Sunday, August 2, 2009

The Elusive Quest for Growth

The baleful effect of Leninism and the Soviet Union on world history since 1917 reaches into some unexpected places. One of the basic ideas behind foreign aid is what was known as the Harrod-Domar growth model (despite the fact that Domar’s original article discussed business cycles in the US and he repudiated the fundamental assumption in 1957). The (simple and simplistic) idea was that production was proportionate to machinery, so investment was basic to growth, so low saving levels were a basic problem so by supplying cheap capital foreign aid could lift investment levels and thus economic growth. Walt Rostow, presidential adviser and policy activist, was instrumental in pushing the investment=growth idea for foreign aid.

Where did Harrod, Domar, Rostow and other economists get the notion that investment=growth? From the experience of mass unemployment of the Great Depression (which suggested that rural “surplus labour existed which could be used without cutting rural production [p30ff]) and observation of the apparently successful forced industrialisation model of the Soviet Union. As William Easterly explains in his The Elusive Search for Growth: Economists Adventures and Misadventures in the Tropics the circle of irony was completed when aid packages based on ideas developed from the alleged success of the Soviet model were applied to ex-Soviet bloc countries after the patent failure of the Soviet model. Where they didn’t work as they had spent decades not working elsewhere.

But, hey, it was good enough for government work.

Easterly puts his finger on the problem very simply. Folk invest if there are likely returns on investment. Merely injecting capital into a country does not, of itself, change the incentives (or lack thereof) to invest. Particularly given there are plenty of alternative uses for such capital (such as consumption). One couldn't generalise from the Soviet case, as Stalin had complete control and, largely due to that, plenty of incentives to invest in things which increased his power which, for various reasons, industrialisation of the Soviet Union did.

Easterly starts the book with some blunt facts and figures about why economic growth matters (dramatic reductions in infant mortality to start with [p.8ff]). Despite all that sneering about trickle down theory, the evidence shows quite clearly than increases in average income translate quite directly into increases in income for the lowest fifth of given societies. Economic growth is good for the poor, economic contraction very bad for them.
Easterly punctuates his chapters with various vignettes, personal stories which bring alive the problems he is discussing. Such as the career of one of his own ancestors in C18th America, bringing home the point that we are all descendants of poverty (Pp16ff)

Easterly discusses very informatively the history and failures of economists’ attempts to grapple with the causes of economic growth. Erroneous assumptions and unconsidered selectivity in evidence abound. Easterly uses the history of policy failure and the findings of empirical studies to particularly good effect. Thus, for example, there is no evidence that education growth has any connection with economic growth (p.74ff). Indeed, there is precious little evidence that capital levels generally do much to explain economic growth. I do have a quibble with some of Easterly’s discussion here, since he is using capital figures in the conventional GDP sense. Admittedly, that is precisely what the “financing gap” approach was based on. Still, capital, as the produced means of production, can also cover social and institutional capital.

Easterly has a particularly revealing discussion of the “Debt Crisis”, noting that there is a long term pattern of “debt-ridden” countries reverting to high levels of indebtedness after debt write-offs. The persistent pattern continues for both demand and supply reasons. On the supply side, as private lenders withdraw, public lenders take up the slack. This is exactly the pattern of lending to duds the private sector wouldn’t touch a la VEDC and Tricontinental that was so disastrous in Victoria circa 1990. Alas, there is no “guilty Party” election to throw the rascals out so thoroughly that Victoria will probably wait another 100 years before anyone does it again. (One of the many unforgivable aspects of the Jolly-Sheahan-Cain financial shenanigans was that it was such a disastrous replay of the land-boomer bust of the 1890s.) On the contrary, the foreign aid debacle just goes on and on.

On the demand side, since the debt pertains to the “nation” and the benefits can be corruptly “privatised”, there is a certain equilibrium “mortgaging away the future” which doesn’t change just because debt has been forgiven. So rulers just borrow back up to the “mortgaging away” equilibrium. Indeed, the basic problem with foreign aid is that appalling governments do not become less appalling just because someone has given them money. On the contrary, it decreases the incentive to become less appalling.

Easterly’s basic theme is the same as Steve Landsburg, The Armchair Economist.
People respond to incentives: all else is commentary(p.xii).
They do not respond to good intentions nor to inputs but to incentives. Growth happens because a self-reinforcing pattern of pro-growth incentives becomes established in a society and it doesn’t happen if they don’t. Merely handing over money does not change the underlying pattern of incentives. Worse, it may actively undermine attempts to change those underlying incentives. But, alas, a lot of aid giving is not about doing good, but about being seen to do good, a very different thing. Judging by intentions is not enough, as Easterly's book shows.

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