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Growth Problems in Developing Countries

Overview. Context: Why this is so importantThe Washington Consensus": A failure? Or good start?Role of inequality in growthAn old (but still heated) debateIs this the right focus?Are we focusing on the wrong thing?Role of poverty and wealth distributionRole of mobility

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Growth Problems in Developing Countries

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    1. Growth Problems in Developing Countries Kristin Forbes MIT-Sloan School of Management February 2, 2006

    2. Overview Context: Why this is so important The “Washington Consensus”: A failure? Or good start? Role of inequality in growth An old (but still heated) debate Is this the right focus? Are we focusing on the wrong thing? Role of poverty and wealth distribution Role of mobility & opportunity

    3. Context: Why This is So important

    4. GDP Per Capita in 1980 Source: World Development Indicators, World Bank

    5. GDP Per Capita in 2003 Source: World Development Indicators, World Bank

    6. Inequality in China

    7. The “Washington Consensus”

    8. Key Tenets Countries should maintain fiscal discipline… Education and health are high-priority expenditures; indiscriminate subsidies are to be condemned Taxes should be levied on a broad base, w/moderate marginal tax rates Interest rates should be market determined; avoid negative real interest rates A competitive real exchange rate is the first essential element of an outward-oriented economic policy The second element is import liberalization. Tariffs are far better than licenses and quotas, and …limited tariff dispersion Foreign direct investment is viewed with considerable favor Privatization of public enterprises has been viewed with favor Deregulation is an important step in the modernization of economies that carry heavy burdens of detailed state control… Property rights are fundamentally important… Source: Harberger, A. "Monetary and Fiscal Plicy for Equitable Economic Growth" in Tanzi, V. & K. Chu, Income Distribution and High-Quality Growth.

    9. Evaluation An abysmal failure? As evidenced by Argentina? False! Or a good start—but missing key components? Role of institutions (low levels of corruption, fair & effective judicial system, etc.) Role of inequality/income distribution/mobility

    10. Role of Inequality

    11. An Old Debate Early work: A positive relationship between inequality and growth—especially for developing countries Kaldor (1978): higher inequality initially important in development to raise aggregate savings to finance investment Kuznets (1955): as country initially develops, inequality will increase as small share of labor force moves from low-productivity agriculture to high-productivity industry Therefore, countries faced a tradeoff: steps to reduce inequality might hamper growth

    12. Sea Change in the 1990’s Country experience: East Asia : low inequality ? high growth Latin America: high inequality ? low growth Cross-Country Growth Regressions: A negative effect of inequality on growth Alesina and Rodrik (1994), Birdsall, Ross and Sabot (1995), Clarke (1995), Persson and Tabellini (1991) Specific Channels: Why inequality has a negative effect on growth Lowers investment in human capital Increases political Instability Supports development of institutions that favor elite Lowers domestic demand and slows industrialization If true, a great result: steps to reduce inequality will also have the additional benefit of raising growth

    13. The More Recent Debate Serious flaws in analysis using cross-country growth regressions Omitted variables bias, data comparability across countries, unrepresentative samples Results not robust Positive relationship between inequality and growth in within-country growth regressions Forbes (2000) Recent country examples: US, China Closer look at models: Many depend on other factors: level of development, aggregate wealth, political institutions Many predict multiple equilibria Non-linear relationship (Banerjee & Duflo, 2003)

    14. Is This the Right Focus? Previous focus: income inequality Income can vary across years & life cycle Inequality can increase even as everyone gets better off Focus on inequality in wealth distribution instead of income distribution Even harder to measure Focus on absolute levels of poverty instead of inequality Examples: China, India (?) Poverty is the “real enemy” Evidence on inequality and “happiness” Focus on specific policies & relationship to inequality, poverty & growth, rather than direct link between inequality & growth Promoting basic education: inequality ? , poverty ? & growth ? Higher income taxes: inequality ? , poverty ? and growth ?

    15. Is This the Right Focus? Income mobility? Belief that can move up or down income ladder Improves toleration of inequities in income distribution The “American Dream” Becoming a “Chinese dream”? Perceived mobility/opportunity? Possibly even more important than actual mobility

    16. Final Thoughts Growth and development is difficult Can get a lot right, but just one thing wrong can derail progress Debate on inequality, distribution and growth Increased focus and priority Inequality does matter, but relationship with growth probably indirect Should not focus on inequality at expense of poverty Still more to learn: role of mobility—possibly even more important than inequality

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