FRBSF Economic Letter
97-15; May 15, 1997
Does Singapore Invest Too Much?
Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Monetary and Economic Studies within the FRBSF's
Economic Research Department.
During the past 30 years, the economies of several East Asian nations
grew on average by about 8% per year. Such rapid growth
over such a long period of time is historically unprecedented. Recently,
Paul Krugman (Foreign Affairs 1994) sparked a controversy by
arguing that this growth is unsustainable. He based his argument on the
pioneering work of Alwyn Young (1995). Young conducted a detailed empirical
analysis of four economies - Hong Kong, Korea, Singapore, and Taiwan.
For each of these economies he decomposed output growth into two parts.
One part measures growth in the inputs to production, like capital and
labor. The other part measures how efficiently these inputs are used.
Young's startling finding was that most of the growth in these economies
is accounted for by growth in inputs. Productivity growth played a minor
role. This contrasts sharply with the western industrialized countries,
where long-term output growth is mostly due to productivity growth.
The relevance of this finding to the sustainability of Asia's rapid
growth is that factor accumulation tends to be self-limiting. Eventually
you run out of labor, and supplying a given labor force with more and
more capital equipment eventually runs into diminishing returns. In contrast,
ideas and human ingenuity, which are the wellsprings of productivity growth,
seem to escape the forces of diminishing returns. Breakthroughs in science
and engineering are happening as fast today as they were in the 1800s.
This Letter provides a follow-up to Young's analysis of Asian
growth. Like Young, I analyze the efficiency of this growth. However,
I shift the focus of analysis from technological efficiency to allocational
efficiency. In addition to producing goods, an economy also allocates
the goods it does produce to various groups within society. In general,
economists cannot judge the efficiency of a particular allocation, since
it typically requires weighing one person's gain against another person's
loss. Balancing these kinds of trade-offs is a task for the political
system. However, when it comes to allocating resources over time,
i.e., to individuals of different generations, it turns out that it is
possible to assess the efficiency of an allocation. In particular, we
can say whether current generations are saving and investing too much
and consuming too little. Roughly speaking, an economy is investing too
much when it consistently gets less back from its investment projects
than it puts in.
This Letter applies this intertemporal efficiency criterion
to Singapore. Of all the world's nations, Singapore seems to be a prime
candidate for excess saving and investment. Singapore's saving and investment
rates are the highest in the world, and much of this saving and investment
is mandated by the government. I find that we cannot rule out the possibility
that Singapore invests too much. This is in sharp contrast to western
industrialized countries, where previous work has shown (not surprisingly)
that there is no evidence of excess saving and investment. If anything,
the opposite is more likely to be true. However, to understand what this
means we must first understand how it can happen that an economy invests
too much, and how economists can diagnose this situation.
Assessing Dynamic Efficiency
In a private enterprise economy, saving and investment are determined
by the desire of individuals to provide for their retirement. Diamond
(1965) was the first to show that there is no guarantee that these individual
saving decisions translate into a socially efficient outcome. In particular,
he showed that it is possible for each generation to save too much. This
can happen if individuals care only about their own lifetime income and
consumption profiles and are not concerned with what happens after they
die. If this is the case, then a strong desire to save may depress the
rate of return on saving below the economy's underlying growth rate, which
is determined by labor force growth and technological progress. This would
be inefficient. From a technological standpoint, the economy has the ability
to transfer resources into the future at a rate that exceeds the market
rate of return on savings and investment. Diamond argued that if this
happens it is desirable for the government to step in and provide an alternative
savings vehicle that diverts individuals' savings out of physical assets,
like capital (which are subject to diminishing returns), and into paper
assets, like government bonds. Doing this would raise the market rate
of return and make everyone wealthier, and therefore better off. (Note,
because of diminishing returns, less capital investment produces
a higher rate of return.) Alternatively, the government could
set up a tax and transfer scheme (like a pay-as-you-go social security
system) that would tax young people and give the money to retired people.
Since the tax base is growing faster than the interest rate, the government
can offer young people a higher return than the market and still run a
balanced budget each year!
The theoretical model Diamond used to illustrate this point is highly
abstract. He purposely made it this way in order to illustrate the basic
point in the clearest manner possible. Unfortunately, the abstract nature
of Diamond's model makes it difficult to apply. For example, according
to Diamond dynamic inefficiency is indicated by an investment return that
is less than the economy's growth rate. But what rate of return should
we use? Annual (real) returns on short-term U.S. government securities
have averaged only a few tenths of a percent during the post-war period,
while the economy has grown about 2 to 3% per year. This suggests the
U.S. economy saves too much! However, the stock market (real) rate of
return has been closer to 7%, so if we use it instead we would conclude
that the U.S. economy is indeed dynamically efficient. The problem is
that Diamond ignored uncertainty, and in the real world, investment returns
reflect uncertainty. Savers require a higher rate of return on riskier
investments. Thus, to apply Diamond's efficiency criterion it is essential
to incorporate uncertainty into Diamond's analysis, which was done by
Abel, Mankiw, Summers, and Zeckhauser (1989).
Abel, et al., show that with uncertainty we can be sure an economy is
dynamically efficient if gross capital income consistently exceeds gross
investment (where capital income is defined as the sum of profit, rental,
and interest income). If this is the case, then the financial sector is
making more resources available for future consumption than it is using.
(Of course, this doesn't rule out the possibility that distortions cause
investment to be inefficiently too low.) Conversely, if investment consistently
exceeds capital income then the financial sector is draining resources
from the economy. This is inefficient, since the whole point of investing
is to augment future consumption possibilities. As a caveat, however,
one should realize that historical observations on investment and capital
income can never definitively establish dynamic inefficiency, since it
is always possible that future capital income becomes much higher.
Abel, et al., apply their efficiency criterion to seven industrialized
nations (i.e., the G-7). They find that in all seven, capital income consistently
exceeds investment. Hence, these economies appear to be dynamically efficient.
This is true even for Japan, which has a much higher investment rate than
the others. As an example, Figure 1 reproduces their results for
the U.S. It plots investment and capital income (both expressed as a percentage
of GNP) for the period 1975-1985. Note that capital income in the U.S.
has consistently been about 27% of GNP while the investment rate has only
been about 16% (although it fluctuates somewhat more). Thus, the investment
sector consistently yields a dividend of about 11% to U.S. consumers,
and thus, there is no evidence of dynamic inefficiency.
Is Singapore Dynamically Efficient?
Applying the Abel, et al., dynamic efficiency criterion to Singapore
is not as straightforward as it is for the G-7 countries. Unlike the G-7,
Singapore does not publish detailed historical data on labor and capital
income. As a result, I take an indirect approach. I infer labor
and capital income (as a share of GDP) from estimates of a production
function, which relates output to inputs. These data are readily available.
The main drawback to this indirect approach is that it requires assumptions
about the nature of the production function, and it presumes competitive
market conditions.
The particular estimates I use are taken from van Elkan (1995). Although
many researchers have estimated production functions for Singapore, van
Elkan's estimates are the only ones I found that include land as a separate
factor of production. This is important because if land is ignored then
the productivity of labor and capital are overstated, and hence, so are
their incomes. This would bias the results toward dynamic efficiency.
It turns out that land rents consistently account for about 9% of Singapore's
national income.
Figure 2 contains a plot
of Singapore's investment rate along with the (implied) share of capital
income in GDP. The first thing to notice is the extremely high investment
rate in Singapore. During the past 20 years it has averaged about
37%, and for several years during the 1980s it approached 50%! Thus, Singapore
typically invests between two and three times as much of its income as
the United States. Much of this investment comes from other countries.
For example, during the 1980s foreign investment accounted for about 25%
of total fixed capital formation, and for over 60% of investment in manufacturing.
At the same time Singapore's government and businesses have been undertaking
massive investment, its citizens have been saving at unrivaled rates.
As reflected by its persistent current account surplus, Singapore's saving
rate is even higher than its investment rate! However, much of this saving
is "forced." Since 1955, the government has operated a compulsory
savings program called the Central Provident Fund. Like the U.S. social
security system, this program requires a "contribution" from
both employees and their employers. The current contribution rates are
21.5% for employees and 18.5% for employers. This sort of forced savings
policy, along with tax incentives that lure in foreign investment, raise
the suspicion that Singapore could be a dynamically inefficient economy.
However, the second thing to notice in Figure 2 is that capital income
in Singapore has also been quite high. During the past 20 years it has
averaged about 35.5% of GDP, although capital's share is steadily falling
as labor's share rises (presumably due to improvements in education).
Overall, the evidence in Figure 2 does not allow us to make a
definitive judgement about dynamic efficiency. However, unlike the G-7
countries, we cannot rule out the possibility that Singapore
invests too much and is dynamically inefficient. During the early 1980s,
investment consistently exceeded capital income, and over the full sample
the average investment rate has slightly exceeded capital's average income
share.
Kenneth Kasa
Economist
References
Abel, Andrew B., N. Gregory Mankiw, Lawrence H. Summers, and Richard
J. Zeckhauser. 1989. "Assessing Dynamic Efficiency: Theory and Evidence."
Review of Economic Studies 56, pp. 1-20.
Diamond, Peter A. 1965. "National Debt in a Neoclassical Growth
Model." American Economic Review 55, pp.1126-1150.
van Elkan, Rachel. 1995. "Accounting for Growth in Singapore."
In Singapore: A Case Study in Rapid Development. IMF Occasional
Paper No. 119.
Young, Alwyn. 1995. "The Tyranny of Numbers: Confronting the Statistical
Realities of the East Asian Growth Experience." Quarterly Journal
of Economics 110, pp.641-680.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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