Does the impact of private education on growth differ at different levels of credit market development?

• Published date: 01 February 2023
• Author: Michael Hatcher,Panayiotis M. Pourpourides
• Date: 01 February 2023
• DOI: http://doi.org/10.1111/rode.12952

REGULAR ARTICLE

Does the impact of private education on growth

differ at different levels of credit market

development?

Michael Hatcher | Panayiotis M. Pourpourides

Department of Economics, University of

Southampton, Southampton, United

Kingdom

Correspondence

Panayiotis M. Pourpourides, Cardiff

Business School, Cardiff University,

Aberconway Bldg, Colum Drive, Cardiff,

CF10 3EU, UK

Email: pourpouridesp@cardiff.ac.uk

Abstract

Using an overlapping generations model, we show that

the impact of private financing of education on growth

depends on credit market development, being positive

when credit markets are adequately developed but neg-

ative if sufficiently low levels of credit market develop-

ment occur alongside relatively high private financing

intensities. Employing cross-country data, we find that

reduced-form growth relationships are statistically sig-

nificant and robust under various controls and samples.

We also lay out conditions under which economies

with missing credit markets are dynamically efficient

and outperform, in terms of growth, economies with

complete credit markets. The latter may explain large

cross-country differences in savings and growth, while

facilitating the evaluation of policies on financing

education.

KEYWORDS

credit market development, economic growth, private

education

JEL CLASSIFICATION

I25, O16, O41

Received: 9 August 2021 Revised: 19 September 2022 Accepted: 21 September 2022

DOI: 10.1111/rode.12952

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distrib ution and

reproduction in any medium, provided the original work is properly cited.

© 2022 The Authors. Review of Development Economics published by John Wiley & Sons Ltd.

Rev Dev Econ. 2023;27:291–322. wileyonlinelibrary.com/journal/rode 291

1|INTRODUCTION

Education is widely thought to be a driver of long-run development and economic growth.

Empirical work, however, has reached mixed conclusions about the impact of education on

growth (Hanushek & Woessmann, 2010). This raises some important questions. Does the type

of education –public versus private –matter for the impact of education on growth? What are

the consequences of not having well-developed credit markets for financing education in many

developing economies? In this paper, we study the impact of private transfer arrangements

between parents and children on human capital and economic growth, bearing in mind that

public education is not always easily accessible. Whereas the implications of public education

and related government interventions have been widely studied in the literature, less is known

about the consequences of private education, that is, private financing of education that is

arranged within families. Such informal relationships are of particular importance in develop-

ing economies where access to credit is limited, as emphasized in Banerjee and Duflo's Poor

Economics (Banerjee & Duflo, 2011). Following this lead, this paper provides new insights on

the relationship between private financing of education and economic growth and explores its

implications for dynamic efficiency.

We start out by documenting cross-country differences in private financing of education,

relating it to a newly constructed index of credit market development. The latter incorporates

three indicators of credit provision and financial development. The evidence indicates that most

parents pay for the education of their children while the intensity of private financing of educa-

tion varies significantly across countries, with high levels of intensity in regions such as East

and South Asia and low levels in western economies such as the European Union (EU) and the

United States. Here, the intensity of private financing of education is defined as the ratio to

household consumption, thus correcting for the relative size of different economies. Countries

in East and South Asia such as China and India with high private financing intensities are also

characterized by high economic growth rates and less developed credit markets, whereas econo-

mies in the western world, such as the US and the EU economies, are characterized by low pri-

vate financing intensities, moderate growth rates and more developed credit markets.

We set out an overlapping generations model to explain these observations. In the model,

private financing of education matters for economic growth, but the impact on growth varies at

different levels of credit market development. We subsequently estimate the reduced-form

growth relationships implied by the model and find that they are empirically supported after

controlling for public education and a host of other variables. In the model, growth is endoge-

nous, and parents make transfers to children, which they may use to acquire education. Paren-

tal transfers play an important role because the young would like to invest in human capital

but face incomplete credit markets for educational loans. Parents find it optimal to make such

transfers because they derive utility from the amount transferred to their children. If parents

choose consumption and transfers optimally, then the share of parental transfers in household

consumption is related to the parental joy-of-giving parameter, or parental transfer motive; we

therefore refer to this share as the intensity of private financing.

1

We demonstrate that, at adequately high levels of credit market development, the relation-

ship between the intensity of private financing and economic growth is positive, whereas at low

levels of credit market development, the relationship is negative, as long as the intensity

exceeds a certain threshold. We also show that economies where markets for education loans

are absent may have higher growth rates than economies with complete credit markets and a

dynamically efficient balanced growth path. Low growth rates and dynamic inefficiency are

292 HATCHER AND POURPOURIDES

linked to high ratios of physical to human capital, which occur owing to either over-saving or

under-borrowing. In particular, we show that economies with missing credit markets exhibit

higher growth rates than economies with complete credit markets, either when both the inten-

sity of parental transfers and intergenerational persistence of human capital are relatively low

or when they are both relatively high. We also show conditions under which an economy with

borrowing constraints exhibits higher growth than an otherwise identical economy in which

credit is not rationed.

A meaningful role for private education is present in our model owing to credit market

imperfections. As demonstrated by Boldrin and Montes (2005), if young individuals cannot bor-

row to finance educational investment and parental giving is ignored, then the competitive

equilibrium in an endogenous growth economy is dynamically inefficient and involves stagna-

tion. To alleviate the dynamic inefficiency and restore growth, they propose government inter-

vention, accompanied by a pension scheme. Our findings suggest that such intervention is not

necessary to restore dynamic efficiency if the intensity of parental transfers exceeds a certain

threshold. We show that if private financing is sufficiently high, then in-family transfers can

substitute for missing credit markets for education loans, enabling dynamic efficiency along the

balanced growth path. Furthermore, while economies with missing credit markets are dynami-

cally efficient at sufficiently high levels of the private financing intensity, identical economies

with complete markets are not. We also clarify that dynamic inefficiency of the competitive

equilibrium allocation may occur even in the absence of capital over accumulation because a

low intensity of parental transfers leads to an under-provision of human capital for future gen-

erations. This result arises because human capital has positive externalities and, hence, from a

social perspective, may be underinvested in by the young.

Our results provide a possible explanation for the high growth rates of several emerging East

Asian economies with high levels of parental investment in education but relatively

undeveloped credit markets. For instance, Seth (2002) discusses the history and cultural roots of

education fever, the very high levels of parental investment in education in South Korea –and

similarly high levels of parental investment in education have been noted in other East Asian

economies (BBC, 2013; Economist, 2013). Such differences in parental investment across coun-

tries may be a factor behind the mixed findings in the empirical literature on borrowing con-

straints and growth: Jappelli and Pagano (1994) conclude that borrowing constraints promote

growth, whereas De Gregorio (1996) reaches the opposite conclusion. Our results suggest that,

at certain levels of the intensity of parental transfers, over-investment in physical capital

reduces growth relative to the growth of an otherwise identical but credit-constrained economy.

Our results are also consistent with the observation, highlighted in Coeurdacier et al. (2015),

that savings in emerging Asian markets with high growth rates are higher than savings in

advanced economies with lower growth rates. Thus, the mechanisms we highlight may be a fac-

tor behind cross-country differences in saving and growth that the literature has hitherto had

difficulty explaining.

Our paper is related to a large literature on credit market development and economic

growth. Galor and Zeira (1993) show that the combination of credit market imperfections and

initial wealth differentials can drive persistent differences in economic development through

the impact on human capital accumulation. Much of the literature has focused specifically on

borrowing constraints and growth. Using an endogenous growth model, Jappelli and Pagano

(1994) show that borrowing constraints can raise economic growth owing to higher accumula-

tion of physical capital that drives productivity growth. This result depends on the absence of

human capital investment. If there are borrowing constraints which hinder investment in

HATCHER AND POURPOURIDES 293