Open First; Then Invest

Abstract

Contrary to the consensus among neoclassical economists, this study argues that investment does not necessarily lead to economic growth. In fact, a reverse causation between investment and growth could be more plausible. This study explores the impact of trade openness (as complementary to terms of trade) on economic growth. Furthermore, this study attempts to replace the traditionally “overestimated” role of investment with trade in growth empirics. It adopts the new growth model as developed by Mankiw, Romer, and Weil (1992) and Barro and Sala-i-Martin (1995), and uses a panel setup of twenty countries randomly selected from four major regions and continents from 1982 to 1997. Findings reveal that: (1) trade openness eliminates most of the explanatory power of investment, (2) trade openness has a significant positive impact on growth per capita, and (3) growth seems to precede investment, rather than the reverse. Therefore, results suggest that in open economies, trade openness could replace investment and investment may not be a determinant of growth as is traditionally assumed, but rather a consequence. Governments in relatively open economies should give priority to liberalizing their trade rather than initiating policies that induce savings and investments.

Key Words:

• Openness
• investment
• growth models