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Center for Global Development

When capital earns a 20% real return, what is left for labor?
A glimpse into Latin American Reality

Center for Global Development

10 August 2007

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Transcript of the talk by Al Harberger, 10 August 2007

Dennis de Tray: Let me tell you how today is going to go, but before I do that, let me thank my colleagues from the U.S. Agency for International Development for being the impetus behind this meeting, helping us – allowing us to bring Al here. They are actually sponsoring Al’s visit to Washington as part of his ongoing consulting – or advisory work for the USAID, but thank you for allowing us to include Al in this event. For those of you who have been to Center for Global Development events before, you will know the format. We will begin with a talk by Al on a subject of his choice and we will then regroup here, myself, Al, and two eminently qualified discussants to talk a bit about what Al has to say. Bit of a conversation among that group and then open it up for conversation and comments from all of you.

As I began to prepare for this event, there was a sort of epiphany. I realized that had this discussion – had this presentation been just one month later, it would have been Al’s and my fortieth anniversary. I met Al 40 years ago next September, as an entering Ph.D. student at the University of Chicago, and I have to tell you my first impressions of Al were mixed. Al was at that point the chairman of the department, as he was for a number of years, and as chairman it was Al’s duty to welcome all entering Chicago Ph.D. students. For those of you who don’t know the Chicago tradition, Chicago admits a much larger number of students than they eventually graduate, which was good for me because I would’ve never gotten in if they hadn’t had this sort of random lottery of effect at one end.

But Al gives this very warm welcome remark and then he says, look to your right and look to your left. Only one of you is going to get out of this institution with a Ph.D., which put the fear of God in everybody sitting around that room. But it was an extraordinary time and Al was a major input into that extraordinary time at the University of Chicago. There’s no counter factual. I wouldn’t know what it would have been like to go to another Ph.D. program, but it was, in my judgment, an extraordinary program. The relationship between faculty and students was – on this I’m quite sure – was remarkable and unique and I think shaped all of us for the future.

It is a very good thing that Harberger needs no introduction because his curriculum vitae is 27 pages long, and it needs updating, Al, because it stops in 2003. Al has the most remarkable output. It’s worth going and just scanning over his CV to see the breadth and depth of areas he’s worked in. Al has contributed to the fundamental vocabulary of economics. There are the famous Harberger Triangles, and if you go to Robert Gordon’s web site, it’s Northwestern University, you can see a picture of Al dressed as Triangle Man at a Christmas party in the late 60s in Chicago. He was, as I said, the chair of the – in my unbiased judgment, the best graduate economics department in the world for a number of years at the University of Chicago. He has taught at a host of who’s who universities, and he has advised almost everyone you can think of at one point or another in the past 40 or 50 years.

Al will speak today on when capital earns 20 percent, a 20 percent rate of return, what is left for labor, and I’m quite sure that Hugo Chavez is waiting to hear the answer to that question. Don’t be put off by the board. I’ve told Al this cannot be a lecture to his students. It’s actually got to have content and relevance that’s for a broad audience, and he’s promised me he will do that, and with that let me say, Al, it’s an enormous personal and professional pleasure to welcome you on behalf of myself and the Center for Global Development, and the podium is yours. Al Harberger.

Arnold “Al” Harberger: Okay. Well, it’s a great pleasure to be here and thank you very much, Dennis, for that overly generous introduction. I want to say that the look to your right and look to your left and so on, it was not I, but was McCluskey; at that time Donald, now Deirdre. In any case, that story is generally quite exaggerated. The mortality of people at Chicago. Nearly everybody got and earned Master’s out of the same and most of the people who didn’t get the Ph.D. failed to get it because they had to go back to their home countries, not because they flunked out of the program.

But anyway, I hope that this title of this talk will not mislead you too much. Dennis was very anxious to have a catchy title and we had about a five-minute silence on the phone and we were mulling around for what in the world we could have as a catchy title, and suddenly this one came to mind, and actually it’s more than that. I’ll tell you the story of the title, which has partly to do with this whole presentation. I’ve been interested in rate of return to capital going way back to the 50s and 60s and have been measuring this in different places as I’ve wandered around, and I became very impressed in El Salvador in about 93 when I was doing a set of measurements of the real rate of return to capital **** careful and so on, and this real rate of return started at around 20 percent in the 1970 – early 1970s, and then there was this great coffee boom of the 70s and capital was pouring in, investment was up, capital stock grew, and the rate of return drifted down from 20 to 19, 18, 17, and so on as the capital stock emerged.

Then came the civil conflict in El Salvador. It went way down to about 6 percent and then even while the conflict was going on, the real rate of return began to recover. By the time peace broke out in Salvador, it was breaking through 30 percent and damn it all, it went 20 to 25 to 30 percent and little over 30 percent. This was the rate of return to capital in the money-earning sector of the economy. And I want to emphasize that. And I was nonplussed by this. We were doing this with FUSADES, which is a wonderful foundation that they have and very dedicated people who are mostly the oligarchs of Salvadoran economy and there they – I would be talking about this around the table and I figured they’re gonna just cream me when I tell ‘em they’re earning a 30 percent return. They’re gonna shudder and say no, no, no, this isn’t true. I’ve been talking about this from 93 until now with those guys and every time I mention yeah, yeah, yeah. Not a single objection that I’m over estimating this rate of return.

And recently I was in Nicaragua and with the corresponding Directorate of ****, a great business school that they have there, and that board of directors was sitting around a lunch table and I was talking 25 percent real return and things like that and they nod their heads. Never a single objection. So I feel quite confident that this is quite real. And for those who haven’t learned the rule of 72, a 24 percent real return doubles in three years. To think about what kind of a return to capital that is. I was really thrown when I started picking up these things. Well, then we went to Mexico and we were starting a system of public sector project evaluation in Mexico and the – there were studies being done of the economic rate of return to capital to work up the relevant discount rate, and we measured this private sector rate of return for Mexico from 1970 up to about the year 2000 and by God there wasn’t a single year in which that rate of return was not more than 20 percent. And it really kind of shook me up.

Now I have to tell you about how that rate of return is calculated. We build up a capital stock by taking the investment of each year and we add that to last year’s capital stock and then we allow for the depreciation; a rolling system where you go adding investment, and you have to start somewhere and there are certain tricks that I won’t go into here, but that enable us to get a reasonable estimate of a starting capital stock. But if that’s far in the past it hardly matters because by the time you get up to the present that starting capital stock will have been mostly depreciated and you will be really working with pretty solid numbers. And then we have the actual returns that accrue to capital and we take those actual returns of interest, profits, rents, etc. that come from the national accounts, but sometimes we have to work with kind of judgment call. Why is that? Because the wages and salaries bill of an economy is not the total earnings of labor. You have the farmer who is the owner/operator. You have all the owner/operators in the kiosks and the stores. All these unincorporated enterprises whose income is partly due to labor and partly due to capital.

So some kind of an assumption has to be made about how that income is divided and you have to assign part to labor and part to capital. So that’s one of the stories. Second piece of the story is that as you build up this stock of capital, you’re taking the actual investments that appear in the national income accounts, what resources were devoted to investment. Well, you’ll catch the leveling of land or the digging of an irrigation ditch, but you won’t catch the land itself. So you have to deal with land either by making an estimate of the value of the land or the country or by sequestering the income from land and taking it out of the income side.

Well, what we do – we’ve learned by bitter experience, do not try to estimate the value of land. It’s just too terrible. Work with the income from agriculture and the income from the housing sector and you take away that income so you have a rate of return that has the reproducible business capital stock in the denominator and the return to it in the numerator. I said business capital because we also take out housing when we do this kind of estimate because the people who own their houses aren’t earning these 20 and 25 percent rates of return. We think we’re generous in assigning something like a 6 percent real measured return to housing. That is to say what is measured in the GDP is 6 percent of the value of the house. If there’s an appreciation going on, that’s on top of what we measure in the GDP.

So we think we’ve got a pretty solid, pretty conservative way of measuring these rates of return, and in Mexico, as I said, from 70 on until we finished this work at the end of the 90s, we were getting 20 percent or more all the time. Well, what happens? I look at that rate of return. I look at the climate in Salvador. I look at the climate in Mexico. And then AID sends me one time to Haiti. And I look there and I just shudder. I said if people are getting 20 percent real return and more in Salvador and in Mexico, what would it take to induce a rational person to put money into this place? And I really think that the people who put money into Haiti, if they’re rational, are doing so in the expectation of a 30 percent real return, not a 20.

And then I said well, gee, if capital as a whole is getting 30 percent real return, what indeed is left for labor? And I was led by this circuitous route to an absolute conviction that aid to countries like Haiti and many others in the world have to be based on altruism, on charity, and not on human interact – human sentiment rather than on the expectation that these are gonna be very productive, we are going to really reform this place, and all of that. Yes, we hope reform will happen. Yes, we hope transformation will happen, but if you think that’s what you’re buying with your aid, I think you’re making a mistake and that one has to justify a more human grounds. So there we are. That was just the motivation of the title.

And now I want to talk a little bit more carefully about the role of the rate of return in economic growth and in our analysis. Those of you who are economists and have studied even an early course on economic growth, probably even in elementary economics these days, you’ll find a breakdown of the growth where a piece of growth is attributed to the increments of labor, another piece of growth is attributed to increments of capital, and then you have another piece of growth that comes from what I call real cost reduction.

Total factor productivity increase. I hate that word. I talk to a businessman, I say how has your total factor productivity done in the last five years and he looks at me with glassy eyes. I say well, what about real cost reductions in your firm, and he says well, well, we had this and we had that and we had the other and this saved us so much money, this saved us so much other money, and why can’t we use a language that people can understand and that is perfectly transmits the underlying idea that we’re after instead of this sort of gobbledygook kind of stuff that only people with courses in economics know what’s going on.

Well, as we take this breakdown of growth into these three pieces, the capital contribution is usually measured by the share of capital in GDP times the rate of growth of the capital stock. Now that doesn’t resonate particularly with anybody. Again, it turns out that identical mathematics can represent the same thing in the following much more interesting way. What fraction of your income do you save and what rate of return do you get on that fraction? So if I save 10 percent of my income and I get a 15 percent return, 15 percent of 10 is 1Ѕ points. That’s how much my income is gonna jump as a consequence of my having saved that and earned that return.

So the way I like to represent the capital contribution to growth is net investment, which is the relevant numerator, as a fraction of GDP multiplied by the real rate of return on that investment. And if we’re talking about gross domestic product, that real rate of return is gross of depreciation just because GDP is gross of depreciation. So that’s the way we to about thinking of the contribution of capital to growth. Now why is that so much more interesting than the share of capital times the rate of growth of the capital stock? It’s because it focuses directly on the fraction of your GDP that is devoted to net investment, and on the rate of return. The old way of thinking the rate of return never appeared and I think the rate of return is incredibly important.

There are institutionalities, there are policies in the situation where a lot of money gets dumped into areas of low rates of return, zero rates of return, even negative rates of return and to sort of have an analysis that somehow leaves these rates of return out of the picture is, I think, a tragedy. That people will think more clearly about economic growth, will understand the process much better if we think of it as a fraction of income invested times a real rate of return. Now I’m gonna come over here and draw a very simple picture, which even contains a triangle. It’s not the real triangle, but anyway **** keep **** happy. We’re gonna put here capital and here the marginal product of capital and the idea is that as you add more to the capital stock, the incremental gain you make goes down.

So what is the equilibrium of the economy if you have real rate of return here then this is earnings of capital and up here, this part of the product that doesn’t go to capital goes to labor. So that is a picture that I hope, Dennis, is straightforward enough that it doesn’t give you any problems. Now what happens in a country that has bad policies? That has insecure property rights, probabilities of expropriation, distortions of the price system so that you don’t know if your inputs are arbitrarily going to be too cheap or too expensive or your outputs be forced down by price controls to too low a price. You have all of that uncertainty and what’s gonna happen? You’re gonna be less likely to invest. What’s gonna happen is this capital stock instead of being out here, is going to be here. Now look at what goes to labor. And when you get the cases like Allende’s Chile or Alan Garcia No. 1’s Peru or Daniel Ortega No. 1’s Nicaragua, you’re gonna get even less of a capital stock and the wage return – the labor force pretty much stays constant.

It’s mitigated by out migration of people, but the rate of such out migration is never big enough to make a hell of a lot of difference in the story that you’re really – the absence of capital is one of the biggest provable reasons why those countries that have very low real wages – why those wages are low. And the impact of policy in generating in a country a big capital stock, a middle-sized capital stock, or a small capital stock for its labor force, those policies are precisely the ones that kind of dictate what’s left for labor. It’s so to speak the what’s left for labor story is a question that is not answered by looking at labor. It is answered by looking at the incentives to capital. And when you have more capital, you might think that oh, gee, that means more going to capital and less to labor, but it doesn’t work that way as our little picture shows. That the more capital there is combining with a given labor force, the higher will be the average real wage of that labor force.

Okay. Now these very high rates of return that we see in some developing countries come because the international capital market is not totally connected and integrated with the country. It takes a great deal to bring about a total integration, but what we do see in many countries is that if they start out with a high rate of return and if their policies are halfway decent, capital does flow in from the rest of the world and if they’re having good economic growth, their capital stock is enhanced by the savings of their own people, and as a consequence there is a drifting down of this rate of return. That is all –drifting down connected with there being a bigger capital stock, and obviously, if you like, the perceptions of risk have to be squeezed in order to generate that. You have to have a better policy environment, a better expectations environment.

Perceptions of risk are a tremendous mess. I know people, personal friends, who have – who emigrated from Mexico prior to the recent election because they didn’t want to be around when Lopez Obrador won and so they’re somewhere else than in Mexico because of that I feel utterly confident that people who were thinking about investing in Mexico prior to that last election were saying eh, we don’t know what’s gonna happen there. We’re going to be careful. How does that carefulness work out? They want a high rate of return and a quick payback of their investment. What does that mean? They’re leaving off the list of interesting investments; those with a 15, 20, 30-year life or those without this very high rate of return, but with rates of return that are perfectly acceptable in most parts of the world. They’re just squeezed out of that.

It isn’t even by bad policies. It’s just by this expectation of what might happen if. And we have that in all kinds of places. We have it in El Salvador with the FMLN sitting in the sidelines and waiting to jump in. We had it in Nicaragua with the Sandinistas and to a degree with Ortega again in power. It is still there as a deterrent to people who want to invest and to overcome this kind of uncertainty is not sufficient that the government will come in and say well, you know, we did bad things in the past or we said bad things in the past, but we’re not gonna say or do those things any more. Everything’s going to be different. People are not going to react quickly to that kind of statement. What they’re gonna react to are actions of government and their own experience as time goes on.

So you have to realize that if you start from one of these places with bad expectations, it’s gonna be a while before all of that gets turned around, and the rates of return are gonna go down gradually and the capital stock as a multiple of GDP is going to go up only gradually, etc., etc. Now what we have on the good side of the story – well, I am just enormously pleased with the evolution that has happened in Chile. My students were involved in making some of the early reforms in Chile and I’m very proud of them, but I say there Chile has really had at least two miracles.

One was the economic miracle where in a period where – we used to call it cepalismo – was dominant where import substitution, protectionism, price controls, market interferences, all of those things – approvals for everything you – and a business wanted to do needed approval from some bureaucrats before it could be done. That changed a great deal in Chile and proved to generate 5, 6, 7 percent growth over a very substantial period of time. But the other miracle is the political miracle. The military government was succeeded by what is now four different presidents under what they call the Concertacion; a coalition of anti-military partners.

And so this coalition gets into power and what does it do. Does it tear down the structure of economic policy, etc., that the – that had been in place and that was performing quite well? Not at all. Just the opposite in fact. Patricio Aylwin was the first Concertacion president and I’ll never forget something I saw on TV. He was in campaign for the presidency, and he was making a speech on TV, and after the speech, he had a panel of newspaper reporters who were asking him a bunch of questions. And so one reporter said well, surely when you get to be president you’re not gonna keep the value-added tax on food items and on newspapers and periodicals and books and things like that. You’re not gonna be such a cretin as all that. And Aylwin in the middle of the campaign said look, my experts tell me this value-added tax is one of the best technical taxes in the world and that the right way to have an administer of value-added tax is to have a broad-based and a uniform rate, and when I get to be president that’s what we’re gonna have. We’re not gonna fall prey to the kind of arguments that you, sir, are presenting. And to do that in the middle of a presidential campaign, I say, takes a lot of honesty as well as a lot of guts, and I was so pleased to see that happen.

Well, in these four successive presidencies of Chile, as you know, under the Concertacion, not only was the general structure that they inherited from the military government maintained, it was actually more improved than chipped away; that there were a few places where there a few – couple a chips, but the overall picture was further privatization, further deregulation. Aylwin inherited a uniform tariff of 15 percent. It got down to 6 percent within a relatively short period of time under the Concertacion, and if I’m not mistaken, it’s now 5 percent, but the average tariff collected in Chile is much less than 5 percent because they got a ton of free trade agreements with lots of countries so that the average tariff is much less than the legal uniform rate.

So I think that this idea of left wing parties embracing good economics is one of the greatest things that has happened economically in the entire world over the last 20 or 30 years. It’s starting the Felipe Gonzalez in Spain, with Bob Hawke in Australia, with Mr. Lange in New Zealand, with Mr. Blair, with the Chileans. Now, of course, we have Mr. Lula in Brazil, Mr. Menem came in on a sort of a populist campaign, but by God he – his chief economics minister, Domingo Cavallo, bragged to be at one time. He said, Alito, we’ve done all or nearly all of the Chilean reforms, but in half the time. Now that was approximately true in Argentina. They didn’t – not quite as deep, but one of the great mysteries that economists are struggling with these days is how does it happen that Mr. Kirchner, whose economic rhetoric and whatnot are not the greatest. How has he managed to provide Argentina with a growth rate that is astounding lots of people?

Well, I say one of the contributing factors to that is that he inherited from the 1990s a package of economic policies that was infinitely better than what the 90s governments inherited from the 1980s, and it was indeed a pretty – very good package of economic policies. Another thing that contributed to this Argentine advance is that the latter 90 from the 94 onward, there was no doubt that the economics – the real exchange rate wanted to depreciate, but they had a dollarization practically economy and the way that the depreciation was trying to take place was through deflating prices and wages, and prices and wages didn’t want to go down fast enough so they had a 15 percent unemployment throughout that remaining – the last half of the 1990s before the crisis took place and I draw the analogy of that with Great Britain in the 1920s when they tried to restore – when they went back to the gold standard at a very excessively appreciated old parody.

You don’t see many cases of that – such a protracted suffering under a fixed exchange rate situation, but that’s because most countries end of up devaluing before it happens, and here were two cases where they didn’t devalue and really the chronic disease played out. Well that was just – sort of obiter dictum on how Kirchner is with – when they had the crisis in Argentina then they did have a big devaluation and this really sort of allowed the economic forces that were trying to work all this time allowed them to have their scope and really work and that is the second big reason why they’re having this prosperity, and the third is the high prices of their principal export products. So none of my three reasons involves any kudos for Mr. Kirchner’s policies, but it helps us to understand who the Argentine situation got to be what it got to be.

So anyway, what’s the story? We ought to think more about the real rate of return. We ought to think about the real rate of return to private investment and about policies that allow private sector investors to search out and invest in those opportunities that have really high rates of return. On the side of public policy, we have one of the great challenges for the 21st Century, which is to do for the public expenditure side the sort of thing that we did quite well in the last 30, 40 years on the tax side. Tax systems around the world are technically much sounder, much better, much less distortionary than they were 20, 30, 40 years ago and I think the economics profession has a lot of claim – can claim a lot of responsibility for that.

Well, we’re not nearly so – in such good circumstance with respect to public investment and we all know of public investments that have zero real return, negative real return, very low real return. If public investment can be brought to have a 10 percent real return instead of a 2 percent real return, that will actually be a permanent contribution to the growth rate of a country, but we have to work on that. And the political barriers in the way of sound cost-benefit analysis are simply there. You’ve all heard in the United States about Senator Stevens’ bridge to nowhere in Alaska where he wanted to build this bridge that was gonna have a trivial amount of traffic.

Well, actually, to prove that Ricardo Lagos was indeed human, he also made a mistake in advocating and pumping real hard for a bridge between the continent of South America and the Island of Chiloe, which is just like Stevens’ bridge to nowhere, and nothing could stand in the way and it was really in the hopper and ready to be done and stuff like that when President Bachelet came in and I can say in another piece of praise for the Chilean system, one of the early things that the Bachelet government did, was X out that bridge to Chiloe, and I think again another victory for sound economics. Well, I don’t know if I’ve used up my time or not, but in any case, I take it we’re going to have a conversation from here on in. So let me turn the platform over to whoever comes next.

Dennis de Tray: Well, thanks very much for an as always extraordinarily stimulating presentation that ranged over an enormous set of issues from some fundamental and basic economics to some wonderful anecdotes about the successes and failures of the continent that you know so well. So it is really a delight to listen.

The next part of our presentation today, we are extremely fortunate to have two exceptionally well suited commentators on Al’s presentation. Let me introduce them both and then I will ask them to speak briefly. Peter Hakim is the president of the Inter American Dialogue here in Washington. Peter is – any of you who actually follow American issues is one the principal spokes people for issues of north/south relations, of Latin American U.S. relations and frequently cited, frequently published, and a – a leading proponent of good relationships between these two important parts of the world. And Peter, we are delighted that you could find time to be here today.

Our second discussant did not have far to travel. He is here at the Peterson Institute. John Williamson is someone I have known for a great many years and have an enormous amount of respect for. He has an eminent career that is not unlike Al Harberger’s. He has been associated with many of the great universities in the world. He has been active in Latin America since the golden era of populism and – and ****. He is associated with the famous Washington consensus, much maligned, and I think often mistakenly misaligned discussion and – and a wonderful and insightful student of – of development. So we are delighted to have you, John.

Next Speaker: Thank you.

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