Sunday, May 14, 2006

Puerto Rico: Divergence not Convergence

The title link is to a chapter of a doctoral dissertation in economics by Fernando Lefort in June 1997. The basic economic theory he is working with is convergence theory. This is broadly defined as the farther away an economy is from the steady state level compared to it closest trading partners (other states), then the fastest the growth will be relative to the distance from the steady state. Steady state refers to the level of GDP that is relatively stable and growing at a steady pace. Much as what is expected of a mature economy such as the USA in this case. And this appears evident in that the Chinese economy is growing fast to catch up with the USA but by theory this growth rate will decrease as it approaches its steady state. But for Fernando's explanation:
In general, the level of technology can be affected by government policies and regulations that distort the markets and by the degree of integration with other economies with other technologies. The savings rate can be considered to be exogenous or can be endogenously determined by the underlying preference parameters. After completing its transitional dynamics, an economy reaches its long-run level of per capita income when the different per capita variables start growing at the same constant rate of growth given by the rate of exogenous technological progress. At that point, the economy is said to be in steady state, and its level of per capita income is known to be the steady state level.

Consider a group of economies that, because of cultural, political or physical proximity, share the same steady state value of per capita income. The neoclassical model of growth predicts that the countries with lower initial levels of per capita income will have higher rates of per capita income growth. Poorer economies will tend to converge or catch-up to wealthier ones, in per capita terms, if their economies differ only because of initial conditions. Thus, the theory of absolute convergence: of two economies aspiring to the same steady state levels, the economy with the lower, initial level of income will grow faster.

But the world is not that simple:
However, even the simplest of the neoclassical growth models, the Solow-Swan model, requires a restatement of this implication if all economies do not share the same steady state. What if different countries have different savings rates, population growth rates, or different technologies? It can be shown that economies with higher steady state levels will grow at a higher rate in per capita terms than those striving toward lower steady states. Hence, the theory of conditional convergence (after the revisions of the convergence hypothesis by Barro and Sala-i-Martin (1992), and Mankiw, Romer and Weil (1992)): of two economies with the same initial levels of income, the economy aspiring to the higher steady state will grow faster.

He states three other conditional factors for different steady states (ie different savings rates, population growth rates, or different technologies). But I see that there is more to this gap as these factors alone dictate. More later.

In summary, Puerto Rico showed an outstanding catch-up effect in the early post-WWII period compared to the US, out-performing all other Caribbean and Latin American economies. However, since 1973 Puerto Rico's per capita output growth rate has decreased relative to other economies in the region, and there is no clear indication that it will ever be able to close the income gap with the US.

So it did better than all other Caribbean nations but has not narrowed the divide much since the early 1970's. But it does not look as though divergence is happening or that it is becoming poorer relatively to the USA Per Capita Income.

This result remains largely unchanged after controlling for other determinants of the steady state level of income, such as the percentage of high school graduates in the population, the government's share of income, and the per capita level of federal transfers. The remaining gap between the actual and predicted individual effect for Puerto Rico must be attributed to some other unobservable variable. Differences in technology in a broad sense between Puerto Rico and the mainland US appear as the standard explanation for the gap. The high degree of integration of the Puerto Rican and American economies, however, make it implausible to attribute the gap to differences in the access to particular production techniques or any other purely non-economic factor.

So he is wondering why there is not a convergence to a higher steady state as theory would dictate. Again, he may not be considering all factors in this study.

A remaining candidate is the more obvious difference in political institutions. Puerto Rico is the only economy of the sample without the clear and permanent political status of statehood. The uncertainty about the future political status of the island might certainly have hurt Puerto Rico's ability to induce increases in the stock of capital at the rate predicted by the theory for an economy with initial low income and high steady state level of income.

I agree that politics has a major affect on the growth of any economy and in this he is starting on the theory that statehood would increase the steady state level of income.

I found that the coefficient in the non-statehood variable is large, negative, and significant. Given the initial level of per capita income and the structural composition of their income, the economies of the states have grown on average 2 percentage points faster than those of the territories. Although these results must be interpreted carefully, it is clear they highlight the existence of positive effects of the statehood status for growth.

A little technical but just saying that statehood garnered 2% increase more than expected without statehood. So if a state was growing at 3% per year and then became a state then it should grow at 5% per year.

The evidence found in this paper indicates that Puerto Rico is converging to a lower steady state than the one to which the United States is converging -- a shortfall that has meant Puerto Rico has been growing at a rate around 2.5 percentage points lower than the one we could expect from an economy with its initial level of per-capita income and the steady state level of income of the United States. Simple simulations performed using the convergence rates obtained in this paper show that the per capita income level of Puerto Rico could have been almost twice its actual value by 1994, completely closing the income gap with the poorest states, had Puerto Rico been converging towards Mississippi's actual income level since 1955.

The convergence to a lower steady state than the US implies that the income gap will not be closed just by waiting for it to happen. Unless Puerto Rico's steady state level of income increases substantially, the Puerto Rican economy will never be able to close the income gap with the US. In this sense, there is no meaningful economic reason for postponing the decision about statehood for Puerto Rico.

I agree that there is "no meaningful economic reason for postponing the decision about statehood". But I am not certain in the least it will:
All these examples, however, are minor cases of economic cooperation when compared to the potential for Puerto Rico. Were Puerto Rico to become a state, the convergence effect should guarantee Puerto Rico a higher rate of economic growth and its citizens higher income levels. Through the statehood process, Puerto Rico can become an integral part of the largest and wealthiest economy in the world, resolving once and for the question of political uncertainty associated with commonwealth and thereby fully enjoying the economic benefits of the catch-up process.

In Lefort's study he looked at the 48 lower states and Hawaii. But I see that Puerto Rico first is disjointed from the other states and thus may always lag behind the other states unless it finds it specialty and exploits it. In the continental states the Interstate Highway system prevented any state from being left out of the system but it does not apply to the island states. Even Alaska was helped in WWII by the Alaskan highway system even if it was through Canada. It is natural that the states close to each other would converge more easily than an outlier.

But then why did Alaska and Hawaii converge with the USA mainland? First and most importantly was they both offered something unique to the US. Hawaii had crops that could not easily be grown on the mainland and tourism from the west coast was a major growth industry. While Hawaii is a lone tourist destination for the west coast, Puerto Rico has to compete ferociously for tourism between all other Caribbean islands. The naval ports were unique to Puerto Rico but have been scaled back in recent years. As far as Alaska, I would think that it would even be worse than Mississippi if not for substantial Federal Subsidies in infrastructure and the vast oil and gas reserves.

Secondly, English speaking has been implemented in all 50 states. Not all Puerto Ricans speak or read English proficiently. I think this should be a requirement for Statehood, that to graduate all seniors must pass a proficiency in English exam. Thus a diploma means the same in all 50 states. Now they can teach Spanish all they want and even speak it on the streets, but must be able to converse in and read English.

So in conclusion, I want Puerto Rico to become a state if they also want it, but we should realize that it may never be on par with the mainland unless they find their specialty.

Title link broken so this one should work: Puerto Rico: Divergence not Convergence by Fernando Lefort* June 1997 Executive Summary

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