Today’s column continues the discussion on absorption capacity. This is on my list of top-ten development challenges, which spending of Guyana’s expected significant Government Take from first oil and first gas will have to contend with, starting 2020. Thus far, I have identified two broad approaches to the treatment of absorption capacity and, more importantly, its measurement. Measurement is a crucial consideration, if objective indicators of Guyana’s absorption capacity are to be established. This removes sole reliance on inferential reasoning and subjective indicators.
Both of the approaches mentioned, use the productivity of investment spending as a suitable proxy for absorptive capacity. Based on this, one line of analysis (as indicated last week) argues that the more productive is capital investment, the greater is its rate of return on investments. And, the reverse occurs, as the productivity of capital investment declines. Consequently, the greater the rate of return on capital investment, the better is the state of absorptive capacity in the economy. And, therefore, when absorptive capacity is more constrained, the lower is the rate of return and thus productivity of capital investment.
As pointed out in the last column, the other line of analysis is located in the macroeconomics of the circular flow of income. This stresses the indirect causal connection of increased capital investment to output and economic growth. Here, the effect of increased petroleum revenues is similar to that of any other autonomous injection of spending into the circular flow of income in an economy; for example, foreign direct investment (FDI) flows into Guyana’s economy; increased external assistance (foreign aid); or a significant improvement in the terms of trade.
This line of analysis indicates the following: 1) productive investment in an economy with good absorptive capacity always yields an increase in real output; 2) any increase in real output equals an increase in real national income (or growth); and 3) this increased growth directly and indirectly affects all components of a country’s national accounts.
A few general considerations arise from the above analysis. One is that by using the productivity of capital investment as a proxy for absorptive capacity, we are in effect claiming that capital availability is a primary constraint on an economy’s capacity to grow. I am indeed explicitly in support of this view. However, I am not claiming further that capital availability is the sole constraint to the growth of Guyana’s economy. However, it is certainly one of the most pressing; even with the several others around. The consequence of this is I am willing to concede that in some manner or form I am also claiming absorptive capacity speaks to the ability of Guyana’s economy to accommodate successfully, substantial new investment arising from increased petroleum revenues.
This acknowledgement of capital availability as a primary constraint on the functioning of Guyana’s economy, therefore, does not contradict the existence of several other constraints. But, when carefully examined, most of the others are found to be themselves driven by lack of capital and its key accompanying element, lack of technological capability. Among the key constraining factors facing Guyana’s budding petroleum sector are: market size; geostrategic (the Venezuela border claim); organizational; institutional; infrastructure; training and skills; human capital; research and development; technology; and, socio-political.
Satisfactory absorptive capacity further signifies that Government Take can be spent without any pronounced signs of economic inefficiency and/or adverse economic effects flowing from Government spending of earned petroleum revenues. In other words, it reveals whether there are or not signs of likely diminishing returns to spending Government Take.
In this regard, there have been several efforts to construct indexes to portray absorptive capacity in developing countries. One such index is the Composite Index of Absorptive Capacity developed by Feeny and De Silva (2012). This index relies on two variables to measure absorptive capacity. These are capital (both human and infrastructure) and governance (policy and institutional). Other models concentrate on the constituent elements of the above like: macroeconomic constraints; technical constraints; social and cultural constraints, as well as specific sector constraints a particular country may have.
Given all that we know, it is clear that absorptive capacity varies across countries at different times and indeed at different phases of their development profile. One approach that is explicitly based on recognition of this is what may be termed output gap analysis. Simply put, this approach posits that for any economy the output gap or the GDP gap “is the difference between actual output or GDP and its potential GDP.” If potential output is designated as Y* and actual output as simply Y, then the output gap is expressed as a percentage of potential GDP. This is the way this notion is expressed in its simplest form, in all writings on the topic. If the difference between the two is a positive number, then potential output exceeds actual output. If there is zero difference then actual output is matching that of the economy’s potential, and all is as well as it can be. If, however, potential output exceeds actual output there is scope for more growth.
A persistent large output gap shows there is underutilized capacity in the economy. These can be brought into production if there is increased public spending. This yields more jobs, more spending on consumption goods, and also perhaps more private investment spending. Since actual output or GDP is what is measured routinely by statistical services in all countries (including Guyana), what then does potential output or potential GDP mean?
Formally, economists define this as “the level of output that an economy can produce at a constant inflation rate.” So that although an economy can temporarily exceed this rate, it does so by causing rising inflation. This definition comes from the OECD’s Glossary of Economic terms. Its formal elements include: the capital stock, the potential labour force (based on demographic factors and the participation rate), the non-accelerating inflation rate of unemployment (NAIRU) and labour efficiency.
Next week I wrap up this discussion and turn to consider the Enclave Economy threat as the next in line of the top-ten developing challenges which Guyana will have to navigate after first oil and first gas.