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The Solow Model the economic growth of Eastern European countries after 1989

Elena Calarasu Between Western and Eastern Europe there has always been, historically, a gap in terms of both economic growth and socio-political development. In this essay I am going to analyse whether, following the collapse of the USSR and the enlargement of the European Union to the former communist countries, we are experiencing a convergence of these developing countries towards the EU area, in terms of annual income per capita. I will examine the empirical data collected by Eurostat by putting it in relation with the neoclassical growth model developed by Robert Solow during the 1980s. This paper is roughly divided in 4 parts: in the beginning, I will do a brief historical overview describing the main cultural and political differences between western and eastern Europe, that still influence economy and growth nowadays. In the second part, I will explain the theoretical model of convergence, with its assumptions and implications. Then I will demonstrate, through graphs and tables, the economic growth of the former communist countries from the beginning of 1990s until 2012, the period in which the Eurostat data is available. I will conclude by saying that the Solow model is right when stating that poor countries have a higher rate of growth than rich countries and that there is convergence, even if it is sluggish and the growth has been slowed down by the economic and financial crisis that we have been facing since 2008. The concept of economic growth concerns only the last two centuries, since before there were not any political and institutional structures capable of creating impersonal exchange and capital accumulation by the non-productive lite - all assumptions of the system that was born in Great Britain by the end of the 1700 and took the name of Capitalism. Even before that date, however, the Eastern European countries were characterized by a technological, institutional, political and then finally economical backwardness. There was nor private property, because the land was administered in village communities, neither a widespread bourgeoisie lite who could invest in technology. Those territories, rich in raw materials, have been for a long time the subject of dispute between the Russian, Austro-Hungarian and the Ottoman Empires, until finally being devastated by wars in the name of nationalism throughout the 1800s and early 1900's. Following the two World Wars, the Communist system was established in those lands, partly enjoying consensus and partly by using force. Controlled by the USSR, the satellite countries were not allowed to enjoy the ERP aid, could not join the EEC and, despite the economic help from Moscow and the Comecon, they saw indeed a slowdown in growth and technological improvement. The Soviet model, characterized by collective/state ownership in all spheres of society, replacement of the market economy with the rigid five-year planning, inefficiency and backwardness, has proved to be unable to keep pace with the times and with the Western technological development and to overcome the oil crises of the 70s. The growing dissent towards the party and towards the low living standards, accentuated by the huge debts that satellite countries contracted in the 80s with the IMF and the World Bank, led to the collapse of the Soviet bloc. During the early 1990s, the Eastern European countries entered a transition phase, characterized by the opening of their markets to the international economy and the instauration of a democratic regime, as well as starting negotiations for entering the EU. This process was not painless because of the internal conflicts (the violent dissolution of Yugoslavia for instance) and the political instability and corruption of some of these countries, which are still not able to deal with the democratic system nor with the international competitiveness. Eventually, in 2004 the EU opened its gates for Estonia, Latvia, Lithuania, Poland, Hungary, Czech Republic, Slovakia, Slovenia, and in 2007 for Romania and Bulgaria.

I am going to analyse whether the exit of these countries from the Communist system and their adhesion to the EU was beneficial in terms of GDP per capita. According to the neoclassical growth model developed by R. Solow, poor countries tend to grow more rapidly than the rich ones and eventually to converge towards the steady state rate of growth, which depends on the rate of capital accumulation, the population growth ( the rate of labour force growth) and the rate of technological progress. The model assumes that the two countries - the rich and the poor one - have similar production functions Y/L=F(K/L), y=f(k), similar technology and saving rate (s). The slope of the production function curve is due to the diminishing returns to capital (pendenza decrescente dovuta alla PMK). In this model the output per worker (y) is a function of the capital per worker (k); the capital per worker is positively determined by the investment/saving rate per worker, and negatively determined by the population growth n (a high rate of population growth decreases the level of capital per worker) and by the depreciation of capital d. [source: http://en.wikipedia.org/wiki/Neoclassical_growth_model; Macroeconomia, G.Mankiw e M. Taylor] Under these assumptions, if a country starts its growing late, i.e. it has a lower capital per worker than a developed country (K1 < K*), it will grow more rapidly because its saving/investment rate is higher than the saving rate of the developed country, which has already reached the steady state equilibrium (A) and wants to keep k constant and whose growth of GDP per capita is equal to the rate of technological progress. Moreover, the PMK is higher in the beginning (until it reaches the point A where PMK=(n+d)k). This rapid growth is called convergence and it can be spontaneous, it can be accelerated by the contribution of foreign savings (FDI) or by appropriate domestic policies. However, in the real world convergence may not be an automatic process. Many poor countries around the world fail to converge to the steady state of developed countries because their technology is different, labour force has low human capital, saving rates might not be enough or might not be channelled into investment in efficient sectors, they have bad governance or different institutions and cultural approaches to the economy. In other words, if the assumptions of Solows model lack, then convergence process may be slowed down or even interrupted. Using updated data that I collected from the Eurostat website, I developed some graphs that show the levels of GDP per capita in the EU area and in each transition country that has joined the EU, from early 1990s until 2012 (Table 1); a table with the growing rates of GDP per capita before and after former communist countries adhesion to the EU ( Table 2); finally, I calculated the Beta coefficient, which measures the speed of economic convergence of each Eastern European country towards the EU area (Table 3). My analysis considers, on one hand, only the former communist countries that joined the EU (Estonia, Latvia, Lithuania, Poland, Hungary, Czech Republic, Slovakia, Slovenia, Romania and Bulgaria), leaving out the Eastern European countries that didnt (Croatia, Albania, Bosnia, etc.) and

the EU area as a whole on the other hand, both composed by 15 or 27 members. For some of these countries Eurostat provides data from 1991 but for others only since 1995. I compared the level of GDP in different countries by converting their value in according to the purchasing power parity exchange rate. Table 1.

Looking at the graph of Table 1. we can clearly see the difference between the GDP per capita level in the EU area and that of the former communist countries. There is small difference in terms of GDP between EU 15 and EU 27, probably due to the enlargement towards east, which means that nearly the same income had been divided between several states. In fact, when Eastern countries joined the EU in 2004, their GDP per capita was roughly a third that of the EU area: Slovenia and Czech Republic where the countries with the higher GDP per capita (10000 on average, which still was a half that of the EU), while all the other countries had a GDP per capita under 10000 per year. Romania an Bulgaria, which joined in 2007, were and still are the poorest countries of Europe, with a GDP per capita lower than 5000 annual. Although, after the adhesion, the income of most countries started growing more rapidly, the GDP of Romania and Bulgaria grew at a slower rate and now seems to be stagnant. This result may be caused by inefficient use of EU funds, as well as corruption, which is common in that part of Europe. I shaped Table 2. by calculating the annual growth of GDP per capita for each country using the formula: GDP Growth = (2000's GDP 1999 's GDP) / (1999's GDP). There are two things immediately noticeable: first of all, the EU rate of growth is stable at about 2% annually, compared to the other countries one, which tend to have more marked periods of growth and decline because their markets are more sensitive to economic fluctuations. Secondly, there is a widespread recession in both EU area and in the Eastern countries, due to the economic crisis of 2008 (which again seems to be more striking in the former communist countries). Latvia, for instance, which has one of the highest growing rates (12% on average since its adhesion to the EU), lost -16% points of GDP in 2009. The data suggests that countries with a constant rate of growth

tend to react better to economic crisis than countries with an oscillating one. We can also notice that, after a brief economic recovery during 2010 and 2011 all countries GDP, EU included, started to fall again. This phenomenon is probably due to the long term recession and the related problems of huge public debt and unemployment rates. In fact, the crisis is not over yet. Table 2.

Lastly, I verified whether Solows predictions about convergence were truthful in my case. Using Excel, I calculated the Beta coefficient, which expresses the speed of convergence, i.e. how much of the initial gap in income is recovered each year, as a result of the difference between the growth rates. Table 3.

I applied the formula: beta = (G1 - G0) / (Y0 - Y1), where G1 = average annual growth rate in decimal points, in the reference period of each eastern European country G0 = average annual growth rate in decimal points, in the same period, of the reference country (EU area) Y1 = natural logarithm of the initial level of income of the eastern country (1991) Y0 = natural logarithm of the initial level of income of the country of reference (EU area) (1991) We observe an average speed of convergence of Eeastern European countries income equal to 2%, which is similar to the average convergence rate of all developing countries towards the developed ones across the world, according to other studies [Mankiw & Taylor,(pag 182)]. Comparing the average rate of growth before and after the adhesion of developing countries to the European Union, we notice a decrease in terms of growth after the adhesion. However, as I said before, this result is not caused because the EU had a bad influence on their economies but because of the economic crisis. Nevertheless, analysing all the data as a whole, it is difficult to assess the net benefit arising from Eastern European countries adhesion to the EU, because the crisis drew back their fragile economies. To conclude, since early 1990s former communist countries from Eastern Europe started growing at a higher rate than the European Union. This means that the introduction of the market economy system, the economical aid received from the EU in exchange for political conditionality and finally the adhesion to the EU have had a beneficial result on growth and economic development of these countries. Still, it might not be proper to analyse all Eastern countries as a single bloc, since every country has its own characteristics and each one has found different transition paths after exiting socialism [Gokay, 2005]. In fact, more industrialized countries such as Slovakia, the Czech Republic and the Baltic states, had more advanced economies even before 1989, and they are still doing well today. Slovenia, for instance, has the highest standard of living in the post-communist area [Laschi, 2005], while Romania, Bulgaria and Hungary, which have always been the poorest countries of Europe, are those who find it harder to grow nowadays. This suggests that there are some important factors behind the development process, in addition to mere economic growth, such as formal and informal institutions, political stability and culture, which vary from country to country. However, GDP per capita data shows that these countries are converging to the EU income levels at an average rate of 2% per year, even though the speed of convergence has been slowed down by the 2008 economic crisis. Sources: Gokay B., Europa orientale dal 1970 ai giorni nostri, Il Mulino, 2005 Laschi G., LUnione Europea. Storia, istituzioni, politiche, Carocci, 2005 Mankiw G.e M. Taylor, Macroeconomia, Zanichelli, 5 edizione http://en.wikipedia.org/wiki/Neoclassical_growth_model http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

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