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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
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NS4053 Winter Term 2013Theories 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
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 that 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
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
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 adeqate time frame raise capital stock and contribute to growth • Raises households out of poverty • Growth cumulative as households saved and pu blic 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.
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
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 1950-75 period • Similar for 1975-2001 and 1980-2001 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.
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
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.”
The Iraqi Economy I: OverviewHistory and Key Issues Army Human Terrain Team Ft. Leavenworth, Kansas November 13, 2009 Dr. Robert E. Looney relooney@nps.edu
Iraqi Case Study • According to the World Bank, successful economic development is more likely in countries that perform well in these 6 areas of governance: • Voice and Accountability • Political Stability • Government Effectiveness • Regulatory Quality • Rule of Law • Control of Corruption
Corruption and the Economy • Of the governance measures, corruption may have the worst economic consequences because it: • Reduces economic growth • Worsens distribution of income • Increases government inefficiency • Worsens the international balance – foreign investment • Reduces the confidence of the Iraqi people in their own government • Reduces the availability of foreign loans and grants
Corruption and the Insurgency • The insurgency is good for corruption • It justifies bypassing procedures • It increases the necessity for getting things done, regardless of the cost • It provides an excuse for corruption-related losses • Corruption is good for the insurgency • Terrorist groups finance their operations, in part, with proceeds from corruption • Criminal groups that handle smuggled or stolen goods provide routes and safe houses for terrorists, IED makings, etc. • Corruption undermines confidence in the GOI
The Most Corrupt Ministry • Ministry of Trade (MoT) is the most corrupt ministry • It is responsible for the Public Distribution System • It controls a number of State Enterprises • The same officials write regulations, execute them and “investigate” problems • As a result, there are few investigations, no convictions, and almost zero transparency
Consequences of Poor Governance I • The government is unable to manage increased earnings from oil exports in order to develop the economy • While Iraq’s total expenditures increased from 2005 through 2007, Iraq spent a declining share of its budget allocations – 73 to 65 percent from 2005 to 2007. • In each year, Iraq spent a greater percentage of its operating budget, including salaries, than its investment budget. • For example in 2007, the Iraqi government spent 80 percent of its $28.9 billion operating budget and 28 percent of its $12.2 billion investment budget. • The central ministries responsible for providing essential services to the Iraqi people spent a smaller share of their budgets than the Iraqi government as a whole. Further, their investment ratios declined from 14 percent in 2005 to 11 percent in 2007.
Consequences of Poor Governance II • Affect on Policymaking: • Economic policymaking will continue to be constrained by the weakness of central government control. • Consequently the government’s primary aim wil be to improve project implementation in part by encouraging greater local participation and cutting bureaucratic constraints. • Although progress will remain slow and piecemeal, hindered by vested interests and rampant corruption, better security should at least allow progress on upgrading basic services. • Despite failure to pass a federal hydrocarbons law, several development contracts with foreign oil firms are likely to be signed – critical to compensate for the fall in oil prices.
Iraq: Masures of Progress and Unity Anthony Cordesman identifies key tests of progress and unity: • Quality, integrity and equity of government services: education, medical services, water and electricity • Sharing the state budget and oil wealth by region, sect, ethnicity • Volume of oil revenues, development of petroleum sector. • Agricultural reform. • Reform of state industries sector and employment • Employment and income distribution; who gets government jobs and key appointments. • Limits to excessive corruption and power brokers.
Iraq: Progress in State Stability Source: Fund For Peace, Failed State Index, 2009
Summary: Measures of Progress • New York Times State of Iraq, June 22, 2008
Summary: Reconstruction to Date • While there has been some progress since 2003, the picture is still far from encouraging • Unemployment has stabilized at 18% with another 10% underemployed. • The supply of electricity, fuel and water is unreliable and unstable • Many Iraqi households have lower incomes now than in 1980, and there has been massive capital flight and brain drain • There has been a great deterioration in social capital, characterized by a general loss of trust and a corruption rate that is the highest in the Middle East • There is an extremely high crime rate and the Shadow Economy may make up 40% of GDP and 50% of employment
Summary: Concerns for the Future • Despite improved security and reduced violence the economy faces a number of challenges: • Foreign aid is winding down, without effective development and growth of the private sector. • With the decline in oil prices and revenues, the budget goal for 2009 has dropped from $78-80B to $72B to $68B to 62B to 58B. • Macroeconomic data disguise key sectoral problems in services, manufacturing, and agriculture. • Despite attempts to diversify economy government spending remains the glue that holds the government and economy together. • Some 70% of paid jobs linked to the government whose income is 95% driven by the oil sector. • Still have major weaknesses in Ministries, governance and budgetary execution.
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
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.
Middle Income Trap III • Malaysia, Thailand, Indonesia and Philippines all experienced stagnation in global competitiveness over period to 2009
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
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
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.
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
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 2.5 - 3.0 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 10-15%. • Corruption levels must begin declining. • The provinces must gain greater control over their funding.
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.
The Future: Virtuous Circle II • 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.
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?
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
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
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
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 1880-1915 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.
