Development Economics ECON 4915 Lecture 12

1. DevelopmentEconomicsECON 4915 Lecture 12 Andreas Kotsadam

2. Outline • Questions from you on corruption. • Long runeffectsof the slavetrade (Nunn and Wantchekon 2009) • Recap, recap, and recap.

3. Questions from you on corruption • Whencancorruption be good for economicdevelopment? • What is the relationship betweeninequality, institutions, development and corruption?

4. Nunn and Wantchekon (2009) • Research question: Did the slave trade cause a persistent culture of mistrust? • Interesting? Yes, long runeffectsofslavery. Culture and development. The originsof trust. Test the causalmechanismsbehind the results in Nunn (2008). • Original? Yes, their causal channel has not been credibly tested before. • Feasible? Yes, by collecting innovative data and using IV.

5. Whywouldslavetradeaffect trust today? • Early in the slave trade, slaves were primarily captured through state organized raids and warfare. • By the end of the trade individuals - even friends and family members - began to turn on one another, kidnapping, tricking, and selling each other into slavery. • This environment, where everyone had to constantly be on guard against being sold or tricked into slavery by those around them, generates a culture of mistrust.

7. Butwhy do wefindtheseeffectstoday? • Using ‘rules-of-thumb’ can be an optimal strategy in environments where information acquisition is either costly or imperfect. • These rules-of-thumb evolve according to which norms yield the highest payoff. • ”Our view is that in areas more exposed to the slave trade, rules-of-thumb or beliefs based on the mistrust of others would have been more beneficial relative to norms of trust and therefore would have become more prevalent over time.”

8. Cultural transmission • For the explanationtowork the culture must be transmitted over time or culturalchange and social learning must occurslowly. • Note thattheseaspectsare not tested in the paper and in that sense cultural transmission is still a black box.

9. Data: Afrobarometercontainsquestions on trust.

10. Data: Ethnicitylevelslave exports. • The country-level estimates are constructed by combining data on the total number of slaves shipped from all ports and regions of Africa with data on the ethnic origins of slaves shipped from Africa. • The individual samples are originally from a variety of historical records, such as slave runaway notices, plantation inventories, marriage records, death records, etc.

11. Data: Ethnicitylevelslave exports. • The ethnic groups in the historic documents are matched to a common classification scheme and linked to the map provided by Murdock (1959).

14. Estimation OLS: i, individuals e, ethnicgroups, d, districts, c, countries.

15. Basic results

16. Problem • Less trustinggroupsmayhavebeenmorelikelyto be taken during the slavetrade and theycontinueto be less trustingtoday for otherreasons.

17. IV • We need an instrument that is correlated with slave exports, but uncorrelated with any characteristics of the ethnic groups that may affect trust today. • Historic distance of each ethnic group from the coast is used as an instrument for the number of slaves taken during the slave trade.

18. Validity • The criticalissue is whetheran ethnic group’s historic distance from the coast is correlated with factors other than the slave trade that may affect how trusting the ethnic group is today. • What is the mostobvious problem?

20. Validity • Controlling for currentdistanceto the coast, identificationwill be driven by the effect of the slave trade on the trust of individuals that live in a location different from their ancestors. • Thesemay be different typesofpeople, butthey show that, ifanything, aremoretrusting.

21. Results • The firststage shows that the instrument is relevant and thatslave exports is primarilyexplained by historicdistanceratherthancurrentdistance from the coast. • The second stageestimates show similarmagnitudes as OLS. • Hence, OLS is likely not biased.

22. Falsification tests • “As is generally the case with instruments, it is possible that despite our second stage controls, our instrument still does not satisfy the necessary exclusion restriction. For this reason, we also perform a number of falsification exercises to assess the validity of our identification strategy.”

23. Falsification tests • If the assumption is satisfied, then we should not observe a similar positive relationship between distance from the coast and trust in the parts of the world where the slave trade did not occur. • Theyfind no relationship between distance from the coast and trust outside of Africa. • Or in Africancountries not affected by the slavetrade.

24. Mechanisms • Are people less trusting today via the evolution of vertically transmitted norms? • Or because the slavetradedamaged the institutions so thatpeopleare less trustyduetoe.g. weakruleoflaw?

25. Test • Theycreate a measurequantifies the number of slaves that were taken from the geographic location where the individual is living today. • If the slave trade affects trust through internal factors, then mistrust should be correlated with the extent to which their ancestors were heavily impacted by the slave trade. • If the slave trade affects trust through its deterioration of domestic institutions, then mistrust should be correlated with whether the external environment that the individual is living in today was heavily impacted by the slave trade.

26. Result • Bothfactorsaresignificantbutthe magnitude of the internal channel is approximately twice the magnitude of the external channel.

27. Externalvalidity • “it is important to keep in mind that all of the results in the paper apply only to the 17 sub-Sahara African countries included in our sample. The effects of the slave trade for the countries not included in our analysis may be different from the effects we estimate here.” • Whataboutothershocks? Slave trade in Norway. Whatabout the mechanisms?

28. Recap • Email meifyouwantsomethingspecificcoveredduringnextlecture.

29. Rural credit markets • Youshouldhavesomethoughtsabout: • Why the pooroftencannotborrow on the formal market. • Why the poorpay so muchinterest on theirloans, iftheyareabletoborrow. • The roleof institutions. • Whatcan be donetoimprove the situation.

30. Why is credit important? • Credit is needed for efficient production as well as smoothing out consumption. • Production requires investments. • Income streams often fluctuate.

31. There are two basic (and related) problems • Moral hazard: Lenders cannot monitor the actions of the borrowers. • Adverse selection: Lenders cannot distinguish between borrowers with different characteristics.

32. These problems are severe for formal lenders • They don´t have personal knowledge regarding the clients. • They cannot monitor how the loans are used. • Limited liability implies that borrowers take to much risk or default voluntarily. • Collaterals may solve this problem, but this is infeasible for the poorest.

33. Characteristics of rural credit markets • Information problems (also for informal lenders) leading to: • High interest rates. • Segmentation. • Interlinkage. • Interest rate variation. • Rationing. • Exclusivity.

34. Lender’s risk hypothesis for informal lending Assume perfect competition. Let L= Loan amount, r= Lender’s opportunity cost, p= Fraction of loans repaid, and i= Interest rate.

35. The expected profit of the lender is therefore: Setting expected profits equal to zero and solving for the interest rate gives:

36. Main lessonof the model • Hence, even under competition informal sector interest rates are very sensitive to the default risk. • But is it true?

37. Truewith an important twist • Looking at data it is obvious that defaults are quite rare in rural credit markets. • So, this mechanism of potential default is largely circumvented but this is costly. • This cost is basically what drives the observed high interest rates. • And sincesomeofthesecostsarefixed, small loansdemand a higherinterest rate.

38. Information assymetries and rationing • Information assymetriesmay cause creditrationing as lendersare not abletofullyobserveif a borrower is ofhigh or low risk. • Toohighinterest rates may drive away the low risk typeofborrowers. • It maytherefore be optimal tohave a lowerinterest rate and a higherprobabilityofreceiving the money back.

39. Now we know the theory behind: • Why interest rates are high. • Why there is credit rationing. • It all has to do with information asymmetries in the following way:

40. Adverse selection and moral hazard • Adverse selection: If banks raise interest rates the project mix will become riskier. • Moral hazard: If interest rates increase, borrowers themselves choose more risky projects and/or put in less effort to repay.

41. Typicalexamquestion • 1a) Theoretically, informal sector interest rates are very sensitive to the default risk even under perfect competition. Show this using the lender’s risk hypothesis, discuss the implications and relevance. (5 points)

42. Another possibleexamquestion • Credit rationing: • What is it? • Why does it occur, in particular, why doesn’t the lender just raise the interest to lend out more? • Explainintuitivelyhow information asymmetries may cause credit rationing.

43. Policies • A nice (but not so simple) solution would be tobuild up good institutions and eliminate poverty. • In the meantime, wehavecovered: • Government intervention to expand credit (Burgess and Pande 2005). • Microfinance (Banarjee and Duflo 2010).

44. Typical exam question • 2a) Give some arguments for and against the idea that a state led expansion of rural banks should reduce poverty (2 points). • 2b) If we are interested in the effects of rural banks on poverty, why is it a bad idea to draw conclusions by simply comparing poverty in areas that have banks to poverty in areas that do not have banks? (1 point)

45. Typical exam question • 2c) Burgess and Pande (2005) instead use a policy rule in India between 1977 and 1990 that forced banks who wanted to open in a location that already had banks to open banks in four areas that had no banks. In particular, they exploit the trend reversals between 1977 and 1990 and between 1990 and 2000 (relative to the 1961- 1977 trend) in the relationship between a state's initial financial development and rural branch expansion as instruments for branch openings in rural unbanked locations. What arguments are provided for using these instruments? (4 points)

46. Typical exam question • 2d) What are their conclusion and how can it be criticized? (3 points)

47. Their conclusion • “We provide robust evidence that opening branches in rural unbanked locations in India was associated with reduction in rural poverty.”

48. Critical questions • Havetheyreallyshowedthat rural banks matter or just thatthis policy hadeffects? • Does it matterthat the bank openingswere not randomlyassigned? • Is the resultgeneralizable toothercontexts? • Do weknowwhy the reform had an effect? • Whatabout the long term effects? • Was it costeffective?

49. Typicalexamquestion • 3a) Banarjee and Duflo (2010) define microcredit as innovations that lower the administrative cost of making small loans. Describe these innovations and discuss their advantages and disadvantages (5 points).

50. Some innovations and mechanisms • Dynamic incentives. • Group liability. • Repayment frequency and social interactions. • Simplified collection technology. • Temptation and self-control.