When Does Domestic Savings Matter for Economic Growth?
GAICIL Insights
Thrift is one of the oldest prescriptions in development economics.1 This paper finds it works, but only for countries far from the frontier, and for a surprising reason. When Does Domestic Savings Matter for Economic Growth?, by Philippe Aghion, Diego Comin, Peter Howitt and Isabel Tecu, answers that it depends on a country's distance to the technological frontier. In the model, growth comes from innovations letting local sectors catch up with frontier technology.
In poor countries, catching up requires cooperation between a foreign investor familiar with frontier technology and a domestic entrepreneur familiar with local conditions. Domestic savings matters because it lets the local entrepreneur put equity into the venture, mitigating an agency problem that would otherwise deter the foreign investor. The domestic entrepreneur may not deliver on her input contribution unless she has invested sufficient capital, and that co-investment is financed from domestic savings. In rich countries, domestic entrepreneurs already know frontier technology and need no foreign investors to innovate, so domestic savings does not matter for growth. Savings, here, buys trust as much as machinery.
A cross-country regression supports the prediction: lagged savings is positively associated with productivity growth in poor countries and not in rich ones. The authors link this to barriers to adopting new technologies that explain wide cross-country productivity differences. Familiarity with frontier technology lowers adoption costs. Far from the frontier, adoption may be too expensive without outside help, and attracting that help requires local capital.
The mechanism explains why some developing countries overcome adoption barriers and others do not. Countries with more domestic savings can attract the foreign partners they need. Savings play a role in technology diffusion beyond direct investment financing. Skin in the game is the entry ticket to the frontier.
Here is where the paper meets the present. Artificial intelligence diffusion fits the model closely. AI is a frontier technology developed mainly in advanced economies. Developing countries seeking to adopt it may need foreign partners with the relevant expertise. Domestic capital can help attract them by aligning incentives and mitigating agency problems. Countries with stronger domestic savings and financial systems may be better positioned to adopt AI. A national AI strategy without a functioning domestic capital market may struggle to attract serious partners.
The agency problem is the crux. Foreign technology providers need assurance that local partners will contribute effectively, and local equity supplies it. Partnerships between international technology firms and local businesses could benefit from incentive-aligning mechanisms, including local co-investment. A joint venture where the local side risks nothing gives the foreign side little reason to share its best.
Policy for developing countries follows. Promoting domestic savings and developing financial systems able to channel savings to local entrepreneurs could accelerate technology adoption. Paired with openness to foreign investment, such policies could help countries catch up in AI and other technologies. Savings policy and foreign investment policy are two halves of the same diffusion strategy.
Advanced economies face a different problem. Domestic savings matters less because entrepreneurs already have frontier knowledge. Growth depends more on frontier innovation, raising different questions about research, competition and incentives. One size of growth policy does not fit all distances.
Uneven diffusion makes sense in this light. Adoption barriers are substantial, and overcoming them takes knowledge and capital. In AI, where expertise is concentrated, barriers may be especially high. International cooperation helping developing countries build both knowledge and capital for adoption could narrow global gaps.
At bottom, the determinants of growth depend on a country's distance to the frontier. For countries far behind, domestic savings matters because it helps attract the foreign expertise needed to adopt advanced technologies. As AI spreads globally, developing countries can improve their prospects by building domestic capital and creating conditions for productive partnerships with foreign technology providers.
Here is the uncomfortable test for development agencies funding AI in poorer countries: grants that replace local co-investment may weaken the very incentive that makes partnerships work. Helping local entrepreneurs put their own capital in may be a powerful lever for AI adoption.
Introduction
Can a country grow faster by saving more? The paper addresses this question both theoretically and empirically. In the theoretical model, growth results from innovations that allow local sectors to catch up with frontier technology. In poor countries, catching up requires the cooperation of a foreign investor who is familiar with the frontier technology and a domestic entrepreneur who is familiar with local conditions. In such a country, domestic savings matters for innovation, and therefore growth, because it enables the local entrepreneur to put equity into this cooperative venture, which mitigates an agency problem that would otherwise deter the foreign investor from participating. In rich countries, domestic entrepreneurs are already familiar with frontier technology and therefore do not need to attract foreign investment to innovate, so domestic savings does not matter for growth. A cross-country regression shows that lagged savings is positively associated with productivity growth in poor countries but not in rich countries.
Takeaway
There are important barriers to adopting new technologies which explain the wide crosscountry differences in productivity. What is the nature of these barriers, and why do some developing countries manage to overcome them but others don’t? This paper has developed a model where a country’s ability to take advantage of international technology diffusion, is positively correlated with the level of its domestic savings. Familiarity with the frontier technology reduces its cost of adoption. Advanced countries have no problem adopting the frontier technology. However, for countries far from the technology frontier, it may be too expensive to adopt the frontier technology without outside help. Instead, entrepreneurs in these countries need to rely on foreign investors that are familiar with the frontier technology. However, there is moral hazard in the relationship between local entrepreneurs and foreign investors: namely, the domestic entrepreneur may not deliver on her input contribution, unless she has invested sufficient capital in the project. This co-investment is in turn financed out of domestic savings. Overall, the main prediction of the model is that domestic saving is more critical for adopting new technologies in developing than in developed economies. Confronting this predictions to available cross-country panel data, we first showed that simple reduced form regressions support this basic prediction.1
Notes
- Philippe Aghion et al., When Does Domestic Savings Matter for Economic Growth?, 64 IMF Econ. Rev. 381 (2016), https://doi.org/10.1057/imfer.2015.41. Takeaway source: Conclusions, reproduced from a free author or repository copy. ↩
Cite as: Philippe Aghion et al., When Does Domestic Savings Matter for Economic Growth?, 64 IMF Econ. Rev. 381 (2016), https://doi.org/10.1057/imfer.2015.41
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