Identication Problems in Growth Econometrics

Tobias Heinrich
12
Stockholm University
Version: January 27, 2008
This paper shows that cross-sectional analysis, panel data methods and time series
methods without using cointegration tests do not allow to draw conclusions with respect
to long run growth determinants nor to the concern of convergence of GDP or technological
convergence. The paper further illustrates that in these kinds of studies it is in general
questionable to interpret the coecients of interaction terms. The paper additionally
illustrates that using cointegration tests to reveal determinants of long run growth avoid
the identication problem. The mechanisms behind the results are further illustrated for
standard growth models. The results of this paper might be an explanation for the fact
that studies using cointegration tests have completely dierent results then cross-sectional
analysis, panel data methods and time series methods without using cointegration tests.
Key Words: Growth econometrics, Identication, Observational equivalence,
Time series econometrics, Cointegration, Cross-country growth, Human capital,
Technological catch-up
Subject Classication: [JEL classications] C10, C22, O30, O40
1. INTRODUCTION
In their article in the handbook of economic growth Durlauf, Johnson and Tem-
ple (2004) point out the two major themes in the development of formal econometric
analyses of growth. The rst theme revolves around the question of convergence,
i.e. are contemporary dierences in aggregate economies transient over suciently
long time horizons? The second theme concerns the identication of growth deter-
minants, i.e. which factors seem to explain observed dierences in long-run growth?
These questions are closely related in that each requires the specication of a sta-
tistical model of cross-country growth dierences from which the eects on growth
of various factors, including initial conditions, may be identied.
There are in principle two dierent kinds of studies that attack the above ques-
tions. Cross-sectional analysis, panel data methods and time series methods with-
out cointegration tests, which estimate in principle conditional expectations, on one
side and cointegration tests on the other. The regressions are sometimes known as
Barro regressions, given Barros extensive use of such regressions to study alterna-
tive growth determinants starting with Barro (1991). This regression model has
been the workhorse of empirical growth research. In modern empirical analyses, the
equation has been generalized in a number of dimensions. Some of these extensions
reect the application to time series and panel data settings. Other generalizations
1
I would like to thank Jess Benhabib, John Hassler and Fabrizio Zilibotti for their helpful
comments and German Academic Exchange Service for nancial support.
2
Tobias Heinrich, Department of Economics, Stockholm University, 10691 Stockholm, Sweden,
Email: tobias.heinrich@ne.su.se
1
have introduced nonlinearities and parameter heterogeneity. Cointegration tests on
the other side have been used quite rarely, see Jones (1995) or Romero-Avila (2006).
The results dier systematically in the way that studies using cointegration tests
do not nd evidence for long run relationships predicted by growth theory whereas
studies using cross-sectional analysis, panel data methods and time series methods
without cointegration tests normally conrm the predictions of growth theory.
The fact that empirical studies, depending on the used methodology, come to
very dierent results allows for the conjecture that at least one methodology is
wrong. Up to now no paper has claried why both methodologies come to com-
pletely dierent results and what the correct methodology is. Therefore, a clari-
cation of the correct methodology is needed to which this paper should contribute.
The task is to explain and reconcile the fact that cointegration tests do not nd
evidence with respect to certain determinants of long run growth whereas studies
without using cointegration tests indicate evidence. The standard inference prob-
lem of time series data, spurious regression, seems not to be the problem because it
is quite unrealistic that there is no relationship between GDP-growth and reason-
able factors like human capital. The relevant question in this paper is not if there
some relationship at all but rather what kind of relationship.
This paper shows that cross-sectional analysis, panel data methods and time
series methods without cointegration tests, do not allow to draw conclusions with
respect to long run growth. It is further shown that in these kinds of studies a
negative initial GDP level coecient cannot be interpreted as convergence and the
coecients of interaction terms are problematic to interpret which is illustrated
for the case of technological catch-up terms that do not provide information with
respect to technological convergence. The paper shows these results by illustrating
an identication problem, i.e. a reasonable alternative model in which long run
growth is determined exogenously has the same data implications as the so-called
growth model in which long run growth is determined endogenously. The alternative
model is the so called level model, where "level" should indicate that the level of
GDP and not the growth of GDP is determined by this model. One might think of
many other possible alternative relationships with exogenous long run growth rate
but in principle for illustrating the identication problem it is enough to show that
at least one alternative model is able to produce the same data. This identication
problem has been neglected by the econometric analyses of growth so far. The lack
of the empirical growth studies is their focus on the question: Is the data consistent
with the theory? But this is not enough to test a theory because the data might
be consistent with many theories. This is the so-called identication problem,
which is the main issue of this paper. This view resonates with those of many
econometricians, who believe that economic theory must provide the identication
needed to render statistics economically interpretable.
As a special case of the analysis this paper shows that it is not possible to test
the so-called Lucas approach versus the Nelson-Phelps approach with cross-sectional
analysis, panel data methods and time series methods without cointegration tests.
This result follows because the estimation equation of the Lucas approach is a
special case of the level model and the estimation equation of the Nelson-Phelps
approach is a special case of the so-called growth model.
The policy implications of distinguishing between transition eects and long
run eects are signicant. In the former, the benet of an increase is its marginal
product. In the latter, because the level of the determinant aects the growth rate
of total factor productivity, its benet will be measured in terms of the sum of its
2
impact on all output levels in the future. Similarly, it is important to know whether
a poverty trap arises because of dierences in the rates of accumulation, or because
countries lack the absorbing capability that would allow them to benet from their
technological backwardness.
This paper is structured as follows. Section 2 introduces the methodological
background, the use of time series econometrics tools in the econometric analyses
of growth and some denitions and issues about identication. Section 3 shows
the observational equivalence of the level model and the growth model in cross sec-
tion analysis, panel econometrics and using long time series without cointegration
tests. Section 4 illustrates that cointegration theory is able to solve the identi-
cation problem and discusses possible alternatives to the problematic concept of
,-convergence and technological catch-up terms. Section 5 is explicitly devoted to
human capital and technology, reviews selected empirical studies and shows the
observational equivalence of the Lucas approach and the Nelson-Phelps approach
and discusses some extensions. Section 6 oers conclusions.
2. METHODOLOGICAL BACKGROUND
In the following part rst I comment on some general methodological points,
especially on model reduction, and the use of time series econometrics tools in
the econometric analyses of growth secondly I introduce rst some points about
the language of the identication community since the concepts of observational
equivalence and identiability are key for this paper.
2.1. Model Reduction and some Terminology
Since the data generating process specied by most growth models are dynamic
systems a natural starting point for the econometric analysis of growth is a dy-
namic simultaneous equation system, which may be viewed as a generalization of
the autoregressive lag model. However, in growth econometrics normally only one
equation is of interest and estimated. To avoid the resulting so called simultaneous
equation bias IV estimation is used which corequisitely avoids the standard identi-
cation problem in simultaneous equation systems. For the practical advantage to
eliminate noise due to errors in measurement most empirical papers on economic
growth use cross-sectional analysis or panel data methods. Therefore, a large part
of the empirical growth literature reduces the growth models extensively when they
specify the estimation equation.
To point out the source of the identication problem I subdivide this model
reduction into two steps. According to this, the "original" data generating process,
which is the theoretical growth model, implies a data generating process, which is
a single equation time series model, an autoregressive lag model, and this in turn
implies an even more restricted estimation equation for cross-sectional analysis or
panel data methods.
The advantage the intermediate step of the model reduction to get the autore-
gressive lag model is that it provides a direct link between the economic and the
econometric model since growth models describe the economy in the time dimension
and are indeed time series models whereas implications for cross-sectional analysis
or panel data methods are more ad hoc. The important advantage of time se-
ries econometric tools which I use in the analysis in the following sections is the
possibility to distinguish long run behavior from transitions and to break down
3
the dynamics into short run dynamics and dynamics due to deviations from the
long run equilibrium. All that is not possible in cross-sectional analysis or panel
data methods. In section 5 the error correction representation of the respecting
time series model enables to derive all implications from economic theory directly.
The "jump" from the economic model to some estimation equation as e.g. done
in cross sectional analysis omits exactly the steps which sweeps the identication
issue under the table.
From that it should become clear that the identication problem pointed out
here is dierent in nature from the standard one in simultaneous equation systems
and is not caused by multiple equations and can also exist for single equation data
generating processes. In this case IV estimation cannot avoid the identication
problem, other tools are required, i.e. cointegration tests as it will be shown in
section 4.
As will becomes clear in section 2.2 to investigate the identication issue we
need at least two models as potential data generating processes. The reference
model in the analysis is the so-called growth model which is characterized by the
fact that at least some determinant of GDP growth is inside the model. Therefore,
the growth model implies that some variables form a cointegration relationship with
detrended GDP growth. To illustrate the identication problem I need to specify
an alternative set of data generating processes and check whether this alternative
set of data generating processes is able to imply the same data. As the alternative
model I choose the so-called level model which is characterized by the fact that
growth is determined exogenously. In this model the determinants of GDP growth
are outside the model and the variables inside the model determine the level and
not the growth of GDP. Therefore, the level model implies that some variables
form a cointegration relationship with detrended GDP. It is possible to propose
many other alternative models characterized by exogenous growth but to disprove
identiability it is sucient to show that at least one alternative model is able
to produce the same data. Section 5 illustrates that the level model is indeed a
reasonable alternative model. It is important to note that everything in the paper
is related to the reduced form of growth models used in empirical studies, i.e.
an autoregressive lag model or an estimation equation and not to growth models
itself. Otherwise, the terminology "growth model" versus "level model" would be
puzzling because originally all growth models are "growth models". However, after
an extensive model reduction the remaining single equation might not anymore
represent a growth process because only a reduced part of the growth framework is
in the estimation equation, as for the case of the Lucas model this remaining part
in the estimation equation used in many empirical studies does not explain long run
growth because the variables only determine the level of GDP. To get an estimation
equation of the Lucas-approach that is a growth model we need to include variables
that determine long run growth as e.g. the savingrate.
2.2. Identiability and Observational Equivalence
The topic of identication with its concepts of observational equivalence and
identiability was formalized by Koopmans (1949), rst as applied to the simul-
taneous equations model of econometrics and then to scientic inference in gen-
eral. In econometrics identication became a big topic, warranting a chapter in
the Handbook of Econometrics by C. Hsiao (1983). The story of identication in
econometrics is a complex one and various facts are discussed by e.g. Qin (1989)
4
and Aldrich (1994). Writing of the economic context, Koopmans (1949) separates
the process of inference from sample to theoretical structure into a step from sam-
ple to population and one from population to structure. Statistical inference, from
observations to economic behavior parameters, can be made in two steps: Inference
from the observations to the parameters of the assumed joint distribution of the
observations, and inference from that distribution to the parameters of the struc-
tural equations describing economic behavior. The latter problem of inference is
described by the term "identication problem". Step one is the domain of statis-
tical inference in the narrow sense, step two the domain of economic theory or the
structural theory of whichever substantive eld the observations come from. Koop-
manss identication concerned a layer of inference beyond statistical inference and
belonged in the structural theory.
Rothenberg (1971) gives a pair of denitions for the parametric case. Here 1
represents the :-dimensional outcome of some random experiment with density
function ) and represents the :-dimensional parameter space.
Definition 1. Two parameter points (structures) c
1
and c
2
are said to be
observationally equivalent if )(j, c
1
) = )(j, c
2
) for all j in 1
n
.
Definition 2. A parameter point c
0
in is said to be identiable if there is
no other c in which is observationally equivalent.
These descend from denitions in Koopmans and Reiersol (1950) but these do
not reect Koopmanss concerns with inference from population to structure and
the role of prior information in making such inference possible. Rothenbergs may
be a structural parameter or a reduced form parameter. In terms of Koopmanss two
steps, the "statistical identication problem" can be interpreted as encompassing
both steps or just the rst. Rothenberg (1971) opts for the encompassing possibility,
describing the "identication problem" as concerned with the possibility of drawing
inferences from observed samples to an underlying theoretical structure.
To investigate the identication issue in growth econometrics denitions 1 and
2 do not apply directly because the models are not dened by parameter points but
by parameter sets, denoted by c
1
and c
2
. This extended denition is necessary
since most approaches in growth theory do not imply a specic value of a parameter
but rather a positive or negative value. Therefore, the following denitions are more
appropriate.
Definition 3. Two parameter sets (sets of structures) c
1
and c
2
with respect-
ing sets of densities F
1
and F
2
are said to be observationally equivalent if F
1
= F
2
,
where F
I
=
_
)(j, c
I
) : c
I
2 c
I
_
.
Definition 4. A parameter set c
0
2 is said to be identiable if there is no
other c 2 which is observationally equivalent.
Finally, to get applicable denitions I have to take into account that the impli-
cations of growth theory considered by this paper only involve the rst moment.
Thus, I follow Hsiao (1983) and use the following denitions:
Definition 5. Two parameter sets (sets of structures) c
1
and c
2
are said to be
observationally equivalent in the rst conditional moment if they imply the same set
of coecients in the estimation equation describing the conditional rst moment.
5
Definition 6. A parameter set c
0
in is said to be identiable in the rst
conditional moment if there is no other c in which is observationally equivalent
in the rst conditional moment.
Of course, the concept of identiability in the rst conditional moment is weaker
than that of identiability. Since the data generating processes considered in this
paper do not specify the whole distribution function ), but only the rst conditional
moment of 1 , to show observational equivalence it remains to show that both
approaches described by c
1
and c
2
, imply the same coecient set for the estimation
equation. In this paper the possible sets of coecients in the estimation equation
describing the conditional rst moment are R
+
and R

for each coecient in the

estimation equation. Therefore, two data generating processes that imply for each
coecient in the estimation equation to lie in the same set, which is R
+
or R

, are
observational equivalence in the sense of denition 5.
3. THE IDENTIFICATION PROBLEM: GROWTH VERSUS LEVEL MODEL
In this section I show that cross-sectional analysis, panel data methods and time
series methods without cointegration tests involve serious identication problems
which makes it impossible to interpret the coecients in these studies with respect
to long run growth, convergence of GDP, technological convergence and several
other issues associated with interaction terms. I start the analysis with considering
the case of reducing the dynamic simultaneous equation system to an autoregressive
distributed lag model, from now simply ADL-model. The following proposition
summarizes under which conditions the level model and the growth model imply
the same signs on the estimates.
Proposition 1. Let the models , the level model, and 1, the growth model,
be given as follows:
: j
|
= c +

I=1
0
I
j
|I
+
1

|=1
j

=0
c
|
r
||
+ -
|
and
1 : dj
|
= c
0
+

I=1
0
0
I
j
|I
+
1

|=1
j

=0
c
0
|
r
||
+ -
|
,
where j
|
is the endogenous variable, r
||
are / = 1, ..., 1 exogenous variables and
-
|
is a white noise process. Then the following 5 statements hold for the following
estimation equations:
dj
|
= c
00
+

I=1
c
I
j
|I
+
1

|=1
j

=0
,
|
r
||
+ -
|
, (1)
and
dj
|
= c
00
+

I=1
c
I
j
|I

|=1
j

=1
,
|
dr
||
+
1

|=1
_
_
j

=0
,
|
_
_
r
||j
+ -
|
. (2)
6
(i) Both data generating processes and 1 imply the same signs for the long
run eects,
j

=0
,
|
, and therefore the same signs for the coecient of r
||j
in
estimation equation (2) if :iq:
_
_
j

=0
c
|
_
_
= :iq:
_
_
j

=0
c
0
|
_
_
for some /.
(ii) Both data generating processes and 1 imply the same signs for the coef-
cient w.r.t. changes of the r
||
, ,
|
, if :iq:
_
c
|
_
= :iq:
_
c
0
|
_
for some /.
(iii) Both data generating processes and 1 imply a negative sign for the co-
ecient w.r.t. j
|1
, c
1
, if 0
1
< 1 and 0
0
1
< 1.
(iv) For all linear interaction terms of the form (j
|1

l21
a
l
r
l|1
) by which
DGP 1 can be extended so that the interaction term inuences long run growth,
9 an (extended) DGP which implies the same sign for the coecient w.r.t. the
interaction term but the interaction term does not inuences long run growth.
Proof. (i) One can rewrite both models in the following way:
: dj
|
= c+(0
1
1) j
|1
+

I=2
0
I
j
|I

|=1
j

=1
c
|
dr
||
+
1

|=1
_
_
j

=0
c
|
_
_
r
||j
+
-
|
1 : dj
|
= c
0
+

I=1
0
0
I
j
|I

|=1
j

=1
c
0
|
dr
||
+
1

|=1
_
_
j

=0
c
0
|
_
_
r
||j
+ -
|
.
So, if :iq:
_
_
j

=0
c
|
_
_
= :iq:
_
_
j

=0
c
0
|
_
_
for some /, then:
:iq:
_
_
j

=0
c
|
_
_
= :iq:
_
_
j

=0
c
0
|
_
_
= :iq:
_
_
j

=0
,
|
_
_
.
(ii) One can see directly from part (i) of the proof that both data generat-
ing processes and 1 imply the same signs for changes of r
||
if :iq:
_
c
|
_
=
:iq:
_
c
0
|
_
.
(iii) After subtracting j
|1
from both sides DGP becomes:
dj
|
= c + (0
1
1) j
|1
+

I=2
0
I
j
|I
+
1

|=1
j

=0
c
|
r
||
+ -
|
.
After subtracting j
|1
from both sides DGP 1 becomes:
dj
|
= c +
_
0
0
1
1
_
j
|1
+

I=2
0
0
I
j
|I
+
1

|=1
j

=0
c
|
r
||
+ -
|
.
From these equations it is easy to see that both data generating processes imply
a negative sign for the coecient w.r.t. j
|1
, c
1
, if 0
1
< 1 and 0
0
1
< 1.
(iv) Take the simple special case of DGP : j
|
= 0j
|1
+

l21
a
l
r
l|1
+ -
|
.
Rewriting it in the form dj
|
=

l21
a
l
dr
l|
+ (1 0) (j
|1

l21
a
l
r
l|1
) + -
|
shows
immediately that for every conceivable coecient of the interaction term in the
estimation equation there exists a model with corresponding (1 0) that is able
to produce such data.
7
A few comments on proposition 1 might be useful. First, proposition 1 shows
clearly that it is not possible to interpret many coecients from an ADL-model.
The results in part (i) do not change if one uses some mean r over the period
as sometimes proposed by empirical studies. Part (iii) shows that a negative sign
for the coecient w.r.t. j
|1
cannot be interpreted as (conditional) convergence
which is a conrmation of the results by Quah (1993) in a more general setting.
Part (iv) shows that one cannot interpret the coecient of an interaction term
with respect to long run growth, examples are the technological catch-up term by
Benhabib and Spiegel (1994). The reason behind this result is that every DGP
also includes dynamics that have implication on the coecient of the interaction
term and the estimation equations (1) and (2) cannot distinguish long run eects
from certain dynamics. The analysis of part (iv) could easily be generalized to
non-linear interaction terms which would only be a dierent way of modelling the
dynamics.
Proposition 1 considers the case corresponding to one country. The results of
proposition 1 carry over to cross sectional analysis and panel data methods, which
use data of several countries, because these modellings assume explicitly that the
time series are independent for every country. The only dierence is that these
methods require less observations in the time dimension and may allow the processes
to have dierent trends which does not matter with respect to the discussed iden-
tication problem. In other words in these modellings only the sampling process
is dierent but the data is produced by the data generating processes described in
proposition 1 and the results carry over. Both methods even reduce the information
how the process behaves over time which we need to identify growth patterns.
Therefore, proposition 1 shows that no coecient in cross-sectional analysis,
panel data methods and time series methods without cointegration testing is able
to make a statement about the determinant of long run growth, convergence of GDP
nor technological convergence. Thus, no coecient can be interpreted with respect
to the above growth aspects and therefore the results of these kinds of studies do
not provide any basis for policy analysis.
There are a few more general things to note. There is nothing wrong with using
growth regressions with respect to estimation issues, i.e. if model 1 is the data
generating process then running a growth regression is the correct way to estimate
the parameter. The problem is that of identication because model might also be
present and thus one cannot interpret the coecients. The identication problem of
proposition 1 exists for stationary and non-stationary variables in growth regression
whereas spurious regression is only a problem of non-stationary variables in growth
regression. All results of proposition 1 do not depend on how. The main mechanism
behind the results of proposition 1 is the property of stability, i.e. that the transition
dynamics in the level model have the same implication on the estimates as the
long run behavior of the growth model. These transition dynamics also drive the
implications of the level model w.r.t. ,convergence and technological catch-up
terms. By estimating conditional expectations as done in cross-sectional analysis,
panel data methods and time series methods without cointegration testing one
cannot distinguish e.g. between transition growth and long run growth, therefore
one cannot infer from the estimates what causes long run growth. The only think
that these kinds of studies might be able to do is to give a hint which variables are
not determinants of growth. But to do the statistical inference correctly the use of
standard t-values is wrong and therefore even excluding variables as determinants
of growth with these kinds of studies is not advisable.
8
4. SOLUTIONS TO THE IDENTIFICATION PROBLEM
As shown in section 3, cross-sectional analysis, panel data methods and time
series methods without cointegration testing do not provide information concerning
the determinants of long run growth and certain convergence issues. In this section
I want to investigate whether cointegration theory is able to identify determinants
of long run growth and further I discuss how to test convergence of GDP and
technological convergence. It turns out that the standard procedure in time series
econometrics using cointegration theory which was originally designed to solve the
spurious regression problematic and to uncover long run relationships avoids the
identication problem. Additionally, I will discuss possible solutions to identify
certain convergence issues.
As a doubtful reason to use cross-sectional analysis, panel data methods and
time series methods without cointegration testing some empirical studies on growth
argue that spurious regression might not be a problem and thus there is no need
to test for cointegration if the error term is white noise, and thus has no pattern
over time, which is an indication that there is no spurious regression. However,
also the level model implies that the error term is white noise, and has no pattern
over time, so this property does not help to identify the growth model from the
level model. To solve the identication problem one has to distinguish the long run
eects from transition eects which cannot be done by estimating some conditional
expectations because these do not distinguish between the two eects no matter
how long the time period is. However, long run eects can be be distinguished from
transition eects by using cointegration theory. I abstain from the problematic that
everything in the data set might be in transition which makes it dicult to test for
cointegration relationships.
I will now show that using cointegration theory to test for the determinants of
long run growth avoids the identication problem of proposition 1. Suppose there
exist linear functions /(r
|
), )(r
|
), which of course a researcher has to nd out to
investigate growth issues, then the following three cases are possible. First case:
All variables in dj
|
/(r
|
) are 1(1). One rst has to test if (dj
|
/(r
|
)) is 1(0).
If (dj
|
/(r
|
)) is not 1(0), i.e. there is no cointegration relationship, then r
|
does
not inuence long run growth. If (dj
|
/(r
|
)) is 1(0), i.e. there is a cointegration
relationship, then one can interpret the estimates with respect to long run growth.
The fact that all variables in dj
|
/(r
|
) are 1(1) together with (dj
|
/(r
|
)) is
1(0) implies that (j
|
)(r
|
)) is not 1(0), which excludes the level model. This
is because j
|
is 1(2) since dj
|
is 1(1) by assumption and therefore j
|
cannot form
a cointegration relationship with r
|
which is 1(1) by assumption. This is the key
step that distinguishes both models clearly and solves the identication problem.
Second case: dj
|
or r
|
is 1(1) but not both. Then it is possible to conclude that
r
|
does not inuence long run growth because both can never form a cointegration
relationship. Third case: All variables in dj
|
)(r
|
) are 1(0), which is unlikely.
Both models are consistent with this case. If j
|
is 1(0) one can test for the level
model and can interpret the coecients but it is not possible to reject the growth
model because it might be the case that some time series of r
|
are such that dj
|
is 1(0) but this is very unlikely. If j
|
is I(1) it is possible to reject the level model
and to test for the growth model and interpret the coecients. Therefore, in some
way non-stationary variables help to identify growth relationships. In summary,
in all relevant cases cointegration theory is able to identify growth determinants.
The requirement of cointegration is higher and able to identify the models because
9
it tests whether stochastic processes are co-moving or not. This requires more
structure in addition to some correlation between variables which may be due to
both, transitory eects or long run behavior. So, indeed more structure is tested
with cointegration tests.
Finally, I want to make some comments on the testing of convergence of GDP
and technological convergence as well as on the use of interaction terms in general.
The question of convergence of GDP can be investigated by using Markov chains as
suggested by Quah (1993). Markov chains could in principle also be applied to test
for technological convergence. It works the same way as for conditional convergence,
the main dierence is that one does not condition on initial income but on some
measure of technology. However, there seems not to be a general procedure for a
solution to the problem that interaction terms are doubtful in many cases. Many
studies using interaction terms do not investigate convergence issues. For these,
one has to check if the identication problem pointed out by section 3 is relevant
and if necessary, use other proxies that do not form a stable relationship with GDP
or some other endogenous variable.
5. APPLICATION TO HUMAN CAPITAL AND TECHNOLOGICAL
CONVERGENCE: LUCAS APPROACH VERSUS NELSON-PHELPS
APPROACH
Section 3 shows under which conditions the level model and the growth model
imply the same results in cross-sectional analysis, panel data methods and time
series methods without cointegration testing. Thus, section 3 shows under which
conditions it is not possible to identify growth processes from other relevant pat-
terns. However, in the literature there is not only an extensive discussion about the
determinants of growth but also about testing growth theories against each other,
especially the two central ideas in growth theory, the so called Lucas approach ver-
sus the Nelson-Phelps approach. Some researcher might argue that it is very likely
that one of these approaches explains growth since they are quite reasonable and
because growth must come from somewhere and it is a relevant thing to test growth
theories against each other. The sections 5.2 and 5.3 show that testing the two dif-
ferent growth approaches is not possible in the way it is done in the literature which
is reviewed in section 5.1. This does not follow immediately from section 3 because
both approaches have dierent implications and it might be the case that this is
testable in cross-sectional analysis, panel data methods and time series methods
without cointegration testing. The reason for the observational equivalence of both
approaches in the empirical studies reviewed in section 5.1 is that the model re-
duction from the theoretical growth models to the estimation equations is too large
such that the estimation equation of the Lucas approach becomes a level model
discussed in section 3.
First, I categorize growth models according the their answers to the following
questions with respect to human capital and technological convergence: Does the
human capital level determines long run growth? Does the accumulation of human
capital determines long run growth? Is there convergence in technology levels? Does
human capital speed up technological catch up? This classication is a slight ex-
tension of the one by Aghion and Howitt (1998, chapter 10) but for simplication
I keep their terminology and call the model classes Lucas approach and Nelson-
Phelps approach. Firstly, the Lucas-approach, initiated by Lucas (1988), is based
on the idea that growth is primarily driven by the accumulation of human capital.
10
It treats human capital like an ordinary input in the production function. The
Lucas-approach implies that the accumulation and not the level of human capital
determines long run growth, there is no convergence in technology levels and human
capital does not speed up technological catch up. Secondly, in the Nelson-Phelps
approach, which goes back to Nelson and Phelps (1966), growth is driven by the
stock of human capital, which determines the ability to innovate and imitate. The
Nelson-Phelps-approach implies that the level and not the accumulation of human
capital determines long run growth, there may be convergence in technology levels
and human capital speeds up technological catch up. Thus, both approaches are
exclusive in their answers to the four questions raised above and a necessary condi-
tion to be able to answer the four questions stated above is to distinguish the Lucas
approach from the Nelson-Phelps approach. In the view of section 3 the estimation
equation of the Nelson-Phelps approach is a special case of the growth model and
the estimation equation of the Lucas approach is a special case of the level model,
so here the level model is indeed a reasonable alternative model.
3
The following analysis illustrates the consequences of proposition 1 to the testing
of standard growth theory and four central questions of growth with focus on the
eects of education. It will be illustrated that the empirical studies used so far are
not be able to identify the Nelson-Phelps approach from the Lucas approach and
cannot give an answer to the four questions raised above. It is not a question of
the method of estimation, nor of the sample size or of data quality, but of whether
meaningful estimates can be obtained.
4
I use again time series econometrics tools
to provide a direct connection between theory and data generating process. I start
with a review of selected empirical studies.
5.1. Review of some Empirical Studies
Several empirical studies, Barro (1991), Mankiw, Romer and Weil (1992), Gem-
mell (1996), De la Fuente and Donenech (2006) and others have regressed GDP
growth on the growth of human capital or the stock of human capital where the
results vary depending on the data used. To test for technological convergence
so called technological catch-up terms are used by e.g. De la Fuente (2002) and
Benhabib and Spiegel (1994), Engelbrecht (2003), Desdoigts (2004) and Benhabib
and Spiegel (2005) introduce another technological catch-up term to decompose the
contribution of human capital into innovation and imitation. Under this speci-
cation they interpret the results as indicating technological convergence as well a
positive eect of the level of human capital as on technological catch-up.
Instead of giving a broad survey of empirical studies and their results I present
only a few studies to illustrate the main procedures which is proposed in the litera-
ture to test the Lucas- and the Nelson-Phelps approach. Mankiw, Romer and Weil
(1992) propose a Solow model augmented by human capital:
1
I|
= 1
o
I|
H
o
I|
(
|
1
I|
)
~
-
I|
, (3)
where 1
I|
is per capita income, 1
I|
is per capita physical capital, H
I|
is per capita
human capital,
|
is the level of technology, 1
I|
is labor and -
I|
is an error term
3
It should be noted here that also semiendogenous growth models are a special case of the level
model. So there are many models that favor the level model which makes it very reasonable to
take it as the alternative model.
4
Cannon (2000) has already questioned the use of the human capital level to distinguish some
specic semi-endogenous models from the Lucas-approach.
11
for country i at time t.
5
Taking log dierences of the production function and set
4
I|
constant for all countries and over time, where 4 denotes the mean growth
rate over the considered time period, yields the following estimation equation:
41
I|
= c + c 41
I|
+ , 4H
I|
+ 41
I|
.
In their empirical criticism of Mankiw, Romer and Weil (1992), Benhabib and
Spiegel (1994) point out that the countries that accumulated human capital most
quickly between 1965 and 1985 have not grown accordingly. Instead, growth ap-
pears to be related to the initial level of human capital. This nding casts doubt
on the augmented Solow model. Benhabib and Spiegel (1994) suggest that, at least
when explaining the historical experience of developing countries, one should turn
to models in which technology diers across countries, and human capital promotes
catch-up. They found out that past educational attainment remains essentially un-
correlated with growth if one uses the augmented Solow model of Mankiw, Romer
and Weil (1992), in which human capital is nothing but an ordinary input in the
aggregate production function. The eect of past educational attainment levels on
current growth rates becomes signicantly positive if one follows Nelson and Phelps
(1966) in assuming that growth is positively aected by the rate of technological
innovations and also by the rate of adoption or existing innovations and that the
stock of human capital aects both of these rates. Indeed, although the correla-
tion coecient is essentially zero or even negative in the former case, it becomes
positively signicant in the latter case. Benhabib and Spiegel (1994) state that,
especially the more structural specication of their version of the Nelson-Phelps
approach, provides additional support to the endogenous-growth approach. It sug-
gests that the divergence in growth rates across countries could be due not so much
to dierences in the rates of accumulation of human capital, as suggested by Lucas
(1988), as to dierences in the stocks of human capital, which in turn will aect the
various countries ability to innovate and to catch-up with more advanced countries
technologies.
To become more concrete, the production function of the catch-up model spec-
ied by Benhabib and Spiegel (1994) is:
1
I|
=
I|
(H
I|
)1
o
I|
1
o
I|
-
I|
, (4)
where in the more structural specication the growth in the of the technology
I|
depends in some way on H
I|
, specied as:
4
I|
= c + qH
I|1
+ 01
I|1
, (5)
where c is some constant, which represents the exogenous long run growth trend,
qH
I|
represents endogenous technological progress by domestic innovations and
1
I|
=
1
it
Y
t;max
Y
it
is the technological catch-up term, where 1
|,max
is the per capita
income of the technological leader. Taking log dierences of the production function
and inserting equation (5) yields the estimation equation of Benhabib and Spiegel
(1994) :
41
I|
= c + qH
I|1
+ c 41
I|
+ , 41
I|
+ 01
I|1
.
In other studies by Barro (1997), Barro and Sala-i-Martin (2004) and Engelbrecht
(2003) human capital is allowed to be an ordinary input in the aggregate production
5
In the following, I will always refer to the quite abstract term "human capital" which of course
can be measured in several ways and is not something unique. However, the kind of proxy is not
important for the analysis of this paper, although the empirical results depend on the data choice.
12
function but also a determinant of the ability to innovate and imitate. Engelbrecht
(2003) uses also the more structural specication of Benhabib and Spiegel (1994)
and estimates the following equation:
41
I|
= c + qH
I|1
+ 4H
I|
+ c 41
I|
+ , 41
I|
+ 01
I|1
.
The results in Barro and Sala-i-Martin (2004) and Barro (1997) do support the
Nelson-Phelps approach but are not convincing with respect to the Lucas approach.
Engelbrecht (2003) nds both approaches applicable to the data.
In a recent study Desdoigts (2004) species a general convergence equation that
incorporates both the Lucas- and the Nelson-Phelps approach. Growth is thus,
in principle, determined by both the accumulation of human and physical capital
and by technological spillovers, where the capacity to absorb these spillovers is
determined by either human capital stocks or investment rates. Using this unied
framework Desdoigts (2004) estimates growth equations and let the data choose
between the various nested models. Desdoigts nds that, as far as education is
concerned, the Mankiw-Romer-Weil (1992) specication can be improved upon if
a countrys absorption capacity is proxied by human capital measures. Moreover,
the explanatory power of the model improves substantially when the technology
gap term is interacted with a countrys share of equipment investment in output.
Finally, Desdoigts proposes an additional way to compare both models: taking 1960
as the initial point, he calculates the world distribution of incomes in 1985 using
the two estimated models, and compares it to the actual distribution of incomes in
1985.
Benhabib and Spiegel (2005) try to estimate the functional form of technology
diusion process. They use an empirical specication that nests two forms, the
exponential and the logistic one, of technology diusion in a model where total
factor productivity growth depends on initial backwardness relative to the stock of
potential world knowledge, proxied in the model as the total factor productivity
level of the leader country. Their results favor a logistic form of technology diusion.
5.2. Implications of the Nelson-Phelps Approach
Following Aghion and Howitt (1998) the implications of the (extended) Nelson-
Phelps approach are as follows. Firstly, the human capital stock has a positive
impact on the steady state growth rate of technology. Secondly, a countrys tech-
nology growth may depend positively on the technological gap, the distance of the
domestic technology level to the technology frontier, because imitation is easier far
away from the technology frontier. Thirdly, human capital speeds up technological
catch up, i.e. imitation depends on the the technological gap and the human capi-
tal in the country together. Fourthly, technology diusion takes time, so formally,
4
I|
should depend positively on H
I|
for some , 1. To formalize the second
implication it is necessary to specify the technological gap and the relationship
between technology diusion and technological gap. A standard way to proxy the
technological gap is to use the dierences in total factor productivities, de la Fuente
(2002):
/
I|1
a
max
|1
a
I|1
=
_
j
max
|1

_
c/
max
|1
+ |
max
|1
__
(6)
(j
I|1
(c/
I|1
+ |
I|1
) .
It is then normally in the literature assumed that technology growth depends lin-
early on /
I|1
. To formalize the third implication it is standard in the literature to
13
use an interaction term of the form:
/
I|1
/
I|1
. (7)
The fourth implication of the Nelson-Phelps approach, which concerns the transi-
tion dynamics due to technology diusion, implies that 4
I|
depends positively on
4H
I|
for some , 1 and on /
I|
. Most studies then assume a Cobb-Douglas
specication:
1
I|
=
I|
1
o
I|
1
~
I|
-
I|
, (8)
where c, 0 and -
I|
is an error term which is white noise. It should be no-
ticed that economic theory does not specify
I|
as a function directly, it species a
dierence equation to which
I|
is the solution. The existence of a production func-
tion implies a stable long run relationship. Thus, log GDP and the log production
factors form a cointegration relationship, which means a linear combination of log
GDP and the log production factors is weakly stationary and deviations from the
long run relationship will decrease over time, i.e. equation (8) implies that ln-
I|
given by
ln-
I|
= j
I|
(a
I|
+ c/
I|
+ |
I|
) , (9)
is weakly stationary, where small type from now on indicate the logarithm of a vari-
able. Equation (9) is the cointegration relationship. As shown by Granger (1983)
(Engle and Granger (1987)) the cointegration relationship can be represented as an
error correction model, from now on simply ECM. This result is sometimes referred
to Grangers representation theorem. From there, the Nelson-Phelps approach with
a production function given by (8) implies the following autoregressive distributed
lag model as the data generating process:
41
I|
= 4
I|
+ c
0
41
I|
+
0
41
I|
(10)
+c (j
I|1
(a
I|1
+ c/
I|1
+ |
I|1
)) + n
I|
,
where c
0
,
0
0 and stability, i.e. cointegration, implies c < 0. To account for
possible additional short-run dynamics the short run parameters in general dier
from the long run parameters. This is important to stress because otherwise it
might appear that there are exact parameter implications which could be tested.
This is only a casual point since for the results of this paper only the signs of the
parameters are important. If the data generating process is exactly based on (8) and
(9) one have the special case c = c
0
, , = ,
0
, =
0
and c = 1. Combining the four
implications from above and allowing for the possibility of exogenous technological
progress, c
|
, the Nelson-Phelps approach implies:
4
I|
= c
|
+ q
0
/
I|1
+

=0
0

4H
I|
+ q
00
/
I|
+ c
0
/
I|1
+ c
00
/
I|1
/
I|1
, (11)
where 0

0 for all ,, c
0
0, c
00
0. Substituting (11) into (10) yields the data
generating process implied by the Nelson-Phelps approach expressed in variables
that could be observed or proxied:
41
I|
= c
|
+ q
0
/
I|1
+

=0
0

4H
I|
+ q
00
/
I|
+ c
0
41
I|
(12)
+
0
41
I|
+ c
0
/
I|1
+ c
00
/
I|1
/
I|1
+c (j
I|1
(a
I|1
+ c/
I|1
+ |
I|1
)) + n
|
.
14
After rearranging equation (12) one can see directly the parameter implications:
41
I|
= c
|
+ q
0
/
I|1
+

=0
0

4H
I|
+ q
00
/
I|
+ c
0
41
I|
(13)
+
0
41
I|
+ (c
0
c)j
I|1
+ c
0
/
I|1
+ c
00
/
I|1
/
I|1
c (a
I|1
+ c/
I|1
+ |
I|1
) + n
|
.
The Nelson-Phelps approach implies a positive eect of /
I|1
, /
I|1
and /
I|1
/
I|1
on 41
I|
, as expected from economic theory, but also a negative impact of j
I|1
as
well as a positive impact of 4H
I|
on 41
I|
.
5.3. Implications of the Lucas Approach
According to Aghion and Howitt (1998) the Lucas approaches implies that hu-
man capital is an ordinary production factor and a Cobb-Douglas specication is
assumed in the literature:
1
I|
=
|
1
o
I|
H
o
I|
1
~
I|
-
I|
, (14)
where c, ,, 0 and -
I|
is an error term. The existence of the production function
implies that ln-
I|
given by
ln-
I|
= j
I|
(a
|
+ c/
I|
+ ,/
I|
+ |
I|
) , (15)
is weakly stationary. Equation (15) is the cointegration relationship. I can use the
same argumentation as before and apply Grangers representation theorem to the
Lucas approach:
41
I|
= 4
|
+ c
0
41
I|
+ ,
0
4H
I|
+
0
41
I|
(16)
+c (j
I|1
(a
|1
+ c/
I|1
+ ,/
I|1
+ |
I|1
)) + n
I|
,
where n
I|
is an error term, 4
|
is exogenously given by c
|
and c
0
, ,
0
,
0
0 as
well as stability, i.e. cointegration, implies c < 0. Rearranging of equation (16) and
substituting 4
|
= c
|
yields the data generating process of the Lucas approach
expressed in variables that could be observed or proxied:
41
I|
= c
|
ca
|1
+ c
0
41
I|
+ ,
0
4H
I|
+
0
41
I|
(17)
+cj
I|1
cc/
I|1
c,/
I|1
c|
I|1
+ n
|
.
To account for possible additional short-run dynamics the short run parameters in
general dier from the long run parameters. This is important to stress because
otherwise it might appear that there are exact parameter implications which could
be tested. This is only a casual point since for the results of this paper only the signs
of the parameters are important. If the data generating process is exactly based on
(14) one have the special case c = c
0
, , = ,
0
, =
0
and c = 1. Thus, the Lucas
model implies a positive eect of 4H
I|
on 41
I|
, as expected from economic theory,
but also a negative impact of j
I|1
, as also shown by Quah (1993), and a positive
impact of /
I|1
on 41
I|
. It is claimed in the literature that the Lucas approach
implies a zero eect of a technological catch-up term as well of an interaction
term of human capital and the technological gap on economic growth. However,
both interaction terms also represent a long run relationship directly linked to the
production function and therefore, also the Lucas approach with some reasonable
extended dynamics implies a positive eect of a technological catch-up term as well
as of an interaction term of human capital and technological gap on 41
I|
.
15
5.4. Results and Further Discussions
This section shows that the Nelson-Phelps and the Lucas approach are obser-
vationally equivalent in the studies used to test both approaches. From there, it is
not possible to interpret the results from these studies with respect to the level of
human capital, the change of human capital, a technological catch-up term or some
interaction term of human capital and a technological catch-up term. The main
mechanism behind this result is that the empirical studies reviewed in section 5.1
are not be able to disentangle long run properties from transitional dynamics.
The time series econometrics perspective in the previous section makes it visible
that technological catch-up terms simply model some dynamics but one cannot infer
what drives these dynamics, it can be anything, i.e. one cannot claim that some
functional form of dynamics is due to technology diusion. With this in mind there
is no reason to believe that other technological catch-up terms are able to provide
information about technology diusion. Thus, suggestions like that of Benhabib
and Spiegel (1994) to use an interaction term of the form
1
it1
Y
t1;max
Y
it1
, which is a
strictly increasing transformation of (/
I|1
j
I|1
) since in the cross section 1
|,max
is a constant, is nothing else then modeling the functional form of the dynamics
dierently and also bases on a long run equilibrium concept. Therefore, Benhabib
and Spiegel (1994) simply test for some kind of dynamics by using their catch-up
term but not for the Nelson-Phelps approach. For this catch-up term a positive
catch-up coecient represents a tendency back to the long run equilibrium which
may be due to anything. Since also Desdoigts (2004) follows the specication
of Benhabib and Spiegel (1994) he simply compares a more general model, by
allowing additionally dynamics in the form of the catch-up term, with a simpler
one which not surprisingly ts the data better. Also past changes of human capital
cannot distinguish both approaches because a Lucas-approach with more complex
dynamics, i.e. in log of equation (14) might be an MA-process, implies a positive
eect of past human capital changes. A well known example is experience and on-
the-job training which might be ltered out with the help of micro data but other
dynamics might not.
Therefore, with more complex dynamics both approaches have exactly the same
implications for the coecient set of the estimation equation in the studies used to
test both approaches and thus these studies cannot infer whether human capital
is a production factor or a factor that determines innovation and imitation but to
distinguish these two mechanisms is of central importance in growth theory. The
basic reason behind these results is that these studies cannot distinguish long run
eects from transitory eects. Thus, e.g. from a positive coecient of the human
capital level one cannot infer that human capital has a positive impact on growth
since also stability in a model with human capital as a production factor implies
also a positive coecient of human capital level. The argumentation in sections
5.2 and 5.3 does not depend on the common growth trend restriction. One could
simply add an individual eect c
I
into the data generating process and all the al-
gebra works in the same way. The argumentation in section 5.2 and 5.3 does also
not depend on the Cobb-Douglas production function. The analysis could be easily
extended to more general production functions which are then linearly approxi-
mated in the regression. A potential solution could be to impose more structure
which means to extend the theoretical models to make them more dierent, so that
maybe some of the new features can be used to identify the approach. The prin-
ciple problem is that also the other approach could be equipped with some more
16
structure and one has to argue why only one and not the other approach (or other
mechanisms) do imply these extra implications. An example is a recent line of
the Nelson-Phelps approach that has dierent implications for primary, secondary
and tertiary education by Vanderbussche, Aghion and Meghir (2004). But it can
also be argued that a model of the Lucas class may have the same implications
concerning the dierent types of human capital and the analysis from sections 5.2
and 5.3 works in the same way since technological catch-up cannot be distinguished
from other dynamics. However, even if the more structure, without cointegration
tests, can identify the Lucas approach from the Nelson-Phelps approach still one
cannot identify the models from an alternative level model as shown in section 3.
To identify the eects of human capital on economic growth as well as to investigate
the dierent convergence issues one can use the methodologies from section 4.
6. CONCLUSIONS
The main issue of this paper is to close the gap of neglecting the identication
issue in the growth econometrics literature, which focuses exclusively on estimation
and data issues. Thus, this paper concerns with the question whether in fact growth
mechanisms can be identied from other phenomena. By doing so the paper shows
that cross-sectional analysis, panel data methods and time series methods without
using cointegration testing do not allow to draw conclusions with respect to long run
growth determinants, convergence of GDP and technological convergence. Section
3 did that, in detail by showing that other reasonable data generating processes
in which growth is exogenously determined imply the same on the data as data
generating processes with endogenous growth. Additionally, section 5 shows that
the the empirical studies that tend to test the Lucas approach versus the Nelson-
Phelps approach are wrong because there are the same identication problems as
in section 3.
Section 4 shows that the alternative methodology, cointegration theory, can
clearly identify long run growth eects. Therefore, cointegration methods have to
be used in growth econometrics to make a series statement about long run growth.
Thus, all the results from studies that do not use cointegration theory cannot be
interpreted and least of all the quantitative values of the estimates. The basic rea-
son why it is not possible to identify growth eects and to interpret any coecient
in cross-sectional analysis, panel data methods and time series methods without
using cointegration testing is that the extensive model reduction from the theoret-
ical growth model to the estimation equation and thus to much structure is lost
during this reduction. This extensive model reduction also erases all information
concerning inter-country relationships like technology diusion. Thus, empirical
studies should use a Panel-cointegration framework. Another consequence is that
the coecients cannot be interpreted as causal eects with respect to long run
growth or convergence. So, interpretations like "A 1 percentage point increase in
primary (secondary) school enrolment rates is associated with a 2.5 (3.0) percentage
points increase in per capita GDP growth rate" by Barro (1991) are not reliable.
However, the results of this paper should not be seen as discouraging, it should
direct growth econometrics to use cointegration theory. Since cointegration tests
for panel data have been improved enormously in the last decade and are still a
very active research eld in econometrics together with the steadily improving and
extending macro panel data sets open up the need for a large number of interest-
ing studies to do in growth econometrics. With respect to convergence issues this
17
paper conrms the result of Quah (1993), the non-reliability of the concept of ,-
convergence. However, this paper is also able to show that cross-sectional analysis,
panel data methods and time series methods without using cointegration testing
do not allow to draw conclusions with respect to other convergence issues as tech-
nological convergence and additionally that any use of interaction terms is highly
questionable.
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