To design good policies, macro outcomes need to be understood “from the ground up”

What key insights have emerged from development economics in the past decade, and how should they impact the work of the World Bank? A new working paper Toward Successful Development Policies: Insights from Research in Development Economics from the Bank’s research department captures 13 of the most significant insights in the world of development economics.

Here’s insight #4 on how macroeconomic and microeconomic insights need to be understood from the ground-up at the moment of policy design. See all previous insights here: Thirteen insights for successful development policies

Traditionally, macroeconomic outcomes such as growth, economic fluctuations, and reactions to policies and shocks have been studied using aggregate data at the country level. A flurry of new research over the past decade has centered on using micro data at the product, firm, and sector level to shed new light on aggregate outcomes.

Macro insights from firm dynamics  

One approach analyzes the macroeconomic implications of firm-level dynamics and the misallocation of inputs and production across firms.^ref1 By studying macroeconomic performance as a result of the interaction of individual firms and the surrounding business environment, we have learned how policy distortions at the firm level affect firms’ behavior and lead to worse aggregate outcomes.

One example is the allocation of credit. Traditionally, the effect of financial conditions on economic growth was studied by comparing economic performance across countries with different credit market institutions. Developed financial markets foster prosperity by allocating capital efficiently across the various production possibilities in the economy. Even if the cross-country comparison could uncover a positive relation between financial development and growth, it would be silent about the mechanism through which such a positive relation works.

The new firm-level approach to the question proves to be very revealing. Recent research shows that financial markets benefit growth by directly providing credit to firms with good opportunities.^ref2 Although the overall functioning of financial markets is important, the allocation of credit across firms matters for economy-wide growth. Small as well as young firms that create novel products and technologies but that lack the financing to scale up tend to be harmed the most by misallocation of credit. In countries where credit is expensive and hard to access, firms typically are small, leading to a misallocation of credit. Large firms that are relatively less productive end up producing a significant share of the output, while smaller more productive firms are unable to grow and to contribute as much as they could. Credit frictions tend to discourage firm entry and creative destruction, leading to poor economic performance.^ref3

A policy implication is that just developing financial markets might not be enough to generate growth –  ensuring that credit flows to the firms that have growth potential is as important.^ref4,ref5 Beyond financial markets, public policy should take into account how different economic agents respond differently to policies. The regulation of entry, for instance, should consider the incentives for low-scale entrepreneurship to become informal. ^ref6 Similarly, tax policy should anticipate distortions to firm growth that happen when firms of different sizes face differential enforcement.^ref7 These are examples that illustrate the breadth of the importance of understanding the aggregate impact of policies at a more disaggregated level.

Micro evidence on the aggregate welfare effects of trade

Micro-level evidence yields important new insights on aggregate outcomes in the field of international trade as well. Influential recent research shows that the aggregate welfare gains from trade may not be as big as previously thought, particularly for large countries with a smaller share of trade in GDP.^ref8 However, subsequent research based on micro data on products, firms, and industries shows that there are subtle but important nuances in the calculations of aggregate welfare gains from trade that could depend on sectoral linkages and the structure of the tariffs. If the products of one sector are used as inputs in other sectors, then the aggregate welfare gains from trade could be higher as expansion in one sector indirectly benefits the other sectors through these linkages.^ref9 On the other hand, for those countries where higher tariffs are imposed on imported products that respond less to tariff changes, the aggregate welfare gains from trade could be less.^ref10 This could be because firms are locked into fixed import patterns in global value chains and may not switch inputs in response to tariff changes in the short run. All these nuances are missing when we only focus on aggregate statistics such as average tariff rates.

The bottom-up approach yields insights on how trade affects workers, firms, and localities differently. For example, low-cost imports from China increase unemployment, lower labor force participation, and reduce wages in some local labor markets in the United States, contributing to one-quarter of the contemporaneous aggregate decline in U.S. manufacturing employment, even though the aggregate welfare gains from trade with China are positive.^ref11

The firm-level approach also reveals that there are significant downward biases in aggregate measures of domestic value added embodied in exports. This is because aggregate statistics are mainly constructed based on data from large firms, which tend to use more imported material inputs and therefore produce less domestic value added. The new firm-level approach aggregates firms’ domestic value added from the ground up based on customs transaction data for all firms, not just large ones. Based on this firm-level evidence, new research shows that the domestic value added of China’s exports is higher than previously thought, and rising over time due to trade and FDI liberalization.^ref12

One important policy implication from the micro approach to trade is to have targeted redistribution policies in place when countries experience trade shocks, given that trade impacts are often very localized. For example, new World Bank work finds that globalization increases income inequality significantly across locations rather than across industries. Therefore, labor market policies focusing on industries, such as U.S. “Trade Adjustment Assistance”, can be less effective than location-based or active labor market policies, such as Denmark’s “Flexicurity.”^ref13

The World Bank has already taken steps in the direction of helping policy makers design policy based on insights from this ground-up approach. It has been doing so by developing statistical tools that enable countries to track the heterogeneous effects of existing policies, such as the Exporter Dynamics Database and the Enterprise Surveys. Moreover, it has increasingly showcased the importance of a firm-level and sectoral-level approach to macroeconomic variables in its various analytical and research products, such as the latest World Development Report on global value chains.