1

Education, financial markets and economic growth

Lucas Papademos

European Central Bank

35th Economics Conference

on “Human Capital and Economic Growth”

Österreichische Nationalbank

Vienna, 21 May

2

Outline

I. Education and economic growth

II. Education, financial development and economic

performance

III. Policy implications

3

Education and economic growth: conceptual framework

Aggregate Output = f [Capital (physical and human),

Employment, Technological Progress]

Growth of per capita aggregate output:

— Investment

— Human capital accumulation

— Labour utilisation growth

— Total factor productivity growth

4

Determinants of human capital

• Education

– quantity of formal education (average years of schooling)

– quality of education

• On-the-job training and learning, cognitive skills

• Health status (e.g. life expectancy)

5

Direct effects of education on economic growth (I)

• Education as a component of human capital and a

factor of production (extended neoclassical growth theory)

• Macroeconomic evidence:

– Affluent countries are relatively more richly endowed with

human capital;

– Fastest growing economies have also experienced rapid

human capital accumulation;

– Recent research based on improved statistics confirms: better

schooling and faster growth go together – independently of

other relevant factors of economic development (e.g. physical

capital accumulation, country-specific factors).

6

Income and education level

High income OECD countries

AUS

BEL

CANCHE

DNK

ESP

FIN

FRA GBR

GRC

IRL

ISL

ITA JPN

KOR

NLD

NOR

NZL

PRT

SWE

USA

1000

020

000

3000

040

000

5000

0

Rea

l per

cap

ita G

DP

in 2

000

(in U

S do

llars

)

4 6 8 10 12

Source: Data from Barro-Lee (2001) and Penn World Tables; ECB calculations

Average Years of Schooling

7

Human capital accumulation and income growth

High income OECD countries

(1960 – 2000)

All countries

(1960 – 2000)

Argentina

Australia

AustriaBelgium

Bolivia

Brazil

EcuadorChile

Cameroon

Costa Rica

Denmark

Spain

FinlandFrance

UK

Ghana Greece

Guatemala

Hong Kong

Indonesia

India

Ireland

Iran

Iceland

IsraelItaly

Jamaica

Jordan

Japan

Kenya

South Korea

Sri Lanka

Lesotho

Mexico

Mali

Mozambique

Mauritius

Malawi

Malaysia

NigerNicaragua

Netherlands

Norway

NepalNew Zealand

Pakistan

Peru

Philippines

Portugal

Paraguay

Senegal

Singapore

El Salvador

SwedenSyria

Togo

Thailand

Turkey

Taiwan

Uganda

US

Venezuela

South Africa

Zambia

-.02

0.0

2.0

4.0

6

Ave

rage

ann

ual r

eal p

er c

apita

gro

wth

rat

e

0 .05 .1 .15 .2Annual Change in Average Years of Schooling

Australia

Austria

Belgium

Canada

Switzerland

Denmark

Spain

FinlandFrance

United Kingdom

Greece

Ireland

IcelandItaly

Japan

South Korea

Netherlands

Norway

New Zealand

Portugal

Sweden

United States

.01

.02

.03

.04

.05

.06

Ave

rage

ann

ual r

eal p

er c

apita

gro

wth

rat

e

0 .05 .1 .15 .2Annual Change in Average Years of Schooling

Source: Data from Barro-Lee (2001) and Penn World Tables; ECB calculations

8

Direct effects of education on economic growth (II)

• Education as an input of production

• Microeconomic evidence and causality assessment:

– More years of formal schooling lead to higher wages;

– Private returns on education estimated to be between 6.5%-

9.0%: An additional year of schooling leads to 7.5% higher

income on average over working life;

– Social returns to schooling are most likely larger due to

human capital externalities, i.e. knowledge spillovers from

more educated workers to less educated ones;

– Causality established by employing innovative approaches

and techniques (e.g. studies of twins).

9

Labour force quality and GDP growth

Quality of education is also highly relevant, notably:

– quality of teachers (education level; graduate studies; training)

– teacher-pupil ratios

– public spending in education

– Internationally standardised tests (e.g. in math and science)

Macroeconomic evidence:

– Differences in education quality explain more of the growth

variations across countries than quantity measures (such as

average years of schooling; share of college graduates, etc.);

– Higher quality of the labour force also contributes to labour

productivity growth (evidence from the euro area).

10

Indirect effects of education on growth (I)

Education also influences economic growth indirectly

through its impact on other growth determinants, such as:

• labour force participation

• overall labour utilisation

• total factor productivity

• skill-bias of new technologies

• capital-skill complementarities

11

Indirect effects of education on growth (II)

Education positively influences labour force participation

and labour utilisation:

– the higher the education level, the higher the participation in

the labour force;

– more educated workers are more likely to be employed

(e.g. in 2006, the employment rate in the euro area for

university graduates was 83.5% compared to 57.2% for less

educated persons);

– education decreases duration of unemployment.

12

Education and labour utilisation

Education total females total females total femalesbelow secondary

total employment 34197 13235 32561 12810unemployed 5348 2619 3751 1911inactive 20445 16538 15478 11737participation ratio (in %) 65.9 48.9 70.1 55.6 4.2 6.7

above secondarytotal employment 43407 18084 52171 23288unemployed 4220 2247 4158 2109inactive 10339 7583 10485 7497participation ratio (in %) 82.2 72.8 84.3 77.2 2.1 4.4

tertiarytotal employment 21581 8893 31681 14933unemployed 2619 1532 1911 1592inactive 2463 1730 3492 2492participation ratio (in %) 90.8 85.8 90.6 86.9 -0.2 1.1

Source: Eurostat, Labour Force Survey; data for 2006 is up to 2006 Q3

1996 2006 Diff. 1996-2006

Euro area labour force participation(in thousands of persons in the age group 25 to 59)

13

Indirect effects of education on growth (III)

Education supports innovation and the rapid adoption of

new technologies, especially in view of the skill-bias of

modern technology:

– countries with high human capital endowments use existing

technologies better and innovate more;

– education, research & development and entrepreneurial activity

are especially important for advanced economies (like the euro

area) that are closer to the technological frontier;

– technological advances (e.g. ICT) in the 1970s-1990s have been

biased towards highly skilled labour, i.e. favoured educated workers;

– human capital is particularly important for the adoption of

technologies that augment existing skills.

14

Education and the skill-bias of technological change (1)

Education is especially important for the growth of knowledge-intensive

sectors, like pharmaceuticals or computers/office equipment.

311

313

314

321

322323324

331 332

341

342

352

353

354

355356

361

362369

371 372381

382383

384

385

390

3211

3411

3511

3513

3522 3825

3832

3841 3843

1011

1213

14In

dust

ry H

C In

tens

ity H

CIN

T(S

CH

)

-.01 -.005 0 .005 .01Estimated Coefficient on Initial Schooling Level (in 1980)

Source: Ciccone and Papaioannou (2005) and UNIDO

Industry Skill Intensity

High-Skill

3822: Drugs and pharmaceuticals

3825: Office and computing

353: Petroleum refineries

3511: Chemicals

342: Printing and publishing

Low-Skill

321:Textile

3211: Spinning

323: Leather

322: Apparel

324: Footwear

Ave

rage

yea

rs o

f sc

ho

olin

g at

th

e in

du

stry

leve

l

15

Education and the skill-bias of technological change (1I)

Educated societies (i.e. with better quality education) were more

successful in adopting knowledge-intensive new technologies during

the 1980s/1990s.

Source: Ciccone and Papaioannou (2005) and UNIDO

311

313

314

321

322323324

331 332

341

342351

353

354

355356

362369

371 372 381

382383

384

385

390

3211

3411

3511

3513

3522 3825

3832

3841 3843

1011

1213

14In

dust

ry H

C In

tens

ity H

CIN

T(SC

H)

-.05 0 .05 .1 .15 .2Estimated Coefficient on Labor Force Quality (LFQUAL2)

Ave

rage

yea

rs o

f sc

ho

olin

g at

th

e in

du

stry

leve

l

Industry Skill Intensity

High-Skill

3822: Drugs and pharmaceuticals

3825: Office and computing

353: Petroleum refineries

3511: Chemicals

342: Printing and publishing

Low-Skill

321:Textile

3211: Spinning

323: Leather

322: Apparel

324: Footwear

16

Indirect effects of education on growth (IV)

Education can foster investment in physical capital due

to capital-skill complementarities:

• Physical capital is relatively more important for skill-

intensive sectors and tasks;

• Effects of computerisation in the United States:

– Capital invested in information and communication

technologies (ICT) complements educated workers and

substitutes low-skilled employees;

– ICT capital complements cognitive tasks and substitutes

manual tasks.

17

The financial system and economic growth

Financial sector development and efficiency can foster

economic growth in various ways:

1. Positive impact on investment and growth:

– see e.g. cross-country studies on effects of financial liberalisation;

and banking deregulation: 0.5-1.0% increase in investment,

reduction of the cost of capital by 100bp;

2. Positive impact on productivity (efficiency of production):

– sustained increase in total factor productivity;

– especially beneficial for industries which for technological

reasons depend on external finance;

18

Financial development and capital reallocation

Well-developed financial systems support Schumpeterian

“creative destruction”:

• in countries with deep capital markets and efficient financial

intermediaries, capital is reallocated more rapidly across firms

and sectors, thus increasing the economy’s total productivity

growth;

• in Europe especially, financial development and market

integration across borders is important to facilitate capital

reallocation, promote innovation and strengthen competition

(see recent ECB research).

19

Financial development and capital reallocation

Positive relationship between the efficiency of capital reallocation (i.e. fast response to new investment opportunities) and the size of capital markets

Source: Ciccone and Papaioannou (2007); UNIDO; based on Wurgler (2000)

All countries High-income countries

AUS

AUTBEL

BGD

BOL

BRB

CAN

CHL

CMR COL

CYP

DEU (W)

DNK

ECU EGY

ESP

ETH

FIN

FJI

FRA GBR

GRC

GTMHKG

IDN

IND

IRL

IRN

ISR

ITA

JOR

JPN

KEN

KOR

KWT

LBY

MAR

MEX

MLTMWI

MYS

NGA

NLDNOR

NZL

PAK

PER

PHL

PRTSGP

SLV

SWE

SWZ

TUNTUR

TZA

URY

USA

VEN

ZMB

ZWE

00.

51

Inve

stm

ent-

Val

ue A

dded

Gro

wth

Ela

stic

ity

0 0.5 1 1.5Financial Development

Investment-Growth elasticity estimated: controlling for country fixed-effects

AUS

AUTBEL

BRB

CAN

CYP

GER

DNK

ESP

FIN

FRA GBR

GRC

HKGIRL

ISR

ITAJPN

KOR

KWT

MLT

NLDNOR

NZL

PRTSGP

SWEUSA

00.

20.

40.

60.

81

Inve

stm

ent-

Val

ue A

dded

Gro

wth

Ela

stic

ity

0.4 0.6 0.8 1 1.2 1.4Financial Development

Investment-Growth elasticity estimated: controlling for country fixed-effects

20

Financial literacy and education

Financial literacy is important to reap the full benefits of

financial innovation:

• essential for proper retirement planning, diversification of financial risk, participation in stock markets;

• especially in context of ageing populations and shift from public to privately-funded pension schemes.

Pervasive financial illiteracy even in advanced economies:

• in particular among less educated, lower-income groups;

• programmes to enhance financial literacy are needed and can be successful;

• best means to increase the level of financial literacy is to invest in education.

21

Financial integration and development and monetary policy

Improved functioning of monetary union through the

development and integration of Europe’s financial system:

• deep and integrated financial markets facilitate the transmission

of the single monetary policy across the euro area is a smooth

and effective manner;

• better risk-sharing contributes to a more balanced systemic

response to asymmetric shocks and a greater synchronisation of

business cycles.

Overall, financial integration and development will help reduce the volatility of output and employment across the euro area.

22

Education, productivity and monetary policy

Education, via its positive effects on productivity growth

and labour utilisation, influences the environment within

which monetary policy operates:

• raises the growth potential of the economy, thus increasing the

“speed limit” at which the economy can grow in a sustained

manner that is consistent with price stability;

• higher potential growth in the euro area is especially important in

view of ageing populations;

• fosters labour market adaptability and efficiency, as well as

mobility (across sectors, firms and borders) and thus facilitates

the functioning of an important adjustment mechanism, especially

in a monetary union.