Manufacturing Industry in Jordan: Effect on the Economy

1. Introduction

Since the dawn of economics, there has been a heated debate on the causes of economic growth; Economists tried to answer one of the most controversial questions: what drives economic growth? Moreover, how to sustain it? Despite the progress achieved in measuring and modelling economic growth, we are still not capable of finding elusive answer to that question.

The literature of economic growth continued discussing how to encourage economic growth in different economies. Early theories stated that countries should focus its efforts on sectors in which they have comparative advantages. Thus they can produce at a lower both marginal and opportunity cost compared to other economies to trigger growth. On the other hand, While modern theories claim that countries should concentrate on strategic sectors which have unique characteristics to encourage higher productivity and technological advancement such as manufacturing.

Nicolas Kaldor is considered one of the leading representatives of the modern theorists that support the idea of focusing efforts on strategic sectors that have higher productivity and technology improvement such as manufacturing.

In his work described later as “The Three Laws of Economic Growth”, in the first one he noticed a positive correlation between the share of manufacturing in GDP and economic growth, in other words when the share of manufacturing of GDP is rising then the economy is increasing faster with time. Also, Kaldor found that the productivity of manufacturing sector is positively related to the growth in the manufacturing sector which became known as Kaldor-Verdoorn’s law. The last law Kaldor argued that the non-manufacturing sector growth is positively related to the growth of the manufacturing sector.

This growing debate about the engines of economic growth – especially in developing countries such as Jordan- encourages the importance to analyse the role of the manufacturing sector in achieving satisfying economic growth rates was behind examining the validity of Kaldor’s laws, the first law in particular.

Therefore, this paper will test if the manufacturing sector is the engine of economic growth in the Jordanian economy. Moreover, this paper aims to extend the test to cover the service sector to accept or reject the hypothesis that the manufacturing sector is the only engine behind economic growth in Jordan and to examine the possibility that the service sector could act as the only escalator of economic growth. To achieve the previously mentioned goals, Generalised Methods of Moments approach will be utilised to improve the results presented by Kaldor.

The structure of this paper is as follows: section 2 will set the theoretical overview regarding the theories of economic growth in general, then will discuss the kaldorian approach to understand the economic growth mechanism. Also, section 2 will discuss the transmission mechanisms between manufacturing and economic growth. Section 3 summarises the literature review about the topic. Section 4 will present the contribution of both manufacturing and service sectors in GDP of Jordan. Section 5 devoted to explaining the data and methodology and the empirical finding of the model chosen to examine the validity of Kaldor’s law. The last two chapters 6 and 7 will report the regression results and conclusion.

2. Theoretical Background

2.1.  Theories of Growth

After the industrial revolution in late 1800’s was the changing point for the world economy. Most of the large economies of the world witnessed an increase in the Gross Domestic Product. All them started on the growth path. This increase in the National Income led to analysing of the growth structure of the economies. The great depression of 1929 was another crucial year which entailed new ideas. Economist starting from Adam Smith to very recent have tried to explain the growth process.

A.    Classical Theory developed by Adam Smith

Adam Smith in his book Wealth of nation talked about completely free and open market where perfect competition will prevail and following Say’s law, supply will create its demand in the economy. He conceptualised division of labour and opined that it would lead to higher productivity ultimately leading to higher level of growth. He could not have envisaged any market failure or absence of a free market in the labour market. He did not consider the issue of wage ceiling for which the supply cannot create similar demand leading to depression.

B.    New economic growth theories

Post great depression era in 1937 John Maynard Keynes showed that the importance of governmental control and the need for new technologies. These new economic growth theories emphasised on the innovation of new technology. They pointed out that in the case of a perfect competitive market the short run profit being zero, the firms engaged in the production process may not show interest in technological innovation as that increases their cost of production in comparison to other competitors. They were instrumental in advocating more govt. control and the tried to emphasise on the issue of productivity both capital and labour. Place emphasis on increasing both capital and labour productivity. They advocated that labour productivity and capital productivity must increase for an economy to grow. New economic argue that labour productivity increase not always lead to diminishing returns it might sometimes increase it.

C.    Neoclassical growth theories

Neo classical growth theories are more reliant on the theories developed by Adam Smith, David Ricardo, and Malthus. They opined that the increased productivity leads to diminishing returns. Therefore, only increase savings rate will not be sustainable in the long run. The increase in the savings rate only increases the capital available to the hands of the firms, but once the economy reaches a steady state, then an exogenous factor will be needed for that economy to grow further. They opined that is possible only if there happens a technological progress which will lead the economy from the steady state or the low-level equilibrium. They also showed that low-income economies or the developing economies having same savings rate and population increase rate might not reach the same steady state in the long run. Neo classical economists were successful in explaining the huge economic gap between the developed countries and the developing countries. Sometimes empirically it can be visible that developed countries have ten times more per capita income than the developing countries of low-income countries. They emphasised the importance of growth as that leads to increase in technological know-how and increase in the workforce and capital to increase. One point needs to be mentioned here that the empirically it has been observed that in some economies the labour force increased many folds even with the absence of growth.

D.    Endogenous growth theory

By early 1970’s and 1980’s, it was observed that the neo classical growth theories could no longer explain the economic phenomenon of the world. The previous theories took the savings rate, technological growth rate to be exogenous. They could not explain why technological advancement takes place across continents. One has to remember that U.S. and other developing countries experienced a bane in their productivity growth rate around this time. After the Bretton wood conference in 1944, the importance of equal distribution of wealth or wealth inequality became a burning topic. Neo classical growth theories could not explain the vast difference in income in countries. As the saving and investment rate was exogenous in these models, the policy makers could not find the way to influence the economic variables so that they reach higher growth trajectory. Paul Romer in his seminal work in 1986 showed that the main underlying assumption of diminishing returns by the neoclassical growth theorist was counterintuitive. This was a major move from the prior assumptions to facilitate such significant departure. Romer and the other endogenous growth modellers included the human capital and the knowledge capital in the capital function. They showed that if capital is not limited to only physical capital, then it might be the case that the production function has increasing returns. They included both embodied and disembodied technological change in their models. They incorporated the technical change in their model so that productivity of labour increases.

2.         Kaldor’s growth laws

In his attempt to explain the economic growth patterns for the UK economy, Nicholas Kaldor (1966,1978) has highlighted the vital role of manufacturing in economic growth; he described a group of economic laws to explain the economic growth differences between industrialised (developed) countries. These laws presented the role of the manufacturing sector as an escalator of economic growth and as an answer to why economic growth differs between developed economies.

The first law describes the relationship between manufacturing and economic growth as known as Engine of economic growth, Kaldor stated that the faster the manufacturing sector value added (MVA) grows, the faster the GDP grows. In this regard, he is considered the first to find empirical evidence indicates to the correlation between MVA and (Egüez, 2014).

The mathematical formulation of the model built on pooled cross sectional data from 12 different developed countries. The regression model as follows:

GDPg= α+ βMVAg+u ..(1)

Where

GDPgis the growth rate of gross domestic product and

MVAgis the growth rate of manufacturing sector value added. Kaldor concluded that when

MVAggrows 1%, the

GDPgwill increase by 0.614. Although the previous formula reflects a relatively strong and positive correlation, but it is also significantly less than unity, which implies that there is excess growth in manufacturing over nonmanufacturing sectors (EMN for short) allows the economy to grow rapidly, in other words, the larger EMN the faster the overall economy growth rate (Thirlwall, 1983). The next equation captures this fact

GDPg= α+ β(MVAg-NMVAg)+u

..(2)

Where

MVAg-NMVAg  represents EMN in the economy, Kaldor findings were strongly supporting the positive relationship between GDP growth and EMN. In his model he estimated the value

βas 0.95.

Consequently, the correlation between agricultural sector value added

(AVAg) and

GDPgmust not differ from zero due to the fact that the economy is industry led economy. Also the agricultural sector exhibits diminution return to scale (Drakopoulos and Theodossiou, 1991), on the other hand the, Kaldor’s model also implies that the regression coefficient of the relation between Service sector value added growth

(SVAg)and

GDPg should not be significantly different from unity because of the fact that the demand on service is derived from the demand for manufacturing output (McCausland and Theodossiou, 2012).

The first law has attracted considerable attention of many economists over the past decades, many researchers criticism was on the basis of the uncertainty in the causality direction, in the first formulation it is clear that 

MVAg affects

GDPg, but it could be true the other way around, and the model does not reflect a very soled theoretical explanation or theoretical derivation (deeper discussions of the limitations and critiques in the literature review chapter).

The Second Law orKaldor – Verdoorn Law states that the labour productivity in manufacturing sector (

LPMg)growth rate is highly influenced by the

MVAg, the faster

MVAgthen the faster

LPMgdue to increasing return to scale. The idea behind this formulation is that the bigger size of a certain sector the lower average cost of production, also from a dynamic point of view the effect that output has on capital accumulation and technical progress are vital in the context of increasing labour productivity.

There are two versions or two main ways of testing Kaldor-Verdoorn law, a faster growth rate of manufacturing output the faster rate productivity grows. The starting point would be a standard Codd-Douglas production function as follows:

Ym= KmαEmβ ..(3)

Where

Ymis manufacturing sector output, and

Kmα is the capital used as inputs in the manufacturing sector, and finally,

Emβis employment used as inputs in the manufacturing sector.

Differencing equation (3) after taking logs:

Log Ym= αKm+ βEm ..(4)

Alternatively, for simplicity:

ym= αkm+ βem ..(5)

Where k_mand e_mare the growth rates of capital and employment in manufacturing, respectively. Productivity

Pmis the outcome of the difference between the output growth rate

ymand employment in manufacturing sector growth rate

em, as appears in equation (6).

pm= ym- em ..(6)

Rearranging equation (6) and substituting in equation (5):

ym= αkm+ β(pm- ym)

..(7)

pm= αβkm- 1-ββym

..(8)

Assuming that the ratio between capital and output is fixed

Rm=KmYm, taking logs and rearranging we get

km= rm+ ym. Substituting

km in equation (8) we get:

pm= αβrm- α-(1-β)βym

..(9)

pm=b0+b1 ym..(10)

or as in most empirical studies:

p=b0+b1 ym

..(11)

The second version of Kaldor – Verdoorn law was suggested by Kaldor; The model is simply derived by substituting equation (6) in equation (10), then rearranging to get:

em= -b0+(1-b1)ym

..(12)

Equations (11) and (12) reflects the same relationship since

pm= ym- em. in fact, Kaldor’s results for both equations were very close. He concluded that there exist a Verdoorn relation beteween all sectors except Agriculture and mining sectors are not statisticaly accepted. The value of

b1in equation (11) was 0.484 and in equation (12) was 0.516 and R² was 83% and 84% for the two equations respectivly.

The Kaldorian version of the law criticised by (Rowthorn, 1975) and (McCombie, 1983)  they raised questions as What is the exogenous variable: output growth or employment? Moreover, is the direction of causation

pmto

gdpmthrough the relative prices or the other way around through return to scale. Another issue raised by (McCombie, 1983) that the previous charactaristics showed be applied on total productivity ratther than manufacturing productivity (McCausland and Theodossiou, 2012).

The Third law could be derived the same way as the second law (i.e., cobb-Douglas function) as shown in equation (13):

Y= KαEβ

..(13)

Where

Ymis manufacturing sector output, and

Kmαis the capital used as inputs in the manufacturing sector, and finally,

Emβis employment used as inputs in the manufacturing sector.

Again by differencing and taking lags with respect to time

y= αk+βe ..(14)

Where

kand

eare representing the growth rates of capital and employment in manufacturing sector, respectively.

Assuming that the ratio between capital and output is fixed

R=KY, taking logs and rearranging we get

k= r+ y. Substituting

kin equation (14) we get:

y= α(r+y)+βe

..(15)

Rearranging equation (15)

y= α1-αr+ β1-αe

..(16)

Since the total productivity growth rate is the difference between total output and employment growth rates

p= y- e

..(17)

Now by rearranging equation (17) and substituting in equation (16)

p+e= α1-αr+ β1-αe

..(18)

p= α1-αr+ β-(1-α)1-αe

..(19)

Assuming that the employment market is divided into three sectors manufacturing, service, and agriculture (

em, es, ea) respictivly.

e= em+es+ea

..(20)

Equation (20) can be expressed as

e= δem+(1-δ)(es+ea)

..(21)

Where

δis the share of employment in manufacturing sector of the imployment market.

Now by plugging equation (21) into equation (19)

p= α1-αr+ β-1-α1-α(δem+1-δes+ea)

..(22)

p= α1-αr+ β-1-α1-αδem+1-δ β-1-α1-αes+ea ..(23)

Or

p= b0+ b1em+b2es+ea

..(24)

p= b0+ b1em+b2enm

..(25)

Where

enmis the employment in nonmanufacturing sectors. and

b1>0, b2<0

Alternatively, as presented by(Cripps and Tarling, 1973), using equation (12) and substituting in equation (24)

p= a0+ a1ym+a2es+ea..(26)

p= a0+ a1ym+a2enm..(27)

where

a1>0, a2<0

alternatively, as proposed by many researchers

y= a0+ a1em+a2enm..(28)

where

a1>0, a2<0

Kaldor original formulation of the third law as presented in equation (25) reflects the fact that the total productivity growth rate is positively related to the growth rate of manufacturing sector output, and negatively related to non-manufacturing sectors employment. The same conclusion could be reached from equation (28), since the more labour in manufacturing the faster the total output grows. In fact, kaldor found that the over all output is positively correlated with employment growth in manufacturing and negatively correlated with employment growth in nonmanufacturing sectors.

An increase in manufacturing produces a transfer of the workforce from other economic sectors toward the manufacturing sector which enhances the productivity of nonmanufacturing sectors. Such effect combined with the increasing returns to scale in manufacturing leads to a positive relationship between output growth and manufacturing production (Pons-Novell and Viladecans-Marsal, 1999).

As a conclusion Kaldor’s laws have been criticised both empirically and theoretically, although many applied studies confirmed the validity of Kaldor’s laws of explaining economic growth for different countries and different time spans. Many researchers like (McCombie, 1983) and (Thirlwall, 1983), and (McCombie and Thirlwall, 1994) were concerned about what direction the causality follow as discussed previously especially in the second law. The same criticism could be applied to the first and the third law to a certain extent. Researchers as (Mamgain, 1999) has also criticised the second law as appears in equation (11) and (12)  by arguing that the previous formulation might suffer from spurious regression since if

em=0then there will be a perfect correlation between

pmand

ym.

3.         Transmission mechanisms between manufacturing and economic growth

Adam Smith was the first to notice that manufacturing sector is working under increasing returns to scale, while other sectors such as agriculture and mining sectors are working under decreasing return to scale. In the late twenties, many economists proved Adam Smith point of view; they showed that to achieve self-sustaining growth in any sector two conditions must be satisfied: increasing return to scale and elastic demand on products produced by the same sector (Young, 1928). Consequently, Kaldor argued that the rate of productivity growth in manufacturing is higher than other sectors such as agriculture, therefore, labour force start to move from low productivity sector (agriculture) to high productivity sector (manufacturing). As a result of this, the over all productivity and output in the economy will grow significantly. Moreover, manufacturing sector is more likely to generate more backward and forward linkages with other sectors which will eventually drive technical progress to other sectors.

An additional contention is that Under the economies of scale in which manufacturing sector shows more, new technologies are more likely to be used. This in turn, increases growth in manufacturing sector and increase its contribution to over all output growth more than other sectors. Also, the growth of manufacture increases the opportunity for learning by doing, increase productivity and lower marginal costs. Therefore, the growth rate of productivity in manufacturing will depend positively on the output growth rate of manufacturing. Furthermore, has been claimed that manufacturing has certain conditions for capital accumulation which is one of the main features of development and growth. (Egüez, 2014).

3. Literature review

Since Kaldor presented his ideas about the role of manufacturing in economic growth, many researchers have discussed the validity of the three laws extensively. Kaldor’s first law was tested by researchers, (Cripps and Tarling, 1973) examined the very same formulation and sample that Kaldor used but with a longer period, he concluded almost same positive relation that Kaldor concluded predicted. On the other hand (Rowthorn, 1975) found that there are no enough empirical evidences to support the kaldorian relationship especially during the post war period. Moreover, he argued that the results presented by both Kaldor (1966), Cripps and Tarling (1973) have been built on a relatively small sample of countries. Also, he claimed that the conventional way of estimation the relationship (least square regression) used by Kaldor is not enough to get solid conclusions. (Thirlwall, 1983) Confirmed the validity of Kaldor’s law especially in the industrialised countries. (Bairam, 1991) also reached the same conclusion in the case of the Turkish economy in both macro and micro level. (Drakopoulos and Theodossiou, 1991) Found that the patterns of economic growth witnessed by the Greek economy could be explained by Kaldorian growth law, and can give an adequate explanation for its growth in the period under investigation. The study conducted by (Hansen and Zhang, 1996) aimed to examine the validity of Kaldor’s Law using the regional data from 1978 to 2004 in China, the findings were supporting Kaldor first law. The same conclusion reached by (Jeon, 2006). (Dickson, 2007) also found that the manufacturing sector represents a substantial share of the industrial sector in developed countries. In 2010, (Awad, 2010) used the panel co-integration technique in investigating the role of the manufacturing sector in the non-oil economic growth of the Gulf Cooperation Council (GCC) countries. The paper findings were in favour of the existence of a strong link between manufacturing and the non-oil economic growth of the region over the long run. (Egüez, 2014) used a sample of 119 countries over the period 1990-2011 to examine the first law of Kaldor and extended it to the service sector to find out if it could play the role of economic growth escalator as an alternative of manufacturing sector. Egüez (2014) concluded that for low-income countries manufacturing is the only engine of growth. Meanwhile, both manufacturing and service sectors play the role of economic growth escalator, and lastly, manufacturing sector is not the driving force behind economic growth anymore, but service sector is the main force of economic growth. (Wells and Thirlwall, 2003) research indicated that the structural changes in the manufacturing sector increase the rate of economic growth and standard of living in Africa, although the paper found that the rate of economic growth is associated with the growth of manufacturing sector, its role was not greater than other sectors such as service and agriculture. (Dasgupta and Singh, 2006) studied the role of manufacturing and services in developing countries using a Kaldorian framework. The results indicate that manufacturing is still has a significant contribution to economic growth as well as service sector and other sectors especially the one that connected to ICT sector. (Guo et al., 2012) aimed to measure whether Kaldor’s engine of growth hypothesis remains true in the case of the Chinese regions over 1996–2006. They proved that the growth of total output is positively associated with manufacturing output growth. (Szirmai and Verspagen, 2010) concluded that share of manufacturing in total output is positively related to economic growth while the impact of service sector as an engine of economic growth is inconsistent and weaker than manufacturing sector growth rate impact on economic growth. (Lavopa and Szirmai, 2012) with a sample of 92 different economies for the period 1960-2010 and using two-stage least squares method, find strong evidence for the engine of growth hypothesis for manufacturing. (McCausland and Theodossiou, 2012) Discussed the factors that stimulate economic growth through in the light of Kaldor’s laws, they used a sample of 11 countries spanning nearly two decades. The results confirm that manufacturing output growth is a significant factor in both productivity growth and GDP growth and that despite its increasing size, the service sector does not seem to show a similar role. (Kathuria and Natarajan, 2013) Examined  Kaldor’s first law on the Indian states in the post-1990s. The results showed that the manufacturing sector had played the role of engine of economic growth despite its decreasing share over the period. (Libanio and Moro, 2013) provides empirical evidence that supports Kaldor´s first law on the importance of manufacturing sector for economic growth by using a panel data for 11 largest economies in Latin American countries during the period 1980-2006. (Güçlü, 2013) investigated the drivers of regional economic growth in Turkey within the context of kaldorian approach during the period 1990-2000. The results were in favour of the argument that manufacturing has a major role in economic growth. (Pacheco-López and Thirlwall, 2014) they presented a new interpretation of Kaldor’s hypotheses under open economy conditions using an instrumental variable method on 89 open economies of developing countries during the period 1990-2011. They estimated the relationship between the growth of manufacturing output and export growth. Countries producing manufactured goods with a high-income elasticity of demand in world markets will have a higher growth of exports and a higher growth of GDP. (Adugna, 2014) aimed to examine the impact of manufacturing sector on economic growth in Ethiopia using Kaldorian approach during a period between 1980 and 2009. The model estimation revealed that the manufacturing sector affects economic growth by increasing the labour productivity. The results showed that the manufacturing sector in Ethiopia plays the key role in structural transformation in the country.

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