects of regulation on economic growth and the relative size of the informal sector in a large sample of industrial and developing countries. Along with firm dynamics, informality is an important channel through which regulation affects macroeconomic performance and economic growth in particular. The paper concludes that a heavier regulatory burden - particularly in product and labor markets - reduces growth and induces informality. These effects are, however, mitigated as the overall institutional framework improves.

Regulation, government performance, economic growth, informal economy

Abstract:
Albuquerque, Loayza, and Serven analyze the unparalleled increase in foreign direct investment to emerging market economies in the past 25 years. Using a large cross-country timeseries data set, the authors evaluate the dependence of foreign direct investment on global factors or worldwide sources of risk (that is, factors that drive foreign direct investment across several countries). They construct a globalization measure that equals the share of explained variation in direct investment attributable to global factors. The authors show that the globalization measure has increased steadily for industrial and developing countries. For the full sample of countries, the globalization measure rose eightfold from 1985 to 1999. Furthermore, in recent years developing countries' exposure to global factors has approached that of industrial countries, particularly for Latin America. Finally, the globalization measure correlates strongly with measures of capital market liberalization. Overall, the authors find strong support for the hypothesis of increased market integration which implies a greater role for worldwide sources of risk. They discuss the implications of the results for public policies regarding capital market liberalization and policies directed at attracting foreign investment.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand international capital flows.

Capital Market Integration, Emerging Economies, Global Factors, Foreign Direct Investment

Abstract:
Capital flows to developing countries are small and mostly take the form of loans rather than direct foreign investment. Kraay, Loayza, and Serven build a simple model of North-South capital flows that highlights the interplay between diminishing returns, production risk, and sovereign risk. The model generates a set of country portfolios and a world distribution of capital stocks that resemble those in the data.

This paper - a product of Investment Climate, Development Research Group - is part of a larger effort in the group to study international capital flows.

Abstract:
How do countries hold their financial wealth? We construct a new database of countries' claims on capital located at home and abroad, and international borrowing and lending, covering 68 countries from 1966 to 1997. We find that a small amount of capital flows from rich countries to poor countries. Countries' foreign asset positions are remarkably persistent, and mostly take the form of foreign loans rather than foreign equity. To interpret these facts, we build a simple model of international capital flows that highlights the interplay between diminishing returns, production risk and sovereign risk. We show that in the presence of reasonable diminishing returns and production risk, the probability that international crises occur twice a century is enough to generate a set of country portfolios that are roughly consistent with the data.

Abstract:
This paper studies how the effect of trade openness on economic growth depends on complementary reforms that help a country take advantage of international competition. This issue is illustrated with a simple Harris-Todaro model where output gains after trade liberalization depend on the degree of labor market flexibility. In that model, trade protection may ameliorate the problem of underemployment (and underproduction) in sectors affected by labor market distortions; hence trade liberalization unambiguously increases per capita income only when labor markets are sufficiently flexible. We then present some panel evidence on how the growth effect of openness depends on a variety of structural characteristics. For this purpose, we use a non-linear growth regression specification that interacts a proxy of trade openness with proxies of educational investment, financial depth, inflation stabilization, public infrastructure, governance, labor-market flexibility, ease of firm entry, and ease of firm exit. We find that the growth effects of openness are positive and economically significant if certain complementary reforms are undertaken.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
The authors study how the effect of trade openness on economic growth depends on complementary reforms that help a country take advantage of international competition. This issue is illustrated with a simple Harris-Todaro model where output gains after trade liberalization depend on the degree of labor market flexibility. In that model, trade protection may ameliorate the problem of underemployment (and underproduction) in sectors affected by labor market distortions. Hence, trade liberalization unambiguously increases per capita income only when labor markets are sufficiently flexible. The authors then present some panel evidence on how the growth effect of openness depends on a variety of structural characteristics. For this purpose, they use a non-linear growth regression specification that interacts a proxy of trade openness with proxies of educational investment, financial depth, inflation stabilization, public infrastructure, governance, labor-market flexibility, ease of firm entry, and ease of firm exit. They find that the growth effects of openness are positive and economically significant if certain complementary reforms are undertaken.

Openness, Growth, Economic Reform, Policy Complementarity

Abstract:
In developing countries, increases in current account deficits tend to be associated with a rise in domestic output growth and shocks that increase the terms of trade and cause the real exchange rate to appreciate. Higher savings rates, higher growth rates in industrial economies, and higher international interest rates tend to have the opposite effect.

Calderón, Chong, and Loayza examine the empirical links between current account deficits and a broad set of economic variables proposed in the literature.

To accomplish this, they complement and extend previous research by using a large, consistent set of macroeconomic data on public and private domestic savings, external savings, and national income variables; focusing on developing economies by drawing on a panel data set for 44 developing countries and annual information for the period 1966-95; adopting a reduced-form approach rather than holding to a particular structural model; distinguishing between within-country and cross-country effects; and employing a class of estimators that controls for the problems of simultaneity and reverse causation.

Among their findings:

- Current account deficits in developing countries are moderately persistent.

- A rise in domestic output growth generates a larger current account deficit.

- Increases in savings rates have a positive effect on the current account.

- Shocks that increase the terms of trade or cause the real exchange rate to appreciate are linked with higher current account deficits.

- Either higher growth rates in industrial economies or higher international interest rates reduce the current account deficit in developing economies.

This paper - a product of the Regional Studies Program, Latin America and the Caribbean Region - is part of an effort in the region to understand the determinants of external sustainability. The authors may be contacted at crcn@troi.cc.rochester.edu, achong@worldbank.org, or nloayza@condor.bcentral.cl.

Abstract:
Saving rates vary considerably across countries and over time. Policies that spur development are an indirect but effective way to raise private saving rates - which rise with the level and growth rate of real per capita income.

Loayza, Schmidt-Hebbel, and Servén investigate the policy and nonpolicy factors behind saving disparities, using a large panel data set and an encompassing approach including several relevant determinants of private saving. They extend the literature in several dimensions by:

· Using the largest data set on aggregate saving assembled to date.

· Using panel instrumental variable techniques to correct for endogeneity and heterogeneity.

· Performing robustness checks on changes in estimation procedures, data samples, and model specification.

Their main empirical findings:

· Private saving rates show considerable inertia (are highly serially correlated even after controlling for other relevant factors).

· Private saving rates rise with the level and growth rate of real per capita income. So policies that spur development are an indirect but effective way to raise private saving rates.

· Predictions of the life-cycle hypothesis are supported in that dependency ratios generally have a negative effect on private saving rates.

· The precautionary motive for saving is supported by the finding that inflation - conventionally taken as a summary measure of macroeconomic volatility - has a positive impact on private saving, holding other facts constant.

· Fiscal policy is a moderately effective tool for raising national saving.

· The direct effects of financial liberalization are largely detrimental to private saving rates. Greater availability of credit reduces the private saving rate; financial depth and higher real interest rates do not increase saving.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand the determinants of saving in developing countries. The study was funded by the Bank`s Research Support Budget under the research project Saving in the World: Puzzles and Policies (RPO 681-36). The authors may be contacted at nloayza@worldbank.org or lserven@worldbank.org.

Abstract:
Regulation is purportedly enacted to serve specific social purposes. In reality, however, it follows a more complex political economy process, where legitimate social goals are mixed with the objectives of particular interest groups. Whatever its justification and objectives, regulation can have potentially significant macroeconomic consequences, by helping or hampering the dynamics of economic restructuring and resource reallocation that underlie the growth process. This paper provides an empirical analysis of the macroeconomic impact of regulation. It first characterizes the stylized facts on regulation across the world, using a set of newly constructed, comprehensive indicators of regulation in a large number of countries in the 1990s. Using these indicators, the paper studies the effects of regulation on economic growth and macroeconomic volatility employing cross-country regression analysis. In particular, the paper considers whether the effects of regulation are affected by the country's level of institutional development. Finally, the analysis controls for the likely endogeneity of regulation with respect to macroeconomic performance. The paper concludes that a heavier regulatory burden reduces growth and increases volatility, although these effects are smaller the higher the quality of the overall institutional framework.

Regulation, government structure, volatility, economic growth

Abstract:
Economic growth in Chile since the mid 1980s has been remarkable for its high level and persistence. This paper attempts to shed light on the factors behind it and analyze the extent to which they can be sustained in the future. The first part of the paper presents some stylized facts. Taken together, they suggest that the jump in growth was driven by policies and macroeconomic conditions that affected the economy's overall productivity. The second part of the paper considers the recent empirical growth literature to examine the extent to which a cross-country approach can explain Chile's growth. We formulate and estimate - using techniques suited for dynamic models of panel data - a basic model containing the most popular variables in the literature. Our basic model allows us to explain about 45% of the change in the growth rate between 1970-85 and 1986-1998, which was 4.74%. When we expand the basic model to include the quality of the political system and governance, the comprehensiveness and complementarity of policy reforms, and the availability of public services and infrastructure, we can explain 73% of the growth improvement. The last part of the paper starts the evaluation of possible new growth sources for Chile by, first, projecting the country's growth rate for the next decade under various assumptions and, second, proposing some areas with potentially large returns.

Economic growth, productivity, Chile, policy complementarities

Abstract:
The response of economic growth to reforms in Latin America has not been disappointing. Because of those policy changes, and despite a global slowdown, Latin America did well to return to its historic growth rate of 2 percent per capita in 1990-93. After years of poor macroeconomic performance, many Latin American countries undertook ambitious programs of macroeconomic stabilization and structural reform in recent years. This change in policy created high expectations for the region, and some observers have questioned whether actual growth outcomes in several Latin American countries have lived up to these expectations.

Easterly, Loayza, and Montiel offer evidence that the response of economic growth to reforms in Latin America has not been disappointing. Because of those significant policy changes, and despite a global slowdown, Latin America did well to return to its historic growth rate of 2 percent per capita in 1990-93. Latin American growth has responded to changes in policy variables, as would have been predicted by the experience of other times and places. Those earlier experiences are summarized by a panel regression spanning many countries and multiyear periods from 1960 to 1993. To get consistent estimates of the parameters linking growth and policy variables, the authors use a dynamic panel methodology that both controls for unobserved time- and country-specific effects and accounts for the likely joint endogeneity of the explanatory variables.

This paper - a product of the Macroeconomics and Growth Division, Policy Research Department - is part of a larger effort in the department to understand the determinants of economic growth.

Abstract:
This paper reviews the unintended consequences of the war on drugs, particularly for developing countries, and weighs them against the evidence regarding the efficacy of prohibition to curb drug use and trade. It reviews the available evidence and presents new results that indicate that prohibition has limited effects on drug prevalence and prices, most likely indicating a combination of inelastic drug demand (due to its addictive properties) and elastic supply responses (due to black markets). This should turn the focus to the unintended consequences of drug prohibition. First, the large demand for drugs, particularly in developed countries, generates the possibility of massive profits to potential drug providers. This leads to the formation of organized crime groups, which use violence and corruption as their means of survival and expansion and which, in severe cases, challenge the state and seriously compromise public stability and safety. Second, prohibition and its derived illegal market impose greater costs on farmers than on drug traffickers. In many instances, this entails the transfer of wealth from poor peasants to rich (and ruthless) traders. Third, criminalization can exacerbate the net health effects of drug use. These consequences are so pernicious that they call for a fundamental review of drug policy around the world.

Health Monitoring & Evaluation, Crime and Society, Economic Theory & Research, Post Conflict Reconstruction, Markets and Market Access

Abstract:
This paper studies the trends and cycles of informal employment. It first presents a theoretical model where the size of informal employment is determined by the relative costs and benefits of informality and the distribution of workers' skills. In the long run, informal employment varies with the trends in these variables, and in the short run it reacts to accommodate transient shocks and to close the gap that separates it from its trend level. The paper then uses an error-correction framework to examine empirically informality's long- and short-run relationships. For this purpose, it uses country-level data at annual frequency for a sample of industrial and developing countries, with the share of self-employment in the labor force as the proxy for informal employment. The paper finds that, in the long run, informality is larger in countries that have lower GDP per capita and impose more costs to formal firms in the form of more rigid business regulations, less valuable police and judicial services, and weaker monitoring of informality. In the short run, informal employment is found to be counter-cyclical for the majority of countries, with the degree of counter-cyclicality being lower in countries with larger informal employment and better police and judicial services. Moreover, informal employment follows a stable, trend-reverting process. These results are robust to changes in the sample and to the influence of outliers, even when only developing countries are considered in the analysis.

Labor Markets, Economic Theory & Research, Work & Working Conditions, Labor Standards, Inequality

Abstract:
This paper contributes to explain the cross-country heterogeneity of the poverty response to changes in economic growth. It does so by focusing on the structure of output growth. The paper presents a two-sector theoretical model that clarifies the mechanism through which the sectoral composition of growth and associated labor intensity can affect workers' wages and, thus, poverty alleviation. Then it presents cross-country empirical evidence that analyzes first, the differential poverty-reducing impact of sectoral growth at various levels of disaggregation, and the role of unskilled labor intensity in such differential impact. The paper finds evidence that not only the size of economic growth but also its composition matters for poverty alleviation, with the largest contributions from labor-intensive sectors (such as agriculture, construction, and manufacturing). The results are robust to the influence of outliers, alternative explanations, and various poverty measures.

Pro-Poor Growth and Inequality, Population Policies, Economic Growth, Rural Poverty Reduction, Labor Markets

Abstract:
The paper examines the experience in structural reform in five areas- international trade, financial markets, labor markets, and the generation and use of public resources- countries of Latin America and the Caribbean. It develops quantitative indicators for the policy reforms and for their outcomes.

In the late 1980s, after decades of poor economic management, many Latin American and Caribbean countries undertook structural reform that placed them on a path toward superior economic performance.

Loayza and Palacios examine the experience in structural reform in five areas: governance (reforming public institutions), international trade, financial markets, labor markets, and the generation and use of public resources.

To characterize the experience with structural reform in the region, they develop quantitative indicators for different types of policy reform and for their outcomes.

They conclude that the most progress has been made in liberalizing international trade. In this area the region has done almost as well as the Asian newly industrialized countries (NICs).

The least progress has been made in reforming labor markets. In most countries there are still severe constraints on hiring and firing workers, payroll tax rates are high, there are few or no mechanisms for resolving labor disputes, and there is too much public employment.

Financial development has improved, especially the depth of financial intermediation, private sector participation in banking, and the size and activity of stock markets. As for the efficient generation and use of public resources, much has been done to make the value-added tax system efficient and to privatize public enterprises.

Reform gains in governance have been modest. Latin America remains well behind the Asian NICs and OECD countries, especially regarding the rule of law (judicial and police systems) and the quality of public administration (procedural clarity and the bureaucracy's honesty and technical competence).

A great deal has been accomplished, but compared with the Asian NICs and OECD countries, there is still substantial room for improvement.

This paper - product of the Office of the Chief Economist, Latin America and the Caribbean Region - the second chapter of the report The Long March: A Reform Agenda for Latin America and the Caribbean in the Next Decade, presented at the ABCD-LAC conference in Montevideo, June 30, 1997.

Abstract:
External exposure can be measured by the sensitivity of first and second moments of economic growth to openness and foreign shocks. This paper provides an empirical evaluation of external exposure using panel data methods for a worldwide sample of countries. Controlling for domestic conditions, the paper examines the growth and volatility effects of outcome measures of trade and financial integration, as well as four types of foreign shocks: terms of trade changes, trading partners' growth rates, international real interest rate changes, and net regional capital inflows. The paper analyzes the possibility of nonlinearities by allowing the growth and volatility effects of openness to vary with the general level of economic development and by letting the effects of foreign shocks depend on the degree of trade and financial integration. The findings point toward strong non-monotonic effects of openness and external shocks on growth and volatility. Moreover, all in all, the results contradict the view that international integration increases external vulnerability by hurting growth and increasing volatility or by amplifying the adverse effect of external shocks.

External Shocks, Openness, Volatility, Growth, Non-linearities

Abstract:
This paper explores empirically the role of risk and return in the observed evolution of net foreign asset positions of industrial and developing economies. The paper adopts a dynamic approach in which investors' portfolios adjust gradually to their long-run equilibrium, defined by a standard Tobin-Markowitz framework. The parameters characterizing the long-run equilibrium are estimated using data on foreign assets and liabilities of a large number of industrial and developing countries spanning the period from 1965 to 1997. The paper employs a dynamic panel estimation procedure allowing for unrestricted short-run heterogeneity across countries, using the pooled mean group estimator recently developed by Pesaran, Shin, and Smith (1999). The empirical results lend considerable support to the model when applied to countries with low capital controls and/or high and upper-middle income. The results for countries with either high capital controls or low per capita income are less supportive of the stock equilibrium model for net foreign asset positions.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand international capital flows.

Abstract:
Using an "event-study" methodology, this paper analyzes the aftermath of civil war in a cross-section of countries. It focuses on those experiences where the end of conflict marks the beginning of a relatively lasting peace. The paper considers 41 countries involved in internal wars in the period 1960-2003. In order to provide a comprehensive evaluation of the aftermath of war, the paper considers a host of social areas represented by basic indicators of economic performance, health and education, political development, demographic trends, and conflict and security issues. For each of these indicators, the paper first compares the post- and pre-war situations and then examines their dynamic trends during the post-conflict period. It conducts this analysis both in absolute and relative terms, the latter in relation to control groups of otherwise similar countries. The paper concludes that, even though war has devastating effects and its aftermath can be immensely difficult, when the end of war marks the beginning of lasting peace, recovery and improvement are indeed achieved.

Population Policies, Peace & Peacekeeping, Post Conflict Reintegration, Services & Transfers to Poor, Social Conflict and Violence, Civil War

Abstract:
Loayza and Soto present policy and outcome-based ways of measuring the progress of market-oriented reforms in both traditional areas of first-generation reform and the areas of institutional reform that have been emphasized lately. These policy areas are the domestic financial system, international financial markets, international trade, the labor market, the tax system, public infrastructure and public firms, the legal and regulatory framework, and governance. For each of them, the authors first discuss the general principles underlying market-oriented reform. Second, they present various indicators of the policy stance in the area in question. And third, they present various outcome indicators of the policy stance.

This paper - a product of Investment Climate Team, Development Research Group - is part of a larger effort in the group to understand the process of economic reform.

Abstract:
This article examines empirically how domestic structural characteristics related to openness and product- and factor-market flexibility influence the impact of terms of trade shocks on aggregate output. Applying semistructural vector autoregressions to a panel of 88 countries with annual observations for the period 1974-2000, the analysis isolates and standardizes the shocks, estimates their impact on GDP, and examines how this impact depends on the domestic conditions outlined above. The article finds that greater trade openness magnifies the output impact of terms of trade shocks, particularly negative ones, while financial openness reduces their impact. Flexibility of labor and firm-entry are beneficial, with labor flexibility dampening the impact of negative shocks and ease of firm-entry magnifying positive ones only. Domestic financial depth has a more nuanced role in stabilizing the economy. Analysis of interactions across structural determinants reveals complementarities among macroeconomic conditions (trade and financial openness and depth) and, separately, among microeconomic conditions (flexibility of labor markets and ease of firm-entry). Variables across these groups tend to behave as substitutes for each other.

F36, F41, F43

Abstract:
The authors examine empirically how domestic structural characteristics related to openness and product- and factor-market flexibility influence the impact that terms-of-trade shocks can have on aggregate output. For this purpose, they apply an econometric methodology based on semi-structural vector auto-regressions to a panel of 90 countries with annual observations for the period 1974-2000. Using this methodology, the authors isolate and standardize the shocks, estimate their impact on GDP, and examine how this impact depends on the domestic conditions outlined above. They find that larger trade openness magnifies the output impact of external shocks, particularly the negative ones, while improvements in labor market flexibility and financial openness reduce their impact. Domestic financial depth has a more nuanced role in stabilizing the economy. It helps reduce the impact of external shocks particularly in environments of high exposure - that is, when trade and financial openness are high, firm entry is unrestricted, and labor markets are rigid.

Pro-Poor Growth and Inequality, Free Trade, Economic Theory & Research, Inequality, Macroeconomic Management

Abstract:
The 1994 crisis in Mexico, developments in East Asia, and persistent turmoil in world financial markets have dramatized the role of external imbalances in macroeconomic crises. Some believe that the current account should be kept from rising beyond a sustainable level, some that a current account surplus is the only solid external position. Can those rules of thumb be justified analytically?

Calderon, Loayza, and Serven consider external sustainability from the perspective of equilibrium in net foreign asset positions. Under their approach, an external situation is sustainable if it is consistent with international and domestic investors' achieving their desired portfolio allocation across countries. They develop a reduced-form model of net foreign asset positions whose long-run equilibrium condition expresses the ratio of net foreign assets to the total wealth of domestic residents as a negative function of investment returns in the country relative to the rest of the world, a positive function of investment risk, and an inverse function of the ratio of foreign-owned to domestically owned wealth.

To estimate this equilibrium condition, the authors use a newly constructed data set of foreign asset and liability stocks for a large group of industrial and developing countries, from the 1960s to the present. They also develop summary measures of country returns and risks. Their econometric methodology is an application of the Pooled Mean Group estimator recently developed by Pesaran, Shin, and Smith (1999), which allows for unrestricted cross-country heterogeneity in short-term dynamics while imposing a common long-run specification. The estimation results lend considerable support to the model, especially when applied to countries with low capital controls or high or upper-middle income. The results for countries with high capital controls and, especially, lower-income countries are less supportive of the stock equilibrium model.

As a byproduct of the model's estimation, the authors obtain estimates of the long-run equilibrium ratios of net foreign assets to wealth, conditional on the observed values of the country's relative returns, risks, and wealth. Then, for a selected group of industrial and developing countries, they evaluate the extent to which actual ratios diverge from their long-run counterparts - and hence the sustainability of current net foreign asset positions.

This paper - a product of the Poverty Reduction and Economic Management Unit, Latin America and the Caribbean Region - is part of a larger effort to assess the sustainability of the external accounts of the major countries in the region.

Abstract:
There has been a steady increase in the occurrence of natural disasters. Yet their effect on economic growth remains unclear, with some studies reporting negative, and others indicating no, or even positive effects. These seemingly contradictory findings can be reconciled by exploring the effects of natural disasters on growth separately by disaster and economic sector. This is consistent with the insights from traditional models of economic growth, where production depends on total factor productivity, the provision of intermediate outputs, and the capital-labor ratio, as well as the existence of important intersector linkages. Applying a dynamic Generalized Method of Moments panel estimator to a 1961-2005 cross-country panel, three major insights emerge. First, disasters affect economic growth - but not always negatively, and differently across disasters and economic sectors. Second, although moderate disasters can have a positive growth effect in some sectors, severe disasters do not. Third, growth in developing countries is more sensitive to natural disasters - more sectors are affected and the magnitudes are non-trivial.

Natural Disasters, Disaster Management, Hazard Risk Management, Achieving Shared Growth, Economic Conditions and Volatility

Abstract:
This paper examines the determinants of growth for nine South Pacific countries during the period 1971-93, using the analytical framework of the Solow-Swan neoclassical growth model. Chamberlain`s II-matrix estimator is used to account for unobserved country-specific heterogeneity in the growth process, and to control for errors-in-variables bias in calculations of real per-capita GDP. The speed of convergence of South Pacific countries to their respective steady-state levels of per-capita GDP, after controlling for the important regional effects of net international migration, is estimated at a relatively fast 4 percent per year. In addition, private and official transfers emanating from regional donor countries have kept the dispersion of real per-capita national disposable income constant over the period, despite a significant widening in the regional dispersion of real per-capita GDP.

Abstract:
This paper studies the causes and consequences of informality and applies the analysis to countries in Latin America and the Caribbean. It starts with a discussion on the definition and measures of informality, as well as on the reasons why widespread informality should be of great concern. The paper analyzes informality's main determinants, arguing that informality is not single-caused but results from the combination of poor public services, a burdensome regulatory regime, and weak monitoring and enforcement capacity by the state. This combination is especially explosive when the country suffers from low educational achievement and features demographic pressures and primary production structures. Using cross-country regression analysis, the paper evaluates the empirical relevance of each determinant of informality. It then applies the estimated relationships to most countries in Latin America and the Caribbean in order to assess the country-specific relevance of each proposed mechanism.

Labor Markets, Labor Policies, Population Policies, Economic Theory & Research, Debt Markets

Abstract:
This paper studies the cycles of nationalization and privatization in resource-rich economies as a prime instance of unstable institutional reform. The authors discuss the available evidence on the drivers and consequences of privatization and nationalization, review the existing literature, and present illustrative case studies. This leads to the main contribution of the paper: a static and dynamic model of the choice between private and national regimes for the ownership of natural resources. In the model, the basic tradeoff is given by equality (national ownership) versus efficiency (private ownership). The connection between resource ownership and the equality-efficiency tradeoff is given by the incentives for effort that each regime elicits from workers. The resolution of the tradeoff depends on external and domestic conditions that affect the value of social welfare under each regime. This leads to a discussion of how external conditions—such as the commodity price—and domestic conditions—such as the tax system-- affect the choice of private vs. national regimes. In particular, the analysis identifies the determinants of the observed cycles of privatization and nationalization.

Economic Theory & Research, Political Economy, Emerging Markets, Labor Policies, Markets and Market Access

Abstract:
We build a two country asymmetric DSGE model with two features: (i) a product cycle structure determines the range of intermediate goods used to produce new capital in each country and (ii) there are investment flow adjustment costs in the developing economy. We calibrate the model to match the Mexico-US trade and FDI flows. The model is able to explain (i) why US shocks have a larger effect on Mexico than in the US and hence why the Mexican economy is more volatile than the US; (ii) why US business cycles lead over medium term fluctuations in Mexico and (iii) why Mexican consumption is not less volatile than output.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
We build a two country asymmetric DSGE model with two features: (i) a product cycle structure determines the range of intermediate goods used to produce new capital in each country and (ii) there are investment flow adjustment costs in the developing economy. We calibrate the model to match the Mexico-US trade and FDI flows. The model is able to explain (i) why US shocks have a larger effect on Mexico than in the US and hence why the Mexican economy is more volatile than the US; (ii) why US business cycles lead over medium term fluctuations in Mexico and (iii) why Mexican consumption is not less volatile than output.

Business Cycles in Developing Countries, Co-movement between Developed and Developing economies, Volatility, Extensive Margin of Trade, Product Life Cycle, FDI

Abstract:
This paper provides a description of the macroeconomic aftermath of natural disasters. It traces the yearly response of gross domestic product growth - both aggregated and disaggregated into its agricultural and non-agricultural components - to four types of natural disasters - droughts, floods, earthquakes, and storms. The paper uses a methodological approach based on pooling the experiences of various countries over time. It consists of vector auto-regressions in the presence of endogenous variables and exogenous shocks (VARX), applied to a panel of cross-country and time-series data. The analysis finds heterogeneous effects on a variety of dimensions. First, the effects of natural disasters are stronger, for better or worse, on developing than on rich countries. Second, while the impact of some natural disasters can be beneficial when they are of moderate intensity, severe disasters never have positive effects. Third, not all natural disasters are alike in terms of the growth response they induce, and, perhaps surprisingly, some can entail benefits regarding economic growth. Thus, droughts have a negative effect on both agricultural and non-agricultural growth. In contrast, floods tend to have a positive effect on economic growth in both major sectors. Earthquakes have a negative effect on agricultural growth but a positive one on non-agricultural growth. Storms tend to have a negative effect on gross domestic product growth but the effect is short-lived and small. Future research should concentrate on exploring the mechanisms behind these heterogeneous impacts.

Natural Disasters, Disaster Management, Hazard Risk Management, Achieving Shared Growth, Economic Conditions and Volatility

Abstract:
Economies respond differently to aggregate shocks that reduce output. While some countries rapidly recover their pre-crisis trend, others stagnate. Recent studies provide empirical support for a link between aggregate growth and plant dynamics through its effect on productivity: the entry and exit of firms and the reallocation of resources from less to more efficient firms explain a relevant part of transitional productivity dynamics. In this paper we use a stochastic general equilibrium model with heterogeneous firms to study the effect on aggregate short-run growth of policies that distort the process of birth, growth and death of firms, as well as the reallocation of resources across economic units. Our findings show that indeed policies that alter plant dynamics can explain slow recoveries. We also find that output losses associated to delayed recoveries are large.

Abstract:
This paper analyzes common economic patterns across countries and economic sectors in Latin America, East Asia and Europe for the period 1970-94 by means of an error-components model that decomposes real value added growth in each country into common international effects, sector-specific effects and country-specific effects. We find significant comovements in the European and East Asian samples. In the Latin American sample, however, we find country-specific components to be more important than common patterns. These results are robust to different sub-sample time spans and different sub-sample country groups.

Abstract:
Macroeconomic volatility, both a source and a reflection of underdevelopment, is a fundamental concern for developing countries. Their high aggregate instability results from a combination of large external shocks, volatile macroeconomic policies, microeconomic rigidities, and weak institutions. Volatility entails a direct welfare cost for risk-averse individuals, as well as an indirect one through its adverse effect on income growth and development. This article provides a brief overview of the recent literature on macroeconomic volatility in developing countries, highlighting its causes, consequences, and possible remedies. It then introduces the contributions of a recent conference on the subject, sponsored by the World Bank and Pompeu Fabra University, Barcelona.

Abstract:
Using an event-study methodology, the article analyzes the aftermath of civil war in a cross-section of countries. It focuses on cases where the end of conflict marks the beginning of relatively lasting peace. The analysis considers 41 countries involved in internal wars over the period 1960-2003. To provide a comprehensive evaluation of the aftermath of war, a range of social areas is considered: basic indicators of economic performance, health and education, political development, demographic trends, and conflict and security issues. For each indicator the post- and pre-war situations are compared and their dynamic trends during the post-conflict period are examined. The analysis is conducted in both absolute terms and relative to control groups of countries that are similar except for conflict. The findings indicate that even though war has devastating effects and its aftermath can be immensely difficult, when the end of war marks the beginning of lasting peace, recovery and improvement are achieved.

O11

Abstract:
In this article we take an empirical cross-country perspective to investigate the robustness and causality of the link between income inequality and crime rates. First, we study the correlation between the Gini index and, respectively, homicide and robbery rates along different dimensions of the data (within and between countries). Second, we examine the inequality-crime link when other potential crime determinants are controlled for. Third, we control for the likely joint endogeneity of income inequality in order to isolate its exogenous impact on homicide and robbery rates. Fourth, we control for the measurement error in crime rates by modelling it as both unobserved country-specific effects and random noise. Lastly, we examine the robustness of the inequality crime-link to alternative measures of inequality. The sample for estimation consists of panels of non-overlapping 5-year averages for 39 countries over 1965-95 in the case of homicides, and 37 countries over 1970-1994 in the case of robberies. We use a variety of statistical techniques, from simple correlation to regression analysis and from static OLS to dynamic GMM estimation. We find that crime rates and inequality are positively correlated (within each country and, particularly, between countries), and it appears that this correlation reflects causation from inequality to crime rates, even controlling for other crime determinants.

Abstract:
This paper evaluates the empirical relationship between the level of financial intermediary development and (i) economic growth, (ii) total factor productivity growth, (iii) physical capital accumulation, and (iv) private saving rates. We use (a) a pure cross-country instrumental variable estimator to extract the exogenous component of financial intermediary development, and (b) a new panel technique that controls for biases associated to simultaneity and unobserved country-specific effects. After controlling for these potential biases, we find that (1) financial intermediaries exert a large, positive impact on total factor productivity growth, which feeds through to overall GDP growth; and (2) the long-run links between financial intermediary development and both physical capital growth and private saving rates are tenuous.

Growth, Financial Intermediation