The Output Convergence Debate Revisited: Lessons from recent developments in the analysis of panel data models

Abstract

This paper provides a critical examination of the empirical basis of the output convergence debate in the light of recent developments in the analysis of dynamic heterogeneous panels with interactive effects. It shows that popular tools such as Barro's cross-country regressions and two-way fixed effects (TWFE) estimators that assume parallel trends and homogeneous dynamics lead to substantial under-estimation of the speed of convergence and misleading inference. Instead, dynamic common correlated effects (DCCE) estimators due to Chudik and Pesaran (2015a) provide consistent estimates and valid inference that are robust to nonparallel trends and correlated heterogeneity and apply even if there are breaks, trends and/or unit roots in the latent technology factor. It also suggests a way to estimate the effect of slowly moving determinants of growth. The theoretical findings are augmented with empirical evidence using Penn World Tables data, finding little evidence of per capita output convergence across countries, very slow evidence of cross country growth convergence, and reasonably fast within country convergence. Capital accumulation is found to be the most important single determinant of cross-country differences in output while slow moving indicators such as potential for conflict and protection of property rights proved to be statistically significant determinants of the steady state levels of output per capita. We are also able to replicate a positive evidence of democratization on output, but we find that the statistical significance of this effect to fall as we allow for nonparallel trends and dynamic heterogeneity.