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Shocks and growth: Adaptation, precaution and compensation

Paul Collier, Benedikt Goderis and Anke Hoeffler

United Nations (UN)

12 June 2006

SARPN acknowledges the Wider Institute for Development Economics Research as the source of this document.
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Abstract

In this paper we investigate how a wide array of types of shock arising from world prices, natural events, and political violence affect growth. Our results suggest that the impact from political shocks are far greater than from natural shocks. However, our preliminary cointegration results suggest that the cost from primary commodity exporting are very large. Potentially shocks can affect growth either due to their impact, or due to the volatility that repeated shocks generate. In our empirical investigation we find little evidence that volatility is a problem. We investigate the efficacy of economic structure and domestic as well as external policy responses to the various shocks.

What can a government do to moderate the adverse effects of negative shocks and to make the most of favourable shocks? The answer appears to be that governments can do a lot, partly through policies that alter exposure, partly through policies that encourage adaptation and flexibility, and partly by precautionary policies. Countries at risk are better placed with lower levels of debt, smaller fiscal deficits, and larger reserves. In addition international assistance can help to mitigate the impact of shocks. Development assistance as well as remittances can cushion the adverse effect of shocks.

Introduction

In this paper we investigate empirically how shocks affect growth. Our work is preliminary: we are in the early stages of a large project and our results should consequently be viewed with an appropriate degree of caution. We consider a wide array of types of shock arising from world prices, natural events, and political violence. Potentially shocks can affect growth either due to their impact, or due to the volatility that repeated shocks generate. The consequences for growth may depend upon non-policy structural characteristics of the economy, such as its level of income: some types of economy may be more vulnerable to others, not just in the sense of being more subject to shocks, but because a given shock has larger consequences.

The consequences of shocks presumably depend in part upon domestic policy choices. The efficacy of policy responses to shocks, which is the issue which has received most attention, is statistically somewhat demanding to investigate because of the intrinsic endogeneity of responses to the scale of the shock. However, policy choices made prior to the shock may be more important in determining the consequences and are also less problematic to investigate. We focus on three groups of such policies: exposure, adaptation and precaution. The degree of exposure to some shocks, notably those transmitted through international prices, is to some extent a choice variable: governments can influence whether an economy is more or less open. By adaptation we mean those policies which are likely to make the economy more or less flexible and so potentially more or less able to respond to shocks. By precaution, we mean those policies which enhance the scope for the society to cushion adverse shocks, should it choose to do so. All these domestic policy choices are liable to be influenced by the socio-political processes of decision. Hence, we investigate whether political institutions and social structure prior to a shock influence its consequences for growth. Finally, we consider the efficacy of external policies of compensation. Traditionally, the source of such compensation has been thought of as the public sector – international development assistance. However, international private transfers between households are now larger than aid flows and so it is important to integrate them into the analysis. We therefore consider both aid and remittances as potential mechanisms for compensation and insurance.

The paper is structured as follows. It is conventional to begin with a discussion of the predictions from economic theory. However, the many different types of shock that we investigate potentially implicate a very wide range of theory and so, at this preliminary stage we have adopted the alternative strategy of discussing pertinent theory at each pertinent stage in our results. Section 2 discusses our data and our statistical methods. Section 3 reports the direct effects of shocks on growth, including short run effects, longrun effects, and those generated by volatility. Section 4 considers the importance of economic structure: are some economies more vulnerable than others? Section 5, which is the core of the paper, focuses on domestic policies. Section 6 introduces international compensation. Section 7 concludes.



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