Can a country grow faster by saving more? The relationship between saving and growth plays a central role in the neoclassical growth models of Solow (1956) and Cass (1965), Koopmans (1965) and Ramsey (1928). It also features prominently in the AK models starting with Harrod (1939) and Domar (1946), and then more recently by Frankel (1962) and Romer (1986). All these growth models emphasizing capital accumulation as the source of growth, tell us indeed that higher saving rates should foster growth because higher savings imply higher capital investment. But these are closed economy models, and extending them to the case of small open economies with international capital markets would eliminate the effect of local saving on growth.
More recent models emphasizing innovation as the main engine of growth (Romer, 1990; and Aghion and Howitt, 1992), either ignore capital accumulation, in which case there is no role for saving even in a closed economy, or they emphasize the complementarity between capital accumulation and innovation (Howitt and Aghion, 1998), in which case the equilibrium growth rate depends positively upon domestic saving. But even in the latter case the theory does not apply to the case of an open economy with capital mobility.
Thus existing growth theories appear to have little to say about the effect of saving on growth in the global economy, and yet this question is raised recurrently by policy makers, for example when discussing the contrast between the high growth in East Asia and the slow growth in Latin America, two middle income regions with comparable levels of per capita GDP in the 1960s. This contrast could hardly be explained by differences in property right protection or in financial development. Moreover, most Latin American countries have subscribed to the so-called Washington consensus policies (namely, the idea of combining macroeconomic stability, trade and financial liberalization, and privatization), but so far to little avail. On the other hand, if one looks at saving rates in the two regions, we do see a sizeable difference, with East Asian rates being much higher than Latin American rates. Specifically, for the East Asian countries in the sample described in Section 4 below the average private saving rate from 1960 to 2000 was 25%, whereas for Latin American countries in the same sample the average saving rate was only 14%.
In this paper, we develop a theory of local saving and growth in an open economy with domestic and foreign investors. In our model, growth in relatively poor countries results mainly from innovations that allow local sectors to catch up with the current frontier technology. But catching up with the frontier in any sector requires the involvement of a foreign investor, who is familiar with the frontier technology, together with effort on the part of a local bank, who can directly monitor local projects to which the technology must be adapted. Local saving matters for innovation, and therefore growth, because it allows the domestic bank to cofinance projects and thus to attract foreign investment; more specifically, cofinancing encourages local bank monitoring effort by giving the local bank a stake that it will lose if the project fails for want of effort on its part, and therefore raises the expected rate of return to the foreign investor.
The theory also delivers predictions on when domestic saving should matter most for economic growth. In particular it focuses on the interaction between saving and the country’s distance to the technological frontier. The main prediction of our model is that saving affects growth positively in those countries that are not too close to the technological frontier, but does not affect it at all in countries that are close to the frontier.
The reason is that in a relatively poor country higher saving increases the number of projects that can be cofinanced by the local bank on terms that give the bank an incentive to monitor while guaranteeing a sufficient share of profits for a foreign investor to participate. However, in countries sufficiently close to the frontier the local firms are more likely themselves to be familiar with the frontier technology, and therefore do not need to attract foreign investment in order to undertake an innovation project; in such a case every ex ante profitable innovation project will be undertaken regardless of the level of domestic saving because there is no need for cofinance when there is just one agent participating in the project.
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