Investing in Human Capital - Quantity or Quality?

A mail from a friend today alerted me to this fine op-ed in the IHT by Philip Bowring. Bowring's main point is quite neat even if of course the ultimate conclusion to re-write the practices of national accounting may be a bit far-fetched. Bowring's starting point is the economies of East Asia which, I am sure my readers will, agree have performed quite well in the 1990s and 2000s with the important intermezzo of the Asian currency crisis in 1997. In fact, one could argue that with the crisis in 1997 East Asian economies embarked on an even further solidified path of growth driven by investment and accumulation of capital and, we should never forget, foreign exchange reserves. You see, this was part of the scheme at the offset in the sense that these economies would not risk to go hat in hand to the IMF the next time crisis loomed at the doorstep. This is not about the Asian currency crisis and its aftermath per se but if you want more I have a synopsis up here.

Philip Bowring starts off with the simple point that although East Asian economies in general have been doing very well on the investment front with respect to physical capital (and according to many thequality of human capital) they have not been able to halt the demographic transition which to a considerable degree has eroded the quantity foundation of these economies' human capital. In this way and as if guided by an invisible force, these economies have also transcended into lowest low (TFR < 1.5) and in fact some economies are hovering around the "single child per women" mark. This makes Mr. Bowring wonder whether in fact the economic experience of these economies are so stellar as we are lead to believe.

South Korea, Hong Kong, Taiwan and Singapore have over 40 years averaged roughly the highest consistent economic growth rates in the world. All but Korea have steadily accumulated massive surplus savings and foreign reserves. But change the national accounting principles behind these rosy numbers and a different picture emerges, one that the societies concerned have barely begun to grapple with. In one vital respect these countries (soon to be joined by China) collectively may have the worst record of investment in the future since homo sapiens evolved: Investment in the next generation.

They have the lowest fertility rates in the world. Hong Kong is at the bottom (excluding births to non-residents), with around 1.0 births per woman of child-bearing age (the replacement rate is 2.1). Taiwan, Singapore and Macau come in at 1.1, while South Korea, at 1.2. is on par with Europe's lowest, Belarus. None of these economies has had replacement-rate fertility levels since the late 1980s.

(...)

Imagine if these four economies had invested less in infrastructure and reserves and more in people. They would now most likely have much lower foreign-exchange reserves, but they would not be facing a situation in which their work forces - unless replaced by immigrants - will decline dramatically within 20 years as the population over 65 continues to grow. The payback for years of what may well have been the misallocation of resources is not far in the future.

(...)

Almost all developed and many developing countries now face demographic challenges from a reverse in the high fertility rates of the past. There are no easy solutions. But by changing national accounting principles to make child-rearing a priority, attitudes toward it might change too.

Bowring's piece poses a lot of intertwined questions which I cannot dwell by here. One would be whether the cultural edifice of Neo-Confucianism is particularly 'adept' in fostering lowest-low fertility (or high household saving rates perhaps?). In this note I shall neatly bypass this question. However one crucial question which emerges from Bowring's piece is whether economists are adequately defining investment in human capital? Now, Bowring's suggestion to change national accounting practices does not, at a first glance, make sense. It would hardly be possible to make a credible short term/high frequency measure of investment and accumulation (say, quarterly) in quality (e.g. education) and quantity (e.g. some form of fertility gauge) of human capital. Yet national accounting is not the only tool economist use to describe the growth of economies. Consequently, when looking at growth in the longer term economists refer to the collective sub-discipline of growth theory or more specifically neo-classical growth theory.

Within the context of neo-classical growth theory the contributions are multiple and I won't even try to provide an overview. Mankiw, Phelps and Romer's Growth of Nations is an excellent starting point for the intermediate scholar.

Without cutting further corners my main gripe with the growth theory framework is that economists traditionally (and this is especially the case in the context of the whole growth theory framework) tend to separate quantity and quality of human capital in a quite unsatisfactory manner. You see, according to growth theory it is a well known dictum that more people leads to lower growth in the illusive steady state. The point here would be that we are getting more people for the same capital and productivity level and thus more people to share the same sized pie. Yet, human capital does matter. As such, Mankiw et al. famously showed that investment in (i.e. accumulation of human capital) is highly conductive of economic growth. This would then mean that investment in education be considered a highly fruitful policy; I hardly think anyone will disagree here. This point also forms a strong link to Bowring's perspective of East Asia since, apart from choosing export orientation over import substitution, these economies were praised for their high saving rates not least in the context of a strong focus on education and especially high enrollment in basic education. At the time they were thus bathing in the spotlight on the expense of their developing economy siblings in Latin America.

The two points made above on human capital basically shore up at the following main point in the context of growth theory.

Few people of high quality (education) is the way to go!

However, it is pretty clear I think that this is not true. At least, there seems to be quite strong evidence that not only quality matters but also quantity. Moreover, if everybody goes for the low quantity high quality option it will create strong negative externalities. In fact, the quantity/quality nexus of human capital is much more complicated with respect to feedback loops than the current standing theory assumes. Basically, the whole model seems to break down once we get into the situation of lowest-low fertility. Especially in this regard would be the concept of steady state which becomes very difficult to sustain in an empirical context in the sense that it becomes a proverbial moving target.

It is within this somewhat wonkish framework that Bowring's point suddenly makes sense. What he suggests is thus that in stead of focusing solely on the quality of human capital we should also look at the quantity. What he is in fact latching on to is the very finely tuned linkage between the two. The point is simply here that when economies emphasise education (quality of human capital) and especially of women as a natural part of the development process they would be wise in also focusing on quantity measures since, as other economists so famously showed, there is a tradeoff between quantity and quality in child rearing. Add to this the tempo (birth postponement) effect of fertility which comes from pushing the whole life course framework of women as they enter the labour market and you end up with a bad policy if taken too far. Moreover, evidence suggests that once the decision is made to go aggressively for quality without making sure that quantity is kept stable it is very difficult (if not impossible) to bend the stick back again.

This is what many Asian countries now confront I feel.

It's Both Actually ...

In many ways, this should not be too difficult to understand but often the debate gets completely loop sided because people focus on population growth rather than population structure. Moreover, once population structure is incorporated into the growth theory framework the goings get quite tough in terms of mathematical model complexity. Yet, as the main conclusions of the neo-classical framework persist the critique remains the same.

Interestingly, this is also why Bowring's comparison of human capital investment (the quantity) with investment in infrastructure is only as good as it goes. Roads can be built within a reasonable time frame (well, if you have the workers that is) but human capital is another matter. Basically, the decisions you take today will only matter in some 20-30 years time and the decisions you took decades ago are only making their presence felt now. This is what path dependency is all about really and also what policy makers in countries such as India, Turkey, Brazil, Morocco (I think it is too late for China) etc. would be wise to consider; both for their own good and the rest of us . The lesson here is then that while no-one can disagree in putting aside investments for the quality of human capital as well as working to get women integrated into the labour force one would be wise to also consider the quantitative perspective.