Bruka Panonija

Novi Sad, No 4, 2010
International editorial board

John Hall Portland State University (USA)
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(Argentina)
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Sophia P. Dimelis Athens University of Economics(Greece)
Georgios P. Kouretas Athens University of Economics
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Michalis Psalidopoulos University of Athens (Greece)
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Local editorial board

Pavle Petrovi University of Belgrade
Mihail Arandarenko University of Belgrade
Diana Dragutinovi University of Belgrade
Djordje Djuki University of Belgrade
Dragana M. Djuri Faculty of Economics and
Political Science, Belgrade
Nikola Fabris University of Belgrade
Olga Hadi University of Novi Sad
Miomir Jaki University of Belgrade
Miladin Kovaevi Statistical Office
of the Republic of Serbia
Miroljub Labus University of Belgrade
Alpar Loonc University of Novi Sad
Zorana Luanin University of Novi Sad
Boko Mijatovi Center for Liberal-Democratic
Studies, Belgrade
Dejan Miljkovi Megatrend University, Belgrade
Zorica Mladenovi University of Belgrade
Endre Pap University of Novi Sad
Aleksandra Praevi University of Belgrade
Zora Prekajac University of Novi Sad
Miroslav Prokopijevi Institute for
European Studies, Belgrade
Boban Stojanovi University of Ni
Boo J. Stojanovi University of Belgrade
Dejan oki University of Belgrade
Danilo ukovi Institute of Social Science, Belgrade
Ivan Vujai University of Belgrade
Miodrag Zec University of Belgrade
Boko ivkovi University of Belgrade
Contents
Original
scientific
papers
Georgios P. Kouretas and Prodromos Vlamis

The Greek Crisis: Causes and Implications
DOI: 10.2298/PAN1004391K
John Glen and Joseph G. Nellis

The Price You Pay: The Impact of State-Funded Secondary School
Performance on Residential Property Values in England
DOI: 10.2298/PAN1004405G
Nikolaos Giannellis, Angelos Kanas and

Athanasios P. Papadopoulos
Asymmetric Volatility Spillovers between Stock Market and Real
Activity: Evidence from the UK and the US
DOI: 10.2298/PAN1004429G
Senay Acikgoz and Merter Mert

The Endogeneity of the Natural Rate of Growth: An Application to
Turkey
DOI: 10.2298/PAN1004447A
Yasemin zerkek and Sadullah elik

The Link between Government Spending, Consumer Confidence and
Consumption Expenditures in Emerging Market Countries
DOI: 10.2298/PAN1004471
Professional
paper
Book
review
Ivana Prica and Jelica Petrovi Vujai

Financial Services Liberalisation in Transition Countries
and the Role of the WTO
391-404
405-428
429-445
447-469
471-485
DOI: 10.2298/PAN1004487P
487-501
Boo Stojanovi
Economic Theory and Reality
Spontaneous Chaos Economics in a Time of Wolves
Erik S. Reinert
(igoja, Belgrade, 2010)
503-509
PANOECONOMICUS, 2010, 4, pp. 391-404

Received: 27 October 2010.
Georgios P.
Kouretas
Department of Business Administration,
Athens University of Economics and
Business,
Greece
and
CIBAM,
Cambridge Judge Business School,
United Kingdom
kouretas@aueb.gr
Prodromos Vlamis
Centre for Planning and Economics
Research,
Greece
and
Hellenic Observatory,
London School of Economics,
United Kingdom
vlamis@kepe.gr
An earlier version of this paper was

presented at seminars at the University
of Novi Sad and Athens University of
Economics and Business and thanks
are due to seminar participants for
many helpful comments and discussions. We would also like to thank the
Editor Kosta Josifidis, Dimitris Georgoutsos, Kostas Karfakis, Dimitris
Moschos, Athanasios Papadopoulos,
Moise Sidiropoulos and Leonidas
Zarangas for valuable comments. The
usual caveat applies.
UDC 338.124.4(495)2007/2009
DOI: 10.2298/PAN1004391K
Original scientific paper
The Greek Crisis: Causes and

Implications
Summary: This paper presents and critically discusses the origins and causes
of the Greek fiscal crisis and its implications for the euro currency as well as
the SEE economies. In the aftermath of the 2007-2009 financial crisis the
enormous increase in sovereign debt has emerged as an important negative
outcome, since public debt was dramatically increased in an effort by the US
and the European governments to reduce the accumulated growth of private
debt in the years preceding the recent financial turmoil. Although Greece is the
country member of the eurozone that has been in the middle of this ongoing
debt crisis, since November 2009 when it was made clear that its budget deficit
and mainly its public debt were not sustainable, Greeces fiscal crisis is not
directly linked to the 2007 US subprime mortgage loan market crisis. As a
result of this negative downturn the Greek government happily accepted a
rescue plan of 110 billion euros designed and financed by the European Union
and the IMF. A lengthy austerity programme and a fiscal consolidation plan
have been put forward and are to be implemented in the next three years.
Key words: Sovereign risk, Debt crisis, Bonds market, Expectations, Fiscal
guarantees.
JEL: F34, G01, G15.
Paper by invitation
The financial crisis that unfolded in mid-2008 led to a dramatic increase of public
debt in many advanced economies. During the recent months, we have seen the
transformation of the 2007 US subprime mortgage loan market crisis into a sovereign
debt crisis in the eurozone.1 This overwhelming increase in the public debt has been
to some extent the outcome of the effort by the governments to reduce the private
debt that was accumulated during the years preceding the recent financial turmoil
(Paul De Grauwe 2010a). Based on the ECB Quarterly Euro Area accounts for the
years 1999 2010, a number of observations can be made. First, there are periods
during which private debt increased substantially in the eurozone whereas there are
other periods that private debt has been reduced with a great speed. Second, during
periods of economic booms, private debt has risen by an accelerating rate. Third, for
the whole period the increase in private debt was substantially greater than the percentage increase of public debt. Fourth, during the 2005-2007 economic boom, there
is an average annual increase in private debt of the eurozone countries of approxi1
Carmen M. Reinhart and Kenneth S. Rogoff (2009, 2010) provide an excellent analysis of the recent
financial crisis. They also provide evidence on the issue of growth in periods of rising debt.
392
mately 35% of GDP. In contrast during the years of economic recession 2008-2009,
private debt slows down and public debt growth accelerates (De Grauwe 2010a).2
The overall picture from these accounts is that private debt increased more
than public over the whole period. This is exactly what we have observed since the
peak of the crisis in October 2008 with governments being forced to bail out problematic banks, taking over a major share of the debts of failing financial institutions.
Furthermore, they followed expansionary fiscal and monetary policies along with an
array of complementary stimulus programmes in order to increase aggregate demand
and to make sure that their economies will not fall in deep recession. These large
stimulus programmes and bail out schemes are expected to increase total public sector debt of the world developed economies over 100% of the GDP in 2011 (Organization for Economic Cooperation and Development - OECD 2010). The sovereign
debt crisis has important implications for the eurozone raising questions about its
viability and about the future of the euro as a common currency (Adrian BlundellWingall and Patrick Slovic 2010; International Monetary Fund - IMF 2010). As of
this writing the debt crisis in the eurozone is still unfolding since (i) Ireland is the
second country (Greece was the first one) requesting financial support from the rescue mechanism set out by EU/IMF and (ii) spreads on the 10-year government bond
yields of Portugal and Spain have been increased substantially during the last month,
raising fears for a potential domino effect in the eurozone. Part of this increase in
interest rate spreads can be attributed to speculation but the roots of the problem are
laid on the public finances of these countries, which have dramatically deteriorated in
the aftermath of the financial turmoil. More specifically, gross debt/GDP ratio increased across all EMU economies over the period 2007-2010 but not in a symmetric
way; it was increased by 62.3% in Ireland, by 38.2% in Greece and by 36.3% in
Spain. These were the largest increases of the gross debt/GDP ratio in the eurozone.
Therefore, it was made clear that the recent financial turmoil had important consequences for fiscal policy in the economies of the eurozone since the governments of
the EMU countries provided large amounts of money to the domestic banking system
in order to stabilize it. In addition, they adopted countercyclical fiscal policy measures to smooth out the consequences of economic recession (Theoharry Grammatikos
and Robert Vermeulen 2010). An important question at this stage is whether the
overall debt level for eurozone countries is sustainable. It seems that this issue is not
crucial one since the total government debt for the eurozone countries is 86% of
GDP. However, as we have already explained, this is not the case if one considers the
situation in individual countries in the periphery of EMU (see also De Grauwe
2010a, 2010b). Grammatikos and Vermeulen (2010) argue that one needs to decompose total debt into three components in order to evaluate the issue of debt sustainability. These components are: the primary balance, which is fully controlled by the
government; the interest and growth contributions, which are not directly controlled
by the government since it largely depends of expenses made by the government in
the past as well as on the current economic situation; and the stock-flow adjustments,
which are not considered to be direct expenses but can be rather considered as in2
Irving Fisher (1932) argued that there is a tradeoff between private and public debt. When the government tries to reduce the private debt this leads to an increase of the public debt.
vestments that lead to the increase of governments assets. The last component is of
crucial importance when we take into consideration the bank bailouts put forward by
several governments. However, this part of the public debt may be similar to a group
of countries it is the fast increase in the primary deficit due to the high speed of contraction that can lead to a serious debt crisis because of its permanent nature. Greece,
Portugal, Ireland and Spain are the countries with the largest primary balance and
interest and growth contributions. Furthermore, Stephen G. Cecchetti, M. S. Mohanti, and Fabrizio Zampolli (2010) look into the prospects and implications of the future evolution in public debt. They argue that the most worrying aspect of the future
development on public debt is that most of the future budget deficits (and thus public
debt) are structural rather than cyclical in nature.
The current Greek tragedy appears to have at least three key players. First, beyond any doubt the main responsibility for the debt crisis in Greece rests with the
Greek governments and the existence of a weak political system that led to a constant
mismanagement of the domestic economy adding government debt at a rate, which
was much higher than the rest of the eurozone at a time that the level of the public
debt has already been more than 100% of GDP. Therefore, the solution to the Greek
problem in the long run would be to redesign its economic and fiscal policies
whereas in the short run the attempt to ease the problem of liquidity came in the form
of the 110 billion euros three-year rescue package financed by EU and IMF. Second,
the financial markets and in particular the credit rating agencies have been very myopic in predicting the 2007 US sub-prime mortgage loan crisis. This failure led them
to an overreaction in their attempt to unveil potential sovereign debt crises. Greece
and other periphery EMU countries were the natural targets since they had for a long
period of time very large budget deficits. They then downgraded Greece, which
eventually led her to withdraw from the international bond markets (Ireland was recently forced to do the same). Finally, a fair part of blame for the current situation is
linked with the delayed reaction of the European Central Bank as well as by the Eurozone governments. Eurozone countries and in particular Germany failed to give a
clear signal to the markets that they were willing to provide immediate political and
financial support to whichever country was facing financial problems. One reason for
this slow reaction is linked to the issue of whether a bail out of a country-member is
allowed according to the EU treaties. A stronger reason is the lack of political union
in Europe, which has not as yet, in the fear of moral hazard issues, allowed the formation of a federal fiscal budget and a risk-sharing scheme within EU. In early 2010,
the European Central Bank did not have a clear strategy to fight the imminent debt
crisis. In other words, ECB did not provide a clear signal to the markets that it would
keep accepting government bonds as collateral in liquidity provision even in the case
that the credit ratings of the bonds have been downgraded below the A- threshold
rating. It was only when it was made clear that the markets will keep speculating on
the Greek bonds that the ECB announced that it will continue accepting the Greek
government bonds well into 2011 (De Grauwe 2010b, 2010c).3
3
Michael G. Arghyrou and Alexandros Kontonikas (2010) and Arghyrou and John D. Tsoukalas (2010)
analysed the EMU sovereign debt crisis along with the particular case for Greece with an application of
the currency crisis models. They argued that these models can help us to understand the current situation.
393
394
The rest of the paper is organized as follows. Section 1 provides a review of

the sources of fiscal imbalances and the debt crisis in Greece. In section 2 we discuss
the Greek stability programme and the rescue package financed by the EU and IMF.
Section 3 looks into the alternative scenarios for the Greek economy as the debt crisis
deepens in the eurozone with section 4 providing our concluding remarks.
1. What are the Main Causes of the Greek Fiscal Crisis?

A number of factors have contributed to the fiscal crisis that Greece has been experiencing since October 2009. Some of these factors are endogenous; have to do with
the structure of the Greek economy itself, the prolonged macroeconomic imbalances
that the Greek economy faces and the credibility problem of macroeconomic policy.
Other factors are exogenous and have to do with the implications of the recent financial turmoil and the timing of the response of Europe to the Greek fiscal crisis. We
will briefly review first the internal causes of the deteriorating fiscal stance of the
Greek economy and then we will discuss external factors that might have contributed
to the Greek fiscal crisis.
1.1 Endogenous Causes of the Greek Fiscal Crisis
There is no doubt that running consistently widening public deficits in conjunction
with declining external competitiveness played a decisive role on the deteriorating
fiscal stance of the Greek economy. The EU statistics agency, Eurostat, has recently
revised upward the Greek budget deficit for 2009 and this has risen to 15.4% of
GDP. Increased public expenditure in recent years led to dramatic increase in borrowing requirements and high levels of accumulated public debt. The level of Central
Government Debt as of 31.12.2009 amounts to 298.5 billion. Government debt
under Public Debt Management Agencys management represents 93% of total Central Government Debt outstanding (Figure 1). The debt-to-GDP ratio will continue to
increase in coming years because of the 110 billion EU rescue package, most likely
getting above 150% by 2020.
Figure 2 reports the evolution of public debt from the early 1970s to the present time in relation to the political regime and the different governments in office.
We clearly observe that the debt/GDP ratio was constant until 1979 and at very low
levels, about 25%. The inauguration of the socialist government led by the late Andreas Papandreou highlights the new era in the Greek fiscal stance as the structural
break in the series indicates. The socialist government implemented an economic
policy programme that was mainly based on inducing the income of the average
Greek household through extensive borrowing from the markets. This borrowing was
completely streamlined to higher consumption levels in an effort to raise the standard
of living of households. This process was also fuelled by the incoming capital flows
from the EU in the form of agricultural subsidies and from the financing of infrastructure within the broader framework of the convergence and cohesion policies of
In particular for the case of Greece they found that there is a steady deterioration of macroeconomic fundamentals since 2001 and that there is a double shift in markets expectations from a regime of credible
commitment to EMU participation to a non-credible EMU commitment without fiscal guarantees.
the EU. In a relevant study, Stelios Makrydakis, Elias Tzavalis, and Athanassios
Balfoussias (1999) have shown by using data for the period 1958-1995 that the
Greek government failed to satisfy its intertemporal budget constrain and thus public
debt turned out to be unsustainable in the long-run. They argue that the source of the
detected unsustainability was due to a deterministic fiscal policy regime change,
which was estimated to occur around 1979.4 They also claim that the problem of debt
unsustainability is due to endogenous factors and therefore, action should be taken in
order to avoid the prospect of eventual insolvency.5
The lack of the necessary fiscal consolidation during the past ten years, when
Greece was experiencing high growth rates, in relation to the continuous false reporting of fiscal data (in mid-October 2009, the newly elected government announced the
budget deficit for 2009 was estimated to be 12.7% of GDP while the previous government was arguing in September 2009 that deficit would not be higher than 6.5%
of GDP) have undermined the Greeces government credibility. On top of that, the
decline in competitiveness since EMU entry (Dimitris Malliaropoulos 2010) led to a
persistent deficit in the current account. Increased twin deficits together with the
lack of structural reforms in home regarding labour market flexibility, social security
and market competition, obliged Greece to issue new bonds at short maturity periods
and at higher interest rates compared to the anchor of the EMU, that is Germany.
The ability of the Greek government to roll-over its debt has been questioned due to
the perceived by international capital markets high probability of sovereign default.
An important factor contributing to this perception is the maturity profile of
the Greek public debt (Figure 3). As it is evident from Figure 3, balloon payments for
the Greek bonds issued in the past are concentrated in the period 2010-2019, which
affects the probability of sovereign default in these years. As a result, investors are
requiring higher and higher interest rates in order to lend new money to Greece and
this is mirrored in widening and volatile Greek spreads to German Bund. Figure 4
shows how the Greek spreads fluctuated from early November 2009 -just after the
newly elected Socialist government came to power- until Sunday 11 April when Eurozone members agreed to provide, if needed, financial assistance to Greece. More
specifically, in the spring-summer of 2008, the spread of the 10-year Greek government bond yield against the German bund ranged from 25-65 basis points. Then following the credit crunch, the Greek spread reached 285 basis points in March 2009.
There was then a decline the Greek spread reaching 121 basis points in August 2009.
Following the general elections in October 2009 a dramatic increase of the spread
was recorded when it was obvious that public debt was not sustainable. When the
news broke out, the new government in Greece was slow in its response, trying to
reconcile electoral promises with hard reality as well as opposing tendencies within
the party (Tsoukalis 2010, p. 1). It kept rising and it reached 586 basis points in
4
It is safe to assume that a similar study with extended sample until 2010 and using the same econometric methodology would still support this outcome.
5
Contrary to the results of the Makridakis, Tzavalis, and Balfoussias (1999), Athanasios P. Papadopoulos
and Moise Sidiropoulos (1999) were unable to reject the null hypothesis of public debt long-run sustainability for the Greek economy and they also failed to provide evidence of a structural break in the series
of debt/GDP ratio.
395
396
April 2010. As of this writing, it stands a bit higher than 900 basis points following
the fears for a domino effect in the eurozone and the worries regarding the Greek
governments ability and willingness to fully implement the austerity programme.
Figure 5 illustrates the history of Greeces ratings. It shows the most recent
credit rating of the Greek bonds assigned by the main ratings agencies (Moodys,
S&P, Fitch and R&I). These ratings vary from BB+ to BBB-. Greece has been recently downgraded to BBB- because of the high budget deficit and the perceived by
the markets, unsustainable level of public debt.
1.2 Exogenous Causes of the Greek Fiscal Crisis
The Eurozone governments failed to give a clear signal indicating their readiness to
support Greece, while the Greek fiscal crisis was escalating. Legal scepticism and
questions like are bailouts illegal? were raised, mostly by Germany, for an issue
which was partly political. However, there is nothing in the Maastricht Treaty that
prevents a Member State or all EU Member States from helping a country in financial difficulty, individually or with the support of an outside body (IMF, EBRD, EIB,
World Bank etc.). More specifically, Article 100, section 2 of the Maastricht Treaty
states that where a Member State is in difficulties or is seriously threatened with
severe difficulties caused by natural disasters or exceptional occurrences beyond its
control, the Council, acting by a qualified majority on a proposal from the Commission, may grant, under certain conditions, Community financial assistance to the
Member State concerned. Because of these disagreements among EU countries,
markets assumed that the implicit guarantee on Greek debt by other EU countries has
been withdrawn. While Eurozone policy makers were debating whether bailouts are
illegal, at the same time there were some ambiguities about ECBs collateral eligibility criteria that is the ECBs policy to accept or refuse the downgraded (see Figure 5)
Greek government bonds as collateral in liquidity provision presented. These ambiguities created problems for financial institutions holding Greek government bonds.
Another exogenous factor that contributed to the instability of the Greek economy was the lack of solidarity funds at an EU level. EU is a monetary union not an
economic one with a Federal Budget. EU has a common monetary policy set at a
supranational level but economic policy (budgetary policies, wage policies, social
policies, credit regulations etc.) is still in the hands of national policy makers. Whenever a crisis occurs at the EU periphery, there is no adjustment mechanism in place to
deal with such a crisis at a supranational level. The lack of European solidarity was
inevitably mirrored in widening Greek spreads to German Bund. Eventually, the EU
leaders agreed on 25 March 2010 an 110 billion (consisting of 80 billion provided
by the EMU and 30 billion from the IMF) 3-year rescue package for Greece and on
11 February 2010, President Jean-Claude Trichet announced that ECB will continue
to accept Greek government debt as collateral, independently of the ratings assigned
by the rating agencies.
Lastly, Greece and Greeces major trading partners in the Balkan peninsula
were also hit by the 2007 global crisis - originating from the US sub-prime loan market crisis - but with a time lag (Prodromos Vlamis and Evaggelos Karousos 2010).
Nevertheless, recession may have hit Greece somewhat less badly than other counPANOECONOMICUS, 2010, 4, pp. 391-404
tries because a relatively small manufacturing sector and of the large share of the
shadow economy which is estimated to be 25%-30% of GDP.
2. An Overview of the Fiscal Consolidation Programmes of

Greece
2.1 Greeces Government Response to the Crisis
Facing with escalating cost of borrowing in the late 2009 and the beginning of 2010
the Greek government designed and adopted a fiscal consolidation programme in
order to reduce the public debt and provide the framework to improve stability and
growth to the economy. The Greek Stability and Growth Programme submitted to the
European Commission on January 15, 2010. Its main elements on the revenues side
were focused on (i) measures to reduce tax evasion and improve tax collection (estimated to be worth 1.2bn, 0.5% of GDP); (ii) reduction of social contribution evasion (to raise 1.2bn, 0.5% of GDP); (iii) a special levy on profitable companies
(raised 0.87bn, 0.4% of GDP); (iv) acceleration of EU receipts for the public investment programme (to raise 1.4bn, 0.6% of GDP) and (v) increase on several
types of indirect taxes. Regarding the government expenditures the following measures were taken, (i) a 10% cut in general government expenditure on salary allowances (expected to save 0.65bn, 0.3% of GDP); (ii) a recruitment freeze in the public sector for 2010 (to save 0.15bn, 0.1% of GDP); (iii) implementation of a 5:1 retirement/recruitment ratio for public sector employees from 2011 onwards. Termination of many short-term contracts in the public sector, to cut operating expenditures
for ministries 10% (estimated to save 0.12bn, and to result in a cut of 7k-8k teachers
on short-term contracts); (iv) reduction in the budget item linked to social security
and pension funds by 10% (to save 0.54bn, 0.2% of GDP) and (v) other relevant
measures to drastically reduce government expenditures in most public services (see
also Arghyrou and Tsoukalas 2010).
2.2 The EU-IMF Fiscal Consolidation Package
The measures taken by the Greek government were proved to be short-lived since
they were not enough to restore markets confidence. The Greek government was
soon forced to enter in negotiations with the EU commission and the other EMU
member-countries in order to agree on a rescue plan given its difficulties to borrow
from financial markets. On 25 March 2010, an agreement was reached for a rescue
plan, which involved a mechanism that relied on bilateral loans to Greece from other
EU countries and loans from IMF at interest rates, which were lower than the market
ones. The main features of this rescue plan on the revenue side are: (i) Value-added
tax bands to be raised (by 4.5-5.0% for the lowest, 9-10% for the medium band and
19-21% for the standard band). Higher VAT rates are estimated to result in 1.3bn of
new revenues (0.55% of GDP); (ii) a substantial increase in indirect taxes of gasoline, tobacco and alcohol along with higher electricity charge and (iii) an increase of
property taxes, taxes on luxury goods an on offshore companies and real estate. With
respect to the required cuts on government expenses the mail elements are: (i) further
397
398
reductions on total salary payments to employees of the public sector; (ii) a freeze on
state pensions and (iii) Public sector works to be cut 5% (to save 0.5bn) and education spending to be cut 0.2bn. 6
This initial rescue plan was revised on 2 May 2010 with the implementation of
further austerity measures in an effort to achieve the targets set by the EU commission and the IMF. The main features of the revised plan regarding the effort to increase tax revenues are: (i) a further rise of 2% in the main VAT rate to 23% (from
21%). The two lower VAT rates will also be raised (by 1% for the current 10% rate
and by 0.5% for the current 5% rate). The government expects the new VAT increases to generate additional revues of 0.80bn (or 0.3% of GDP) in 2010 and
1.00bn (or 0.4% of GDP) in 2011. This was coupled by measures to broaden the
VAT tax base; (ii) a further increase in the indirect taxes on fuels, tobacco products
and alcoholic beverages, expected to bring in additional revenues of 0.45bn (or
0.2% of GDP) in 2010 and 0.60bn (or 0.3% of GDP) in 2011 and (iii) imposition of
further taxes on luxury goods, on firms profits (a one-off tax) and (iv) introduction
of a green tax. The measures to further reduce the expenses have been again very
drastic. Thus (i) The 13th and 14th annual salary instalments will be abolished for
civil servants earning a gross salary in excess of 3,000/month; (ii) The Public Investment Budget (PIB) for 2010 will be reduced by 0.5bn (or 0.2% of GDP); (iii) a
3-year freeze in wages and pensions and (iv) further cut backs in central government
operational costs.
The implementation of this strict austerity programme will hopefully stabilize
the economy. However, it is expected to cause a substantial decrease in demand for
goods and services pushing the Greek economy to a deep recession. In this case, it
will become more difficult for Greece to meet the requirements of the rescue plan.
Therefore, it is absolutely imperative for the Greek fiscal and monetary authorities to
design and implement economic policies that will boost economic growth and reduce
unemployment (at the moment unemployment is rising at an accelerating rate).
3. Implications of the Greek Fiscal Crisis and Future Challenges

for Greece and Eurozone
Let us say at the outset that it is not in the interest of any country to let one member
of the EMU to run away from its debt obligations, as the associated political and
economic costs would be substantial for everyone. There will be a general confidence loss in ability of EU to deal with its fiscal and wider economic challenges. On
the one hand, if Greece is let/forced to default, contagion to other Eurozone bond
markets and Eurozone financial institutions, that hold significant part of the Greek
bonds, is a strong possibility. Debt crisis in one member country of the Eurozone
might trigger a more general crisis involving other Eurozone countries perceived to
be fragile and have similar budgetary problems (like Spain, Ireland, Portugal).
Spillover from Greece into Balkans might be possible too via trade and, more importantly, via financial links. Financial links via Greek banks are widespread, since
6
See also Arghyrou and Tsoukalas (2010) and Ioannis Kokkoris, Rodrigo Olivares-Caminal, and Kiriakos Papadakis (2010).
Greek banks have a considerable market share in Balkans and the south-eastern
European economies and they are among the more aggressive lenders in these countries. Moreover, if Greece is let/forced to default, Greek commercial banks which
hold government debt (about 45bn) will be in trouble too.
On the other hand, if Greece voluntarily leaves EMU, quits Euro and establishes a national currency, there will be certain economic costs to meet. Firstly, it will
face larger debt payments due to devaluation of the national currency. Secondly, international capital markets for new borrowing will be closed for Greece for a number
of years (Barry Eichengreen 2007). Thirdly, Greece will be violently forced to balance its budget since it will be locked out international markets and it would not be
possible to borrow money to finance budget and trade deficits.
One last point; when discussing possible scenarios about the Greek fiscal crisis one should not forget that the euro project seems to be mostly a political construction and not an economic one. Economic and monetary union was the offspring of
the Franco-German couple, President Mitterrand and Chancellor Kohl to be precise.
It was about high politics and peace on the continent, much less so about economics
(Loukas Tsoukalis 2010). By all means, credibility of the euro is currently at stake
but too much political capital has been invested in it throughout the years to let it die.
At the moment there is no consensus among the EU member states to move towards
political union but, it is absolutely imperative to design and implement an institutional budgetary framework (such as the European Financial Stability Facility) for
supporting financially countries that face fiscal difficulties There is a need for a
close and increasingly binding coordination of national economic policies, combining incentives and sanctions, coupled with effective surveillance and conditional assistance (Tsoukalis 2010). However, at this moment it is clear that there is no consensus within Eurozone member states to move forward into a more coherent political union that would allow the transferring of budgetary and tax responsibilities to
supranational authorities (De Grauwe 2010d, 2010e).
Given that at the moment the monetary union is not coupled with a political
union, two less ambitious -but very important plans for the medium term- have been
proposed in the relevant literature. First, Daniel Gros and Stefano Micossi (2008) and
Gros and Thomas Mayer (2010) have recently proposed the creation of a European
Monetary Fund (EMF). This new institution will receive its funds from those countries that run excessive budget deficits and debt levels. If a similar a crisis arises in
the future, the EMF will be in position to support those countries that need financial
assistance and in addition it will have the authority to impose certain rules when allocating supporting funds. Second, De Grauwe and Wim Moesen (2009) proposed the
creation of a common Eurobond, which might reduce pressures to Eurozone economies with excessive budget deficits. They argue that the interest rate for the Eurobond should be the weighted average of the national interest rates in order to avoid
moral hazard problems. Furthermore, it is expected that the creation of a common
Eurobond market (that will be sufficiently large) will attract foreign investors and
provide with additional liquidity the bond markets in the eurozone economies.
399
400
4. Summary and Concluding Remarks

The sovereign debt crisis in the eurozone is expected to have far reaching implications for the mechanisms of the eurozone as well as for the European Union. The
current debt crisis have shown that a reform of current EU mechanisms must be put
in force, otherwise the stability of the eurozone will be jeopardised and the euro currency itself will be negatively affected.
We hope that it was made clear from our analysis that apart from the endogenous structural problems of countries like Greece and other EMU periphery economies, a fair amount of the current problems could be attributed to the functioning of
eurozone itself. In order for similar crisis to be avoided in the future, a set of mechanisms should be designed and implemented at a supranational level. First, a mechanism that will promote convergence in the competitive position of the individual
members of the EU and will prevent the creation of trade imbalances is necessary.
Second, economic policy (budgetary policies, wage policies, social policies, credit
regulations etc.) is still in the hands of national policy makers. Whenever a crisis occurs at the EU periphery, there is a need for an adjustment mechanism in place to
deal with crisis at a supranational level. If such mechanisms are created that would
literally transform the European Monetary Union into a political union with a common fiscal policy. This task seems to be unattainable for the foreseeable future.
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Appendix
PUBLIC DEBT
MANAGEMENT
AGENCY 94%
MINISTRY OF
FINANCE 6%
Source: General Accounting Office, Ministry of Finance. Includes military debt,

European Investment Bank, Bank of Greece, Council of Europe loans and securitized debt
(accessed September 30, 2009).
Figure 1 Composition of the Greek Government Debt
Greece joins EU
125
Euro (11)
Greece joins Euro
100
% GDP
75
Papandreou Jr.
2010
2008
2004
2002
2000
1998
1996
Simitis
2006
u
Pap
andr
eo
1994
1992
1990
1988
1986
1984
1982
Papandreou
1980
1978
1976
Karamanlis
1974
1972
1970
Junta
Mits
ot
akis
25
Kara
man
lis J
r.
50
Year
Source: Authors construction. The public debt data was taken from the Bank of Greece (2010).
Figure 2 Evolution of the Greek Public Debt
403
EURO
2057
2040
2037
2034
2030
2028
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
34.000
32.000
30.000
28.000
26.000
24.000
22.000
20.000
18.000
16.000
14.000
12.000
10.000
8.000
6.000
4.000
2.000
0
2010
mil EURO
NON EURO
Source: Public Debt Management Agency (2010).
Figure 3 Public Debt: Maturity Profile
450
Sunday 11 Apr
Eurozone members agreed to provide
financial assistance to Greece if needed
Greek 10-yr Spread to Bund (bp)
400
350
300
Thurs 25 Mar (evening)
Eurozone member states are ready to
contribute to coordinated bilateral loans as
part of a package involving IMF financing
250
Thurs 11 Feb
European Council agrees to help
Greece if needed
200
150
November
January
09
February
10
March
April
Source: Reuters EcoWin Pro (2010).
Figure 4 Greek Spreads: Wide and Volatile

Moodys
S&P
Fitch
R&I
A a2
AA
A a3
AA-
A1
A+
A2
A3
A-
Ba a1
BBB+
Ba a2
BBB
Ba a3
BBB-
Ba1
BB+
1997 H1
1997 H2
1998 H1
1998 H2
1999 H1
1999 H2
2000 H1
2000 H2
2001 H1
2001 H2
2002 H1
2002 H2
2003 H1
2003 H2
2004 H1
2004 H2
2005 H1
2005 H2
2006 H1
2006 H2
2007 H1
2007 H2
2008 H1
2008 H2
2009 H1
2009 H2
2010 H1
2010 H2
404
Source: Public Debt Management Agency (2010).
Figure 5 Credit Rating of Greek Bonds

Received: 1 June 2010; Accepted: 29 October 2010.
John Glen
School of Management,
Cranfield University,
UK
John.glen@cranfield.ac.uk
Joseph G. Nellis
School of Management,
Cranfield University,
UK
J.g.nellis@cranfield.ac.uk
The authors are grateful to HBoS plc

for providing the primary database
used in this study. They are also
grateful to HBoS plc for research
funding support and to the referees for
their helpful comments on an earlier
version of this paper.
UDC 339.13:347.235(420)
DOI: 10.2298/PAN1004405G
The Price You Pay: The Impact

of State-Funded Secondary School
Performance on Residential
Property Values in England
Summary: This paper examines the relationship between state-funded secondary school performance and local residential property values in seven major
English cities. When choosing which secondary school they wish their children
to attend, parents will be aware of the schools performance in Key Stage 3,
GCSE and A- level examinations. We suggest that GCSE examination results
will be the measure of school performance that parental choice will be most
closely correlated with. Therefore, secondary schools with good GCSE examination results will be oversubscribed in that more students will wish to attend
these schools than there are places available. Schools will then have to develop mechanisms for rationing the available places - central to rationing
strategies in English schools at the moment is geographical proximity of the
family home to the school of choice. Parents will thus have a strong incentive to
purchase houses in the catchment area of high performing schools. Our results suggest that this is the case, with high performing schools stimulating a
price premium in local residential property markets of between 1% and 3% for
each additional 10% point improvement in the pass rate in GCSE examinations.
Key words: Hedonic, Capitalisation of school performance, Property prices.
JEL: R23, R53, I20.
Stephen Gibbons and Stephen Machin (2008) state that anecdotal evidence, media
reports, and even dinner party discussions lend credence to the claim that good
schools raise local house prices. The capitalisation of school performance into local
property values has been the subject of a number of studies in the US and latterly in
the UK. Typically, these studies have been cross-sectional and have found a positive
relationship between a chosen measure of standardised student test scores performance and local residential property values.
The 1988 Education Reform Act introduced the national curriculum into English schools and legislated for the provision of testing of school children at ages 7, 11
and 14 at the end of Key Stages 1, 2 and 3 respectively. Students would then typically complete GCSE (General Certificate of Secondary Education) examinations at the
end of Key Stage 4, aged 16. The Act placed a focus on measuring the outputs of
state-funded education in England at the end of all four Key Stages. This reflected a
general concern on the part of those legislating to provide outputs from the state education system which would equip the UK labour force with the skills, knowledge and
406
competencies necessary to drive economic growth in an increasingly competitive

global economy (Tom Elkins and John Elliott 2004).
The introduction of testing of school pupils at ages 7, 11 and 14, as well as
public examinations at GCSE and A-level (at age 18), has provided a wealth of information on the performance of school children at specific stages of their school
lives. In addition, the formal inspection of schools by OFSTED (Office for Standards
in Education) has provided additional detailed information on the performance of
children, teaching staff and management in state-funded schools. This has given parents a plethora of data upon which to assess the performance of schools. Furthermore, these data are readily available to parents at the Department for Children,
Schools and Families (DCSF) web site.
The single measure of school performance employed in this paper is the percentage of students gaining five or more GCSE passes at grades A* - C in any one
year. Full performance results (discussed later) are published each year by the DCSF
(now referred to as the Department for Education). It is reasonable to suggest, by
implication, that good school performance will enhance future job possibilities.
However, this particular relationship is outside the scope of this study.
This paper is concerned with the impact of state-funded secondary school performance on house prices in the owner-occupied sector in seven major cities/urban
conurbations in England Greater London, Birmingham, Bristol, Leeds, Greater
Manchester, Liverpool and Newcastle. State-funded schools account for well over
90% of the total student population (see Lorraine Dearden, Chris Ryan, and Luke
Sibieta 2010) while owner-occupied housing represents 87% of all properties (see
Kathleen Scanlon and Christine Whitehead 2004). These cities have been selected on
the basis of geographical diversity and because they represent some of the largest
conurbations in England.
The cities are analysed separately because we wish to allow for the fact that
housing markets in different parts of the country may capitalise school performance
to a different extent. For a discussion and justification of this approach involving
segmentation of the database into a number of metropolitan areas see David M. Brasington and Diane Hite (2005).
The structure of the paper is as follows: the next section provides a review of
the literature on the capitalisation of school performance into residential property
prices, focusing on the so-called hedonic approach to measurement (the methodology
adopted in this study). Section 2 describes the data employed and the main procedures adopted to render it suitable for statistical analysis. Section 3 outlines the modelling framework adopted, while Section 4 discusses the main empirical results. Finally, Section 5 draws together the main conclusions and findings.
1. Literature Review
The value which parents place on good school performance would be easy to assess
if education services were sold in a free and competitive market. However, since
there is no observable market price for state-provided schooling, an indirect method
must be found to place a monetary value on the services provided by state-funded
schools.
The Price You Pay: The Impact of State-Funded Secondary School Performance on Residential Property Values in England
The hypothesis we are proposing in this paper is that, ceteris paribus, a higher
level of school performance will be capitalised into higher property values. In other
words, parents wishing to gain access to schools with a superior academic performance will bid up the price of properties which are most geographically proximate to
a high performing school. They will do this in order to ensure that their children are
in the catchment area of the high performing/oversubscribed school and are therefore
eligible for entry into that school (for a general discussion of the capitalisation of
spatially differentiated environmental amenities as in this study involving property
prices, neighbourhood characteristics and school performance see Sherwin Rosen
(1974) and Roland Benabou (1996).
In reviewing the literature related to this study we are mindful of three key issues. The first is concerned with the question of what parents are implicitly purchasing when they buy a house proximate to a high performing school; that is, what is the
most appropriate measure of good school performance? Secondly, what conditions
are necessary in a local housing market for good school performance to be capitalised into residential property prices? Finally, what are the methodological issues
faced by researchers attempting to model such a relationship?
A body of literature has focused on what parents are buying when they select
schools for their children. In this context Thomas A. Downes and Jeffrey E. Zabel
(2002) in their study of the impact of school characteristics on house prices in Chicago found that homeowners paid attention to school outputs, i.e. test scores, and not
inputs in the form of per pupil expenditures by schooling authorities. David M. Brasington and Donald R. Haurin (2006) examined the extent to which homeowners valued traditional measures of school performance (absolute test scores) of which the
UKs GCSE examination pass rates are an example. These traditional measures contrast with the relatively new value-added measures of school quality, which attempt
to measure the capability of students as they enter the secondary schooling process
and compare this with the test scores on exit, the difference between the two being
the value added. With this approach it is the measure of value added which acts as a
measure of school quality rather than the absolute performance at the end of the
process.
Whilst educationalists may argue that the value-added approach represents a
much more effective evaluation of school performance, Brasington and Haurin
(2006) report that homeowners value average test scores and levels of expenditure on
education above any measure of student value-added when assessing local school
performance. They argue, therefore, that it is average test scores which are capitalised into local property prices rather than value-added measures of school performance.
In relation to what conditions must exist in the local housing market for good
school performance capitalisation to occur David A. Starrett (1981), David E. Wildasin (1987), William H. Hoyt (1999), and Christian A. L. Hilber and Christopher C. J.
Mayer (2002) all argue that where there is a relatively inelastic supply of housing,
land and house prices will rise in those areas which provide relatively more attractive
amenities, to the point where the additional price paid reflects the perceived additional value of high-quality local amenities. The capitalisation of local amenities and
407
408
neighbourhood effects into residential property values has been widely researched in
the USA. Brasington (2002) provides a thorough overview of the capitalisation debate, the key point being that capitalisation of any differential in local amenity is
contingent upon a supply of housing which is inelastic with respect to price. However, Paul Cheshire and Stephen C. Sheppard (2004) challenge this view and argue instead that differences in housing supply elasticities do not imply different levels of
capitalisation. In particular, they point out that it is possible that observed reductions
in capitalisation might exist for other reasons, related to the availability of substitute
sources of education, variations in the physical characteristics of the housing stock
making it more or less suitable for accommodating children or the degree of uncertainty attached to current measures of school quality (pp. 400-401).
Furthermore, Cheshire and Sheppard (2004) concur with Timothy J. Bartik
(1988) who argues that it is the elasticity of supply of the local amenity, in this paper
good schooling, that will influence the extent of capitalisation. On this basis we
might expect a reduction in the premium paid for good school performance, as the
average level of school performance increases.
Some of the literature in this area focuses upon the inter-temporal nature of the
capitalisation of improved local amenity. Bartik (1988) identifies a three stage
process. In the first instance there is an improvement in local amenity. This is followed by a second stage whereby the improvement in local amenity is recognised by
those agents who are active in the local property market. The third stage involves
these agents reflecting improvements in local amenity in their willingness to pay a
premium for properties that embody the improved local amenity. This process is important in the context of this study. Schools are incentivised to improve the academic
performance of their students in public examinations; this improved performance is
then reported in official statistics released by the DCSF and, finally, house buyers
can be expected to react to the improved school performance in their willingness to
pay for properties which are proximate to the high performing schools.
Finally, there is a rich literature dealing with the capitalisation of secondary
school performance on residential property prices based on the so-called hedonic
approach to measurement in which the sale price of a property is a function of the
physical characteristics of the house as well as its environmental amenities and location. Lori L. Taylor (2005) and Ian Davidoff and Andrew Leigh (2007) provide reviews of this literature, citing studies by Kathy J. Hayes and Lori L. Taylor (1996);
Haurin and Brasington (1996), Brian A. Cromwell and William T. Bogart (1997);
Sandra E. Black (1999); David L. Weimer and Michael J. Wolkoff (2001); Downes
and Zabel (2002); Cheshire and Shepherd (2002, 2004); Patrick J. Bayer, Robert
McMillan, and Fernando V. Ferreira (2003); Dennis Leech and Erick Campos
(2003); Leslie Rosenthal (2003); Gibbons and Machin (2003, 2006); Thomas J.
Kane, Douglas O. Staiger, and Stephanie K. Riegg (2005); and Randall Reback
(2005).
A fundamental challenge facing the hedonic approach in this context is to ensure that neighbourhood quality is correctly modelled. Failure to do so would result
in biased estimates of the impact of local school quality (performance) on local house
prices. Specifically, as Black (1999) indicates, the standard hedonic approach will
produce upwardly bias estimates of the impact of school performance on house prices if there are unobserved neighbourhood characteristics that are correlated with
school quality and likely to influence house prices. Residential property prices reflect
not only the characteristics of the properties themselves but also those of the surrounding neighbourhood and it is reasonable to assume that higher status neighbourhoods tend to have better schools due to the pupils family backgrounds, the
general quality of teachers, resources paid for by parents etc. Theodore M. Crone
(1998) argues that empirical evidence is available to show that academic achievement can be improved by the peer group effect. The existence of this endogeneity
problem can be addressed in a number of ways.
Davidoff and Leigh (2007) indicate there are four broad approaches to tackling the endogeneity problem. One approach is to control for variation in neighbourhood effects by using data relating to properties adjacent to but on opposite sides
of school catchment boundaries - see Black (1999) and Gibbons and Machin (2003,
2006). In doing so, this approach implicitly controls for differences in neighbourhood
quality by assuming that such properties will have identical neighbourhood characteristics. This approach, however, does not take into account distance between properties on either side of the school catchment boundaries and the fact that properties at
opposite ends of a particular school catchment boundary may exhibit very different
and perhaps unobservable neighbourhood characteristics.
A second approach is to investigate whether the data allow for any natural
experiments such as changes in school quality over a number of years, schools
which may have been closed, opened or other changes in their characteristics and to
investigate whether property prices follow such changes. This approach is adopted by
Kane, Staiger, and Riegg (2005) and Reback (2005). The weakness of this approach
is that it assumes that the mix of neighbourhood characteristics does not change over
time.
A third approach is do adopt an instrumental variables methodology which
predicts residential property values independent of school performance and then rigorously tests for school quality effects. An example of this approach can be found in
Rosenthal (2003) who uses government inspections as an instrument for school
quality. As Gibbons and Machin (2008) suggest the challenge for such an approach is
to find appropriate instruments which are causally related to variations in school performance while otherwise unrelated to housing prices.
The fourth approach, and the one adopted in this study, is to explicitly include
variables which measure the quality of the residential neighbourhood which may
change over time alongside information concerning the physical characteristics of
houses and the performance of the closest school. Examples of this approach include
Weimar and Wolkoff (2001) and Downes and Zabel (2002). As noted above it is vital that the effect of neighbourhood characteristics is correctly modelled.
The study reported in this paper seeks to make a contribution to this expanding
area of research. This contribution can be gauged in a number of ways: we employ
(a) a data set which has exceptional breadth and depth; (b) we explicitly incorporate
neighbourhood characteristics effects, thereby addressing the endogeneity issue
409
410
common to studies of this kind;1 (c) our ability to disaggregate the data set across
different metropolitan areas allows for housing market segmentation and (d) the inter-temporal nature of our data set allows us to model the impact of changes in average school performance and changes in neighbourhood composition over time.
2. Description of the Dataset

The results reported in this paper are based on an exceptionally large dataset developed by HBoS (the largest residential mortgage lender in the UK). The dataset covers
all the house purchase transactions on which the HBoS plc group has provided mortgage loans although for the purpose of this paper, we have only selected data for the
years 2001 to 2007. This period is chosen as a result of a desire to present estimations of capitalisation which are contemporary rather than historical and, following
Bartik (1988), a desire to allow for a period of time to elapse whereby house purchasers were fully aware of differing school performances and could reflect this in
their willingness to pay for properties.
Data on School Quality
In the analysis below the data on school quality measure the performance of individual schools in terms of the percentage of students attaining five passes at GCSE
grades A* to C. This percentage score was entered as a continuous variable in our
preferred hedonic house price regression model. The data on school performance was
obtained from the DCSF website for the years 2000-2006. The website also provided
us with the required locational data in terms of the postcode of each school. In order
to allow for the capitalisation of school performance into property prices we have
lagged the school performance data one time period. Thus, we have regressed 2002
property prices on 2001 school performance results. The rationale for this approach
is that it is historical school performance data that will impact current offer prices for
residential properties. In addition, we are suggesting that it is the most recent historical school performance data that will have the most immediate impact on the price
offered by house purchasers. We experimented with three-year moving averages of
school performance but found that school performance in the previous year performed more effectively as an explanatory variable.
Data on Physical House Characteristics
The data on physical house characteristics is provided from the HBoS mortgage data
set. The richness of the dataset allows us to analyse the impact of school performance
on residential property values to an extent which we feel has not been possible for
researchers previously in the UK. The database includes a detailed breakdown of the
information on the following house characteristics:
1
We acknowledge the comments made by a referee concerning the importance of addressing the problem
of endogeneity in studies of this kind. The depth and quality of the data set employed here has allowed us
to control for the physical house and neighbourhood environmental characteristics in a way that ensures
that parameter estimates on our focus variable (school performance) are not upwardly biased (See Section 4 below for additional discussion of the empirical results).
Purchase price of the property recorded at the mortgage approval stage;

Property type, ie. whether the house is detached, semi-detached, terraced,
bungalow, flat or maisonette;
Number of habitable rooms;
Floor space area;
Number of bathrooms;
Number of toilets;
Availability of central heating;
Number of garages and garage spaces;
Garden;
Age of property.
Data on Neighbourhood Characteristics
Over and above these physical house characteristics, the database also includes information on the location of each property in terms of postcodes. In order to locate
each property and each school in our dataset, we employed Royal Mail Post Office
postcodes. We then utilised the Royal Mail's POSTZON software to provide us with
an Ordnance Survey (OS) grid map reference. This grid reference effectively places
each property on the bottom left-hand corner of a 100 metre by 100 metre grid. To
each of the Eastings and Northings of the OS grid reference a five was added, which
effectively located each of our properties at the centre of the 100 metre by 100 metre
grid; i.e., at the expected location of any property within a 100 metre grid. We then
developed a simple computer macro which applied Pythagoras's theorem and calculated the straight line distance between each property in the dataset and the nearest
school.
Rosenthal (2003) reports that POSTZON locates each school and house within
a maximum of 70 metres of its true location and concludes that for the purpose of
locating the nearest school to a given residential property, the use of the POSTZON
database is unlikely to result in a serious misallocation of houses to the nearest
school. Gibbons and Machin (2008) suggest that a lack of clearly defined catchment
areas for state schools introduces an amount of ambiguity in the link between residential property locations and accessibility to school. However, of primary interest to
this study is the motivation for parents to purchase a property close to their school of
choice. Parents will do this when they believe that a school is oversubscribed and
that the criteria which may be applied to their childs application for entry, in extremis, is straight line distance from the family home to the school of choice. Interestingly, the incentive to purchase a house close to a high performing school may be
greater in households where the oldest child is about to enter secondary education
and there are younger brothers and sisters. In this case the straight line distance
criteria may be applied to the eldest child but subsequent children would be guaranteed a place on the basis that an elder brother or sister attended the school. We have
not been able to control for this effect in this study.
The dataset also includes a special locational classification regime used in the
UK, known as ACORN, A Classification of Residential Neighbourhoods for the
full details of the ACORN classification system, based on postcodes, see Californian
411
412
Analysis Company Inc. (CACI 2006). This regime allocates ratings according to geodemographic information, allowing for the categorisation of the location of each
property at two levels: at the micro level (immediate residential neighbourhood) and
at the macro level (wider surrounding area). In our study the inclusion of ACORN
codes, in so far as they allow for the influence of the socioeconomic characteristics
of a neighbourhood population, should pick up some of the so-called peer group affects; ie, our study allows for the socio-economic impacts on school performance
noted by Crone (1998).
Based on postcode information, the location of each property is classified into
one of eight main ACORN groups as shown in Table 1 below.
Table 1 Description of Main ACORN Groups
ACORN Group
A
B
C
D
EFG
H
IK
J
Main Characteristics of Group

Areas where residents are wealthy investors
Prospering families
Areas of traditional money
Young urbanites
Areas of middle-aged families (comfortable), contented pensioners and families and
individuals looking to settle down (Middle Aged Comfort (E), Contented Pensioners (F)
and Settling down (G))
Moderate living
Meagre means and impoverished pensioners
Inner city existence (low income singles and couples, multi ethnic young singles renting
flats, high rise poverty dependent on welfare-poor young financially inactive)
Source: CACI (2006).
Finally, it should be noted that prior to estimation the dataset has been
cleansed to exclude properties which are atypical or can be described as outliers as
well as to take account of coding errors in the data entry processes. In addition, houses are excluded if the nearest school is further than 10 kilometres away in order to
provide an outer boundary to the urban conurbations that we have studied.
3. Modelling Framework
In this study we employ the hedonic approach to pricing to determine a monetary
valuation which parents place on the performance of schools. The hedonic method
makes use of information on property prices (Pit) and property characteristics to determine the value of individual attributes. These attributes include physical attributes
of a particular house (denoted by Xht) as described earlier, as well as neighbourhood
variables (Xnt), and environmental variables (Xet) which in this study include the
quality of the most proximate state school.
Thus the general hedonic price model to be estimated is as follows:
Pit = f (Xht, Xnt, Xet, eit)
(1)
where:
Pit = House price i in time period t;

Xht = Physical housing characteristics;
Xnt = Neighbourhood (location) characteristics;
Xet = Environmental characteristics;
eit = Unmeasured factors.
By regressing the physical, neighbourhood and environmental characteristics

of a set of properties against the purchase price as themdependent variable, it is possible to calculate implicit prices for each of the characteristics.2
It should be noted that in hedonic estimation attention must be given to the
choice of an appropriate functional form, the optimal combination of explanatory
variables and the potential problem of multicollinearity. Tests developed by George
E. P. Box and D. R. Cox (1964) are employed in this study and resulted in a semi-log
specification as the most appropriate functional form. This particular functional form
has the advantage of ease of interpretation of parameter estimates. Analyses were
also carried out to determine the optimal combinations and appropriate transformations of the explanatory variables in the regression model. In particular, the results
showed that floor area consistently outperforms the number of habitable rooms in
explaining house prices.
With such a rich data set it is desirable to use as many variables as possible to
define our house price equation; however, in practice, some explanatory variables
may be correlated with each other in other words, the problem of multicollinearity
may exist. Garrod and Willis (1992) indicate that multicollinearity is a common
problem in hedonic price functions and one which is often conveniently ignored.
Tests for multicollinearity were conducted based on the methodology outlined in David A. Belsey, Edwin Kuh, and Roy E. Welsch (1980).
The performance of what Philip Graves et al. (1988) term focus variables
in this paper, the school performance variable - is of primary importance. We experimented with dummy variables including those which separated the dataset into discrete deciles and excluded the deciles which included the national average and local
average school performances; we also experimented with excluding lower deciles
and higher deciles. Dummy variables were included to pick up the effect of better
than and worse than performances with respect to national and local averages. In all
of these cases the dummy variables failed to work as effectively as the continuous
specification of the school performance variable that we ultimately included in our
preferred equation.
Finally, as the preferred regression equation covered more than one time period we have indexed the equation using the time dummy method (Michael C.
Fleming and Joseph G. Nellis 1985). Therefore, with time incorporated as a dummy
variable, percentage changes in price can be observed directly as the coefficient on
the time variable, our base year in all cases being 2001.
2
Hedonic pricing methods have also been employed to calculate the value of a wide range of both welcome and unwelcome local amenities. These include aircraft noise (Terrence J. Levesque 1994), air
quality (Kenneth Y. Chay and Michael Greenstone 2004), hazardous waste sites (Jill J. McCluskey and
Gordon C. Rausser 2000), woodland (Guy Garrod and Ken Willis 1992) and the proximity of churches
(Quang Do, Robert W. Wilbur, and James L. Short 1994; Thomas M. Carroll, Terrance MClauretie, and
Jeff Jensen 1996).
413
414
4. Empirical Results
The final regression model uses the natural log of house price as the dependent variable (ln P). Combinations of the following independent variables were used: dummy
variables to capture the impact of house type (detached, semi-detached, terraced, flat
and bungalow); the existence of a garden; none or partial central heating; the age of
the property (split into five distinct classifications properties built prior to 1919,
properties built between 1919-45, 1945-60, post-1960 and new build). A set of
ACORN ratings dummy variables was included to allow for variability in neighbourhood characteristics while annual time dummy variables were included to allow for
the influence of inflationary effects over the period 2001-2007 not associated with
the physical, neighbourhood or environmental characteristics of the properties in our
dataset. A dummy variable was incorporated to link each property in our dataset with
the nearest secondary school. Continuous measures of numbers of bathrooms, toilets,
garages and garage spaces and the size of a property, which measures the internal
floor space (measured in square metres) were also included in the final equation. Our
data set allowed us to experiment with specifications which included the number of
habitable rooms but this specification was rejected in favour of a continuous floor
space variable on the basis of goodness-of-fit and the overall performance of other
variables in our preferred equation.
Therefore, the model provides an estimate of the influence of property characteristics with reference to a standard house (David Forrest, John Glen, and Robert
Ward 1996). In this study our standard property in each city was determined on the
basis of identifying the modal characteristics. Thus in all cities the standard house
had full central heating and no garden while the excluded house types, house ages
and ACORN types are reported in Table 2 below. The modal characteristics are excluded from our equation and the coefficients on the included dummy variables can
be interpreted as a percentage premium or discount relative to the excluded modal
characteristic.
Table 2 Excluded House Type, House Age and ACORN Code by City
City
Birmingham
Bristol
Leeds
Liverpool
London
Manchester
Newcastle
House type
Semi-detached
Terraced
Terraced
Semi-detached
Flat
Terraced
Semi-detached
House age*
1960+
Pre 1919
1960+
1960+
Pre 1919
1960+
1960+
ACORN
IK
EFG
IK
IK
D
IK
IK
Notes:
*1960+ denotes properties built after 1960, but not new build.
The regression results are presented in the Appendix, Tables A G for each of the seven cities in turn.
Source: Authors calculations.
Table 3 below reports the estimated regression coefficient on the school performance variable in each of the seven cities along with the corresponding average
standard deviation. This allows us to report a percentage house price premium for an
additional one standard deviation of school performance above the average in each
city. The inclusion of the average house price in each city in 2007 allows us to monetise the premium for an additional one standard deviation of school performance
above the mean.
Table 3 Coefficient on School Performance Variable and the Residential House Price Premium for a
Local School with GCSE Performance One Standard Deviation above the Local Average
City
Birmingham
Bristol
Leeds
Liverpool
London
Greater Manchester
Newcastle
Coefficient
Average
standard
deviation of
GCSE results
0.001
0.003
0.002
0.001
0.001
0.002
0.001
17.31
18.07
18.33
21.08
18.64
15.96
16.06
Percentage house
price premium for
one additional
standard deviation
in school
performance
+1.7%
+5.4%
+3.6%
+2.1%
+1.9%
+3.2%
+1.6%
Average house
price
(, 2007)
197,086
250,210
178,284
188,378
367,029
188,372
169,858
House price
premium for one
additional
standard
deviation
(, 2007)
3,350
13,511
6,418
3,956
6,973
6,028
2,718
Source: Average standard deviation based on authors calculations employing DCSF data.
The above results suggest that in Birmingham, Liverpool, London and Newcastle, for every 10% point improvement in the average GCSE pass rate (% or more
GCSEs at grades A*-C), property prices increase by 1%. This would imply that, ceteris paribus, a school which had a pass rate of 80% would give rise to a local property price premium of 4% compared to properties where the local state-funded secondary school had a pass rate of 40%.
In order to facilitate comparison across a number of studies, Gibbons and Machin (2008) and Davidoff and Leigh (2007) summarise the results of various studies
by reporting the percentage increase in house prices stemming from an increase in
school performance equivalent to one standard deviation above the city mean. Table
3 shows the average standard deviation of results, in each city, over the period of this
study and the resulting house price premia (in percentage terms) based on the school
performance coefficients. For example, in Birmingham an additional one standard
deviation of school performance increases residential property prices by 1.7% whereas in Bristol an additional standard deviation of school performance increases
property prices by 5.4%. In addition, Table 3 also shows the value of these house
price premia in absolute terms (). Note that these premia are computed on the basis
of average house prices in each city in 2007 multiplied by the corresponding percentage house price premium averaged over the seven years of this study. It is clear from
these results that the cost of good education varies across the cities studied ranging
from 2.7k in Newcastle to 13.5k in Bristol. This would appear to justify our geographical segmentation approach to modelling the relationship between school performance and house prices. The monetary values attached to a one standard deviation
improvement would not appear to be out of line with those reported by Black (1999)
and Gibbons and Machin (2006). Furthermore, in Greater London in 2006, DCSF
statistics indicate that the range of school performance varied from a pass rate of
21% for the lowest performing school to 98% for the highest performing school. The
415
416
house price premia that the highest performing school generated in 2007 compared to
the lowest performing school is approximately 33,400. This is less than the comparable 2004 figure for Greater London of 61,000 reported by Gibbons and Machin
(2008). This may be partially explained by a greater range of school performance in
2004 (12%-99%) compared to 2006 (22%-98%). It would also appear to be the case
that our preferred strategy for modelling neighbourhood characteristics has resulted
in coefficient estimates on the school performance variable which are not upwardly
biased.
Furthermore, the results provide some support for the assertion in the hedonic
literature that where the elasticity of supply of good schooling is unresponsive then
price premia will be greater. To illustrate this point, Table 4 below reports the percentage of students obtaining 5 or more GCSEs at grades A* - C in the seven cities
over the period 2000 to 2006. Students performance in 2007 is not reported in this
table as our model suggests that house prices in any one year will be contingent upon
the previous years GCSE performance of the nearest state school. Table 4 shows
that Bristol started and ended the period with the lowest average school performance
of the seven cities. This contrasts with Newcastle which started the period with an
unspectacular average performance but exhibited a much greater elasticity of supply
of good schools on the basis of average school performance over the period.
Table 4 Percentage of Students Gaining Five or More GCSE Passes at Grades A* - C (2001-2006)
City
Birmingham
Mean
Bristol
Mean
Leeds
Mean
Liverpool
Mean
London
Mean
Manchester
Mean
Newcastle
Mean
2000
2001
2002
2003
2004
2005
2006
35
36.9
41.3
46.1
48.1
53.9
56.7
32
32.9
32.2
38
36.9
37.5
46.4
37.7
38
39.6
43.2
45.2
50.3
52.3
34.9
36.7
39.5
41.7
45.3
51.6
57.2
43.2
44.6
47.3
50.2
53
54.9
58.1
40.9
41.9
43.7
46
46.4
50.4
53.7
32.1
39.8
41.9
41
45.2
59.6
56.1
Source: Department for Education.3
Finally, in order to examine the impact that including ACORN values had on
the school quality variable we estimated our hedonic equation with housing characteristic variables only and then with housing characteristic and ACORN values included. As Table 5 below indicates, in the cases of Birmingham, Bristol, Leeds,
Greater London, Manchester and Newcastle the impact of adding ACORN codes was
to reduce the coefficient on the school performance variable, suggesting that any endogeneity issues that existed with respect to neighbourhood quality in these local
housing markets have been (at worst, partially) accounted for.
3
Department for Education. 2010. Secondary School Achievement and Attainment Tables, 2000-2006.
www.education.gov.uk/researchandstatistics/attainmenttables (accessed July, 2010).
Table 5 Comparison of School Quality Coefficient When Regression Model Includes Only Housing
Characteristics Variables with a Regression Model Including Housing Characteristic
Variables and ACORN Values (R2 Coefficient of Determination Values are Also Reported)
City
Birmingham
Bristol
Leeds
Liverpool
London
Manchester
Newcastle
School Quality
R
School Quality
R
School Quality
R
School Quality
R
School Quality
R
School Quality
R
School Quality
R
Housing characteristics
included
0.007
0.577
0.007
0.586
0.008
0.536
0.005
0.472
0.004
0.571
0.007
0.537
0.004
0.529
Housing characteristics and

ACORN values included
0.006
0.639
0.006
0.636
0.007
0.587
0.005
0.521
0.004
0.629
0.006
0.574
0.003
0.598
5. Summary and Conclusions

The results in this study provide robust evidence that the differences in state-funded
secondary school performance in GCSE examinations is consistently capitalised into
residential property prices; ie., residential properties which are located proximate to
high performing state-funded secondary schools attract a price premium. The extent
of the price premium varies between different cities. In Greater London, Liverpool,
Birmingham and Newcastle a 10% point differential in GCSE performance produces
a 1% point differential in residential properties located close to the high performing
school. In Greater Manchester and Leeds the same differential in school performance
produces a 2% point increase in residential properties located close to the high performing school, while in Bristol a 10% point differential in GCSE performance produces a 3% point increase in residential properties located close to the high performing school. Note that this implies that in Bristol a property where the closest school
had a pass rate of 80% compared to a property where the closest school had a pass
rate of 40% would attract a price premium of 12% points, ceteris paribus. Using average prices in 2007 and the average percentage premia for an improvement in
school performance since 2001, we find that the value placed on good education in
terms of a premium on house prices ranges from 13.5k in Bristol to 2.7k in Newcastle.
We experimented with different representations of school performance. Specifically, we examined if there were threshold values of GCSE pass rates which defined a good school. We also examined the relative performance of schools to ascertain if a house price premium was paid for an above local average or above national average performance. In all cases none of the alternative specifications of
school performance produced superior results to our preferred specification. This
reinforces the suggestion that it is the absolute performance of the nearest state
417
418
funded secondary schools that parents focus upon when making house purchasing
decisions.
The cities which attracted the highest price premia for good school performance were those where the average pass rate in GCSE examinations was the lowest.
In other words, in those cities where the supply of good schools was lower, the price
premium for a good school, in terms of the rate at which school performance was
capitalised into local property prices, was higher. This finding has implications for
students ability to access high performing schools, in so far as their parents have an
inability to pay the price premium required to purchase a house which would guarantee access. The response of the current UK government to the paradox of pupils being denied access to state-funded education due to their parents inability to pay a
shadow price that exists in the local residential property market is to introduce a lottery into the allocation of places at oversubscribed schools. We would suggest that
this is inappropriate in that it deals with the symptoms of the problem rather than the
causes. We would argue that the government should focus on improving school quality as doing so would remove the extent of the price premium that high performing
schools attract, thereby reducing the extent to which students would be excluded
from state-funded secondary education because of their parents inability to pay the
price in local residential property markets.
Finally, it may be the case that the private sector may be willing to fund improvements in state-funded secondary schooling, as low performing schools will
mean that they may find it difficult to attract workers with children of secondary
school age to areas where secondary school performance is poor. In such circumstances workers may require wages which allow them to educate their children at private schools or in extremis they may not move to a particular city. In addition, appropriate public transport policy may enable students to access good performing
schools from a greater geographical distance and perhaps alleviate any upward pressures on local house prices. These points are worthy of further investigation.
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421
422
Appendix: Tables A-G

Table A Birmingham
Variable
Constant
House Type
Detached
Terraced
Bungalow
Flat
Number of Bathrooms
Number of Toilets
Number of Garages
Number of Garage Spaces
Garden
Size (in square metres)
Availability of Central Heating
None
Partial
Age of Property
Pre-1919
1919-1945
1945-1960
New
Acorn Classification
A
B
C
D
EFG
H
J
Time
Yr 2002
Yr 2003
Yr 2004
Yr 2005
Yr 2006
Yr 2007
School Quality
Coefficient
10.482
Standard Error
0.007
T-statistic
1398.444**
0.157
-0.114
0.133
-0.200
0.116
0.051
0.083
0.035
0.106
0.003
0.005
0.004
0.012
0.006
0.004
0.003
0.003
0.002
0.008
0.000
30.731**
-30.089**
11.459**
-31.713**
31.813**
18.532**
29.270**
22.201**
14.004**
72.675**
-0.066
-0.055
0.004
0.005
-17.616**
-11.718**
0.070
0.071
0.029
0.097
0.005
0.004
0.005
0.006
15.173**
18.879**
6.248**
16.021**
0.617
0.433
0.435
0.444
0.284
0.173
-0.035
0.007
0.006
0.008
0.007
0.004
0.004
0.005
83.179**
66.959**
57.806**
60.832**
71.109**
42.342**
-6.402**
0.234
0.417
0.515
0.580
0.624
0.669
0.001
0.006
0.005
0.006
0.005
0.005
0.005
0.000
41.514**
76.379**
93.308**
110.609**
119.508**
129.969**
18.133**
Sample size
Adjusted R
F-Statistic
38,456
0.772
4348.164
Note: **Significant at the 5%, or higher level, of significance.

Source: Authors estimations.
Table B Bristol
Variable
Constant
House Type
Detached
Semi-detached
Bungalow
Flat
Number of Bathrooms
Number of Toilets
Number of Garages
Garden
None
Partial
Age of Property
1919-1945
1945-1960
1960+
New
A
B
C
D
H
IK
J
Time
Yr 2002
Yr 2003
Yr 2004
Yr 2005
Yr 2006
Yr 2007
School Quality
Coefficient
10.938
Standard Error
0.011
0.190
0.084
0.125
-0.073
0.134
0.061
0.089
0.034
-0.038
0.003
0.008
0.006
0.013
0.008
0.005
0.004
0.004
0.003
0.009
0.000
24.540**
15.107**
9.278**
-8.813**
27.555**
14.417**
22.016**
13.584**
-4.268**
56.701**
-0.014
-0.065
0.007
0.009
-2.098**
-7.418**
-0.048
-0.117
-0.123
-0.103
0.007
0.008
0.006
0.009
-6.862**
-14.913**
-20.193**
-11.172**
0.252
0.116
0.103
0.188
-0.068
-0.224
-0.176
0.010
0.008
0.011
0.007
0.006
0.007
0.014
25.580**
15.137**
9.386**
25.879**
-11.032**
-34.156**
-12.246**
0.256
0.346
0.417
0.439
0.534
0.609
0.003
0.009
0.008
0.008
0.008
0.007
0.007
0.000
29.399**
41.816**
51.046**
56.215**
73.467**
83.455**
24.614**
Sample size
Adjusted R
F-Statistic
T-statistic
1031.013**
13,698
0.774
1561.433

423
424
Table C Leeds
Variable
Constant
House Type
Detached
Semi-detached
Bungalow
Flat
Number of Bathrooms
Number of Toilets
Number of Garages
Garden
None
Partial
Age of Property
Pre-1919
1919-1945
1945-1960
New
A
B
C
D
EFG
H
J
Time
Yr 2002
Yr 2003
Yr 2004
Yr 2005
Yr 2006
Yr 2007
School Quality
Coefficient
10.133
Standard Error
0.007
0.230
0.102
0.217
0.042
0.139
0.071
0.104
0.037
-0.025
0.003
0.005
0.004
0.007
0.006
0.004
0.003
0.003
0.001
0.006
0.000
43.328**
27.111**
30.926**
6.517**
38.986**
23.791**
38.990**
25.507**
-4.177**
83.712**
-0.103
-0.074
0.003
0.006
-31.379**
-12.351**
-0.005
0.014
-0.025
0.052
0.004
0.004
0.005
0.006
-1.300
3.660**
-5.289**
8.580**
0.612
0.391
0.391
0.505
0.288
0.173
-0.082
0.007
0.006
0.007
0.007
0.004
0.004
0.007
84.666**
68.846**
52.240**
73.340**
77.070**
47.179**
-11.656**
0.211
0.402
0.571
0.686
0.756
0.824
0.002
0.005
0.005
0.005
0.005
0.005
0.005
0.000
40.816**
80.616**
112.998**
140.757**
160.369**
174.231**
27.721**
Sample size
Adjusted R
F-Statistic
T-statistic
1466.668**
44,278
0.794
5681.224

Table D Liverpool
Variable
Constant
House Type
Detached
Semi-detached
Bungalow
Flat
Number of Bathrooms
Number of Toilets
Number of Garages
Garden
None
Partial
Age of Property
Pre-1919
1919-1945
1945-1960
New
A
B
C
D
EFG
H
J
Time
Yr 2002
Yr 2003
Yr 2004
Yr 2005
Yr 2006
Yr 2007
School Quality
Coefficient
10.267
Standard Error
0.010
T-statistic
977.921**
0.125
-0.152
0.128
-0.034
0.117
0.057
0.102
0.043
-0.056
0.003
0.008
0.006
0.013
0.008
0.005
0.004
0.005
0.003
0.007
0.000
15.994**
-26.672**
9.581**
-4.066**
21.849**
13.697**
22.469**
16.398**
-8.352**
52.314**
-0.065
-0.012
0.006
0.005
-11.774**
-2.249**
0.070
0.130
0.039
0.110
0.007
0.006
0.007
0.008
10.153**
22.866**
5.570**
13.522**
0.598
0.416
0.470
0.452
0.330
0.224
0.030
0.013
0.010
0.011
0.011
0.006
0.006
0.013
44.689**
41.192**
42.314**
39.993**
56.030**
38.875**
2.257**
0.008
0.008
0.008
0.007
0.007
0.007
0.000
19,506
0.772
2200.021
0.010
20.013**
51.218**
80.198**
100.985**
109.475**
112.168**
12.589**
0.158
0.386
0.625
0.739
0.783
0.814
0.001
Sample size
Adjusted R
F-Statistic
10.267
977.921**

425
426
Table E Greater London

Variable
Constant
House Type
Detached
Semi-detached
Bungalow
Flat
Number of Bathrooms
Number of Toilets
Number of Garages
Garden
None
Partial
Age of Property
Pre-1919
1919-1945
1945-1960
New
A
B
C
D
EFG
H
J
Time
Yr 2002
Yr 2003
Yr 2004
Yr 2005
Yr 2006
Yr 2007
School Quality
Coefficient
11.499
Standard Error
0.004
T-statistic
2940.455**
0.223
0.208
0.165
0.267
0.254
0.064
0.035
0.012
0.048
0.004
0.005
0.003
0.002
0.008
0.002
0.002
0.002
0.001
0.002
0.000
45.849**
67.335**
70.117**
34.091**
137.899**
40.188**
17.343**
9.728**
22.272**
167.389**
-0.023
-0.029
0.002
0.004
-9.640**
-7.933**
-0.100
-0.183
-0.211
-0.178
0.002
0.003
0.002
0.004
-44.586**
-59.782**
-96.259**
-42.480**
0.020
-0.126
-0.227
-0.294
-0.373
-0.483
-0.291
0.005
0.005
0.008
0.002
0.003
0.003
0.002
4.085**
-27.624**
-29.390**
-124.190**
-120.579**
-138.289**
-124.842**
0.003
0.004
0.003
0.003
0.003
0.003
0.000
167,807
0.699
13003.140
0.004
47.055**
69.459**
82.525**
107.994**
140.998**
178.558**
24.127**
0.163
0.245
0.279
0.330
0.420
0.523
0.001
Sample size
Adjusted R
F-Statistic
11.499
2940.455**

Table F Greater Manchester

Variable
Constant
House Type
Detached
Semi-detached
Bungalow
Flat
Number of Bathrooms
Number of Toilets
Number of Garages
Garden
None
Partial
Age of Property
Pre-1919
1919-1945
1945-1960
New
A
B
C
D
EFG
H
J
Time
Yr 2002
Yr 2003
Yr 2004
Yr 2005
Yr 2006
Yr 2007
School Quality
Coefficient
10.082
Standard Error
0.006
T-statistic
1580.512**
0.233
0.133
0.218
0.111
0.153
0.054
0.087
0.061
-0.083
0.003
0.005
0.003
0.007
0.006
0.003
0.003
0.003
0.001
0.004
0.000
46.175**
38.038**
30.836**
20.015**
47.627**
20.702**
33.226**
41.786**
-20.070**
94.968**
-0.036
-0.062
0.004
0.007
-10.072**
-9.517**
0.102
0.082
0.006
0.110
0.004
0.004
0.005
0.005
26.737**
22.602**
1.408
22.106**
0.712
0.449
0.437
0.508
0.337
0.191
-0.023
0.007
0.005
0.006
0.006
0.004
0.004
0.007
106.397**
93.784**
67.623**
81.769**
95.624**
52.921**
-3.168**
0.005
0.005
0.005
0.004
0.004
0.004
0.000
60,502
0.776
7006.727
0.006
34.905**
70.920**
117.642**
147.466**
166.047**
180.704**
21.378**
0.168
0.332
0.545
0.651
0.708
0.759
0.002
Sample size
Adjusted R
F-Statistic
10.082
1580.512**

427
428
Table G Newcastle
Variable
Constant
House Type
Detached
Semi-detached
Bungalow
Flat
Number of Bathrooms
Number of Toilets
Number of Garages
Garden
None
Partial
Age of Property
Pre-1919
1919-1945
1945-1960
New
A
B
C
D
EFG
H
J
Time
Yr 2002
Yr 2003
Yr 2004
Yr 2005
Yr 2006
Yr 2007
School Quality
Coefficient
10.509
Standard Error
0.012
T-statistic
856.103**
0.084
-0.089
0.102
-0.173
0.144
0.052
0.121
0.035
-0.014
0.003
0.007
0.005
0.009
0.007
0.005
0.004
0.004
0.003
0.007
0.000
11.668**
-16.156**
10.794**
-23.150**
28.842**
13.255**
30.089**
11.565**
-2.056**
55.719**
0.017
-0.064
0.006
0.010
2.962**
-6.671**
0.114
0.062
0.016
0.093
0.006
0.006
0.006
0.008
17.712**
11.064**
2.555**
11.883**
0.569
0.348
0.350
0.465
0.270
0.151
0.071
0.012
0.009
0.010
0.009
0.005
0.006
0.011
47.837**
40.009**
33.478**
54.551**
49.393**
25.714**
6.552**
0.010
0.009
0.009
0.009
0.009
0.009
0.000
15,206
0.729
1361.268
0.012
23.525**
41.649**
58.073**
62.962**
68.039**
73.474**
3.566**
0.237
0.382
0.527
0.575
0.611
0.663
0.001
Sample size
Adjusted R
F-Statistic
10.509
856.103**


Received: 10 June 2010; Accepted: 27 July 2010.
Nikolaos Giannellis
Department of Economics,
University of Ioannina,
Greece
ngianel@cc.uoi.gr
Angelos Kanas
University of Piraeus,
Greece
akanas@unipi.gr
Athanasios P.
Papadopoulos
University of Crete,
Greece
appapa@econ.soc.uoc.gr
The authors acknowledge financial

support from the European Social Fund
and National resources. Moreover, the
authors would like to thank two
anonymous referees for helpful
comment and discussion on a previous
draft of the paper. Of course, any
remaining errors are our own.
UDC 336.761.5(420+73)
DOI: 10.2298/PAN1004429G
Asymmetric Volatility Spillovers

between Stock Market and Real
Activity: Evidence from the UK
and the US
Summary: This paper examines the short-run dynamic relationships between
stock market and real activity, within a country, for the UK and the US. The
Cross Correlation Function testing procedure is applied to test for causality in
mean and in variance between the stock market and the real economic sector.
Besides variance causation, volatility spillover effects are examined through the
multivariate specification form of the Exponential GARCH model. There is
evidence of significant reciprocal volatility spillovers between the two sectors
within a country, implying stronger interdependencies in the UK rather than in
the US and asymmetric behavior only in the case of the UK.
Key words: Stock market, Real activity, Volatility spillovers, UK, US.
JEL: C32, E44, G12.
The relationship between the financial system and economic growth is captured by a
large amount of theoretical and empirical works.1 From a theoretical point of view,
Joseph A. Schumpeter (1912) argues that banks can spur technological innovation
and economic growth by funding productive innovations. However, there are theoretical papers arguing that the relationship between financial institutions and economic
growth is not significant. For example, Joan Robinson (1952) states that financial
institutions follow the developments in the real economic sector. Similarly, Robert
Lucas (1988) supports the view that the role of the financial system has been badly
over-stressed. However, most of the subsequent theoretical papers have shown that
there is a positive relationship between the financial sector and the real economic
sector. In a comprehensive review of the literature, Ross Levine (1997) mentions that
the financial institutions may affect economic growth through two channels: (i) capital accumulation and (ii) technological innovation. Levine (1991) shows that stock
markets decrease liquidity risk and increase the incentives to investing in longduration investment projects. Furthermore, Michael B. Devereux and Gregor W.
Smith (1994) and Maurice Obstfeld (1994) show that financial institutions that ease
risk diversification provoke portfolio shifts toward investments with high expected
return.
1
For an analytical review of the literature, see Levine (1997).
430
Nikolaos Giannellis, Angelos Kanas and Athanasios P. Papadopoulos
Turning to the empirical part of the literature, there is a plethora of empirical

works dealing with this issue, especially for developed countries. For the US, Stanley
Fischer and Robert C. Merton (1984), Robert J. Barro (1990), Eugene F. Fama
(1990), and William G. Schwert (1990) find that real stock returns can lead changes
in real activity. Furthermore, Christis Hassapis and Sarantis Kalyvitis (2002), using
Granger causality in a Vector Autoregressive (VAR) framework, and Jongmoo J.
Choi, Shmuel Hauser, and Kenneth J. Kopecky (1999), using the bivariate out-ofsample prediction test of Richard Ashley, Clive W. J. Granger, and Richard Schmalensee (1980) (AGS) also find evidence of causality from US stock returns to US
industrial production growth. Under the framework of a VAR analysis, Bong-Soo
Lee (1992) and David E. Rapach (2001) find a significant positive relation between
stock returns and real activity in US. On the contrary, Nikiforos T. Laopodis (2006)
finds no supportive evidence that stock returns signal changes in future real activity
in US. Alireza Nasseh and Jack Strauss (2000), using a Vector Error Correction
(VEC) model, find significant long-run relationships between stock prices and industrial production in five European countries, including the UK. In addition, Paolo
Mauro (2003) states that stock market developments should be taken into account in
forecasting output in both developed and developing countries.
However, all these studies have not tested if volatility in one sector can be imported to the other. Most importantly, they have not taken into account any possible
asymmetries in the volatility transmission mechanism between stock market and real
economic activity. Dale L. Domian and David A. Louton (1997) find evidence of
asymmetry in the predictability of industrial production growth by stock returns for
the case of US. Negative shocks in the stock market affect industrial production
growth more than positive shocks. Although this study introduces the asymmetric
nature of dependences between the series, the asymmetric nature of the volatility
transmission mechanism has not been investigated.
In this work, we examine the short-run dynamic relationships between stock
market and real activity for the UK and the US. Specifically, we investigate whether
volatility causation and transmission (volatility spillover) characterize the relation
between the two sectors. To capture this kind of relationship we employ two similar
empirical methodologies. Specifically, to examine causality in both the mean and the
variance between real stock returns and real growth rates, we apply the two-stage
Cross Correlation Function (CCF) testing procedure, developed by Yin-Wong
Cheung and Lilian K. Ng (1996). Moreover, we look for potential asymmetries in the
volatility transmission mechanism between the two sectors, within an economy. We
explicitly test whether a negative shock in one sector (for example, stock market) has
exactly the same impact on the other sector (for example, real economic sector) with
a positive shock. To capture this kind of asymmetry, we employ a bivariate exponential GARCH (EGARCH) model, which was originally presented by Daniel B. Nelson
(1991). There are an adequate number of empirical studies which find that conditional volatility responds asymmetrically to innovations (good or bad news). Fischer
Black (1976) was the first who observed that stock prices respond asymmetrically to
new information due to the leverage effect. In the context of volatility transmission,
Gregory Koutmos and Geoffrey G. Booth (1995), Koutmos (1996), and Angelos Ka-
Asymmetric Volatility Spillovers between Stock Market and Real Activity: Evidence from the UK and the US
nas (1998) find significant asymmetric volatility spillovers among international stock
markets.2
To the best of our knowledge of the literature, this paper is the first that examines the asymmetric nature of the volatility transmission mechanism between the
stock market and the real economic sector for the cases of the UK and the US. A new
finding that arises from this analysis is that the short-run dynamic relationship between stock market and real activity is characterized by a bi-directional asymmetric
behavior, especially for the case of the UK. In addition, this analysis entails important economic and policy implications. Given that price stability and financial stability are highly complementary objectives, the question for policy makers is whether
they should be concerned about the stock markets volatility. Ben Bernanke and
Mark Gertler (2000) argue that monetary authorities should be concerned about asset
price volatility if this is caused by nonfundamental factors, such as the poor regulatory practice and the irrational investing behavior in stock markets. This is because
nonfundamental financial instability can be seen as an independent source of real
activity instability.
This is actually the case of the recent global financial crisis of 2008. Namely,
nonfundamental factors, such as the high-risky investment policy of the financial
institutions and the poor regulatory policy of the monetary authorities, are considered
as main causes of this crisis. Hence, the origin of the recent financial crisis and the
ongoing slowdown of the global economy indicate the linkage of this study with the
recent global financial crisis. Specifically, the evidence in favor of asymmetric volatility spillover effects sheds light on the selection of the appropriate monetary policy
that should be applied. For example, evidence of asymmetry would imply that bad
news (falling stock returns) exports more volatility to the real activity sector than
good news (increasing stock returns). This means that policy makers should apply a
monetary policy framework suitable for protecting real economic activity from unexpected stock market shocks in periods of financial instability. To preview our results,
we have found evidence of significant interdependencies between stock market and
real activity, within an economy, implying stronger interdependencies in the UK rather than in the US. In addition, volatility spillovers from the stock market to the real
sector are found to be symmetric only in the case of the US. This fact may be explained by the applied monetary policy in the US and by the good condition of the
US balance sheets during the 1990s. Finally, this study provides lessons for policy
makers, especially in developing countries with unstable financial markets. In periods of high financial instability, monetary authorities should adjust interest rates in
a systematic way until the economy and the financial system are stabilized. An appropriate monetary policy framework is of the form of flexible inflation targeting,
increasing interest rates when stock prices rise and reducing them when stock prices
are falling.
2
The Exponential GARCH model has been applied to various fields of economic interest, such as the
relation between US and Eurodollar interest rates (Yiuman Tse and Booth 1996), the dynamic relationship between stock returns and exchange rates (Kanas 2000), the relationship between interest rates and
exchange rates (Raymond W. So 2001), the dynamic correlation in European bond market (Vasiliki D.
Skintzi and Apostolos N. Refenes 2006) and volatility spillovers across swap markets (Francis In 2007).
431
432
The structure of the remaining paper is as follows. The next section describes
the data used in this study and Section 2 presents our estimation output. A final section summarizes and provides policy implications for developing economies.
1. Data
The data set consists of monthly observations over the period January 1970
December 2002 for UK and US stock prices (s), UK and US industrial production, as
well as UK and US producer price indices. Real industrial production (IP) is calculated by dividing the industrial production index by the producer price index, while
its growth rate (y) is calculated as the first difference of real IP. Real stock prices (s)
are calculated by dividing nominal stock prices by the price index, and real stock
returns (r) are calculated as the first difference of real stock prices. All variables are
presented in natural logarithms. Jargue-Bera statistics reveal that the hypothesis of
normality is rejected for all variables. The distributions of stock returns and real IP
growth are negatively skewed and leptokurtic relative to the normal distribution. The
Ljung-Box statistics applied to the series and squared series using 12 lags imply evidence of significant linear and nonlinear dependencies. The ARCH test (Robert F.
Engle 1982) for time-varying conditional heteroskedasticity confirms the evidence of
volatility clustering in the distributions of the above series.
When it comes to the stationary nature of the variables, a variety of alternative
unit root tests provides evidence of non-stationarity for the stock prices and the industrial production. Accordingly, real stock returns and real IP growth rate appear to
be stationary. Johansens trace test for cointegration between industrial production
and stock prices, within a country, implies no evidence of long-run cointegrating relation. Given that real stock returns and the real IP growth rate are stationary, and
that there is no cointegration, a VAR model for real stock returns and real IP growth
rate should be used.3
2.1 Results from the CCF Test
The empirical application of the CCF test entails a two-stage procedure. The first one
involves the estimation of the univariate EGARCH (p,q) model for both series, whereas the second includes the construction of the standardized and squared standardized residuals. Then, the constructed residuals are used to calculate the CCF test
statistics. For the real stock returns and the real IP growth, we estimate AR(2)EGARCH (1,1) models of the following form
The employed unit root tests are the Augmented Dickey-Fuller (ADF) test, the Graham Elliot, Thomas
J. Rothenberg, and James H. Stock (1996) and Elliot (1999) GLS-ADF, and the Serena Ng and Piere
Perron (2001) GLS versions of the modified Peter C. B. Phillips and Perron (1988) unit root tests. Furthermore, the KPSS stationarity test (Denis Kwiatkowski et al. 1992) is employed to ensure robustness.
Preliminary statistics as well as unit root and cointegration test results are not reported to save space.
However, they will be available upon request.
xt
x ,0
1 x t 1
xt2
(1)
x ,t
x2,t exp{ax,0 bx log(x2,t1) x[( zx,t 1 E zx,t 1 ) x zx,t 1]}
(2)
where x r , y .
Equation (1) is the conditional mean equation and Equation (2) stands for the
conditional variance equation. The order of the autoregressive GARCH term (p) and
that of the moving average ARCH term (q), as well as the order of the autoregressive
process, have been determined using the Likelihood Ratio test.4
Table 1 presents the results from the univariate AR(2)-EGARCH (1,1) models. Starting from the conditional mean equations, most of the estimated parameters
are found to be statistically significant. Moving on to the conditional variance equations, the coefficient , which measures the ARCH effect, is found to be statistically
significant in all series at 1% significance level. In each model, the degree of volatility persistence (b) is less than one. Moreover, by employing two test statistics (i.e. the
t-statistic and the F-statistic), we managed to reject the hypothesis that b is equal to
one. This implies that all conditional variances are stationary. The asymmetric effect
parameter ( ) is found to be statistically significant at 1% significance level for the
US real stock returns and the US IP growth rate. Similarly, UK real stock return series is statistically significant at the 10% level of significance.
Table 1 Univariate EGARCH (p, q) Models
UK
Parameters
0
1
2
a0
B
H0: b=1
L()
LB (12)
LB2(12)
Skewness
Kurtosis
JB
4
Stock Returns
p=1, q=1
0.002
(1.22)
0.17*
(2.33)
-0.14***
(-1.87)
-0.96*
(-2.87)
0.88*
(18)
t=-3z, F=5.76z
0.35*
(2.56)
-0.09***
(-1.86)
598.24
14.29
8.48
-0.56
4.12
41.87n
US
Real IP Growth
p=1, q=1
-0.003*
(-5.89)
-0.11**
(-1.95)
-0.15*
(-2.65)
-4.11*
(-5.71)
0.60*
(7.13)
t=-5z, F=22.2z
0.87*
(4.86)
-0.17
(-1.60)
1132.45
1.88
0.78
-0.73
5.61
147.51n
Stock Returns
p=1, q=1
0.005*
(2.23)
-0.10*
(-2.54)
-0.03
(-0.76)
-2.54*
(-3.76)
0.61*
(5.58)
t=-3.5z, F=11.7z
0.24*
(2.23)
-0.25*
(-3.67)
652.97
17.56
14.17
-0.37
4.31
37.69n
Real IP Growth
p=1, q=1
0.0005
(1.51)
0.14*
(2.62)
0.12***
(1.82)
-0.94*
(-3.73)
0.92*
(34.45)
t=-4z, F=8.25z
0.25*
(2.01)
-0.17*
(-3.59)
1325.66
0.09
0.94
-0.26
4.15
26.41n
These test statistics are not reported to save space. They will be available on request.
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434
Notes: *, ** and *** denote statistical significance at the 1%, 5% and 10% level, respectively. z denotes rejection
of the null hypothesis. n denotes rejection of the normality hypothesis. LB stands for Ljung-Box statistics, while JB
stands for the Jargue-Bera statistic. Robust t-statistics in parentheses. p is the order of the autoregressive
GARCH terms. q is the order of the moving average ARCH terms. 0 and a0 are the constant terms of the mean
and variance equations, respectively. 1 and 2 are the coefficients of the first and second order autoregressive
process of the mean equation. b is the GARCH term, which measures volatility persistence. t is the t-statistic and
F is the Wald test statistic for testing the null hypothesis H0: b=1. is the measure of the ARCH effect.
measure of the asymmetric effect.
is the
However, the UK real IP growth rate is not statistically different from zero.
For the stock returns, the asymmetric effect corresponds to the leverage effect in
stock markets, which states that stock returns tend to be more volatile when stock
prices are falling (Black 1976). On the other hand, the evidence of asymmetry in US
real IP growth rate implies that IP growth is more volatile during economic recession. This is in line with William G. Schwert (1989), who states that production
growth rates are more volatile during economic recessions.
Descriptive statistics, shown in Table 1, examine the statistical adequacy of
the selected AR(2)-EGARCH(1,1) models. The Ljung-Box test statistics imply that
the null hypothesis of no autocorrelation is accepted for all the standardized and the
squared standardized residuals. This finding reveals that the selected EGARCH models have successfully captured all linear and nonlinear dependencies in the series. In
addition, the rejection of the normality hypothesis in all series supports the use of
robust to non-normality standard errors (Tim Bollerslev and Jeffrey Wooldridge
1992).
We now proceed to the second stage of the process. The Cross Correlation
Function (CCF) testing procedure is based on the calculation of the sample cross correlation coefficients, r ( k ) and rUV ( k ) . The null hypothesis of no causality in
mean against the alternative hypothesis of causality at lag k is tested by the following
test statistic
CCFm statistic T r ( k )
(3)
Accordingly, to test the null hypothesis of no causality in variance against the

alternative hypothesis of causality at lag k, we compute the following test statistic:
CCFv statistic T rUV ( k )
(4)
The above CCF statistics have an asymptotic standard normal distribution

(Cheung and Ng 1996). Furthermore, Cheung and Ng (1996) have shown that the
CCF statistic is robust to non-symmetric and leptokurtic errors and asymptotically
robust to distributional assumptions. Thus, if the above test statistic is larger than the
critical value of the standard normal distribution, the null hypothesis is rejected.
At this stage we compute the CCFm and CCFv test statistics for up to two
lags and leads to test for causality in mean and in variance between the series, respectively. The CCF test statistics are shown in Table 2. Lags (-1, -2) refer to causality
tests from stock returns to real IP growth, whereas leads (+1, +2) refer to causality
tests from real IP growth to stock returns. First, we present the results for causality in
mean between the real economic sector and the stock market. For the case of the UK,
the CCFm test statistic is significant only at the second lead. This implies that
changes in stock returns cannot lead changes in IP growth rate. In contrast, the above
finding implies that changes in IP growth rate can cause movements in stock returns
two months ahead. Despite the evidence of instantaneous causality (feedback in
mean) in the US model, both lags are not statistically different from zero. However,
there is evidence of causality in the opposite direction. Like the UK case, US real IP
growth rate changes can lead movements in US stock returns two months ahead.
Table 2 Cross-Correlation Function (CCF) - test Statistics
Lag/Lead
-2
-1
0
+1
+2
UK
Causality in Mean
0.503
-0.218
1.13
1.528
1.695***
Causality in Variance
3.379*
0.005
0.266
-0.111
1.617
Causality in Mean
0.545
1.267
2.01**
1.387
1.958***
US
Causality in Variance
-1.213
0.099
3.528*
-0.241
-0.274
Notes: *, ** and *** denote statistical significance at the 1%, 5% and 10% level, respectively.
Turning to the variance causality test, the results show that UK real stock returns volatility cannot be influenced by the UK IP growth rate variance. On the contrary, the causality in variance from UK real stock return to UK IP growth rate is statistically significant with a lag of two months. This means that there is evidence of
volatility spillover from the stock market to the real sector. Moreover, there is evidence of instantaneous causality (feedback in variance) between US stock returns
and US IP growth rate. However, there is lack of explicit causality in variance in
both directions because neither lag nor lead is statistically significant.
Summing up, the CCF testing procedure has shown that causality in mean is
statistically significant with two lags from real IP growth rate to real stock returns for
both UK and US models. This evidence is consistent with the view that changes in
the expected future economic activity cause changes in current stock prices. For example, an expected future slowdown of the economy increases uncertainty and investment risk, thereby creating disincentives to investing in stock markets. Such a
development reduces current stock prices.5 When it comes to causality in variance
tests, there is explicit evidence of causality in variance from UK real stock returns to
UK IP growth rate with two months lag. The mechanism of variance causality from
the stock market to real economic activity may work through two possible channels:
(a) the consumption channel and (b) the balance sheet channel. The first channel
shows that changes in asset prices may affect consumption spending by affecting
households wealth. However, this channel does not seem to be illustrative as much
5
This finding is not unexpected and does not contradict previous arguments in the literature. For example, Robinson (1952) argues that financial institutions (including stock markets) follow developments in
real economic sector.
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436
of the households investment in stocks is held in pension accounts (Bernanke and

Gertler 2000). Indeed, the empirical evidence in literature (see, for example, Jonathan A. Parker 1999, and Sydney Ludvigson and Charles Steindel 1999) presents no
strong connection between stock market movements and consumption. Instead, the
second channel is the most significant one. Bernanke and Gertler (1995) show that
asset price fluctuations affect real economy through their effects on the balance
sheets of households, firms, and financial intermediaries. For example, a decrease in
asset prices reduces the available collateral (households and firms use their assets as
collateral when they are borrowing) and shrinks the borrowers ability to have access
to credit capital. This can have negative short-run effects on aggregate demand and
long-run effects on aggregate supply.
2.2 Results from the Bivariate EGARCH (p,q) Model
We estimate bivariate EGARCH (p,q) models in order to examine the relation between stock returns and industrial production growth, within a country, in a multivariate context. Testing among alternative specifications of the EGARCH model, the
Likelihood Ratio test statistic has implied the estimation of the bivariate EGARCH
(1,1) model for the case of the UK and the bivariate EGARCH (2,1) model for the
case of the US.6 Focusing on the estimated parameters of the conditional variance
equations, Table 3 shows that all spillover coefficients (rr,1; yy,1; ry,1; yr,1) are statistically different from zero. This implies that short-term volatility dynamics between the stock market and the real economy, within a country are characterized by
conditional heteroskedasticity. Moreover, br and by coefficients in both countries are
less than one but close to unity, implying that volatility is very persistent in the stock
market and real economic sectors.7
Next, we focus on volatility spillover effects. For the case of the UK, we have
found positive and significant reciprocal spillover effects between the stock market
and real activity. Spillover effects from the stock market to real economic activity
(yr,1=0.55) are slightly higher than those from the opposite direction (ry,1=0.52).
Both are significantly high, which implies that an increase in stock return volatility
entails an increase in IP growth volatility, and vice-versa.
As in the causality in variance case, the volatility transmission mechanism
from the stock market to real economic activity can be explained by the balance sheet
channel. As stock prices change, the cost of borrowing for the firms changes as well.
In case of stock prices decline, firms available collateral is reduced and the limited
borrowers access to credit capital causes a fall in investment and in future output.
Similarly, volatility can be transmitted from the real economic sector to the
stock market. This is because changes in the current and future IP growth rate cause
reallocations of portfolio assets. However, this is possible to activate a cyclical volatility transmission mechanism, which may be influenced by the balance sheet channel
as well. Specifically, Carlstrom et al. (2002) argue that the economic slowdown re6
These test statistics, which have not been reported in order to save space, are available upon request.
Volatility persistence coefficients (br and by) are given by

, and
, . The unconditional variance is finite if br<1 and by<1.
7
duces stock prices, hence, the value of the firms assets. Then, as the amount of collateral decreases and the cost of borrowing becomes higher, real economic activity
exhibits an unstable downward behavior.
A question arises is whether volatility transmission is symmetric or asymmetric. Both spillover effects are asymmetric since ry ,1 and yr ,1 are statistically significant and negative. This means that a negative shock (bad news) in the stock market
increases volatility in real economy more than a positive shock (good news). In other
words, a fall in stock return causes higher volatility in IP growth rate than an increase
in stock return. This asymmetric effect is similar to the leverage effect, which states
that stock returns tend to be more volatile when stock prices are falling. As a result,
negative shocks increase stock market volatility which, through the balance sheet
channel, is exported to the real economy. In other words, the leverage effect works in
the direction of exporting more volatility to the real sector when stock returns fall
(bad news).
Table 3 Bivariate EGARCH (p, q) Models
Parameters
br
by
rr,1
yy,1
ry,1
yr,1
ry,1
yr,1
ry
Log Likelihood
UK
p=1, q=1
0.96*
(685)
0.97*
(194)
0.47**
(2.04)
0.47**
(1.96)
0.52*
(11.45)
0.55*
(2.89)
-0.07*
(-5.46)
-0.05*
(-3.28)
0.16
(1.79)***
1656.72
US
p=2, q=1
0.95*
(170)
0.93*
(116)
-0.06*
(-3.17)
0.15*
(4.67)
0.18*
(6.84)
0.14*
(4.32)
-0.013***
(-1.91)
-0.014
(-0.88)
0.06
(1.64)
1880.98
Notes: p is the order of the autoregressive GARCH terms. q is the order of the moving average ARCH terms.
b r and b y
measure volatility persistence of stock returns and real IP growth, respectively. rr,1 and yy,1 are the measures of the ARCH
effect in stock returns and real IP growth, respectively. ry,1 is the volatility spillover from real IP growth to stock returns. yr,1
is the volatility spillover from stock returns to real IP growth. ry,1 and yr,1 are asymmetric spillover effects. ry is the
correlation coefficient of the standardized residuals between stock returns and real IP growth. *, ** and *** denote statistical
significance at the 1%, 5% and 10% level, respectively. Robust t-statistics in parentheses.
Moreover, the negative and statistically significant coefficient of ry ,1 (-0.07)

implies that negative disturbances in the real economic sector cause higher volatility
to the stock market than positive developments. This is consistent with the evidence
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438
that asset returns are more volatile during economic slowdown, as originally observed by Robert R. Officer (1973), Black (1976), and Schwert (1989). These authors
have argued that during economic recessions, assets value decrease and the proportion of the levered value increases. Hence, stock returns are more volatile during recessions because highly levered assets are riskier (i.e. exhibit higher volatility).
When it comes to the US model, significant spillover coefficients imply that
volatility can be imported from one sector to the other. Specifically, both coefficients
( ry 0.18 & yr 0.14 ) are statistically significant and positive, implying a bidirectional spillover effect. The spillover effect from the stock market to real activity
is slightly lower than that of the opposite direction. Furthermore, the spillover effect
from the stock market to the real economic sector is found to be symmetric because
the asymmetry coefficient yr ,1 is not statistically different from zero. This finding
implies that a decrease in stock returns has the same effect on IP growth volatility as
an increase in stock returns. In contrast, the coefficient of asymmetry ry ,1 is statistically significant at a 10% significance level. This implies that the US stock market is
expected to be more volatile when US output growth falls.
In line with the evidence from the UK model, the volatility transmission
mechanism from the stock market to real economic sector runs through the balance
sheet channel. Similarly, volatility from the real output growth to the stock market is
transmitted via the changes in the expectations for the domestic economy and the
economic condition of the firms which both alter stock prices. Furthermore, the stock
market tends to be more volatile when IP growth rate falls because of the higher
volatility of the highly levered assets. However, the symmetric nature of the volatility
spillover effect from the stock market to the real economic sector needs to be investigated. The lack of asymmetry does not mean that the leverage effect is inactive in the
US stock market. Indeed, the results from the univariate EGARCH analysis, as
shown in Table 3, imply the validity of the leverage effect in the US stock market.
One possible explanation is that the leverage effect does hold, but the applied
US monetary policy may have weakened the linkage between the stock market and
the real activity sector, such that the leverage effect cannot export extra volatility
to the real sector. This policy is the inflation targeting regime applied by the FED
during the 1990s. The key fact of this regime is that monetary authorities adjust interest rates in front of stock market instability in order to isolate the real economy
from financial instability. Specifically, they apply the leaning against the wind policy, increasing interest rates when stock prices rise and reducing them when stock
prices are falling. By lowering interest rates (i.e. expansionary monetary policy) in
front of stock prices decline, the balance sheet channel has a neutral effect on the
transmission mechanism, reducing the vulnerability of the real economy. Namely,
monetary policy easing makes access to credit less complex even if balance sheets
become worse as a result of stock market losses. A complementary explanation is
given by Bernanke and Gertler (2000), who show that an asset price decline may not
affect the real economy only if balance sheets are initially strong. They argue that
this was actually the case for the US economy during the 1990s (i.e. US balance
sheets were in excellent condition).
Comparing the results from the UK model with those from the US model, we
observe that, in each economy, both sectors are characterized by a dynamic short-run
relationship, implying a bi-directional volatility spillover effect. The size of the spillover effects in the UK is much higher than the corresponding spillovers in the US.
Specifically, the estimated coefficient of volatility spillover from the UK real IP
growth to the UK stock market is 0.52, which is considerably higher than the corresponding estimated coefficient (0.18) for the case of the US. Likewise, the estimated
coefficient measuring the transmission of stock market volatility to the real sector is,
by far, higher in the UK (0.55) than in the US (0.14). This means that there is
stronger interdependence between the stock market and real activity in the UK than
in the US. This may also be explained by the applied leaning against the wind policy in the US, as outlined above. However, the UK monetary policy, in the form of
an explicit inflation targeting regime, is not considerably different from the US
monetary policy. Thus, the query is what is different in the case of the US. A careful
look at historical data of stock indices and interest rates provides us with the view
that US monetary authorities have applied the leaning against the wind policy in a
more systematic way than UK monetary authorities have done.8 Historical facts confirm that US monetary authorities have reacted in that way. For example, FED decreased interest rates in periods of high financial instability, such as the stock market
crises in 1987 and in 2001. Along the lines of the inflation targeting regime, monetary authorities should ignore stock prices movements that are not expected to create
inflationary pressures (Bernanke and Gertler 2000). Hence, the low level of the UK
inflation rate may explain why UK monetary authorities decided not to adjust the
interest rate all the time.
Examining the symmetric nature of the volatility transmission mechanism
from the stock market to real activity sector, there is evidence of symmetric spillover
effects only in the case of the US. In contrast, bad news in UK stock market increases
volatility in UK real activity more than good news. A fall in stock returns causes excess stock market volatility in the UK because of the leverage effect. Thus, the increased stock market volatility is exported, via the balance sheet channel, to the real
sector. On the other hand, although the US stock market does not escape from the
leverage effect, the applied US monetary policy in the form of an implicit inflation
targeting regime works as a shield, insulating the real economy from the stock market in periods of high financial instability. Similarly, the more systematic application
of the leaning against the wind policy in the US than in the UK may explain the
presence of asymmetry in the volatility transmission mechanism only in the UK. In
contrast, volatility from the real activity sector to the stock market is asymmetrically
transmitted in both countries.
This statement is derived based on the examination of the monthly basis movements in US and UK
stock markets in comparison with changes in FEDs and Bank of Englands interest rates. Since 1990, we
have found more violations of the leaning against the wind rule in the UK rather than in the US.
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440
Table 4 EGARCH (p,q): Diagnostics

Residuals Stock Returns
LB (4)
LB2(4)
Residuals Real IP Growth
LB (4)
LB2(4)
LB2(16)
Cross Product
LB (4)
LB2 (4)
UK
US
5.93
2.29
0.60
1.57
9.27
21.68*
28.36
19.26*
0.16
-------
1.71
0.75
0.96
0.19
Notes: * denotes statistically different from zero at 1% significance level. LB stands for Ljung-Box statistics.
Finally, we apply diagnostic tests, as shown in Table 4, on the standardized residuals and cross-standardized residuals to confirm robustness of our estimation. The
Ljung-Box statistics, applied on the standardized and squared standardized stock
market residuals, imply that in both models the residuals are serially uncorrelated. On
the other hand, the same test applied on the standardized real activity residuals implies evidence of autocorrelation in the residuals for the case of the US. However,
there is no evidence of autocorrelation in the squared standardized residuals.
Although UK standardized real activity residuals are not autocorrelated, there
is some evidence of serial correlation in the squared standardized residuals, which
can be eliminated by including a higher order of lags (i.e. 16 lags). The Ljung-Box
test statistic, applied on the cross product of the standardized residuals for the two
variables, implies that the assumption of constant conditional correlation (Tim Bollerslev 1990) can be accepted for both EGARCH models. Therefore, the validity of
the above assumption and the robustness of our estimation are confirmed.
3. Conclusion
The main research objective of this study was to identify the short-run dynamic relationships between stock market and real economy for the cases of the UK and the
US. Due to the evidence of linear and nonlinear dependencies between the series,
which imply volatility clustering between the series, we estimated univariate as well
as bivariate EGARCH (p,q) models. The univariate EGARCH (p,q) model is the
benchmark model for the utilization of the two-stage Cross Correlation Function
(CCF) testing procedure developed by Cheung and Ng (1996). The results show that
causality in mean is statistically significant with two lags from the real IP growth rate
to the real stock returns for both UK and US models. On the other hand, there is evidence of causality in variance from the UK real stock returns to UK IP growth rate
with two months lag.
Next, by estimating bivariate EGARCH (p,q) models, we found that volatility
in both sectors is very persistent. Moreover, we found evidence that volatility from
one sector can be transmitted to the other, implying significant interdependencies
between the stock market and real activity, within an economy. The volatility trans-
mission mechanism from the stock market to the real sector runs through the balance
sheet channel. Stock price fluctuations affect real economy through their effects on
the balance sheets of households and firms. For example, a decrease in stock prices
reduces the available collateral and shrinks the borrowers ability to have access to
credit capital. Similarly, volatility can be transmitted from the real economic sector
to the stock market. This is because changes in the current and future IP growth rate
cause reallocations of portfolio assets.
Besides the evidence of stronger interdependence in the UK rather than in the
US, volatility spillovers from the stock market to the real sector are found to be
symmetric only in the case of the US. The symmetric nature of the spillover effects
means that negative shocks (bad news) and positive shocks (good news) in the stock
market affect real activitys volatility in the same way. However, this does not happen in the case of the UK. In line with the leverage effect, a decrease in UK stock
returns has a greater effect on the volatility of the UK real activity than an increase in
returns. Conversely, a decline in US stock returns equally affects US real sectors
volatility as an increase in stock returns. This finding does not seem strange if we
examine the objectives of the monetary policy framework applied by the FED. Although the US stock market does not escape from the leverage effect, the FEDs policy to insulate the real economy from stock market instability explains the lack of
asymmetry in the volatility transmission mechanism for the case of the US. Specifically, they apply the leaning against the wind policy, increasing interest rates when
stock prices rise and reducing them when stock prices are falling. Monetary policy
easing makes access to credit less complex even if balance sheets become worse as a
result of stock market losses. Then, the balance sheet channel has a neutral effect on
the transmission mechanism, reducing the vulnerability of the real economic sector.
Given that UK monetary policy is not substantially different from the US
monetary policy, what could explain the lack of variance causality, the lower estimated spillover coefficients, and the symmetric nature of the transmission mechanism in the case of the US? One possible explanation is that the leaning against the
wind policy has been applied more systematically in the US rather than in the UK.
An alternative explanation is given by Bernanke and Gertler (2000). They argue that
the excellent condition of the US balance sheets during the 1990s has protected the
US economy from negative disturbances. Finally, volatility from the real activity
sector to the stock market is asymmetrically transmitted in both countries. During
economic recessions, stock prices decrease and the proportion of the levered value
increases. Hence, stock returns are more volatile during recessions because highly
levered assets exhibit higher volatility.
Beyond the above explanation, this study provides lessons for policy makers,
especially in developing countries with unstable financial markets. Thus, the lesson
states that policy makers should be concerned about financial instability and must
take steps in order to protect real activity from unexpected instability shocks. An appropriate monetary policy framework is of the form of flexible inflation targeting,
adjusting interest rates in a stabilizing way in case of stock market instability. Specifically, they have to apply the leaning against the wind policy, increasing interest
rates when stock prices rise and reducing them when stock prices are falling. The
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442
necessity of policy steps is even stronger when stock returns are falling because the
leverage effect produces more stock market volatility. Thus, in periods of high financial instability, monetary authorities should adjust interest rates in a systematic way
until the economy and the financial system are stabilized. In front of a decrease in
stock prices, the loosening of the monetary policy (i.e. lower interest rates) inactivates, in some degree, the balance sheet channel, making real economic activity less
vulnerable to financial distress. In addition, the inflation targeting regime can also
stabilize the stock market because the low inflation rate provides the investors confidence and stabilizes the financial markets.
Finally, in relation with the recent global financial crisis, we can state that the
source of this crisis (i.e. nonfundamental factors, such as the poor regulatory practice and the irrational investing behavior) may explain its impact on the global economy. However, an interesting fact is that the applied monetary policy, in the form of
an inflation targeting regime, in the US, in the UK, and in other major economies,
could not protect the global economy from financial instability. This finding may
imply that the monetary policy cannot always insulate the real economic sector from
negative shocks, especially in periods of extreme uncertainty, panic, and general pessimism. Another feature of the latest financial crisis, which has not been adopted in
our analysis, is that it had an international impact on financial markets, causing
knock-on effects on domestic financial sectors, and thus, on national economies.9
Although the relevance of this study with the recent global financial crisis does exist,
the conclusions of this study do not completely fit to the case of the recent crisis. To
provide an explanation for this result, the special characteristics of the recent crisis
should be thoroughly investigated. This is left for a future study.
In this study, we have examined the relationship between the financial sector and the real economic
sector, within a country, for the UK and the US. We have not taken into account any spillover effects
between the two sectors across countries.
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THIS PAGE INTENTIONALLY LEFT BLANK

Received: 4 August 2009; Accepted: 12 July 2010.
Senay Acikgoz
Department of Econometrics,
Faculty of Economic and Administrative
Sciences,
Gazi University,
Turkey
asenay@gazi.edu.tr
Merter Mert
Department of Econometrics,
Faculty of Economic and Administrative
Sciences,
Gazi University,
Turkey
mertermert@gazi.edu.tr
We would like to thank Muhtesem

Kaynak and Muzaffer Sarimeseli from
Gazi University for encouraging our
study. We are also very grateful to
Mehmet Balcilar from Eastern
Mediterranian University for his
valuable ideas and suggestions.
Finally, we would like to thank the
anonymous referees for their invaluable
comments.
UDC 330.35(560)
DOI: 10.2298/PAN1004447A
The Endogeneity of the Natural

Rate of Growth: An Application to
Turkey
Summary: The purpose of this paper is to examine the sensitivity of the Turkish economys natural rate of growth to the actual rate of growth, covering the
period 1980-2008. To determine the reason why the natural rate of growth is
endogenous, the long-run and the causality relationships between real gross
domestic product and each of the production factors (labour force and physical
capital stock) are investigated with the bounds test. The natural rate of growth
for the Turkish economy is found to be at 4.97 percent and the actual rate of
growth in boom periods is approximately 35.6 percent; indicating endogeneity.
However, according to the causality test results, the endogeneity of the natural
rate of growth may be attributed to the total factor productivity rather than the
labour force and physical capital stock. This result is important and the debate
on this subject may lead to further studies.
Key words: The natural rate of growth, The endogeneity of the natural rate of
growth, ARDL approach, Causality tests.
JEL: O40, E10, E23, C22.
The endogeneity of the natural rate of growth was demonstrated by Miguel LonLedesma and Anthony P. Thirlwall (2002) in their study on Organization for
Economic Co-operation and Development (OECD) countries; whereas the Harrod,
neoclassical and endogenous growth models assume the natural rate of growth to be
exogenous. The present study aims to use the least squares and autoregressive
distributed lag methods to examine the Turkish economy for the period 1980-2008.
The areas for investigation include: i) What is the natural rate of growth for Turkey?
ii) What is the sensitivity of the natural rate of growth to the actual rate of growth?
iii) If the natural rate of growth sensitive to the actual rate of growth, so, if the
natural rate of growth is endogenous, what is the reason for the endogeneity?
Lon-Ledesma and Thirlwall (2002) tested the reasons for the endogeneity
applying causality tests between the real gross domestic product and total factor
inputs. In this study, the causality relationships among the real gross domestic
product and each of the production factors, i.e. labour force and physical capital
stock, are analyzed. We investigate whether the reason for the endogeneity of the
natural rate of growth stems from an increase in labour force or an increase in labour
productivity over an increase in the physical capital stock. This decomposition is
critical, particularly in developing countries, because the positive and negative
effects of the endogeneity of the natural rate of growth can be highlighted.
448
We investigate the causality relationships among the real gross domestic

product, labour force and physical capital stock. If a causality relationship from the
real gross domestic product to labour force is established, then a reason for
endogeneity can be shown. Also, if a causality relationship from the real gross
domestic product to physical capital stock is established, another reason for
endogeneity can be revealed, in the sense that more capital intensive methods causes
an increase in labour productivity.1
In order to investigate the reasons behind the endogeneity of natural rate of
growth, the bounds testing approach to cointegration, developed by M. Hashem
Pesaran, Yongcheol Shin, and Richard J. Smith (2001) is used. Compared to the
other tests two stage estimation of Robert F. Engle and Clive W. J. Granger (1987)
and full information method of Soren Johansen (1988), Johansen and Katerina
Juselius (1990) the bounds testing approach can be applied irrespective of whether
the underlying regressors are purely I(0), purely I(1), fractionally integrated, or
mutually co-integrated and it has better small sample properties.2
As pointed out in Narayan and Seema Narayan (2005, p. 425), an important
advantage of the autoregressive distributed lag approach is that it has better small
sample properties than the widely used approaches of Engle and Granger (1987) and
Johansen (1988), Johansen and Juselius (1990).
Interestingly, empirical results indicate that although the natural rate of growth
is endogenous for the Turkish economy, there are no causality relationships from the
real gross domestic product to labour force and physical capital stock. If the natural
rate of growth is endogenous, there must be a reason for the endogeneity. So, this
finding may emphasize the role of the total productivity in the growth process as it
will be mainly discussed in the conclusion section.
The paper is organized as follows: the literature review and theoretical
foundations are found in Section 1, the methodology in Section 2, results and
discussion in Section 3, and finally the concluding remarks are found in Section 4.
1. Literature Review and Theoretical Considerations

The endogeneity of the natural rate of growth was tested by Lon-Ledesma and
Thirlwall (2002) on OECD countries (Australia, Austria, Belgium, Canada,
Denmark, France, Germany, Greece, Italy, Japan, the Netherlands, Norway, Spain,
the U.K., and the U.S.) for the period 1960-1995. They used the ordinary least
squares method and autoregressive distributed lag approach based on Pesaran and
Shin (1999). They found that the natural rate of growth is not an exogenously given
1
Capital intensive methods may also result in substitution of capital to labour, so, if there is a causality
relationship from real GDP to physical capital stock, it may imply a decrease in labour force and an increase in output-labour ratio (labour productivity).
2
Paresh Kumar Narayan (2004, 2005) examined the small sample problem within the context of the
bounds testing approach. He generated the critical values for F-statistics to accommodate small sample
sizes. There are several studies with small samples which are employed the bounds test. Charalambos A.
Pattichis (1999) applied the bounds test with 20 observations. Jai S. Mah (2000) and Tuck Cheong Tang
and Mahendhiran Nair (2002) have observations of 18 and 28, respectively. Imam Alam and Rahim
Quazi (2003) test their hypothesis with 27 observations.
The Endogeneity of the Natural Rate of Growth: An Application to Turkey
rate due to the fact that labour force and labour productivity are both elastic to the
output growth (Lon-Ledesma and Thirlwall 2002, p. 455). Based on this study, Lena
Vogel (2009) analyzed the endogeneity of the natural rate of growth for the 11 Latin
American countries (Argentina, Bolivia, Brazil, Chile, Costa Rica, Columbia,
Mexico, Nicaragua, Paraguay, Peru and Venezuela) for various periods using
seemingly unrelated regression method. The results of the Vogel (2009) support the
hypothesis of the Lon-Ledesma and Thirlwall (2002). Gilberto A. Libnio (2009)
provided empirical evidence that the natural rate of growth is endogenous in 10 Latin
American Countries (Argentina, Brazil, Chile, Colombia, Costa Rica, Ecuador,
Mexico, Peru, Uruguay, Venezuela) in the various periods. The author emphasized
aggregate demand fluctuations which affect the potential output in the long run.
Libnio (2009) also analyzed whether the real GDP series are stationary or not. The
author found that the real GDP series are non-stationary, so the real GDP series have
unit roots. Therefore, Libnio (2009), documented that both supply and demand
sided shocks may have significant impacts on the 12 Latin American economies
(Argentina, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador,
Guatemala, Mexico, Peru, Uruguay, Venezuela) in the period 1970-2004.
The above studies rested on the argument that the natural rate of growth is not
exogenous in contrast to the Harrod, neoclassical and endogenous growth models.
Roy Harrod (1939) described the natural rate of growth as a maximum rate of growth
which is determined by exogenous factors such as population growth, physical
capital stock growth etc. Robert Solows (1956) main critique of the growth models
in the line of Harrod-Domar is based on the issue of the substitution of capital and
labour. However, Solow did not deal with the exogenously given natural rate of
growth. Likewise with the Harrod and neoclassical growth models, the new growth
theories, or so called the endogenous growth theories (Paul Romer 1986; Robert
Lucas Jr. 1988), also did not consider the endogeneity of the natural rate of growth.
The seminal works of Nicholas Kaldor (1957) and Kaldor (1961) emphasize the
effects of the demand conditions on the economic growth process. These effects
depend on Petrus Johannes Verdoorns law (1949), where the natural rate of growth
can be considered as endogenous rather than exogenous. If demand conditions
matter, the actual rate of growth exceeds the natural rate of growth in the boom
periods. As Lon-Ledesma and Thirlwall (2002, p. 442) puts it briefly, the reasons
for this situation may be as follows: i) increase in labour force, ii) increase in labour
productivity in the boom periods. Thus, in these periods, if the actual rate of growth
exceeds the natural rate of growth, this means that the labour force and/or labour
productivity have increased due to, for example, increase in participation rates,
immigration of labourers, economies of scale, etc. (Lon-Ledesma and Thirlwall
2002, p. 442). Therefore, there are two major consequences of the endogeneity of the
natural rate of growth: 1) Since the natural rate of growth is the ceiling of the fullemployment, unemployment may still be a problem even in the boom periods. 2)
Demand constraints can be considered as a major determinant of the economic
growth.
The method on the estimation of the natural rate of growth depends mainly on
the work of Thirlwall (1969). Thirlwall (1969) estimated the natural rate of growth
449
450
following Arthur Okun (1962). Okun (1962) analyzed the relationship between the
change in the percentage level of unemployment and the output growth rate using
equation (1).
%U g
(1)
where U represents the level of unemployment, %U shows the change in the

percentage level of unemployment, g gives growth rate of real output. and are
parameters to be estimated.
When %U = 0, i.e. there is no change in the percentage level of
unemployment, the natural rate of growth equals to . Thirlwall (1969) estimated
this relationship using equation (2) where dependent variable is the growth rate of
real output.
g %U
(2)
where and are parameters to be estimated. Therefore, when %U = 0, gives the

natural rate of growth. It can be recognized that g represents both the actual and
natural rate of growth. Then, it is expected that the actual rate of growth deviates
from the natural rate of growth in the boom periods, if the natural rate of growth is
endogenous. In order to find the deviation, a dummy variable is described. This
variable is defined as D = 1 for the years that actual rate of growth exceeds the
natural rate of growth and D = 0 for the other years.
g D %U
(3)
If the parameter is statistically significant, it means g = + when
%U 0 . Besides, when the sum of + is greater than ( + > ), then this
means the natural rate of growth increases in the boom periods. This situation implies
that the natural rate of growth, i.e. the growth rate which keeps the unemployment
constant, rises in the boom periods. This is why the natural rate of growth is called
endogenous.
Lon-Ledesma and Thirlwall (2002), attribute endogeneity to two reasons:
increase in labour force and increase in labour productivity. They analyzed the
causality relationship between the real gross domestic product and total factor inputs
which is defined as follows:
LTFI t wLt 1 wK t
(4)
where LTFI , L and K represent natural logarithmic form of the total factor inputs,
labour and capital stock, respectively. w indicates the weight of employees
compensation in the national account.
However, in this study, contrary to Lon-Ledesma and Thirlwall (2002),
causality tests are applied in order to investigate the relationships among the real
gross domestic product, labour force and physical capital stock. A causality
relationship from the real gross domestic product to labour force and/or physical
capital stock can account for the endogeneity of the natural rate of growth. LonLedesma and Thirlwall (2002) implicitly assume that if there is a causality
relationship from the real gross domestic product to physical capital stock, an
increase in physical capital stock causes an increase in labour productivity. Thus,
while the causality relationship from the real gross domestic product to labour force
indicates labour force itself, the causality relationship from the real gross domestic
product to physical capital stock indicates labour productivity.
If labour force and labour productivity are analyzed separately in contrast to
Lon-Ledesma and Thirlwall (2002), it allows decomposing the positive and
negative effects of the endogeneity of the natural rate of growth, especially for the
developing economies. Unemployment, informal economy and low level of
productivity are critical issues for the developing economies. If the main reason of
the endogeneity of the natural rate of growth is the increase in labour force, it means
that a rise in demand may cause an increase in unemployment and/or informal
economy. If the main reason of the endogeneity of the natural rate of growth is an
increase in labour productivity, it means that a rise in demand may result in an
increase in labour productivity.3 Hence, the former and the latter situations
emphasize the negative and positive effects of the endogeneity of the natural rate of
growth, respectively. So, these two effects must be decomposed especially for the
developing economies.
However, if there is no causality relationship from the real gross domestic
product to the labour force and physical capital stock, then the importance of the total
factor productivity as a production factor apart from labour force and physical capital
stock can be emphasized. Moreover, since an increase in total factor productivity
means technological progress, it gives another dimension to the endogeneity of the
natural rate of growth debate regarding the nature of the technological progress, i.e.
Solow-neutral, Hicks-neutral etc. This will be discussed further in the conclusion
section in the light of the empirical results.
2. Methodology
In the first part of empirical study, the natural rate of growth for the Turkish
economy is estimated using ordinary least squares (OLS) estimation method. In the
second stage, causality relationships among output and factor inputs are investigated.
It is necessary to establish that there is a long-run relationship among the variables.
For this purpose, the long-run relationships among the variables are investigated by
the bounds test of Pesaran, Shin, and Smith (2001) based on the autoregressive
distributed lag approach (ARDL) of Pesaran and Shin (1995, 1999).
The ARDL approach to testing for the existence of a relationship between
variables in levels which is applicable irrespective of whether the underlying
regressors are purely I(0), purely I(1), or mutually cointegrated. The statistic
underlying the procedure is the familiar Wald or F-statistic in a generalized DickeyFuller type regression used to test the significance of lagged levels of the variables
3
However, as it is noted in the second footnote, capital intensive methods may also lead to substitution of
capital to labour. Therefore, unemployment may also rise due to this effect.
451
452
under consideration in a conditional unrestricted equilibrium correction model

(Pesaran, Shin, and Smith 2001, pp. 289-290). This approach is summarized as
follows.
The empirical model specification which relates the real gross domestic
product (GDP) (Yt) to physical capital stock (Kt) and labour force (Lt) is given by
equation (5).4
ln Yt 0 1 ln K t 2 ln Lt t
(5)
where the variables are taken in their natural logarithm; t indicates the random error
term. Equation (5) is a long-run level relationship and provides the basis for the
models estimated in this study. The major empirical question in this study is the
existence of the level relationship in equation (5). This relationship should be
estimated using co-integration estimation methods due to the nonstationarity of the
data.
Suppose that with respect to our model, the theory predicts that there is a longrun relationship among the variables lnY, lnK, and lnL. Without having any prior
information about the direction of the long-run relationship among the variables, the
bounds testing approach estimates an unrestricted error-correction model (UECM)
taking each of the variables in turn as dependent variable. For instance, UECM, when
lnY is dependent variable, takes the following general form:
ln Yt c0 c1t 1 ln Yt 1 2 ln K t 1 3 Lt 1
p
j 1
j 1
j 1
j ln Yi j j ln K t j j ln Lt j Dt ut
(6)
where Dt is a vector of exogenous variables such as the structural change dummies

and indicates first difference operator. The first stage in bounds testing approach is
to estimate equation (6) by OLS. According to our model, the null hypothesis of no
co-integration (1 = 2 = 3 = 0) against the alternative of a long-run levels
relationship (1 2 3 0) is performed as a Wald restriction test. The asymptotic
distributions of the F-statistics are non-standard under the null hypothesis of no cointegration among the variables in the UECM given in equation (6), irrespective of
whether the variables are purely I(0), purely I(1), or mutually co-integrated.
Two sets of asymptotic critical values are provided by Pesaran, Shin, and
Smith (2001, pp. 300-301, pp. 303-304). In the first and second set, it is assumed that
all variables are I(0) and all variables are I(1), respectively. Decision rules to reject
the null hypothesis are as follows:
Human capital stock is not included in the regression model following Lon-Ledesma and Thirlwall
(2002, p. 452). As the authors pointed out in their paper, it can be admitted that most of the human capital and new invention are introduced in the production process through labour and capital inputs. Therefore, theoretically, the exclusion of the human capital from the production function can be accepted.
Additionally, as it is shown in Pesaran and Shin (1999), the bounds testing approach is possible even
when the explanatory variables are endogenous.
Reject the null hypothesis of no co-integration and conclude that there

exists a long-run equilibrium among the variables, if the computed Fstatistics is greater than the upper bound critical value (second critical
value set);
Accept the null hypothesis of no co-integration, if the computed Fstatistics is less than the lower bound critical value (first critical value set);
and
The bounds test is inconclusive, if the computed F-statistics falls within the
lower and upper bound critical values.
If a long-run relationship has been established in the first stage, a two-step

procedure is followed. In the first step, a conditional ARDL(p1,q1,q2) long-run model
for lnY can be estimated as given in equation (7).
p1
q1
q2
j 1
j 0
j 0
ln Yt c0 j ln Yt j 1 j ln K t j 2 j ln Lt j Dt ut
(7)
where all variables are defined as above and the lag lengths p1,q1,q2 relating to three
variables in the model are selected using the Akaike (AIC) or Schwarz Bayesian
(SBC) Information Criterion.
The second step of the second stage of the bounds testing ARDL approach
involves estimating a conditional error-correction model. The conditional errorcorrection model is specified as follows:
p
j 1
j 0
j 0
ln Yt j ln Yt j j ln K t j j ln Lt j
(8)
ECM t 1 Dt u t
where j, j and j are the coefficients relating to the short-run dynamics of the
models convergence to the equilibrium. The coefficient of error correction term
(ECM), measures the speed of adjustment and the ECM term is defined as given in
equation (9).
ECM t ln Yi 0 1 ln K t 2 ln Lt
(9)
The long-run parameters 0 , 1 and 2 in equation (9) can easily be

obtained from the OLS estimates of the conditional ARDL model given in equation
(7).
As pointed out in Narayan (2004, p. 7), the estimates obtained from ARDL
approach of co-integration analysis are unbiased and efficient given the fact that: (a)
it can be applied to studies that have a small sample; (b) it estimates the long-run and
453
454
the short-run components of the model simultaneously and (c) the ARDL method can
distinguish between dependent and independent variables. For these reasons, the
ARDL approach of Pesaran, Shin, and Smith (2001) is employed in this part of the
study.
In terms of the causal relationships between real GDP and production factors,
Engle and Granger (1987) show that if the series X and Y are I(1) and co-integrated
then there would be a causal relationship at least in one direction. The variable X is
said to be the Granger cause of the variable Y if the prediction error of the variable Y
decreases by using past values of the variable X in addition to past values of the
variable Y. In this study, tests for Granger causality are made on the vector errorcorrection models (VECM) of long-run co-integrating vectors. These VECMs are
given below.
p
j 1
j 1
ln Yt 10 11, j ln Yi j 12, j ln K t j
(10)
13, j ln Lt j 1 ECM t 1 u1t

j 1
j 1
j 1
ln K t 20 21, j ln Yt j 22, j ln K i j
(11)
23, j ln Lt j 2 ECM t 1 u 2t
j 1
j 1
j 1
ln Lt 30 31, j ln Yi j 32, j ln K t j
p
(12)
33, j ln Lt j 3 ECM t 1 u3t

j 1
In equations (10), (11) and (12), s are parameters to be estimated, uts are
serially uncorrelated error terms, and ECMt is the error correction term estimated
from equation (9). The F-statistics on the lagged explanatory variables in these errorcorrection models indicates the significance of the short-run causal effects. The tstatistics on the coefficients of the lagged ECM terms (j) in equations (10)-(12)
indicate the significance of the long-run causal effects.
3.1 Data
The variables considered in the first part of the application are the rate of growth of
the real gross domestic product (gt) and the change in the percentage level of
unemployment (%Ut). Growth rate is defined as the first-difference in the

logarithmic form of the real GDP calculated with 1998 prices in domestic currency.
%Ut is defined as the change in the percentage level of unemployment. Data of the
real GDP and unemployment are obtained from Turkish Statistical Institute data
base5 and Tuncer Bulutay (1995), respectively.
The physical capital stock data used in the second part of the application are
calculated by the authors using gross capital investments defined as 1998 prices in
domestic currency. Following Vikram Nehru and Ashok Dhareshwar (1993),
Abdelhak Sendhadji (2000), and Barry Bosworth and Susan M. Collins (2003), the
physical capital stock series are computed as given in equation (13).
K t (1 d ) K t 1 I t
(13)
In equation (13), K t 1 indicates the physical capital stock in the initial period.
d is the depreciation rate (0 < d < 1) and It is the gross capital investment in period t.
K t 1 is computed as given in the equation (14).
K t 1 I t ( g d )
(14)
where g indicates the average growth rate. Following Mustafa Ismihan and Kivilcim
Metin-Ozcan (2006), d is taken 0.05 for Turkey.
Quarterly unemployment and labour force data of Turkey have started to be
published officially since 2000 [although data are available beginning from 2000, we
again constrained with small sample (28 observations)]. The gross capital investment
data are taken from Seref Saygili and Cengiz Cihan (2008). The data set generated in
Saygili and Cihan (2008) are the combined data which are given by Turkish
Statistical Institute for the post-1987 period, and the State Planning Organization for
the pre-1987 period. Therefore, this data set can be assessed more appropriately for
the present study. Because of data problems, quarterly data cannot be used to
estimate the natural rate of growth and to analyze the reasons for its endogeneity.
Finally, in the first and second part of the application, all empirical results are
obtained using yearly data covering the period of 1980-2008.
3.2 Estimation of the Natural Rate of Growth
Estimation of the natural rate of growth and test for its endogeneity are performed in
two stages. In the first stage, following Lon-Ledesma and Thirlwall (2002), the
natural rate of growth equations (2) and (3) defined in the previous section are
estimated and tested for the endogeneity of the natural rate of growth using OLS
estimation method. In the second stage, long-run and causality relationships among
the variables are tested and investigated.
Parameter estimates are presented in Table 1, where g and %U are defined as
above. Two different models are used in order to estimate the natural rate of growth
5
Turkish Statistical Institute. 2009. Employment, Unemployment and Wages: Labour Statistics.
http://www.tuik.gov.tr/isgucuapp/isgucu.zul (accessed June 29, 2009).
455
456
for the Turkish economy and to test whether it is endogenous or not. Estimation
results given in the first column belong to the basic model (equation (2)). The second
column indicates the parameter estimates for the natural rate of growth employing a
dummy variable (Dt) for the years when actual rate of growth is greater than the
natural rate of growth. We also consider the negative growth periods of the growth
process for the Turkish economy. In order to account for the effect of depression
years (1994 and 2001) and the earthquake year (1999), another dummy variable (D1t)
is added to the model. Parameter estimates of this model are given in the third
column of Table 1.
Before discussing all the findings, it is necessary to explain some econometric
issues. Firstly, due to the short time series, the results obtained here have to be
interpreted carefully.
Secondly, as pointed out in Lon-Ledesma and Thirlwall (2002), the change in
the percentage level of unemployment should be regarded as an endogenous variable
which will bias the coefficient estimates in equation (2). Under this problem,
instrumental variable (IV) estimation method is performed to analyze whether the
values obtained for the intercept term (i.e., the natural rate of growth) are biased or
not. The IV method produces a consistent estimator in a situation in which a
regressor is contemporaneously correlated with the error term. The most difficult
aspect of IV estimation is, in general, to find instruments that are both relevant and
exogenous. Therefore, the lagged values of the variables are used as instruments in
this study.6 Following Russell Davidson and James G. MacKinnon (1993), the
endogeneity of the change in the percentage level of unemployment is tested using
these instruments.7 Under the null hypothesis that the variables in instrument
variables set are exogenous, with only one endogenous variable and relatively small
sample, adding the fitted value of %Ut to the Equation (2) and obtaining the tstatistic of its coefficient can be considered as sufficient to do the test. This testing
procedure, originally proposed by James Durbin (1954) and then extended by DeMin Wu (1973) and Jerry Hausman (1978), is called the Durbin-Wu-Hausmann test.
In order to apply the testing procedure, a number of combinations of the
lagged variables are tried. The t-statistics of the coefficients of the fitted value of the
%Ut variable obtained in the most of these specifications are statistically
insignificant, implying that the null hypothesis can be accepted at the 1% and 5%
significance levels. These results can be interpreted as the %Ut variable is not
endogenous. However, the failure to reject the null hypothesis at a specific
probability of a Type I error does not prove exogeneity. For this reason, Equation (2)
is also estimated using the IV method. According to the IV estimates, the estimated
values of the natural growth rate change between 0.0441 and 0.0469. Briefly, when
performing the IV method, the values obtained for the natural rate of growth are not
6
As noted in Peter Kennedy (2003, p. 162), it may be possible to use as an instrument the lagged value of
the independent variable in question; it is usually correlated with the original independent variable, and
although it is correlated with the disturbance vector, because it is lagged it is not contemporaneously
correlated with the disturbance assuming the disturbance is not autocorrelated.
7
A lagged value of the endogenous regressor may not be a good instrument. For this reason, more than
one lagged values of both growth rate and the %Ut variable are used together in the estimation process.
quite different from those obtained using least squares, but in some cases, the lags of
the variables do not seem to be appropriate as instruments. Dynamic specifications of
Equation (2) which include lags of the variables are also estimated. These results also
change between 0.0455 and 0.0525 and close to its OLS estimate. According to these
results, the bias can be ignored in the study.
Thirdly, residuals from equation (2) and (3) first two columns have
heteroskedasticity problem at the 1% and 5% significance levels when it is tested
using Breusch-Pagan-Godfrey (BPG) and White tests.8 Breusch-Pagan LM test
statistics indicate that there are not the first, second and higher order autocorrelation
problem in the residuals obtained from all equations (see Table 1). For this reason,
standard errors for the coefficient estimates given in the first two columns are
computed using heteroskedasticity consistent covariances of Halbert White (1980),
because this estimator provides correct estimates of the coefficient covariances in the
presence of heteroskedasticity.
The OLS estimates of the natural rate of growth and the coefficient the %U
variable given in the first column of Table 1 are statistically significant at the 1%
level. F-statistic indicates that the model is significant entirely at the 5% level.
According to the coefficient estimates, a 1 percent increase in the %U leads on the
average, to about a 2 percent statistically significant decrease in the rate of growth of
the real GDP as expected. Holding the unemployment constant (i.e., %U = 0), the
estimate of the constant term indicates the natural rate of growth which is estimated
at 4.97% for the Turkish economy.
Because the actual rate of growth is either above or below the natural rate of
growth, a dummy variable is defined. The dummy variable (Dt) takes on the value of
1 when the actual growth rate is greater than the natural growth rate (for boom
periods).These estimates are given in the second column of the Table 1. All the
coefficient estimates except for the constant terms are statistically significant in the
second column.
As mentioned above, we added another dummy variable to consider negative
growth periods of the growth process for the Turkish economy. As can be seen from
the third column of Table 1, all the coefficient estimates are statistically significant at
the 1% level. The coefficient of dummy variable (D1t) indicating negative growth
process of the Turkish economy shows that there is an approximately 7.7% decrease
in the growth rates in the crises and earthquake years than the other years. The
coefficient of dummy variable (Dt) is significantly positive, and the sum of the
constant term and the coefficient of the dummy variable indicate that the natural rate
of growth in boom periods is greater than the natural rate of growth by approximately
35.6%. These empirical results emphasize that the natural rate of growth is
endogenous for the Turkish economy. However, it should be emphasized again that
the OLS estimates of the parameter should be interpreted carefully.
BPG heteroskedasticity test is an asymptotic test. It should be noted that in small samples, the test is
sensitive to the assumption that the residuals are normally distributed. In our case, the JB test indicates
that residuals obtained from all equations are normally distributed at the 1% level.
457
458
Table 1 Estimation Results for the Natural Rate of Growth

Dependent
Variable: g t
Constant
%U
Dt
(I)
(II)
(III)
0.0497
(9.398)***
0.1892
( 2.882)***
0.01359
(1.383)
0.1441
( 3.906)***
0.0609
(6.076)***
0.0228
(6.294)***
0.0540
( 1.947)*
0.04457
(7.830)***
0.0773
( 7.700)***
0.697
28.711***
1.888
0.184
[0.832]
3.023
[0.067]
2.368
[0.083]
1.958
[0.375]
0.912
83.537***
2.554
2.043
[0.138]
1.451
[0.253]
0.733
[0.628]
1.825
[0.401]
D1t
Natural Rate of Growth

in the Boom Periods
Natural Rate of Growth
R2
F-stat.
DW
FBP-stat.
FBPG-stat.
FWHITE-stat.
JB-stat.
0.211
6.951**
2.178
0.168
[0.846]
11.299
[0.004]
5.862
[0.008]
0.766
[0.681]
Notes:
Dt
1
0
the actual rate of growth is grater than the natural rate of growth
D1t
1
0
1994, 1999, 2001
the actual rate of growth is smaller than the natural rate of growth
the other years
t-statistics are given in brackets, and ***, ** and * indicate that the test statistic is statistically significant at the 1%, 5% and
10% levels, respectively.
FBP is the Breusch-Pagan LM test for autocorrelation. Maximum lag length is taken 4, but the results are for lag 2.
FBPG is the Breusch-Pagan-Godfrey LM test for heteroskedasticity.
FWHITE is the White test for heteroskedasticity and it includes cross-term.
JB-stat. is the Jarque-Berra normality test statistic.
p-values of FBP, FBPG, FWHITE and JB are given in square brackets.
3.3 Causality Relationships between Output and Factor Inputs
In the previous section, it is shown that the empirical results support the hypothesis
of the endogeneity of the natural rate of growth for the Turkish economy. In this
section, the possible reasons for the endogeneity can now be analyzed. For this
purpose, the long-run and causality relationships between the output and factor inputs
are investigated. In the first step, time series properties of the series are examined via
unit root tests and through their descriptive statistics.
Before applying the ARDL bounds test, the stationarity status of all variables
is investigated to determine their order of integration. The augmented Dickey-Fuller
(ADF) test (David A. Dickey and Wayne A. Fuller 1979), the generalized least
squares detrended Dickey-Fuller (DF-GLS) test (Graham Elliot, Thomas J.
Rothenberg, and James H. Stock 1996), and the Kwiatkowski-Phillips-Schmidt-Shin
(KPSS) test (Denis Kwiatkowski, Peter C. B. Phillips, Peter Schmidt, and Yongcheol
Shin 1992) are used in order to determine the order of integration of the series. The
ADF, DF-GLS, and KPSS test results are given in Table 2.
The ADF, the DF-GLS and the KPSS test results show that real GDP is the
first-difference stationary series at the 1% level. The ADF test and DF-GLS unit root
tests results point out that physical capital stock is the first-difference series at the 1%
and 10% levels, respectively. The first two unit root tests show that the integration
order of the natural logarithmic form of the labour force is 1, whereas the KPSS test
results indicate that it has neither 0 nor 1 integration order.9 Although the unit root
test results differ from each other, all series considered in this study can be accepted
as I(1) series but not I(2).10
Table 2 Unit Root Test Results
Series
lnY
lnY
lnK
lnK
lnL
lnL
k
0
0
2
0
0
0
ADF a
t-stat.
-0.687
-6.462***
-1.915
-11.732***
-1.404
-5.855***
k
0
0
1
1
2
1
ADF b
t-stat.
-2.666
-6.355***
-3.281*
-2.960
0.705
-6.028***
k
2
0
1
0
0
0
DF-GLS a
t-stat.
0.016
-6.588***
3.162
-1.740*
-0.362
-5.898***
k
0
1
1
0
0
0
DF-GLS b
t-stat.
-2.667
-3.767**
-0.333
-3.074*
-1.549
-6.122***
k
2
0
1
0
0
6
KPSS a,c
LM-stat.
15.845
0.060
252.4
8.247
52.946
4.077
K
0
1
1
0
0
6
KPSS b,c
LM-stat.
0.391
0.046
14.795
1.246
1.240
0.976
Notes:
a The test regression includes an intercept but no trend.
b The test regression includes an intercept and a linear trend variable.
c Spectral estimation method is AR spectral GLS-detrended.
The appropriate lag length is chosen by SBC.
The null hypothesis of the ADF and DF-GLS tests is the series is non-stationary and ***, ** and * indicate the unit root
hypothesis is rejected at the 1%, 5% and 10% significance levels, respectively.
The null hypothesis of the KPSS test is that the series is stationary and indicates the rejection of the alternative
hypothesis.
Descriptive statistics for the first differences of all the data are given in Table
3. There are 28 observations available for estimation. The variables indicate positive
kurtosis and negative skewness except for lnK leading to the rejection of the
normality for three series. In our data set, only lnK series are affected outlier
corresponding to the year of 1981 which is normal because of computing the initial
year value of the physical capital stock data.
KPSS test is sensitive to the spectral estimation methods. When Bartlett kernel spectral estimation method is used, lnL and lnK are found to be first-difference stationary series. It is also investigated whether
or not lnK and lnL series are trend-stationary. We find no evidence that these series are trend-stationary
series.
10
When the empirical analysis indicates that the estimated F- or t-statistics is higher than the upper
bound of the critical value, then the null hypothesis of no cointegration is rejected. When the computed
test statistic falls inside the upper and lower bounds, a conclusive inference cannot be made without
knowing the integration order of the regressors.
459
460
Table 3 Descriptive Statistics

Series
No. of Obs.
Mean
Std. Error
Skewness
Kurtosis
Minimum
Maximum
JB-stat.
lnY
27
0.044
0.043
-1.576
2.004
-0.077
0.088
15.701*
lnK
27
0.126
0.110
2.668
8.541
0.023
0.554
lnL
27
0.011
0.026
-0.689
2.313
-0.055
0.074
114.106*
8.153*
Notes:
Descriptive statistics based on the first-difference order of the series.
indicates that the data has outlier at 5% significance level.

* indicates that the data are not normally distributed at the % 1, 5 and 10 significance level.
The first step in ARDL bounds testing approach is to estimate equation (6) by
OLS in order to test for the existence of a long-run relationship among the variables.
The unrestricted error-correction model is estimated by taking each one of the
variables lnY, lnK and lnL as the dependent variable. The linear trend term in the
unrestricted error-correction model may cause a misspecification when the data are
not indeed trending. In order to be robust against the misspecification of the linear
trend, each model is estimated with or without a linear deterministic trend.
Before estimating the conditional error-correction models, it is necessary to
specify the lag length p for each model to be estimated. Maximum lag length is
chosen as 3 because of having a small sample. In this stage of the study, a dummy
variable is not used in the estimation process because of the same reason. When
maximum lag length is chosen as 2 and a dummy variable indicating economic crises
is used, all estimation process produce similar results according to p chosen by AIC
or SBC.
Table 4 Statistics for Selecting the Lag Order of the lnY, lnK and lnL Equations
With Constant
Series
With Constant and Deterministic Trend
AIC
2(1)
2(4)
AIC
2(1)
2(4)
lnY
-4.574
0.011
(0.917)
0.853
(0.931)
-4.939
6.517
(0.011)
7.043
(0.134)
lnK
-6.999
0.044
(0.833)
2.697
(0.609)
-7.079
0.522
(0.469)
4.417
(0.352)
lnL
-4.772
0.575
(0.448)
10.738
(0.030)
-4.819
0.018
(0.892)
11.472
(0.023)
With Constant
Series
p
With Constant and Deterministic Trend
SBC
2(1)
2(4)
0.853
(0.931)
SBC
2(1)
2(4)
-4.417
4.484
(0.034)
6.922
(0.140)
lnY
-4.141
0.011
(0.917)
lnK
-6.567
0.044
(0.833)
2.697
(0.609)
-6.599
0.522
(0.469)
4.417
(0.352)
lnL
-4.474
0.000
(0.998)
8.992
(0.061)
-4.398
0.113
(0.736)
10.080
(0.039)
Notes:
p is the lag order chosen according to Akaike (AIC) and Shwarz Bayesian (SBC) Information Criterion. 2(1) and 2(4) are
LM statistics for testing no residual serial correlation against order 1 and 4, respectively. p-value of 2 statistics are given in
brackets.
In order to determine p, both AIC and SBC are used. For each lag length, are
the first and fourth order residual autocorrelations or serial correlations are also
tested using the Breusch-Pagan Lagrange Multiplier (LM) statistics. These
autocorrelations are distributed as 2(1) and 2(4), respectively. AIC, SBC, and LM
test statistics are computed for each model. Table 4 reports these optimal lag lengths
and corresponding AIC, SBC values as well as the LM tests with their p-values. The
lag lengths chosen by AIC and SBC are different except for lnK. Residual
autocorrelation can be rejected at 1% level at the lags chosen by AIC and SBC. In
order to be robust against the lag length choice, the bounds tests are performed at p
values chosen by both AIC and SBC.
Table 5 F- and t-statistics for Testing the Existence of Levels in lnY, lnK and lnL Equations
Series
AIC
lnY
lnK
lnL
p
3
2
3
SBC
lnY
lnK
lnL
p
2
2
1
With Deterministic Trend

F-iv
F-v
6.279 c
6.497 c
20.219 c
12.327 c
3.549 a
2.194 a
F-iv
F-v
9.285 c
7.931 c
20.219 c
12.327 c
3.248 a
2.794 a
t-v
-4.991 c
-2.556 a
-2.392 a
p
2
2
3
t-v
-3.909 b
-2.556 a
-2.886 a
p
2
2
1
Without Deterministic Trend

F-iii
t-iii
6.832 c
-2.242 a
23.592 c
-1.938 a
3.958 b
-1.954 a
F-iii
t-iii
6.832 c
-2.242 a
23.592 c
-1.938 a
4.040 b
-2.738 a
Notes:
F-iv is the F-statistics for testing 1 = 2 = 3 = 0 and c1 = 0 in equation (6); F-v is the F-statistics for testing 1 = 2 = 3 = 0
in equation (6); t-v is the t-statistics for testing 1 = 0 in equation (6). F-iii is the F-statistics for testing 1 = 2 = 3 = 0 in
equation (6) with c1 set equal to 0, and t-iii is the t-statistics for testing 1 = 0 in equation (6) with c1 set equal to 0 when the
linear trend is excluded from equation (6).
a indicates that the statistic lies below the 5% lower bound.
b indicates that the statistic falls within the 5% bounds.
c indicates that the statistic lies above the 5% upper bound.
For k = 2, 5% critical value bounds of F-iv are [3.88 4.61].
For k = 2, 5% critical value bounds of F-v are [4.87 5.85].
For k = 2, 5% critical value bounds of t-v are [-3.41 -3.95].
For k = 2, 5% critical value bounds of F-iii are [3.79 4.85].
For k = 2, 5% critical value bounds of t-iii are [-2.86 -3.53].
Five variants of the bounds test are used when a linear deterministic trend is
present or not as used in Pesaran, Shin, and Smith (2001). The bounds test results are
given in Table 5 when each of all variables is taken as dependent variable. The no
co-integration hypothesis is rejected at the 5% level according to F-iii, F-iv, F-v and
t-v statistics when lnY is dependent variable. Thus, there is evidence that lnY
cointegrates with factor inputs. There is a co-integration relationship among the
variables at the 5% level according to F-iv and F-v statistics when lnK is taken as
461
462
dependent variables. We find no evidence of co-integration when lnL variable is

taken as the dependent variable.
Although we have 29 observations (T), the critical values of the F-statistics
modified by Narayan (2005) to accommodate small sample sizes are reported here.
For k = 2 and T = 30, 5% critical value bounds of F-iv, F-v and F-iii are [4.54 5.42],
[5.55 6.75] and [4.27 5.47], respectively. It can be said that the bounds test results are
supported in most cases when using critical values tabulated in Pesaran, Shin, and
Smith (2001).
The coefficients of the long-run levels equation (5) are estimated with
parameters obtained using the ARDL approach. The conditional ARDL(p1,q1,q2)
long-run model given in equation (7) is estimated by selecting the lag length
according to SBC, and then the long-run parameters are computed from equation
(7).11 The standard errors of these long-run parameter estimates are computed using
the Delta-method. The estimated coefficients of the long-run relationship are given in
Table 6.
The coefficient estimates of lnK and lnL have the correct sign and magnitude
as expected for the Turkish economy when lnY is taken as dependent variable in both
equations (with or without linear deterministic trend). In other words, physical
capital stock and labour force are positively related to the real GDP. These estimates
are also interpreted as output elasticities of the physical capital stock and labour
force. According to level estimations with constant, over the period of the study,
holding the labour input constant, a 1 percent increase in the physical capital stock
input leads on the average to about a 0.64 percent statistically significant increase in
the output. This result is consistent with 0.41 elasticity coefficient for the model with
linear deterministic trend. On the other hand, output elasticities of labour estimated in
the constant model differ significantly from the trend model for lnY. The sum of
these two output elasticities indicates that the Turkish economy can be characterized
by diminishing returns to scale, over the period of the study.
Table 6 Estimates of Long-run Parameters
Variables
Constant
lnK
lnL
with
Constant
lnYa
-2.753
(-0.704)
0.639
(10.892)*
0.220
(0.469)
with Deterministic
Trend
lnYaa
3.360
(1.481)
0.414
(5.819)*
0.0101
(0.038)
Variables
Constant
lnY
lnL
with
Constant
lnKb
8.309
(1.103)
1.597
(10.524)*
-0.777
(-0.882)
with Deterministic
Trend
lnKbb
-1.864
(-0.298)
2.228
(5.827)*
-0.443
(-0.298)
Notes:
t-statistics are given in brackets.
* indicates that the test statistic is statistically significant at 1% level.
a selected model is ARDL(1,2,0)
aa selected model is ARDL(1,2,0)
b selected model is ARDL(2,1,0)
bb selected model is ARDL(2,1,0)
11
We prefer to use SBC in the second stage of ARDL approach, because of p-values of LM statistics
computed for the chosen lags with SBC are greater than those with AIC in most cases to accept no serial
autocorrelation hypothesis.
Since there is a co-integration relationship among the variables when lnK is

taken as dependent variable, the long-run estimates of this relationship are also
estimated. The coefficient of the real GDP is estimated positively and statistically
significant with or without linear deterministic trend.
The results of the short-run dynamic coefficients associated with the long-run
relationships which are obtained from the error-correction models for lnY and lnK are
presented in Table 7. The sign of the short-run dynamic impact of the labour force is
found to be negative and statistically insignificant. The sign of the short-run dynamic
impact of the physical capital stock on the real output is estimated to be positively
significant; however, its magnitude in the short-run is greater than in the long-run. In
particular, the ECM terms are statistically significant and negative in all equations,
implying a fairly high speed of convergence to equilibrium with the estimated
magnitudes which are given in Table 7.
The equilibrium correction coefficient is estimated -0.091. It is highly
significant, has the correct sign and implies a very low speed of adjustment to
equilibrium after a shock for lnK variable.
Table 7 Estimates of Error-Correction Models Parameters
Variables
Constant
lnK
lnKt-1
lnL
ECM t-1
R2
F-ist.
2(1)
2(4)
JB-stat.
FBPG
FRESET (2)
CUSUM
CUSUMQ
With Constant
lnYa
0.0023
(0.251)
2.298
(8.468)***
-0.869
(-6.103)***
-0.059
(-0.332)
-0.461
(-5.282)***
0.817
24.687**
0.000
[0.997]
0.104
[0.979]
1.163
[0.558]
0.623
[0.651]
5.959
[0.001]
Stable
Stable
with Deterministic Trend

lnYaa
0.0112
(1.433)
2.717
(11.237)***
-0.857
(-7.449)***
-0.039
(-.287)
Variables
Constant
lnK t-1
lnY
lnL
-0.666
(-7.382)***
0.881
40.779***
1.225
[0.281]
0.806
[0.537]
0.142
[0.931]
3.767
[0.018]
5.209
[0.015]
Stable
Stable
ECM t-1
R2
F-ist.
2(1)
2(4)
JB-stat.
FBPG
FRESET (2)
Stable
Stable
with Constant
lnKb
-0.00005
(-0.001)
0.309
(9.479)***
0.260
(8.423)***
-0.070
(-1.300)**
-0.091
(-9.694)***
0.994
858.9***
0.363
[0.553]
0.319
[0.861]
1.140
[0.865]
0.944
[0.457]
2.158
[0.142]
Stable
Stable

lnKbb
-0.002
(-0.899)
0.318
(11.487)***
0.293
(10.842)***
-0.055
(-1.169)***
-0.091
(-11.164)***
0.994
1088.6***
0.409
[0.529]
0.759
[0.565]
0.295
[0.862]
4.154
[0.012]
0.136
[0.872]
Unstable
Stable
Notes:
t-statistics are given in brackets.
***, ** and * indicate that the test statistic is statistically significant at the 1%, 5% and 10% levels, respectively.
2(1) and 2(4) are the Breusch-Godfrey LM test for the first and forth order autocorrelation.
FBPG is the Breusch-Pagan-Godfrey LM test for heteroskedasticity.
FRESET (2) is the Ramsey test for omitted variables/functional form.
p-values of these statistics are given in square brackets.
463
464
We applied a number of diagnostic tests to the error-correction model. There

is no evidence of autocorrelation in the residuals of all equations. The JB test
statistics computed for the residuals of all error-correction models indicate that the
residuals are normally distributed. The RESET test indicates that the model is
correctly specified for lnY with deterministic trend and lnK at 1% significance
level. The stability of the regression coefficients is detected using the cumulative
sum and the cumulative sum of squares (CUSUM and CUSUMQ) test for structural
stability. The regressions, except for lnK equation with deterministic trend, appear
stable according to CUSUM and CUSUMQ test statistics which are within the 95%
critical bounds.
Results of the short-run and long-run Granger causality tests are reported in
Table 8. The short-run causality tests show some sensitivity to whether a
deterministic trend is included or not in the error correction models for the lnY. The
test results indicate no short-run Granger causality for the lnK and lnL. There is a
one-direction short-run causality relationship from lnL to lnY at the 10% level
when the deterministic trend is including in the error correction model for lnY. For
the lnY series the long-run causality hypothesis is not rejected at the 10 % level.
Table 8 Results of Granger Causality Tests
Y/X
lnK
F-stat.
lnL
F-stat.
lnY
F-stat.
Y/X
lnK
F-stat.
lnL
F-stat.
lnY
F-stat.
lnK
F-stat.
1.639
(0.222)
0.056
(0.945)
lnK
F-stat.
1.202
(0.323)
1.611
(0.227)

lnL
lnY
F-stat.
F-stat.
2.491
0.219
(0.111)
(0.806)
0.287
(0.754)
1.790
(0.195)
lnL
lnY
F-stat.
F-stat.
2.092
0.295
(0.152)
(0.747)
0.205
(0.816)
3.022
(0.074)
ECM t-1
t-stat.
1.951
(0.067)
-0.706
(0.489)
0.318
(0.754)
ECMt-1
t-stat.
0.196
(0.846)
-0.155
(0.878)
-1.797
(0.089)
Notes:
H0: The variable X does not Granger cause of the variable Y.
p-values are given in brackets.
The lags chosen by SBC for bounds test with/without deterministic linear trend are also used in causality test equations.
4. Conclusion
In this paper, the sensitivity of the natural rate of growth to the actual rate of growth
is analyzed for the Turkish economy for the period 1980-2008. The results indicated
that the natural rate of growth is 4.97% and it increases approximately 35.6% in the
boom periods. Thus, the natural rate of growth is endogenous for the Turkish
economy.
Our study provides empirical evidence to the argument that the natural rate of
growth is endogenous and there is no fixed full employment ceiling. This finding is
especially important in that it emphasizes the demand-constrained growth. In other
words, economic growth can be stopped due to demand constraints before reaching
the full employment ceiling as Lon-Ledesma and Thirlwall (2002) indicated,
because the full employment ceiling also increases. Thus, since it is found that the
natural rate of growth is endogenous, one may consider the possibility of the demand
constrained growth in the case of Turkey.
In this study, in contrast to Lon-Ledesma and Thirlwall (2002), the positive
and negative effects of the endogeneity of the natural rate of growth are decomposed.
On the other hand, the causality test results indicate that there is no causality
relationship from the real GDP to the labour force or physical capital stock, i.e. there
are neither positive nor negative effects of the endogeneity of the natural rate of
growth. Thus, increases in participation rates, immigration, etc. are not the reasons
for the endogeneity of the natural rate of growth since there is no causality
relationship from the real GDP to labour force. Likewise, an increase in labour
productivity stemming from the use of more capital intensive methods is not a reason
for the endogeneity, since there is no causality relationship from the real GDP to
physical capital stock. So, what is the reason for the endogeneity?
This finding implies that the reason of the endogeneity may be total factor
productivity in the sense that it embodies factor apart from labour force and physical
capital stock. Indeed, for example, Ismihan and Metin-zcan (2006) documented
that total factor productivity is the main source of growth for Turkey for the period
1960-2004. Saygili and Cihan (2006) found that the growth rate of total factor
productivity accelerated for the post-1980 period relative to the pre-1980 period.
Sumru Altug, Alpay Filiztekin, and Sevket Pamuk (2006), using 8 different models,
estimated that the percentage contribution of the total factor productivity to the
output growth rate was between 24.4% and 94.5%.
We can now discuss the results with regards to boom periods corresponding to
the years 1983, 1984, 1986, 1987, 1990, 1992, 1993, 1995, 1996, 1997, 2000, 2002,
2003, 2004, 2005 and 2006. The common major feature of these years is the
increasing total factor productivity (TFP) as pointed out by Saygili and Cihan (2008),
Ismihan and Metin-Ozcan (2006).These studies have reported TFP increases with
respect to the previous year. In contrast, TFP decreases were observed in the years
which have smaller growth rate than the natural rate of growth corresponding to the
years 1985, 1988, 1989, 1991, 1994, 1998, 1999 and 2001. Although the years 1981,
1982 and 2007 are the years which have smaller growth rate than the natural rate of
growth, TFP increases at small rates in comparison with the other years. Thus, it can
be possible to claim that our findings are justified by the other studies.
Moreover, our findings on the total factor productivity being the main reason
for endogeneity, means that, theoretically, an increase in the total factor productivity
may cause an increase in the labour force and/or labour productivity. Since an
increase in total factor productivity means a rise in the level of technology, i.e.
465
466
technological progress, the exact nature of the technological progress is an important

subject that should be examined. Therefore, [holding physical capital stock (K)
constant] i) if an increase in total factor productivity causes an increase in labour
force (L) but does not cause an increase in the labour productivity (Y/L), this means
that the technological progress must be Solow-neutral, ii) if an increase in total factor
productivity causes an increase in labour productivity (Y/L) but does not cause an
increase in labour force (L), this means that the technological progress must be
Hicks-neutral and iii) if an increase in total factor productivity causes an increase in
labour force (L) and labour productivity (Y/L) together, this means that the
technological progress must be Harrod-labour using.
That the endogeneity of the natural rate of growth implies automatic
convergence of the actual rate to the steady-state equilibrium cannot be expected
(Vogel 2009, p. 49) neither can it be expected that the nature of technological
progress is Harrod-neutral since steady-state growth can only occur if the nature of
the technological progress is Harrod-neutral.
Theoretically speaking, if our logic on the relationship among technological
progress, labour force and labour productivity is valid, it implies that there exists a
significant connection between demand conditions and the nature of technological
progress. In contrast to the supply-side explanation, the pattern of the demand
structure in the boom periods is one of the factors that determine the nature of
technological progress. This is a significant interpretation and a suggestion of the
present study for further analysis.
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Received: 13 January 2010; Accepted: 30 March 2010.
Yasemin zerkek
Faculty of Economics and Administrative Sciences,
Marmara University,
Turkey
yasemin.ozerkek@marmara.edu.tr
Sadullah elik
Faculty of Economics and Administrative Sciences,
Marmara University,
Turkey
scelik@marmara.edu.tr
UDC 336.5:330.567.2
DOI: 10.2298/PAN1004471
The Link between Government

Spending, Consumer Confidence
and Consumption Expenditures in
Emerging Market Countries
Summary: The impact of government spending on private consumption is
extensively studied in the literature. However, the main theme of these studies
is the possible crowding-in or crowding-out impact of government spending on
consumer spending. This paper attempts to introduce a new variable to this
well-known literature by investigating the existence of a relationship between
government expenditure, consumer spending and consumer confidence for a
group of emerging market countries. We examine whether a change in consumer confidence causes any change in government spending. Moreover, we
analyze whether there is a feedback from government spending and private
consumption to consumer confidence. Our empirical findings demonstrate the
important role of consumer confidence on government spending and private
consumption expenditures.
Key words: Government spending, Consumer confidence, Consumption
spending.
JEL: C23, E21, E62.
One of the hotly debated issues in macroeconomics literature is the impact of government spending on private consumption expenditures. Several studies assess the
existence of crowding-out versus crowding-in effects of government spending on
private consumption expenditures. The effects of changes in government spending on
aggregate economic activity and the transmission of these effects into household behavior are important in conducting macroeconomic policy.
In this context, several studies have linked the private consumption expenditures to government spending and have searched for this relationships direction and
magnitude. Studies in the neoclassical tradition usually predict a negative effect on
private consumption (Marianne Baxter and Robert G. King 1993), while studies employing Keynesian models usually favor a positive response (Olivier J. Blanchard
and Roberto Perotti 1999). Although these issues have been studied extensively,
there is still no widespread agreement on policy making from either a theoretical or
an empirical point of view (Jordi Gali, J.David Lopez-Salido, and Javier Valles 2005;
Davide Furceri and Ricardo M. Sousa 2009).
John G. Matsusaka and Argia M. Sbordone (1995) draw attention to the the
link between consumer confidence and economic activity. They examine whether
consumer sentiment causes fluctuations in GNP and find evidence consumer confidence is an important independent factor in economic fluctuations for the US economy for the period 1953-1988.
472
Considering the importance of consumer confidence, this paper attempts to incorporate this variable into the link between government spending and private consumption by investigating the existence of a relationship between government expenditure, consumer spending and consumer confidence for a group of emerging
market countries. We examine whether a change in consumer confidence gives rise
to a change in government spending. Moreover, we investigate whether government
spending and private consumption are determinants of consumer confidence for a
group of emerging economies.
Studying a panel of economies should construct a broad picture of the relationship between our variables of interest. Furthermore, emerging markets constitute
an appropriate group to test the validity of such conceptual theories derived for developed nations. It is informative observing the robustness of standard theories for
countries where public finance is inherently volatile, consumer reactions to changes
in the economic environment are rather mixed and a dynamic nature amplifies the
significance of consumer expectations. Hence, favorable empirical results will not
only strengthen the theoretical propositions but also lead to further research into the
sources of identical behavior in emerging economies.
The rest of the paper is organized as follows. Section 1 includes a brief literature survey on the relationship between government spending and consumer expenditures and identifies some of the studies in consumer confidence literature. Section 2
briefly describes the data and the methodology of panel unit root tests and panel
cointegration tests and presents the empirical findings we obtain employing these
powerful tests. Section 3 concludes with some remarks.
1. Literature Survey
The literature on the relationship between government expenditure and consumer
spending is clear cut on the transmission mechanisms and the results of policy actions. On one side stands the standard Real Business Cycle (RBC) model and on the
other the corresponding Keynesian IS-LM model. The impacts of government spending on private consumption for these two strands of literature differ remarkably.
According to the RBC model, an increase in government spending should
cause a decline in consumption. The RBC model relies on the consumption decisions
of infinitely-lived Ricardian households subject to intertemporal budget constraints.
Ceteris paribus, higher taxes needed to finance higher government spending negatively affect private wealth and consumption1. Conversely, the well-known Keynesian IS-LM model asserts consumption rises in response to an increase in government
spending. Consumers exhibit non-Ricardian behavior in the IS-LM model and consumption is a function of current disposable income. Therefore, the impact of an increase in government spending relies on how the government spending is financed
(Gali, Lopez-Salido, and Valles 2005)2.
See also Rao S. Aiyagari, Lawrence J. Christiano, and Martin Eichenbaum (1992), Christiano and Eichenbaum (1992), Baxter and King (1993) and Antonio Fats and Ilian Mihov (2002), among others.
2
See Blanchard (2003) for further details.
The Link between Government Spending, Consumer Confidence and Consumption Expenditures in Emerging Market Countries
Some studies find a degree of substitutability between government spending

and private consumption (a crowding-out effect), while other results show a complementary relationship (or crowding-in effect)3. Martin J. Bailey (1971) first proposes potential substitutability between government spending and private consumption. Robert J. Barro (1981) incorporates this hypothesis into a general model to analyze the effects of government spending. Roger C. Kormendi (1983), David Alan
Aschauer (1985), Shaghil Ahmed (1986), Aiyagari, Christiano, and Eichenbaum
(1992), Baxter and King (1993), Tsung-wu Ho (2001) and Furceri and Sousa (2009),
among others, find private consumption responds negatively to an increase in government spending.
Georgios Karras (1994) finds government spending and private consumption
described as complementary goods when an increase in government consumption
tends to increase (or leave unchanged) the marginal utility of private consumption.
Other studies associating government spending with an increase in private consumption are Michael B. Devereux, Allen C. Head, and Beverly J. Lapham (1996),
Blanchard and Perotti (2002), Fats and Mihov (2002) and Chien-Chung Nieh and
Ho (2006).
Using an estimated New-Keynesian dynamic stochastic general equilibrium
model, Gnter Coenen and Roland Straub (2005) show the presence of nonRicardian households is generally conducive to raising the level of consumption in
response to government spending shocks in the euro area from 1980 to 1999. However, their results suggest there is only a small chance government spending shocks
crowd in consumption4.
Another issue of interest in macroeconomics is the relationship between personal consumption expenditures and consumer confidence (Daron Acemoglu and
Andrew Scott 1994; Christopher D. Carroll, Jeffrey C. Fuhrer, and David W. Wilcox
1994; Alan Garner 2002; Andy C. C. Kwan and John A. Cotsomitis 2004, 2006;
Sydney C. Ludvigson 2004; Sadullah elik and Yasemin zerkek 2009). Consumer
confidence indexes measure the confidence of consumers about the state of the economy and their spending power5. Studies like Acemoglu and Scott (1994) and Carroll,
Fuhrer, and Wilcox (1994) search for the forecasting ability of sentiment for changes
in consumption to validate additional information content of consumer confidence.
Their argument is based on the notion improvements in consumer sentiment should
stimulate consumption growth in the short-run. elik and zerkek (2009) examine
the relationship between consumer confidence, personal consumption and other relevant economic and financial variables for nine European Union countries. The panel
cointegration findings show a long-run relationship in the sense consumers can detect
early signals about future rates of economic growth as they communicate through the
consumption channel.
3
See Ludger Linnemann (2006) among others.

Coenen and Straub (2005) point out this is mainly because the estimated share of non-Ricardian households is relatively low, but also because of the large negative wealth effect induced by the highly persistent nature of government spending shocks.
5
Consumer confidence index (CCI) is considered as a significant leading indicator in economics due to
its earlier announcement compared to other indicators (variables) in the economy. The concern in consumer attitudes stems from the idea that consumers' expectations of future economic circumstances play
an important role in macroeconomic results.
4
473
474
2. Data, Methodology and Empirical Findings

2.1 Data
This paper uses quarterly data for the variables of private consumption (PC), consumer confidence index (CCI) and government spending (GS). The countries included in the analysis are Brazil, Czech Republic, Hungary, Poland, South Africa and
Turkey. The data is balanced panel and covers 2002: Q1 2008: Q36.
2.2 Methodology and Empirical Findings
We first ask whether the consumer confidence index (CCI) can be used as a proxy
for private consumption (PC) in the relationship between government spending (GS)
and private consumption. To this end, we look at the Granger causality results between these variables. The results of bivariate regressions of the form
yt 0 1 yt 1 ... l yt l 1xt 1 ... l xl t

xt 0 1xt 1 ... l xt l 1 yt 1 ... l yl ut
(1)
for all possible pairs of (x, y) series in the group are used. The reported F-statistics
are the Wald statistics for the joint hypothesis: 1 2 ... l 0 for each equation.
Using the lag lengths of 4 and 67, Granger causality results show that a) consumer confidence causes government spending and private consumption and b) government spending causes private consumption8. The rise in consumer confidence implies that the optimism of households about future economic conditions increases.
Accordingly, private consumption goes up. This rise in consumption - a component
of aggregate demand - leads to an increase in income. Then the rightward shift in IS
curve results in an interest rate increase. Ceteris paribus, two effects appear: 1) the
increase in consumption should result in an increase in tax revenue and 2) government interest payments should increase as a result of an increased interest rate. The
change in government spending depends on the dominant effect. In other words,
government spending increases (or decreases) if interest payments exceed (or lag) tax
revenues.
We then employ Equation 2 to test the significance of government spending
along with personal consumption on consumer confidence by using panel data analysis for six emerging market countries9.
The data source for GS is Reuters for all countries. The data for PC is obtained from Reuters for all
countries except Turkey for which it is collected from Central Bank of the Republic of Turkey. CCI is
obtained from Reuters for all countries except Turkey for which it is collected from CNBC-e and for
Poland from http://www.bankier.pl/inwestowanie/notowania/macro/profil.html?id=51.
7
The lag selection is done according to Schwarz Information Criteria. The results are in Table A in Appendix.
8
The results of the causality tests are in Appendix.
9
PC and GS are seasonally adjusted and all variables are in their natural logarithms.
lo g ( C C I it ) i lo g ( P C it ) lo g ( G S it ) it
(2)
where PCit denotes private consumption at time t, CCIit shows consumer confidence,
GSit denotes government spending.
The panel data analysis focuses particularly on unit root and cointegration
properties of variables in an attempt to increase statistical power as the conventional
unit root tests or cointegration tests are of comparatively low power for nonstationary data10. The panel unit root tests are classified as first generation11 (Andrew
Levin, Chien-Fu Lin, and Chia-Shang James Chu 2002, hereafter LLC; Breitung
2000; Kyung So Im, Pesaran, and Yongcheol Shin 2003, hereafter IPS) and second
generation (Hyungsik R. Moon and Benoit Perron 2004; and Pesaran 2007)12. In our
analysis, we use panel unit root tests of LLC, IPS, Moon and Perron (2004) and
Pesaran (2007).
Table 1 reports the results of the first generation panel unit root tests for six
emerging market countries. We fail to find a unit root in the levels of the variables
for 3 out of 12 cases in LLC and IPS tests. Only in the case of government spending
we are unable to find a unit root for both tests when a constant and trend is included
Table 1 Panel Unit Root Tests in Levels (First Generation)
Variable
Common unit root
Individual unit root
LLC
IPS
Constant
-0.699
(0.242)
-0.070
(0.472)
Constant and Trend
-0.458
(0.323)
-0.103
(0.458)
Constant
-2.581*
(0.004)
0.599
(0.725)
Constant and Trend
2.499
(0.993)
0.727
(0.766)
Constant
-1.041
(0.148)
0.256
(0.601)
Constant and Trend
-2.923*
(0.001)
-4.160*
(0.000)
Case
CCI
PC
GS
Note: The null hypothesis for LLC and IPS are unit root. The numbers in brackets are the p-values for all tests. (*)
denotes significance at 5 % level.
10
See Jrg Breitung and Mohammed H. Pesaran (2008) for a review of the literature on panel unit root
and panel cointegration tests.
11
These first generation panel unit root tests ignore cross-sectional dependence. There are other first
generation tests such as Kaddour Hadri (2000), Fisher-ADF and Fisher-PP tests developed by Gangadharrao S. Maddala and Shaowen Wu (1999) and In Choi (2001) utilizing Ronald A. Fisher (1932) results.
12
Pesaran (2007) is based on single common factor with correlation coefficients for cross sectional dependency. There are other second generation tests such as Peter C. B. Phillips and Donggyu Sul (2003),
Jushan Bai and Serena Ng (2004). Christian Gengenbach, Franz C. Palm, and Jean-Pierre Urbain (2004)
show that Pesarans CIPS and CADF statistics exhibit powerful properties.
475
476
in the equation. Due to considerable criticism of these first generation panel unit root
tests, coupled with the ongoing research usually advocating the powerful characteristics of second generation panel unit root tests, our next step is to apply two of the
most powerful second generation panel unit root tests.
Table 2 includes the empirical findings for the second generation panel unit
root tests of Pesarans cross-sectionally augmented IPS test (CIPS)13 and the Moon
and Perron test14. In Pesaran CIPS test, employing different specifications for p, we
Table 2 Panel Unit Root Tests in Levels (Second Generation)
Pesaran CIPS Test Statistics (with constant)
p=2
p=3
-1.410
-1.297
-1.096
-1.026
-1.652
-1.627
CCI
PC
GS
p=1
-1.445
-1.241
-1.822
CCI
PC
GS
Pesaran CIPS Test Statistics (with constant and trend)

p=1
p=2
p=3
-2.448
-2.225
-1.997
-1.202
-0.986
-0.904
-2.448
-2.225
-1.997
CCI
PC
GS
CCI
PC
GS
Moon and Perron Test Statistics (with constant)

k=1
k=2
0.024
0.062
0.388
1.075
0.010
0.008
2.828
0.734
0.021
0.026
4.238
7.896
p=4
-1.228
-0.996
-1.228
k=3
0.052
1.596
0.009
1.812
0.021
9.132
k=4
0.029
0.828
0.013
14.515
0.014
6.276
Moon and Perron Test Statistics (with constant and trend)

k=1
k=2
k=3
-0.468
-0.542
-1.740
-0.340
-0.468
-1.648
-1.077
-1.058
-2.189
-0.343
-0.343
-1.492
-3.003*
-6.508*
-5.899*
*
*
-2.289
-5.791
-5.538*
k=4
-3.277*
-3.470*
-0.252
-0.258
-1.483
-1.304
ta*
tb*
ta*
tb*
ta*
tb*
ta*
tb*
ta*
tb*
ta*
tb*
p=4
-0.913
-0.835
-1.020
Note: For CIPS test, the critical value in the case of a constant is -2.33 and in the case of a constant and trend is -2.86 at
5% significance level, respectively. For the Moon and Perron test, see Gengenbach, Palm, and Urbain (2004) and Gutierrez
(2005) for the critical values of ta* and tb*. (*) denotes significance at 5% level, meaning the rejection of the null of unit root.
13
Pesaran (2007) shows that CIPS test has satisfactory size and power even for relatively small values of
N and T which is important for our data set.
14
The Moon and Perron (2004) test is a pooled panel unit root test based on de-factored observations.
Hence, they propose estimating the factor loadings by the principal component method. The asymptotic
properties of Moon and Perron test under the unit root null and local alternatives exhibit good asymptotic
power if the model does not contain deterministic (incidental) trends.
detect a unit root for each variable in both constant and constant-and-trend cases as
we are unable to reject the null of a unit root. However, we would like to enhance our
findings from Pesaran test by also employing the Moon and Perron test, using a residual factor model to account for the cross section dependence in the panel data.
Moreover, in view of the considerable uncertainty that surrounds the choice of common factors, we compute ta* and tb* statistics of Moon and Perron for different values of k (from 1 to 4). Moon and Perron do not consider samples with less than 100
time series observations in their simulation so we consider Gengenbach, Palm, and
Urbain (2004) and Luciano Gutierrez (2005). From the tables of Gengenbach, Palm,
and Urbain (2004), both constant and constant-and-trend statistics of Moon and Perron have rejection frequencies lower than the nominal size if T = 50 and N = 10.
Therefore, CCI, PC and GS exhibit non-stationary characteristics.
Table 3 Panel Cointegration Tests
Peter Pedroni (2004)
Test
Panel v-statistic
Panel -statistic
Panel pp-statistic
Panel adf-statistic
Group -statistic
Group pp-statistic
Group adf-statistic
Test
Statistics
Weighted Statistic
0.342
( 0.376)
-0.985
( 0.246)
-2.582*
( 0.014)
-3.432*
( 0.001)
-0.189
( 0.392)
-2.446*
( 0.020)
-2.905*
( 0.006)
-0.815
( 0.286)
-1.219
( 0.189)
-3.194*
( 0.002)
-3.557*
( 0.001)
Joakim Westerlund (2007)

Constant
Constant and Trend
-3.260*
-6.859*
0.098
2.270
-0.794
-5.135*
0.297
1.756
Westerlund and David L. Edgerton (2007)

lm statistic
Constant
Constant and Trend
0.619*
bootst p-val
0.753*
asymp p-val
0.268*
lm statistic
2.659*
bootst p-val
0.116*
asymp p-val
0.004
Note: For Pedroni (2004), except for panel v-statistic and for Westerlund (2007) all statistics have -1.645 as 5 % critical
value. The critical value of v-statistic is 1.645 at 5 % level. The null for Westerlund and Edgerton (2007) is cointegration. (*)
denotes significance at 5% level.
477
478
The existence of non-stationarity at the same integration order is the priority in

order to implement cointegration analysis. We employ panel cointegration tests of
Pedroni (1999, 2004), Westerlund (2007) and Westerlund and Edgerton (2007). The
results of these tests are presented in Table 3. For Pedroni (1999) and Pedroni (2004),
six of eleven cointegration tests for constant and constant-and-trend case result in
rejecting the null of no cointegration. Westerlund (2007) tests to check the existence
of cointegration and we are able to reject the null of no cointegration in three of eight
cases. However, when we apply the Westerlund and Edgerton (2007) test, with more
powerful characteristics due to its bootstrapping methodology, we fail to reject the
null of cointegration in three of four cases. Hence, our empirical findings suggest the
panel cointegration between CCI, PC and GS exists.
Once detecting panel cointegration, it is important to obtain coefficient estimates for the variables in question. In this study, we prefer to use the fully modified
ordinary least squares (FM-OLS) method developed by Pedroni (2000) for coefficient estimations in cointegrated panels15. We start with CCI as the variable for normalized cointegrating coefficients and repeat the same exercise for GS. In Table 4,
FM-OLS estimates of PC and GS are displayed for six emerging market countries
individually and for the panel group. We have statistical significance for GS except
for the case of Hungary. We reject the null of no significance for only Poland in case
of PC with a negative coefficient. This runs counter to our a priori theoretical expectations and shows ineffectiveness of the private consumption channel on a country
basis analysis. This is hardly valid for the case of GS where we have only one significant and positive coefficient case of South Africa. Nevertheless, panel group estimates of FM-OLS are both statistically significant and provide support for our theoretical framework.
Table 4 FM-OLS Test for Coefficient Estimations of PC and GS
Normalized Variable: CCI COUNTRY
Brazil
Czech Republic
Hungary
Poland
South Africa
Turkey
Panel Group
PC
GS
1.17
(0.36)
-1.14
(-1.29)
-0.27
(-0.85)
-2.10*
(-8.68)
1.61
(0.58)
1.18
(0.19)
0.07*
(-3.96)
-0.06*
(-8.18)
-1.73*
(-3.32)
1.46
(0.97)
-0.79*
(-1.78)
0.15*
(-2.31)
-0.92*
(-4.71)
-0.31*
(-7.89)
Note: The values in the brackets are the t-ratios. FM-OLS test includes a constant and a trend. (*) denotes significance at 5
% level.
15
We also employed the dynamic ordinary least squares (DOLS) technique of James Stock and Mark W.
Watson (1993). The results have been somewhat similar and are available from the authors upon request.
As expected, the sign of the coefficient for PC in the panel is positive. When
private consumption rises, the utility of consumers increases, therefore consumers
feel better off. This, in turn, should be reflected in higher levels of confidence in the
leading terms, meaning an increase in consumer sentiment. However, this mechanism ignores how (and why) consumers could spend more than the previous period.
Our empirical findings show that a 1% increase in private consumption causes about
0.07% increase in consumer confidence in the corresponding term16.
At the same time, considering the negative coefficient on GS in the panel
group, it is well known an increase in non-productive government spending has to be
financed through some means. There are several ways to create this revenue. One
method affecting consumers directly is imposing new taxes (or increasing the rate of
taxation on some regularly consumed items). If taxes are used to finance an increase
in government spending, fiscal action has no impact on the size of the government's
budget deficit or surplus. In this case, the expectations of consumers about future
finances turn pessimistic as they would be subject to higher than normal taxes. This
mechanism will create a negative wealth effect, leading to lower consumer sentiment17. A second way to finance government spending is to issue bonds/bills. This
definitely leads to an increase in interest rates and raises the cost of borrowing, which
in turn may reduce consumer confidence. However, realizing this effect depends on
several factors, such as the size of and the participants in the bond/bill market, the
volatility of the bond/bill market and the amount of bonds/bills issued in the specific
auction. A third possible way to finance government spending is to increase the
money supply - rarely pursued under inflation targeting monetary policy. Nevertheless, a rise in money supply causes an increase in the inflation rate, in turn resulting
in a fall in the purchasing power of the consumer. This fall should induce a decline in
consumer confidence after a certain amount of time18. Hence, we find that a 1% increase in government spending results in a 0.31% decline in consumer confidence19.
Overall, the total change in consumer confidence due to changes in private
consumption and government spending depends on the difference between the increase in tax revenue and the increase in interest payments. The tax revenue increases
due to rising private consumption and the interest payments increase due to rising
interest rates as bonds/bills are auctioned for additional government spending. There
is no consensus on the results of this issue and our empirical findings show that the
effect of government spending is higher in magnitude than the effect of private consumption in our emerging markets20.
16
This seems rather small but there is no consensus on even the existence of a relationship between the
two variables. Among others, see Andy C. C. Kwan and John A. Cotsomitis (2004, 2006).
17
The mechanisms underlying those effects are described in detail in Gali, Lopez-Salido, and Valles
(2005).
18
In their analysis for Sweden 1975-1994, Lennart Berg and Reinhold Bergstrom (1996) find two important factors affect the consumer indices: changes in real interest rates and changes in the inflation rate.
19
This also seems rather small but there is not even a study which includes consumer confidence as a
potential variable in the relationship between personal consumption expenditures and government spending.
20
Two reasons could be a low real wage due to high inflation and the expectation of a lower nominal
wage increase in the future by the public workers, constituting a significant portion in emerging market
economies.
479
480
Another very significant point is to reverse the question of interest and consider the effects of changes in private consumption and consumer confidence in our
cointegrated variables. In Table 5, we show the FM-OLS estimates of PC and CCI
for our six emerging economies individually and for the panel group. We have statistical significance for PC except for the case of Brazil, Hungary and Turkey. We fail
to reject the null of no significance for only Brazil in the case of CCI. The signs of
significant coefficients are against our a priori theoretical expectations for two countries in the cases of both PC and CCI. Our results show the dynamic nature of household spending and consumer confidence in emerging economies when each country
is analyzed itself. Income is close to subsistence and consumption is the major determinant for tax revenues. Moreover, consumers view the government as creating
benefits for its own sake rather than the public. This in turn leads to an inverse relationship between consumer confidence and government spending. Nevertheless,
panel group estimates of FM-OLS are both statistically significant and result in theoretical support for our empirical analysis.
Table 5 FM-OLS Test for Coefficient Estimations for PC and CCI
Normalized Variable: GS COUNTRY
Brazil
Czech Republic
Hungary
Poland
South Africa
Turkey
Panel Group
PC
CCI
2.16
(0.99)
0.23*
(-1.83)
1.67
(2.07)
-0.39*
(-8.41)
-2.72*
(-12.22)
0.90
(-0.18)
0.31*
(-7.99)
-0.27
(-1.72)
-0.18*
(-16.95)
0.26*
(-12.88)
-0.07*
(-13.07)
0.01*
(-6.48)
-0.39*
(-8.31)
-0.11*
(-24.25)
Note: The values in the brackets are the t-ratios. FM-OLS test includes a constant and a trend. (*) denotes significance at
5% level.
A 1% increase in PC leads to a 0.31% increase in government spending, showing the effect of an increase in tax revenue on government spending. Moreover, a 1%
increase in consumer confidence decreases government spending about 0.11%, signaling a tightening of the government budget when the private sector is leading the
economic cycle. The sentiment seems to lack the magnitude of response by private
consumption. This is not surprising for a group of emerging economies with high tax
rates for almost any good or service and the existence of a large public sector with
many relatively inefficient workers depending on government revenue. Moreover,
the consumer confidence in such economies should cause a positive response from
the budget side as government should feel free to expand when public confidence is
high. Although this is true for two countries in our panel, our empirical results show
support for an inverse relationship overall. This seems to be the response of monetary
policy and fiscal policy combination seeking to cool the economy when private consumption peaks due to fears of inflation and higher rates of interest.
3. Conlusion
The deregulation efforts of recent decades, including massive privatizations and restrictive laws on governments and monetary authorities have led to tremendous
amounts of risk taking in many parts of the economies with no real value created in
return. Recently, this unsustainable system has collapsed, leading to major implications for the revision of the orthodoxy that has dominated the economics literature
since the Great Depression. One of the important relationships still intact in this chaotic environment is the one between government spending and private consumption.
However, this rather superior theoretical proposition has lacked an important aspect
that has probably been the reason for its long standing. In such a dynamic world of
information flows, it is hard to imagine economic agents fail to incorporate expectations of the future economic outlook into consumption decisions. Hence, the driving
force for the relationship between government spending and private consumption is
consumer behavior, or the state of consumer confidence in an economy.
This paper attempts to designate consumer confidence the role it deserves in
the existence of a relationship between government expenditure and consumer spending. In this sense, we prefer to use a group of emerging market countries where the
expectation formation reacts very fast to the general economic outlook and seems to
affect the future economic outlook. Hence, we assess whether a change in consumer
confidence leads to any changes in government spending. Furthermore, we examine
the existence of feedback from government spending and private consumption to
consumer confidence. Our empirical findings show the presence of a long-run relationship between the three variables. Moreover, we demonstrate the important role of
consumer confidence on government spending which could probably be used as a
proxy for private consumption expenditures.
Consequently, we believe consumer confidence should be incorporated into
different functional forms studying the relationship between public and private sectors. The information content of consumer sentiment should provide valuable links
between these studies and reflect the important role the sensitivity of economic
agents has on the future path of an economy.
481
482
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Appendix: Bilateral Causality Analysis

Table A Pairwise Granger Causality Tests
Pairwise Granger Causality Tests
GS does not Granger cause CCI
CCI does not Granger cause GS
PC does not Granger cause CCI
CCI does not Granger cause PC
F-Statistic
(k=4)
F-Statistic
(k=6)
1.98042
(0.1013)
2.96061*
(0.0223)
0.81875
(0.5154)
4.39035*
(0.0023)
0.60498
(0.7259)
2.32667*
(0.0372)
0.73143
(0.6253)
2.77447*
(0.0149)
Note: k stands for the number of lags used and the values in the brackets are the p-values. (*) denotes significance at 5%
level.
485
486

Received: 30 December 2009; Accepted: 14 March 2010.
Ivana Prica
Faculty of Economics,
University of Belgrade,
Serbia
ivanapopov.prica@gmail.com
Jelica Petrovi
Vujai
Faculty of Transport and Traffic
Engineering,
Serbia
j.petrovic@sf.bg.ac.rs
UDC 339.7:339.54] (494)

DOI: 10.2298/PAN1004487P
Professional paper
Financial Services Liberalisation in

Transition Countries and the Role
of the WTO
Summary: While a bulk of economic theoretical and empirical research deals
with various aspects of financial liberalisation, there is far less research devoted to the measurement of financial liberalisation. In this paper we calculate
an index of financial liberalisation in 18 transition countries in the Central, Eastern and South-East Europe (CESE) and the Commonwealth of Independent
States (CIS). This index was previously developed in works of Aaditya Mattoo
(1999) to measure financial liberalisation that the WTO member countries have
committed to. We make a slight modification to scaling to take into account the
specific aspects of CESE and CIS countries and also apply the index to a nonWTO member (Serbia) using its currently applied regime. In this paper we will
examine the influence of the General Agreement on Trade in Services (GATS)
framework on liberalisation commitments in financial services sector in the
target countries.
Key words: Financial services, Financial liberalisation, Transition, WTO.
JEL: G15, G21, G22, G28.
This paper discusses the level and the scope of financial liberalisation in 17 World
Trade Organization (WTO) Central, Eastern and South-East Europe (CESE) and the
Commonwealth of Independent States (CIS) member countries. This heterogeneous
group of countries includes central European EU accession countries on one side to
small central Asian countries on the other side of the spectrum. These countries are
Albania, Armenia, Bulgaria, Croatia, Czech Republic, Estonia, Georgia, Kyrgyzstan,
Latvia, Lithuania, Hungary, Macedonia FYR, Moldova, Poland, Romania, Slovak
Republic and Slovenia. Some were already GATT members (Czech and Slovak Republics, Hungary, Poland, Romania and ex-Yugoslavia) but most were not. Today all
of the countries in the group, except Serbia, are WTO members and four countries
are OECD members: the Czech Republic, Hungary, Poland and the Slovak Republic.
We also examine the financial services commitments to the General Agreement on Trade in Services (GATS) of the 17 CESE and CIS countries that are WTO
members. We also calculate liberalisation indices for banking and insurance sectors
using methodology developed in Aaditya Mattoo (1999). The results of the financial
services liberalisation analysis are considered against the GATS framework as an
indication of the countries real level of liberalisation and financial sector development. Based on these findings we try to assess the role of GATS in the countries
financial services reform.
488
1. The General Agreement on Trade and Services (GATS)

GATS was negotiated during the Uruguay Round (1986-1994) and is the first and
only set of multilateral legally-enforceable rules that govern international trade in
services of 149 country-members. Similar to the General Agreement on Trade and
Tariffs (GATT), GATS encompasses the following three elements: general rules and
disciplines, Annexes to regulate sector specificities and the Schedule of Specific
Commitments that show specific obligations a particular Member has undertaken in
the particular service sector. Unlike GATT, GATS has a specific fourth element: List
of Article II (MFN) exemptions. This list shows the sectors in which the Member is
temporarily not going to apply the Most-Favoured Nation (MFN) principle of nondiscrimination legally-enforceable rules that govern international trade in services of
149 country-members. Many countries have made use of this exemption: the EU for
audio visual services, non-life insurance and canal transportation, the US for financial services and pipeline transportation and most OECD countries for airtransportation.
The generally accepted definition of trade in services, as provided in Article I,
Paragraph 2 of the GATS, recognizes this specific aspect of services and defines
trade in services by way of four services supply modes:
Mode 1: Cross-border Supply The services are delivered across the country border, the service provider resides abroad while the consumer remains
in the home country, similar to trade in goods (e.g., when financial credit is
extended or insurance policy purchased from a bank/insurance company
located abroad);
Mode 2: Consumption Abroad - The consumer travels into the country in
which the services are delivered by the foreign services supplier (e.g., obtaining financial services when travelling abroad);
Mode 3: Commercial Presence - Service supplier of one country supplies a
service in another country by establishing, through foreign investment, a
commercial presence in that country (e.g., commercial presence of foreign
banks or insurance companies);
Mode 4: Presence of Natural Persons - This applies to the temporary
movement of individuals (which are natural, not legal persons as is the
case in the previous mode) and arises when a service is delivered in a foreign market; these individuals may be independent service providers (such
as consultants), or foreign employees of a service-supply company (e.g.,
solicitation on domestic territory of insurance products by agents from a
foreign country, foreign manager of a domestically-established bank).
According to Rudolf Adlung and Martin Roy (2005), the estimates of the Statistical Division of the WTO Secretariat are that mode 3 (commercial presence) has
more than 50% share of total service trade value, while mode 1 (cross-border supply)
and mode 2 (consumption abroad) account for 30% and 15% of the total value of
service trade.
Due to the specific nature of services and the consequent definition of services
trade outlined above, barriers to services trade generally cannot be defined in terms
Financial Services Liberalisation in Transition Countries and the Role of the WTO
of tariff protection. The application of the GATS is not confined to product-related

measures, as provided for under the GATT, but covers producer-related laws and
regulations as well, as discussed in Adlung and Roy (2005). Counterbalancing its
broader coverage in terms of economic transactions and permissible policy measures,
GATS allows use of virtually any conceivable trade instrument (from supply quotas
to discriminatory subsidies).
The level of the foreign trade in services liberalisation is weighed against the
restrictions of Market Access (MA) or National Treatment (NT) for each of the four
service supply modes and for every service sector. Concrete liberalisation commitments of a WTO member country, defined against this framework, are entered into
that countrys Schedule of Specific Commitments (the Schedule) related to GATS,
through which it commits to a particular level of liberalisation in trade in services.
The MA and NT commitments are scheduled applying the positive listing approach.
Only those sectors specifically listed are covered by the liberalising provisions in the
Schedule.
We have examined WTO commitments in financial services in 17 CESE and
CIS countries that are WTO members. This analysis encompasses the following financial service sectors:
i. Insurance and insurance related services, i.e. (i) to (iv) according to the Annex 5.(a);
ii. Banking services, which comprise sub-sectors (v) to (ix) in 5.(a) of the Annex; and
iii. Other financial services (securities, money broking asset management etc),
or sub-sectors (x) to (xvi) of the Annex 5(a).
Only the first three modes of supply, cross-border, consumption abroad, and
commercial presence, were taken into account. Limitations to mode 4 (movement of
natural persons) are based on different set of regulations and the scope of mode 4 is not
at all significant for the financial services sector. Residency requirements for employees and management bodies that were listed as mode 3 limitations in some Schedules
were not taken into account either.
2. Numerical Evaluation of the Financial Services Liberalisation

Scope
The commitments in the banking and insurance sectors summarized in Table 1 were
used to calculate the liberalisation indices in financial services sector. This was performed using the methodology that was first developed by Mattoo (1999) and consequently applied in a number of studies, such as Mattoo, Randeep Rathindran, and
Arvind Subramanian (2001), Alexei Kireyev (2002), Ramkishen S. Rajan and Graham Bird (2002), Rajan and Rahul Sen (2002), Phillipp Harms, Aaditya Mattoo, and
Ludger Schuknecht (2003), and Li-Gang Liu (2005).
The commitments are analyzed for 18 countries, which include Serbia and 17
other countries previously mentioned. Information on limitations applicable for each
of the 17 WTO member countries are gathered from their GATS Schedules, in line
489
490
with the above analysis and in accordance with the model set out in Mattoo (1999).
Regarding Serbia, since it is not a WTO member (hence does not have a Schedule)
the liberalisation indices were calculated on the basis of its currently applied regulatory regime. On one hand, this means that without changing the current regime, Serbia cannot have a higher liberalisation index. On the other hand, it is possible and
quite probable that during negotiations for accession Serbia would be expected to
commit to a higher level of liberalisation compared to the current regime, meaning
that the WTO membership would result in a higher liberalisation index (effectuated
by the appropriate regulatory change). In short, results for Serbia would not be directly comparable to those of the other countries if the currently applied regime in
those countries significantly differs from the commitments in their respective Schedules.
2.1 Methodology
The liberalisation index created by Mattoo, and used in this research, belongs to a class
of frequency measures of a degree of services liberalisation. These measures were
originally constructed simply to reflect the frequency of appearance of commitments in
the WTO Schedules and have since evolved in two directions. These are: (1) creation
of sophisticated scales of restrictiveness to capture different types of restrictions and to
provide adequate measure of the level of restrictiveness of each (sector-specific) measure; and (2) development of different weighing schemes to form an adequate aggregate
measure.
One of the first researches to develop a sophisticated frequency measure for financial services sector is that of Mattoo (1999). He created a liberalisation index, separately for banking and insurance sectors, which runs in the interval [0,1]. The index is
calculated based upon the WTO commitments by identifying the most restrictive
measure by mode of supply and by service sub-sector. Each measure is then assigned a
restrictiveness score, according to a restrictiveness scale that was developed to capture
the specificities of both the observed sectors and the country pool. Each restrictiveness
score is then weighted, using weights to capture the relative importance of a particular
mode of supply of a particular sub-sector, to obtain a sector-specific aggregate measure
dubbed the liberalisation index.
The scope of analysis is limited to two sub-sectors of direct insurance: life insurance and non-life insurance, and two sub-sectors in banking: acceptance of deposits and other repayable funds from the public (acceptance of deposits), and lending of
all types including consumer credit, mortgage credit, factoring and financing of commercial transactions (lending).
In our analysis, the most restrictive measure for each of the 17 WTO members
can be found in Table 1. The restrictiveness scale, based on the model provided by
Mattoo, was developed to reflect the specific features of the WTO commitments of the
CESE and CIS countries. The situation where there are no restrictions on a particular
service or mode of supply is considered the situation of full liberalisation and the
score value is 1. If no commitments were taken for the studied service and supply
mode, the score value is 0. Between these two extremes there are many levels of
partial liberalisation, defined by specific commitments. Thus, in the case of mode 3
many countries impose restrictions on legal form of entrye.g., it is required that a

domestic entity be founded (no business can be conducted through affiliate offices)
and the appropriate score value is 0.75.
After we assigned the restrictiveness score for each of the two types of services and for each of the three supply modes investigated, what we needed was a
suitable means (e.g., weighting scheme) to aggregate the data.
The weighting scheme, which is supposed to define the relative significance of
each of the studied service categories, was calculated based on USA foreign trade
data. While the restrictiveness scale we developed (see Table 1) is somewhat different
to that of Mattoo, the modal weights are the same as the ones employed by this research. Both of these are described in Table 1.
Table 1 Modal Weights and Restrictiveness for Calculation of the Mattoo Index of Liberalisation in
Financial Services
Modal weights in insurance and banking
Cross-border supply
Consumption abroad
Commercial presence
Life
0.12
0.03
0.85
Non-life
0.20
0.05
0.75
Deposits
0.12
0.03
0.85
Lending
0.20
0.05
0.75
Insurance:
Banking:
Restrictiveness scale by commitment type for modes 1, 2 and 3

Restrictiveness
Limitation type
score
Modes 1 and 2
0.00
No, or virtually no commitment
No commitment, or virtually no commitment
Mode 3
0.10
No new entry or unbound for new entry
0.25
Discretionary licensing or economic needs testing for new entry
0.25
Reciprocity condition
0.50
Partial liberalisation
Exemption of certain sub-sectors (e.g., exclusive suppliers)
0.75
Limitation on the legal form of entry
0.75
Other minor limitations
1.00
Full liberalisation
Full liberalisation
Source: Adapted following the approach in Mattoo (1999), pp. 37-38.
491
3. Results of Application
Mattoo liberalisation indices calculated as explained above run in the interval [0,1],
where 0 represents the particular sub-sector being fully closed and 1 represents full
liberalisation on all modes of supply. By aggregating the scores using the modal
weights, we have calculated four separate liberalisation indices for two groups of insurance services: life insurance and non-life insurance, and for two groups of banking services: acceptance of deposits and lending. We have applied the approach to the
information on commitments in 17 countries in Table 2 in the Appendix and on the
information on the Serbian applied regulatory regime. The results are presented in Table 3 in the Appendix. Here we have ranked the countries according to their total liberalisation level, so that the first country, Estonia, has the most liberal, and the last country, Hungary, the least liberal WTO regime for trade in financial services.
Serbian index calculated upon its current applied regime is listed last and is the
lowest. Serbia maintains significant limitations on cross-border transactions (no life
insurance, almost no non-life insurance as well as no bank-deposits abroad). In addition, it has discretionary licensing requirements for establishing a bank or an insurance
company. The main reason for this is the reluctance on the part of the government to
liberalise these sectors further on the arguments of the unfinished financial regulatory
reform, weak oversight structures and incomplete privatization of the sector.
Finally, using the two indices for each sector, we calculated a simple average
for insurance services and for banking services. This result is outlined in Figure 1,
where countries are ranked by their date of accession to the WTO such that the leftmost countries, Czech Republic, Hungary, Romania, Slovak Republic, Poland and
Slovenia, are the original members, followed by Bulgaria (which acceded in 1996,
but submitted its Schedule in 1997), and ending with Macedonia as the country that
among the WTO members acceded last. On the right end of the figure is Serbia
which had begun the process of WTO accession.
1.00
0.80
0.60
0.40
0.20
insurance
banking
Serbia
Macedonia, FYR
Armenia
Moldova
Lithuania
Croatia
Albania
Georgia
Estonia
Latvia
Kyrgyzstan
Bulgaria
Slovenia
Slovak Republic
Romania
Poland
Hungary
0.00
Czech Republic
492
Source: Authors calculations based on the methodology developed in Mattoo (1999).
Figure 1 Mattoo Liberalisation Indices for Banking and Insurance in CESE and CIS
As previously discussed, CESE and CIS countries have much more liberal
commitments in mode 3 (commercial presence) than in modes 1 and 2. When analyzing the results in Table 3 and Figure 1, it is important to bear in mind that mode 3
also has the highest impact in the calculation of the Mattoo liberalisation index. For
that reason the penalty impact of MFN exemption in case of Hungary was a very low
liberalisation score. They are joined by Serbia which has discretionary licensing procedures for establishing foreign commercial presence.
The results listed in Table 3 in the Appendix show that at the bottom of the table, with the lowest liberalisation scores, are only the original WTO members and
Bulgaria which joined only one year after (plus Macedonia which has pre-committed
to future liberalisation in 2008, when its score will be in the upper half of the table).
The newly acceded WTO members including all CIS countries are at the top of Table
3. This finding, that the newly acceded members have a higher liberalisation score, is
more obvious in Figure 1, where countries were ranked by the date of WTO membership.
The fact that the lowest scored are the original WTO members and also the
most developed countries in the pool, clearly points to the possibility that actually
applied regulatory regime in those countries may be more liberal than their GATS
commitment (autonomous liberalisation). As Table 3 and Figure 1 show, OECD and
EU member-countries: Czech Republic, Hungary, Poland and Slovak Republic are
among the lowest-ranked. Yet those countries have liberalised their policies in order
to achieve OECD and EU requirements. This conclusion is in accord with the findings of Felix Eschenbach and Bernard Hoekman (2006), who analyzed the overall
GATS commitments of CESE and CIS countries and the EU commitments and compared their GATS commitments to the actually applied policies in the service sector
as a whole. They find that all countries that had the prospect of accession to the EU
apply much higher overall level of services liberalisation than the level they committed to in GATS. In our analysis of the financial services sector this result applies only
to the countries that were the original members. Countries that only recently acceded
to the WTO (which precedes EU accession) and soon after became EU members
have already committed to a high liberalisation level in financial services in GATS.
The highest financial services liberalisation indices in Table 3 are those of two
EU member countries (since 2004): Estonia and Lithuania. These are followed by
three CIS countries: Georgia, Kyrgyzstan and Armenia. The countrys size and/or the
size of the financial markets also play an important part in the decision to liberalise.
Asli Demirguc-Kunt (2006) finds that small financial systems tend to under-perform
since they fall short of minimum efficient scale and have much to gain from liberalising and sourcing some of their financial services from abroad. All the countries
with the highest financial services liberalisation index in Table 3 fall in this category. This may partially explain why their governments were willing to accept such
high level of commitment in financial services.
On the other hand, many of those countries may have regretted accepting a
high level of commitment. We found that in the special session of the Council for
Trade in Services on March 6, 2003, newly acceded WTO members including Albania, Croatia, Georgia, Kyrgyzstan, Lithuania and Moldova, indicated that they had
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494
undertaken major liberalisation efforts in their WTO accession processes and had
little or no margins for further flexibility (International Centre for Trade and Sustainable Development 2003). This also underlines the fact that the WTO structure
and accession negotiation procedure demands increasingly higher levels of commitments from the prospective members. Furthermore, Eschenbach and Hoekman
(2006) find that in five countries, namely Armenia, Georgia, Kyrgyzstan, Moldova
and FYR Macedonia, the actual applied regime in all service sectors is less liberal
than their GATS commitments.
Eschenbach and Hoekman (2006) also compared CESE and CIS country rankings according to the GATS commitment index (for total services) and according to
the EBRD Services Reform Index (EBRD Index), which measures the success of
overall services policy reform. While ranking according the GATS commitment index for all services is similar to our ranking of financial services in Table 3, the ranking according to the EBRD Index is almost reversed. Here Hungary has the highest
score, followed by Poland, Estonia, Czech Republic and Slovenia. The EBRD index
is lowest for Kyrgyzstan, followed by Georgia, Moldova and Armenia, which are all
CIS countries that fare among highest in our financial services sector liberalisation
index in Table 3.
4. Conclusion
In this paper we have examined liberalisation commitments of WTO member countries in CESE and CIS in financial services sector. We conclude that of the three financial services sectors, insurance, banking and others (securities), banking is the
most liberal sector according to the WTO commitments, which is also the most developed of the three financial services sectors in CESE and CIS countries. The level
of commitment seems to be lowest for insurance sector, where a few countries
schedule exclusive provision of mandatory insurance schemes in mode 3, and only
one allows cross-border life insurance services.
While all countries have achieved a high level of liberalisation in mode 3
(commercial presence) except for Hungary, Slovenia and Serbia, most of them maintain some level of capital mobility limitations and modes 1 and 2 are more restricted.
Liberal scores on mode 3 especially in banking signal the countries recognition of
the positive role foreign banks may play in domestic financial system and find that to
be an important vehicle for achieving internal competitiveness. However, fewer
countries were willing to allow cross-border branching (whereby achieving full liberalisation in mode 3). This signals that these countries may not be willing to commit
to a higher level of external exposure. However, for some countries that are
OECD/EU members, the actual level of liberalisation is higher than their GATS
commitments. In other CESE countries, this is an indication that the financial services industries are still relatively under-developed and wish to establish internal
competitiveness before being exposed to international competition.
Compared to the newly-acceded countries, the original WTO members have
committed to a far lower level of liberalisation in financial services. However, the
actually observed policies are often more liberal then the GATS commitments in the
original member countries. This situation, referred to as autonomous liberalisation,
presents an important drawback for GATS which in its successive negotiation rounds
still proves to be unable to capture this liberalisation level. In fact, at one point it was
hoped that a nice outcome in services would be one in which members bind
autonomous liberalisation which they have carried out since the conclusion of the
Uruguay Round of trade negotiations a decade ago (from interview of Amb. Fernando de Mateo y Venturini, Chairperson for services negotiations, in Washington
Trade Daily, 2/13/07).
On the other hand, quite a few newly-acceded members, who faced much
higher accession requirements, have problems in applying the level of liberalisation
they committed to in the WTO GATS. Some of them may even have actual policies
that undermine their GATS commitments. Over-protective prudential measures is
one possible explanation for the applied regime in financial services to be more restrictive than the respective GATS commitment. The GATS Annex on Financial Services provides for the prudential carve-out, that is prudential regulations are allowed
for financial services sector and need not be scheduled. Furthermore, bearing in mind
that the GATS framework does not provide for the definition of prudential regulations (except that they should be justifiable), it stands to reason that in a specific
country they may be defined in such a way as to significantly impair GATS commitments in financial services sector. One of the future directions for financial services sector liberalisation at global and individual country level should be development of international standards and rules regarding prudential regulations, in order to
further identify their scope, define what constitutes justifiable prudential measures
and limit their derogatory impact on financial services trade. While the issue of
autonomous liberalisation has been widely discussed and is at core of the current negotiations, there are only few mentions of the issues of prudential regulations in this
aspect (such as Sydney J. Key 2003; and Stijn Claessens 2006b).
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496
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Appendix
Table 2 Liberalisation Commitments in Financial Services for CESE and CIS Countries
Country
Albania
Armenia
Mode 1
Mode 2
Full commitment.
Limitations on capital outflow (until

2010 at the latest).
Mode 3
Mode 1
Full commitment.
Full commitment only for marine and aviation
transport insurance; reinsurance and retrocession.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
Mode 2
Mode 3
Bulgaria
Mode 1
Mode 2
Mode 3
Croatia
Mode 1
Mode 2
Czech Republic
Insurance
Banking
Full commitment only for marine and aviation No commitment.
Mode 3
Mode 1
Mode 2
Mode 3
Estonia
Mode 1
Georgia
Mode 2
Mode 3
Mode 1
Hungary
Mode 2
Mode 3
Mode 1
Mode 2
Mode 3
Significant limitations including those on

capital movement.
Significant limitations including those on
capital movement.
Foreign entry only through participation in
the existing insurance companies or authorized branches. Exclusive providers of mandatory non-life insurance.
transport insurance; reinsurance and retrocession
Full commitment.
No commitment.
No commitment for life insurance of permanent residents, insurance of property and

liability for loss and damage on domestic
territory.
Limitations on legal form of entry and exclusive providers of compulsory motor third
party liability.
Full commitment.
Full commitment.
Full commitment.
No commitment for life and non-life except
for international transport regarding imports
to Georgia. Full commitment for reinsurance
and retrocession.
Full commitment.
Full commitment.
MFN exemption (reciprocity condition).
Other (securities etc.)

No commitment (until
development of appr.
prudential regulation, 2010
at the latest).
Limitations on capital
outflow (until 2010 at the
latest).
Full commitment.
No commitment.
Full commitment.
Full commitment. Foreign branches
may not provide deposit services.
No commitment.
Full commitment.
Full commitment.
No commitment.
No commitment.
Limitation on legal form of entry.
Limitation on legal form of

entry.
Full commitment except for acceptance of deposits.
No commitment for trading,

and underwriting and issue
of securities.
Capital mobility limitations.

Full commitment.
No commitment for deposit services,
payments and trade in foreign exchange assets. Otherwise full commitment.
No commitment.
No commitment for deposit and

mortgage loan services. Otherwise
mostly full commitment.
Full commitment.
No commitment for participation in issue of securities, asset management,
settlement & clearing and
trading transferable securities.
No commitment for asset
management, otherwise
mostly full commitment.
Limitations on legal form of entry.

Branches allowed.
Limitations on legal form of

entry.
No commitment for deposit services.

Otherwise full commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
No commitment.
Full commitment.
Full commitment.
No commitment.
No commitment.
No commitment.
MFN exemption (reciprocity condition). MFN exemption (reciprocity

condition).
Country
Kyrgyzstan
Latvia
Lithuania
Macedonia,
FYR
Mode 1
Mode 2
Mode 3
Mode 1
Mode 2
Mode 3
Mode 1
Mode 2
Mode 3
Mode 1
Mode 2
Mode 3
Moldova
Poland
Mode 2
Limitation on legal form of entry, branches

allowed from 2008.
Full commitment.
Mode 3
Full commitment.
Mode 1
Full commitment only for reinsurance and

retrocession and goods in international
transport.
Full commitment only for reinsurance and
retrocession and goods in international
transport.
Limitations on legal form of entry. Branches
allowed.
No commitment except for reinsurance of the
part of the risk that cannot be placed on
domestic market.
No commitment except that ceding reinsurance on international market allowed for
reinsured risk that cannot be placed on
domestic market.
Allowed only as a joint venture with a domestic person
territory and air and maritime insurance.
Otherwise full commitment.
Mode 1
Mode 2
Mode 3
Romania
Mode 1
Mode 2
Mode 3
Slovak
Republic
Insurance
No commitment, except for insurance of
cargo transportation, brokerage and reinsurance.
Full commitment.
Full commitment.
No commitment except for reinsurance.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
transport insurance; insurance of commercially licensed transportation vehicles; and
reinsurance and retrocession.
transport insurance; insurance of commercially licensed transportation vehicles; and
reinsurance and retrocession
Mode 1
Mode 2
Mode 3

territory. Otherwise full commitment.
Limitations on legal form of entry and exclusive providers of mandatory insurance
schemes.
Banking
Full commitment.

Full commitment.
Full commitment.
Full commitment.
No commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
No commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
Full commitment.
No commitment.
Full commitment.
Full commitment.
No commitment.
Full commitment except for deposit

services which will be liberalised upon
phase II of Stabilisation and Association Agreement (SAA).
No commitment, full commitment will be awarded

gradually to trading, with
the application of SAA with
the EU.
entry.
No commitment.
Limitation on legal form of entry.

Branches allowed from 2008.
No commitment
Full commitment except that outgoing Full commitment except

capital transactions require approval. that outgoing capital
transactions require approval.
Limitations on legal form of entry &
branches.
entry.
No commitment.
No commitment.
No commitment.
No commitment.

Branches allowed.
entry. Branches allowed.
Full commitment except for payments No commitment.
where no commitment.
Only with the National Bank permission.
No commitment.
Full commitment.

entry.
No commitment for participation in issue of securities, asset management,
settlement & clearing
services and trading
transferable securities.
No commitment for asset
management. Capital
mobility limitations.
No commitment for deposit services,

payments and trade in foreign exchange assets. Capital mobility
limitations.
No commitment for deposit services.
Branches allowed.
Legal form of entry.
499
500
Country
Slovenia
Mode 1
Mode 2
Mode 3
Insurance
Full commitment for marine and aviation
transport insurance and goods in international transit. Otherwise no commitment.
Full commitment for marine and aviation
transport insurance; goods in international
transit and reinsurance and retrocession of
the part of the risk that cannot be placed on
domestic market (to be abolished upon
adoption of new Law). Otherwise no commitment.
Only as a joint venture with domestic entities
and upon approval. Maximum foreign ownership 99% (to be abolished upon adoption
of new Law). No commitment for privatization.
Banking
No commitment. Only inbound credit, No commitment.
guarantees and commitments allowed,
except for consumer credits (to be
allowed upon acceptance of new
Law).
No commitment.
No commitment.
Potential discretionary licensing for

foreign participation. No branches. Will entry.
be liberalised upon adoption of new
Law. No commitment on privatization.
Note:
No commitment market closed (although in effect it may be open, the country did not make any obligation to keep it so);
Full commitments fully open market
Mode 1 cross border trade,
Mode 2 consumption abroad,
Mode 3 commercial presence
Source: Authors analysis of the WTO financial services commitments of the above countries.1
1
The analysis was performed as background research for the calculation of the liberalisation indices in
Table 3.
Table 3 Liberalisation Indices for Direct Insurance and Banking in CESE and CIS
Country
EU and OECD
membership
WTO
membership
date
Direct insurance
Banking
Life
insurance
Non-life
insurance
Acceptance of deposits
All types of loans
Estonia
EU
1999,
13-Nov
1.00
1.00
0.88
1.00
Lithuania
EU
2001,
31-May
0.88
0.90
1.00
1.00
Georgia
2000,
14-Jun
0.88
0.80
1.00
1.00
Kyrgyzstan
1998,
20-Dec
0.88
0.80
1.00
1.00
Armenia
2003,
5-Feb
0.88
0.90
0.79
1.00
Croatia
2000,
30-Nov
0.85
0.88
0.85
0.98
Albania
2000,
8-Sep
0.88
0.90
0.87
0.78
Latvia
EU
1999,
10-Feb
0.88
0.80
0.88
0.80
Moldova
2001,
26-Jul
0.88
0.90
0.67
0.61
Romania
EU
1995,
1-Jan
0.64
0.56
0.99
0.98
OECD, EU
1995,
1-Jul
0.85
0.75
0.64
0.56
2003,
4-Apr
0.64
0.69
0.64
0.61
Slovenia
EU
1995,
30-Jul
0.64
0.69
0.43
0.63
Bulgaria
EU
1996,
1-Dec
0.64
0.48
0.64
0.56
OECD, EU
1995,
1-Jan
0.43
0.50
0.64
0.69
OECD, EU
1995,
1-Jan
0.44
0.40
0.64
0.81
OECD, EU
1995,
1-Jan
0.21
0.31
0.21
0.19
0.21
0.19
0.21
0.29
Poland
Macedonia, FYR
Slovak
Republic
Czech
Republic
Hungary
Serbia
not a member
Note: Higher levels of index indicate higher liberalisation commitments

Source: Authors calculations based on the methodology developed in Mattoo (1999).
501
502
Book review
Received: 24 November 2010.
Boo Stojanovi
Faculty of Economics,
Serbia
bstojanovic@ekof.bg.ac.rs
Economic Theory and Reality

Spontaneous Chaos
Economics in a Time of
Wolves
by Erik S. Reinert
igoja, Belgrade, 2010.
I
The ongoing world financial crisis has caused numerous reactions both amongst the
academic economists, as well as amongst those more practically oriented. Economists from different schools and of different orientations are trying to uncover the
reasons that have brought it about, and to suggest appropriate measures so that future
crises of large proportions can be prevented or at least weakened. Some analysts are
also using the contemporary financial crisis as a good reason for a much deeper and
far-reaching questioning of the very foundations of economic science (precisely,
questioning the dominant economic paradigm). First of all, the question arises, what
is happening to economic science if it is not able to recognize an economic crisis before it steps on it? How is it possible that the economic science was caught off
guard yet again? Besides, what is the implication for the status of economics as a
science if it is not able to successfully deal with real economic problems? This is the
critical approach of the Norwegian economist Erik S. Reinert in his interesting book
Spontaneous Chaos economics in a time of wolves.
Erik Reinert studied economics in Switzerland, and then in the United States,
first at Harvard, and then at Cornell, where he obtained his doctorate in 1980. The
title of his doctoral dissertation was International Trade and the Economic Mechanisms of Underdevelopment. Reinert was searching for the answer to the question why
the economic growth so unevenly distributed. International trade and its influence on
the economic growth and development are topics that directly or indirectly appear in
most of his studies, including the book that is the topic of this review.
Reinert is a visiting professor at several universities in different countries. He
is the founder of the organization The Other Canon, which he has established as an
alternative to traditional economic theory (the theory he has in mind is neoclassical
economics). The Other Canon supports an economics based on empirical inquiry into
economic history, and not on sophisticated mathematical models which rest on the
idea of equilibrium. The Other Canon is also a way of thinking, but one in which the
knowledge of relevant facts is the most important. In his texts and lectures, Reinert
has stood against the orthodoxy both on the left and on the right. Besides his academic work, he has shown himself to be a successful businessman and a consultant,
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which has contributed to his work always as it always has a pulse of real economic
life.
Erik Reinert has published numerous texts on economic theory and economic
history, development economics, as well as on the history of science (he especially
deals with technology and innovation). His most famous book is How Rich Nations
Got Rich and Why Poor Countries Stay Poor, published in English in 2007, and by
now translated to numerous languages. (The translation of the Norwegian version
from 2004 to Serbian was published in 2006).1 This book was on the Financial Times
bestseller list and it has brought Reinert the prestigious Myrdal Prize for the best
book in the field of evolutionary political economy in 2008.
The book that is the topic of this review has been published in Norwegian in
2009 and in the rest of the text, I will focus on the key thesis that Reinert supports in
it.
II
The book Spontaneous Chaos is comprised of texts that were written for various occasions and on different economic topics. Parts of the book have been published in
Norwegian daily and weekly newspapers, which have made them free of excess
technical jargon and accessible for a wider readership. The author himself states that
the book is not meant to be strictly academic, but rather an attempt to make analytical
insights, gathered over the course of several decades of theoretical and practical work
available to the wider public. Even though the texts were written for various reasons,
the basic idea that binds them is easily recognizable.
A Time of Wolves is the term that Erik Reinert uses to mark the period from
the fall of the Berlin Wall to the outbreak of the world financial crisis in 2008. That
was the time, according to Reinerts opinion, when theories of spontaneous order and
the economic and social consequences that it brings about were undoubtedly dominant. He staunchly defends the thesis based on historical experience that an unregulated market can create spontaneous order, but also spontaneous chaos. Reinert
directly associates the key ongoing problems of the world economy with the economic science. That is, he considers these problems to be a direct consequence of an unreasonable insistence on the application of questionable economic theories. Therefore, the first step in the process of healing should be to free ourselves from unsustainable theories.
Reinert writes about the Ricardian and Krugmanian vices (he wrote about
them for the first time in the book How Rich Nations Got Rich and Why Poor Countries Stay Poor). The Ricardian vice consists out of constructing economic models
based on the assumptions that are unrealistic (Reinert would say made up), while the
Krugmanian vice consists out of having models that are undoubtedly more relevant
than Ricardos theory, but not applying them in the economic analysis and not basing
economic policy on them. In this book Reinert repeats a point that he makes often as
well, namely that developed countries are recommending undeveloped countries pol1
Erik S. Reinert. 2006. Globalna ekonomija kako su bogati postali bogatiji i zato siromaniji postaju
siromaniji. Beograd: igoja.
Spontaneous Chaos Economics in a Time of Wolves, by Erik S. Reinert
icies that are opposite to what they themselves have used both in recent and far past.
After climbing to the top, they try to kick the ladder.
A special target of his attack is the theory of international trade, and in that
context Ricardos theory of comparative advantage and Samuelsons thesis about
factor price equalization (that international exchange will equalize factor prices).
Reinert draws our attention to the fact that Ricardos theory of international trade
was not warmly received outside of England. It was especially unpopular in Germany, Japan and the United States. As an illustration of this attitude, Reinert reminds us
that Thomas Jefferson was against publishing Ricardos Principles of Political Economy in the United States.
III
What, according to Reinerts opinion, leads to financial crises? Under normal circumstances, the financial economy supports the real economy. Problems arise when
the financial sphere gets decoupled from the real, and when it grows into something
that is very hard to control and begins to deform economic processes as a whole.
Reinert also thinks that Ricardo failed to establish money as a separate category, so
he has left economic science unprepared for situations in which the financial economy begins to get out of control. He also contends that the German economic tradition
has produced very good (useful) analyses of money and financial markets, but that
this tradition has disappeared after the Second World War.
Reinert points to three key mechanisms that have caused the money (financial)
sphere to tear away from the real sphere (he first presented them in a text published
in 1998). The first mechanism is the interest paid on interest, which Reinert calls the
Hammurabi effect. After a while, this effect by itself (interest on interest) leads to
an exponential growth of the financial sphere. The second effect is the Perez effect
(named after the Venezuelan economist Carlota Perez), and it focuses on the possibility that innovations in real economy can create large bubbles in the financial economy. Financial bubbles are often caused by new financial instruments, as is shown
by the economic history. This has been the case in the latest crisis as well.
Finally, the third effect is the Minsky effect which points to economic problems that arise from the sphere of financial markets. Hyman Minsky (an American
economist whose ideas have been pushed aside, but who has been rediscovered
due to the latest crisis) argued that too much deregulation of financial markets leads
to financial crises. A deregulated banking sector encourages competition among
banks for market shares. After a while, the battle for the market share increases the
risk and banks change their behavior strategy and begin to withdraw assets so as to
increase liquidity. This increases the risk in the economy as a whole and a downward
spiral begins to take shape. On the other hand, clients also begin to withdraw money
from banks, which further destabilizes the financial system. At one point, the financial bubble bursts and the crisis becomes a fact. Reinert argues that one of the more
important points of Minskys analysis is his insistence on the fact that the ruling
economy theory prevents us from seeing when a system crisis is about to strike.
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All in all, Reinert defends the thesis that financial crises are associated with a
wrong balance between the financial and the real economy. The point is in the misbalance between these two economic sectors. A misbalance so large that this was
Reinerts prediction before the contemporary financial crisis struck after the financial bubble bursts, it will have far-reaching negative consequences for the real economy. Financial crises are system crises and they can be prevented only on that level.
What is a possible (effective) solution? It is necessary, according to Reinert, to bring
the financial sector once under control again and subordinate it to the needs of the
real economy.
IV
In one of his articles, Reinert has presented the argument that economics has made a
full circle from scholasticism to new scholasticism. More precisely, he considers that
after the scholastic period, a serious advance in economics has been made, but that
over time economics has reverted to new scholasticism. Therefore, Reinert suggests
that we should return to the old economists whose analyses and insights he considers crucial for understanding real economic phenomena and processes. Who does
Reinert see as the representatives of old economics used to offer relevant theoretical insights? Those are thinkers which have been pushed aside by the dominant academic economic paradigm. More precisely, Reinert reminds us of the ideas of economists who had a different vision of how the economy works, and who had a different interpretation of the factors of economic growth and development than the dominant economic paradigm.
In a short, but brilliantly written, chapter, Necrology department, Reinert
presents the key ideas of List, Veblen, Schumpeter, Abramowitz, Nurkse, Galbraith,
as well as of the Norwegian economist Torkel Halvorsen Aschehoug. By reminding
us of the basic viewpoints of these economists, Reinert wishes to point out that there
is a different way of understanding the economy than the one offered by the neoclassical economics. Friedrich List is a thinker whose ideas have been an important precondition for the welfare state (Reinert considers that the idea that the welfare state is
exclusively a compromise between liberalism and Marxism is wrong). Two key challengers to the standard economic theory are institutional and evolutionary economics.
Reinert argues that Veblen is the founder of both those schools. He also reminds us
that Veblen argued that the market system behaves differently when it is dominated
by the productive capital, compared to when it is dominated by the financial capital.
When the economy is dominated by the financial capital, public capital gets privatized, but no new public wealth gets created. Joseph Schumpeter brought the notion
of the entrepreneur into the economic picture, and put him at its very center. Without
entrepreneurship and innovativeness, there is no economic dynamics. The entrepreneur breaks the equilibrium through innovations and in doing so he makes the market
more dynamic.
The Estonian economist Ragnar Nurkse is significant due to his contributions
to development economics. He argued that the vicious circle of underdevelopment
must be broken by the industrialization, but that in doing so, one must keep a ba-
lanced growth of both the supply and demand. This concept does not accept the idea
that poor countries should specialize in delivering raw materials to developed countries. Moses Abramowitz proved in his time that capital and labor account for only
about 15% of the economic growth in the United States in the period 1870-1950. The
rest is residual. Reinert says that it was exactly Abramowitzs residual that formed
the key point in his own doctoral dissertation. Reinert argued that the residual is unequally distributed between different economic activities, which makes the choice
between industries extremely important for economic growth. More precisely, the
wealth of a country depends on what it produces. The Norwegian economist Aschehoug (18221909) has presented, among other things, the basic elements of the
theory that is today associated with Hyman Minsky, and he also stressed the role of
the entrepreneur in the economy before Schumpeter. He was amongst those economists who were against the Ricardian economic theory. Galbraith consistently dealt
with topics which the dominant economic paradigm simply ignored: economic power
and its misuse, poverty and system crises.
Reinerts key objection is that academic economics has distanced itself from
life (from reality) and history, and that it has been reduced to complex models taken
from the world of physics which rest on mechanical adjustments and the idea of equilibrium. In short, such a theory is not applicable to the problems of real life, nor does
it deal with them at all. As a key step in this direction, Reinert points to Friedmans
book Essays in Positive Economics, in which the famous thesis that the realisticness
of the assumptions of economic theory is not decisive for its validity. This viewpoint
has, according to Reinerts opinion, fenced off economics from economic life, and
it has begun living on its own. Reinert is explicit: We have to get rid of a theory in
which prestige is increased proportionately with the level of abstraction, and in its
place bring back old economics in which prestige increases proportionately with
practical relevance. (p. 92).
V
Reinert offers a different understanding of capitalism as a solution to the ongoing
global economic challenges, that is, a capitalism which would have a different form
than the current one. This form would consist of three key elements: entrepreneurs, a
strong state which ensures that the way people earn money is also useful for society,
and new knowledge and technology. The author stresses that this view is grounded
both on the ideas of the left and the right, but that it also contains elements that are
completely alien to both. The idea that the state plays an important role in the economy is retained from the left political orientation (among other things, Reinert speaks
of the need to create world Keynesianism, but adds that he does not know how it
should look), and placing the entrepreneur and entrepreneurship at the very center of
the economy is taken from the right political orientation. An evolutionary understanding of the economy, according to Reinerts opinion, opposes the left-right division that is traditionally forced on economic policy.
Technology is the starting point that is alien to both the left and the right. The
technology, and not capital, is placed at the very center among the driving forces of
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the economy. Technology and new knowledge are key variables in this context. In
this way, Reinert is reviving Schumpeters thesis from the beginning of the twentieth
century that innovations and new knowledge are the key drivers of economic development. He notes that if one looks at the economic movements in the twentieth century, one can see that the enormous economic growth in that century was caused by
two factors: technological changes and economies of scale. Seen from a different
angle, that means that in modern markets it is important to create a comparative advantage in knowledge.
An abundance of capital does not create the incentives for a timely preparation
for a new techno-economic paradigm. Reinert reminds us of Michael Porters theory
that economic stagnation begins when societies are no longer set in motion by the
innovation, but by wealth. The author especially notes the fact that changes in technological paradigms change the economy, but that they also change society as a
whole. Reinert repeats in several places in the book that society is a system whose
structure of institutions, education and way of thinking are shaped around one type of
technology. He also argues that innovations are necessary primarily in order to maintain wealth. So, entrepreneurship, new technology and a strong state are key concepts
for sustainable economic growth. The economic growth is a synergetic phenomenon.
VI
One special topic that Reinert deals with in this book is overcoming poverty. That is
a topic that economics has been facing since the very begining. He argues for a general thesis that it is necessary for undeveloped countries to develop manufacturing
industry. All other measures directly or indirectly amount to the same thing aid
colonialism. Undeveloped countries must make their economies more diversified,
and that means that they have to give up their one-sided specialization in agriculture.
In order to support this argument, Reinert uses both economic theory and economic
history.
To illustrate his point, in several places in the book Reinert points to the views
that the Italian economist Antonio Serra presented in 1613. Serra claimed that Venices wealth was the product of a great division of labor and economies of scale.
Reinert also reminds us that John Stuart Mill, in his Principles of Political Economy,
recommended poor countries to industrialize (J. M. Keynes held a similar opinion).
Reinert points to the fact that the industrial sector is important because of its economies of scale. All in all, before engaging in free trade (before they are capable of engaging in free trade), undeveloped countries should have the right to use those economic policies that were used by todays developed countries. In order to help the
poor in the right way, it is necessary to create economic growth where they live.
From this perspective, Reinert questions some of the existing strategies to help the
poor. For example, in this context he points out that microcredits undoubtedly help
the poor, but that they by themselves they cannot be the solution to the problem of
underdevelopment. It is not microcredits, Reinert notes, which have made Europe
rich.
Reinert also points to the current problems within the European Union. The
transition strategy has led to a sudden deindustrialization of former socialist countries
(which have become new EU members). Their existing economic structure was thoroughly altered. They were then integrated into the EU over night. These countries
are, according to Reinert, the Achilles heel of Europe in the ongoing financial crisis.
The key problem is that these countries have no manufacturing industry, that is, the
basic mistake was that they were integrated without preserving their industrial sector.
Hence, the short- and long-term consequences of the financial crisis will be far worse
for these countries than for countries which have a developed manufacturing industry.
VII
Considering that Erik Reinert consistently insists on the relevance of economics for
real economic life, the reader will think differently about everyday economic topics
after closing the pages of this stimulating book. Even though the author mainly refers
to the Norwegian society and its problems and challenges in this book, it is important
to note that the topics that Reinert talks about are very important for Serbia as well, a
country which faces the challenge of determining its economic development strategy
and questioning its experience of the transition process. Hence, the publishing of this
book in the Serbian language will raise the level of the academic and public debate
and stimulate it in new directions. In any case, it will enrich it with new topics and
shake up some existing stereotypes.
This book is very interesting and provocative, and it both directly and indirectly questions the very foundations of the theories and ideologies that contemporary
economies and societies are based on. Besides, the book is replete with interesting
details from economic theory, the history of economic ideas and political philosophy,
but also with skillfully chosen examples from real economic life. All in all, this book
will not leave the reader indifferent. The main tone of the book means that it will
face two groups of readers: those who agree with it and those who hold a different
opinion. Both will find it useful. For those who agree with it, the book will offer additional support (new arguments), and for those with different opinions, the book will
be a great challenge and will stimulate them to react.
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October 26, 23-32.
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Example: The Economist. 1991. The Ins and Outs of Outsourcing ," August 31, 54-56.
Online Magazine Articles

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Business Week, April 19. http://bwarchive.businessweek.com/index.jsp.
368
Boko ivkovi and Jelena Minovi
Conference Announcement and Call for Papers

15th International Conference on Macroeconomic Analysis
and International Finance
26-28 May 2011
Department of Economics, University of Crete, Rethymno, Crete, Greece
Keynote Speakers:
John Geanakoplos (Yale)
Robert G. King (Boston)
Maurice Obstfeld (UC, Berkeley)
Helen Rey (LBS)
SUBMISSION INSTRUCTIONS
The conference will solicit papers in all areas of macroeconomic theory and policy and international
finance. All papers will be submitted electronically through URL: http://www.soc.uoc.gr/macro/. For
this purpose a specific script-form will be released in due time. The deadline for submission is December 31, 2010.
Jointly authored papers should be submitted by the person who will present the paper, if it is accepted. Please note that each participant may present at most one paper. Upon acceptance of a
paper the registration fee is 300. The registration fee for Ph.D. students is 200 (a letter of proof of
Ph.D. student status is required from the head of the department). Registration fees are not refundable. In case there is more than one author per paper, only one registration fee is required. Additional
registration is applied when all the authors participate in the Conference.
Special Issue (Guest Editors: Georgios P. Kouretas and Athanasios P. Papadopoulos)
The Journal of International Money and Finance will publish a special issue with papers presented
at the conference. The selected papers will be presented during the conference in special "JIMF Sessions". All submitted papers will be considered for this special issue. Papers accepted for the special
issue will have the registration fee waived. The general topic of the issue is "Financial Stress in the
Eurozone". Papers of high quality in this general area will be considered.
Special Issue (Guest Editors: Georgios P. Kouretas and Athanasios P. Papadopoulos)
Panoeconomicus will publish a special issue with papers presented at the conference, especially the
best papers by junior researchers and recent Ph.D. holders. Papers of high quality will be considered
for this special issue.
For further queries please contact:
Professor Athanasios P. Papadopoulos
Department of Economics
University of Crete
University Campus
GR-74100, Rethymno, Greece
e-mail: appapa@econ.soc.uoc.gr

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Novi Sad, No 4, 2010

International editorial board

Alain Parguez Universit de Franche-Comt at Besanon

Joao Alberto de Sousa Andrade Universidade de Coimbra

Petros E. Ioannatos Kettering University (USA)

Local editorial board

Georgios P. Kouretas and Prodromos Vlamis

John Glen and Joseph G. Nellis

Nikolaos Giannellis, Angelos Kanas and

Senay Acikgoz and Merter Mert

Yasemin zerkek and Sadullah elik

Ivana Prica and Jelica Petrovi Vujai

PANOECONOMICUS, 2010, 4, pp. 391-404

An earlier version of this paper was

The Greek Crisis: Causes and

Georgios P. Kouretas and Prodromos Vlamis

PANOECONOMICUS, 2010, 4, pp. 391-404

The Greek Crisis: Causes and Implications

Georgios P. Kouretas and Prodromos Vlamis

The rest of the paper is organized as follows. Section 1 provides a review of

1. What are the Main Causes of the Greek Fiscal Crisis?

The Greek Crisis: Causes and Implications

Georgios P. Kouretas and Prodromos Vlamis

The Greek Crisis: Causes and Implications

2. An Overview of the Fiscal Consolidation Programmes of

Georgios P. Kouretas and Prodromos Vlamis

3. Implications of the Greek Fiscal Crisis and Future Challenges

PANOECONOMICUS, 2010, 4, pp. 391-404

The Greek Crisis: Causes and Implications

PANOECONOMICUS, 2010, 4, pp. 391-404

Georgios P. Kouretas and Prodromos Vlamis

4. Summary and Concluding Remarks

PANOECONOMICUS, 2010, 4, pp. 391-404

The Greek Crisis: Causes and Implications

Georgios P. Kouretas and Prodromos Vlamis

PANOECONOMICUS, 2010, 4, pp. 391-404

The Greek Crisis: Causes and Implications

Source: General Accounting Office, Ministry of Finance. Includes military debt,

Figure 1 Composition of the Greek Government Debt

Greece joins Euro

Figure 2 Evolution of the Greek Public Debt

PANOECONOMICUS, 2010, 4, pp. 391-404

Georgios P. Kouretas and Prodromos Vlamis

Source: Public Debt Management Agency (2010).

Figure 3 Public Debt: Maturity Profile

Greek 10-yr Spread to Bund (bp)

Source: Reuters EcoWin Pro (2010).

Figure 4 Greek Spreads: Wide and Volatile

Source: Public Debt Management Agency (2010).

Figure 5 Credit Rating of Greek Bonds

PANOECONOMICUS, 2010, 4, pp. 391-404

PANOECONOMICUS, 2010, 4, pp. 405-428

The authors are grateful to HBoS plc

The Price You Pay: The Impact

John Glen and Joseph G. Nellis

competencies necessary to drive economic growth in an increasingly competitive

PANOECONOMICUS, 2010, 4, pp. 405-428

John Glen and Joseph G. Nellis

PANOECONOMICUS, 2010, 4, pp. 405-428

PANOECONOMICUS, 2010, 4, pp. 405-428

John Glen and Joseph G. Nellis

2. Description of the Dataset

PANOECONOMICUS, 2010, 4, pp. 405-428