NS4053 Winter Term 2013 Theories of Economic Development Trap Models, Vicious Circles

Economic Development Theories Broad Classes of Theories Stage Theories Rostow – 5 stages Bremer and Kasarda – failed take-off – New Second World Porter – modern upgrading Sachs – environmental settings World Economic Forum competitiveness stages (empirical section) Trap Theories Poverty Traps Middle Income Trap Vicious Circles Balanced vs. Unbalanced Growth Big Push Theories Sector/Dualism Models Lewis – classical model Fei-Ranis – two sector 2

Trap Models I Trap models cover a variety of situations. One set of problems involves starting growth in situations where gradualism and incremental actions are unlikely to result in permanent increases in income – poverty traps Another set of problems occur when growth comes up against constraints that cause it to stall-out -- transition/growth traps All countries possess growth enhancing factors and elements that suppress growth. Trap models assume that the growth suppressing forces neutralize growth enhancing factors, so tha t a quantum shift in policy is needed to start growth Trap models often involve some sort of feed-back effect enforcing the trap – vicious circle Early models largely poverty traps. As growth has stalled in some countries, newer transition gap models developed 3

Trap Models II Early poverty trap models assumed rapid rates of population growth, peaking out at some biological maximum. If the rate of growth of population exceeds that of the economy – forces per-capita income down to low level – growth may be slow because of potential savings used to raise children rather than flow into investment For increases in per-capita income to be sustained to reach higher standards of living, need to have rapid growth above that of the population – once occurs savings flows into investment 4

Trap Models III More recent poverty trap models focus on situations whereby an individual, a group of households, a country or geographic region occupies a stable equilibrium at a low level of wealth and output Have provided one rational for foreign aid programs and were the impious for the UN’s Millennium project Many of the newer models follow Sachs’ research in Africa Substantial level of foreign aid over an adequate time frame raise capital stock and contribute to growth Raises households out of poverty Growth cumulative as households saved and public investments were facilitated by household taxation Research has shown that aid has not generated the big growth effects anticipated by the existence of poverty traps. 5

Trap Models IV Easterly, formerly with the World bank found: Growth is lower in aid-intensive countries than in developing countries that get little aid Aid has risen over time as a percent of income in Africa, but Africa’s growth rate has fallen over time The difference in growth rates between the poorest one fifth of countries in 1950 and the others ranked by per-caita income over time to 2001 was not statistically significant Countries that filed to grow within the poorest group – Chad, DRC – were offset by those that did grow – Botswana, Lesotho, China, India Easterly also finds no evidence for the poverty trap based on the assumptions of: A lower growth rate for the poorest countries and A per-capita growth rate of zero in the poorest countries 6

Trap Models V Easterly statistical findings on poverty trap No statistical difference between the growth rate of the poorest 20%, 1.9% and others over period Similar for and periods Data from 1985 suggest poorest countries have fared worse, but comes at a time when poorest countries were getting more foreign aid as % of their incomes. 7

Trap Models VI In sum, evidence for poverty traps based on an income criteria is easily refuted Still no denying that some countries remain poor while others become richer The scenario of a widening income disparity over time between poorer and richer countries is another form of poverty trap – a divergence trap What maintains the inequality trap? Insufficient savings as suggested by the poverty trap or An institutional poverty trap Current thinking: countries with sound institutional frameworks – property rights, sound legal system experience higher rates of growth also that higher rates of growth is good for poverty reduction 8

Trap Models VII Importance of institutions: The effectiveness of public policies designed to encourage capital accumulation, knowledge and technological creation depend on underlying institutions Right institutions can provide incentives for economic growth Clearly a reward structure that provides incentives for individuals and corporations to undertake investments in new technology and human capital that are necessary for growth The political system – authoritarian or participatory – creates different types of reward structure with the latter found to provide a growth-promoting cluster of institutions Governments that do not provide a reward structure – often corrupt and oversee a system of weak institutions. Easterly attributes the unsatisfactory growth record of the poorest countries to having “more to do with awful government than with a poverty trap.” 9

Middle Income Trap I The middle-income trap refers to situation whereby a middle-income country is failing to transition to a high-income economy Rising costs Declining competitiveness Few countries successfully manage the transition from low to middle to high income Many countries in Latin America and Middle East regions have been stuck in this middle income trap Struggling to remain competitive as high volume, low cost producers in the fact of rising wage costs The hallmarks of success become the binding constraints for these countries Evidence to support the middle-income trap indicates a leveling off of income per capita and a decline or stagnation in an economy’s competitiveness 10

Middle Income Trap II Korea, Brazil, Philippines and Syria took off in growth from the mid 1970s. Korea continued to growth through the 1980s, achieving almost $8,000 per capita income in 2006 The other countries leveled off over the period. 11

Middle Income Trap III Malaysia, Thailand, Indonesia and Philippines all experienced stagnation in global competitiveness over period to

Middle Income Trap IV Research at the World Bank identifies two key ingredients that comprise a number of others: High levels of investment that embody new technologies Innovation-conducive policies Investment levels of 25% of GDP or more are needed to achieve strong growth Investment rates in Korea and Japan have averaged 31% since their respective takeoffs in 1978 and 1950 Transitioning to a high-growth economy requires a move up the value chain Innovation in new products and processes both in adoption and development as well as business operation is critical A good innovation policy requires Creating incentives for productive entrepreneurship Providing adequate skills to the workforce Ensuring good transmission of information and ideas; and Making sure that financing is available for start-ups, upgrades and commercialization 13

Vicious Circle Models: I A variant of the trap models entails vicious circles Theory indicates that poverty perpetuates itself in mutually reinforcing vicious circles on both the supply and demand side Supply Side Because incomes are low, consumption cannot be diverted from capital formation Lack of capital results in low productivity which perpetuates low income A country is poor because it was previously too poor to save and invest. Demand Side Because incomes are low market size (for many consumer goods) is too small to encourage investors Lack of investment leads to low productivity and continued low income A country is poor because it was previously too poor to provide the market to spur investment 14

Vicious Circle Models II Critique – Insufficient Savings Vicious circle seems plausible to those who imagine the entire population is poor and hungry – surprised anyone saves Reason to believe developing populations can save substantially more than they do. Highest income groups often live far above subsistence levels India’s richest 10 percent receive about 34 percent of national income – amount per head nine to ten times that of the poorest 10 percent Evidence indicates that consumption levels are determined less by absolute income than by relative income (income in comparison to neighbors and community members) Thus richer income classes could save considerably if they were sufficiently motivated. 15

Vicious Circle Models III One reason may not do so is because of the demonstration effect of consumption levels in the West and of elites in their own countries Still personal savings is usually a small proportion of developing country savings Corporate saving, government saving, public enterprise profits, social security premiums, and the like may be other sources of saving Always seems to be plenty of money for waging war Critique: Small Markets Fact is many markets are ample for using modern production methods – sugar mills, textiles etc Studies have found that “economies of experience” are more important for large-scale production than economies of scale from increased market size. As with trap models, modern vicious circle models usually incorporate some type of institutional failure as responsible for stagnation 16

Vicious Circle Models IV 17

Vicious Circle Models V 18

Vicious Circles: Iraq Case Study I Many of the economic/social/political forces in Iraq are interrelated. The key to growth is to draw on these compatibilities and create an environment in which each builds on the other. To accomplish this: The economic reform process needs to be deepened and completed. Major improvements in governance are essential. Oil production needs to expand to million b/d. The political environment must become encompassing. There needs to be a more equitable direct sharing of oil revenues. Macroeconomic stability must be maintained with inflation at %. Corruption levels must begin declining. The provinces must gain greater control over their funding. 19

Vicious Circles: Iraq Case Study II A number of key components can work together to create virtuous circles of growth and institutional development: Infrastructure programs create critical imbalances that stimulate follow-on private sector investment, thus making decision-making easier and reduce the uncertainty over future costs. Encouraging Iraq’s entrepreneurial talent promotes the dual-track policy of stimulating the formation of new small- and medium- sized enterprises (SMEs), while drawing informal economy firms into the formal economy. This, in turn, leads to maximum job creation and genuine economic progress, thus weakening the pull of the insurgency. Price reforms remove many of the incentives to revert to the shadow economy and, in turn, facilitate anti-corruption campaigns. With reduced insurgency and corruption, private investors respond to the investment opportunities created by the infrastructure program.

Maintenance of improved macroeconomic stability facilitates development of market-based financial instruments, allowing the Central Bank of Iraq to gain better control of monetary and credit policy. Banking system reforms in a stable macroeconomic environment lead to increased funding of small and medium sized enterprises – Track II SMEs. Possible direct distribution of oil revenues helps develop domestic markets, thus creating real demand for new and growing enterprises. New firms, workers, and a large portion of the population have a stake in moving the reform process ahead. Expanded reforms reduce corruption and improve the regulatory climate – perhaps slowing or reversing the brain drain. With improved governance comes higher economic growth and the stimulus for further expansion. The Future: Virtuous Circle II

Vicious Circles: Iraq Case Study III

Vicious Circles: Iraq Case Study IV Critical intangibles likely to influence Iraq’s future economy include: The extent to which economic progress can be made without a significant reduction in corruption The speed and degree to which trust can be restored The ability of the financial system to play a significant role in private sector investment The extent to which a growing economy and expanding job creation can undermine the insurgency. The level to which religious influences are likely to mold the country’s economic institutions and whether they will make the movement to a liberal market economy more difficult The extent to which the Iraqi government can evolve into a development state – a democratic version of the 1970s regime. The effectiveness of CERP, PRT and other programs in creating viable and dynamic economic activity at the local level.

Contrasting Views “If I am permitted to dream, Iraq will develop into the Japan of the Middle East.” Talib al-Tabatie, Chairman, Iraq Stock Exchange “It seems that many Iraqis do not understand…why a market economy can make the poor people much better off than they ever were when Saddam controlled the oil wealth and doled out perks to the Iraqis like a stern parent rewards small children for being seen and not heard.” Ronald Rotunda – George Mason University Foundation Professor of Law. “We want to go back to the old healthy management of the 1970s. Thamir Ghadhban – Oil Minister, Iraqi Interim Government

Balanced/Unbalanced Growth I Many contemporary disputes repeat themes from mid- twentieth-century debates, balanced growth versus unbalanced growth Sometimes the debate is semantic – what is balance? Rigid formula with all sectors growing at same rate? More flexible that some attention be given to all major sectors? Other issues in the debates What are the relative merits of strategies of gradualism vs. a big push? Is capital or entrepreneurship the major limitation to growth? 25

Balanced/Unbalanced Growth II Balanced growth Synchronized application of capital to a wide range of different industries One way of escaping from the vicious circle of poverty Early theories were pessimistic about exports, so usually applied to sectors of the domestic economy Big Push Thesis Advocates of synchronized application of capital to all major sectors support the big push thesis Argue a strategy of gradualism is domed failure Substantial effort is essential to overcome the inertia inherent in a stagnant economy Analogy to a car being stuck in snow – will not move with a gradually increasing push – needs a big push Led Tony Blair to call for a big, big push forward in Africa 26

Balanced/Unbalanced Growth III Early versions based on idea that the factors that contribute to growth like demand and investment in infrastructure do not increase smoothly, but are subject to sizable jumps or indivisibilities Indivisibilities result from flaws created in investment market by external economies Cost advantages rendered free by one producer to another These benefits spill over to society as a whole or to some member of it rather than the investor concerned. Example – increased production from investment in the steel industry will benefit other industries as well Greater output stimulates demand for iron, coal and transport Lower costs may make vehicles and aluminum cheaper Other industries may benefit later by hiring laborers who acquired skills in the mills Thus the social profitability of this investment exceeds its private profitability – Unless government intervenes, total private investment will be too low 27

Balanced/Unbalanced Growth III Indivisibility in Infrastructure: Need whole system – cannot increase incrementally Can’t build a smaller Aswan Dam or shorter Monterrey-Mexico City telegraph line Indivisibility in demand Arises from the interdependence of investment decisions Prospective investors uncertain whether output from project will find a market The workers in an individual project will not buy all of that product However investment in a wide variety of industries will create enough purchasing power to buy the available increase in supply Return on individual project may be 5% with high uncertainty. Investment on a broad front increased return to 15% with greater certainty What is not true for the individual factory is true for the complementary system of many enterprises The new producers are each other’s customers and create additional markets through increased incomes Complementary demand reduces risk of not finding a market increases incentive to invest 28

Balanced/Unbalanced Growth IV Possible Examples Situations today where world trade is costly – landlocked countries like Bolivia Domestic agriculture or exports may not be sufficient for industrialization So economies need large domestic markets Historic examples: Colombia’s tobacco export boom failed to lead to widespread economic development as incomes went to a few plantation owners who spent on luxury imorts Later from boom in coffee exports, grown on small family enterprises benefited large numbers who demanded domestic manufacturers For industrialization, incomes from the leading sector must be broadly distributed, providing demand for manufacturing. 29

Balanced/Unbalanced Growth V Critique Balanced Growth Advocated of balanced growth emphasize a varied package of industrial investment often at the expense of investment in agriculture Comparative advantage suggests that a country cannot grow rapidly if it fails to specialize where production is most efficient Recent experience of developing countries suggests they cannot neglect agricultural investment if they are: to feed their populations, supply industrial inputs and earn foreign currency 30

Balanced/Unbalanced Growth VI Critique Balanced Growth cont.: Infrastructure is not as indivisible as advocates imply. Roads, rivers, canals, or air traffic can substitute for railroads Roads my be dirt, graveled or paved and various widths Power plants can differ greatly in size. Controversy in Iraq over state of art power grids or small generators Large infrasture facilities, although perhaps economical at high leves of development are not essential for growth Resources required for carrying out strategy vast If country had these resources, probably wouldn’t be undeveloped Where will country obtain the capital, skilled labor and materials needed for such an expansion Although new industries may be complementary on the demand side, they are competitors for limited resources on the supply side. 31

Balanced/Unbalanced Growth VII Advocates of balanced growth often assume the country starts from scratch In reality every country starts from a position that reflects previous investment decisions Thus at any time there are highly desirable investment programs that are not balanced in themselves but are well integrated with existing capital imbalances The strategy was tarnished by the widespread evidence that developing countries have grown rapidly without any attempt at massive investments in the wide range of industries that advocates considered essential 32

Balanced/Unbalanced Growth VIII Hirschman’s strategy of imbalance Part of economic strategy for Iraqi reconstruction Idea that unbalanced investment to complement existing imbalances. He contends that deliberately unbalancing the economy, in line with a predesigned strategy is the best path for growth Argues that the big push thesis may make interesting reading for economists, but most countries don’t have the skills or resources needed to launch such a massive effort The major shortage in most developing countries is not the supply of savings but the decision to invest by entrepreneurs, the risk takers and decision makers Hirschman believes poor countries need a development strategy that spurs investment decisions. He suggests that because resources and abilities are limited, a big push is sensible only in strategically selected industries 33

Balanced/Unbalanced Growth IX Hirschman’s Intentional Unbalancing Strategy 34

Balanced/Unbalanced Growth X Growth then spreads from one sector to another – similar to Rostow’s concept of leading and following sectors While Unbalanced Growth advocates usually stress the advantages of free markets, they often restrict this to areas outside of investment Example – Profitability of projects a function of the order in which they are taken Truck factory = return of 10% and steel factory 8% If interest rate is 9% then invest in truck factory Later as a result of this investment returns on the steel factory increase to 10% so investment then in that industry 35

Balanced/Unbalanced Growth XI Or might get situation where: Establishing a steel factory would increase the returns in the truck factory from 10% to 16% Society would be better off investing in the steel sector first and the truck enterprise second rather than making independent decisions based on the market Planners need to consider the interdependence of investment projects so that they maximize overall social profitability Need to make the investment that spurs the greatest amount of new investment decisions Investments should occur in industries that have the greatest linkages including backward and forward linkages 36

Balanced/Unbalanced Growth XII Criticisms of unbalanced growth strategy As in balanced growth case, many types of infrastructure – may be cheaper to have smaller projects utilized fully than large projects that are underutilized – white elephants Assumes that there is a lack of decision making in the private sector, but that the government has no trouble in this regard Japan grew through the reverse mechanism – entrepreneurs invested and then pressured the government to alleviate bottlenecks However Mexico after the Revolution in the early 1900s found government unbalancing accelerated growth Often not as clear cut where the greatest shortage of decision making lies – public or private sectors. Eventually both strategies lead to balance 37