Development economics: theory and practice

¶ … Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics" by William Easterly. In it he talks at great length about the various methods used by global banking institutions to promote growth in poor and developing countries. He describes several panaceas, or approaches, which have been used over the years by these financial institutions, such as the World Bank and the IMF. In most of the cases, there is a spotlight shone upon the shortcomings of each of the approaches.

Throughout his book, Easterly uses the expression "people respond to incentives."

The primary problem facing poor countries is the policies of institutions that should be helping them. Throughout Easterly's book he gives multitudes of examples in which the facts do not support the methods of aid that are currently being used. Some of the methods are even based on outdated or false economic theories.

One prime example is Domar's growth rate theory. Domar wrote his theory in a series of articles in 1946. These articles assumed one essential point: that the amount of machinery was linked to productivity. Since that time, data has been collected that clearly states that there is no connection between the two. Domar was writing in the wake of the Great Depression. Unemployment was at an all time high, therefore Domar concluded that labor would be available to whatever extent it was needed to operate newly purchased machinery. Domar intended his theory to be used to bring about growth over the short-term, not the long-term. In fact, Domar himself repudiated his own theory in 1957, just eleven years later. Despite this, his idea gained in popularity and the financial institutions responsible for giving aid to these countries have based the financial gap policies on this disproven theory.

Many countries are also hampered by a lack of infrastructure. The success and failure of certain programs, like the financial gap approach, are shown to have promoted growth and good performance in countries with strong, consistent policies. In countries with weak policies, the system fails, resulting in no economic growth. This has been the case with adjustment lending as well, where many recipient countries fail to make policy changes simply because they lack the ability to do so effectively.

Economics provides the vision of what works and doesn't. The point of Easterly's book is to show that economics itself proves that many of the current techniques applied to the problem of poor and developing countries are ineffective. Each of the panaceas presented is a surprisingly in depth exploration of the failings of the methods endorsed by the World Bank in particular. Economics as an objective science shows that many methods just don't measure up, yet they continue to see practice.

Why is this the case? People respond to incentives. In every case, it is shown that there was a distinct lack of proper incentives to both the borrower and the lender. Without an environment that gives a high return on investment, people instead use their income to buy consumer goods. After all, why invest when the money is more valuable now? Why wait and take the chance that the value of that money will fall, as is most often the case? Simply put, there is no incentive for investment. Obviously the incentives are there for the lending institutions, as they continue to give out loans despite a country's failure to make the necessary reforms.

Economics provides us with the hard data necessary to making well-informed decisions concerning the growth of poor countries. If economics is saying that these methods do not achieve the desired end, then there is obviously a need to discontinue these fruitless activities in pursuit of new methods.

However, new methods may not be altogether necessary. Some of the approaches have shown promise, but lacked the policies and conditions necessary to be put to the best use. In the case of adjustment lending, which gives out a loan based upon reform, countries with poor governance lacked the ability or will to implement the changes that were required. Those countries with a strong policy environment, on the other hand, performed better. It is up to economics to provide the proper incentives for change.

The aid to investment panacea presented in the book is an example of economic projections falling short of their mark. Economists thought that any aid given would naturally reflect in a country's national savings on a one for one basis. Coupled with savings incentives, the return to aid in investment should be higher than one to one. Essentially, as long as a country has more money, saving will happen naturally. Therefore economists calculated for each country what they thought would be the minimum requirement to sustain growth. This difference from what the country had to what it needed became known as the financial gap. The financial gap, in turn, determined how much aid a country received. In the end, the idea was that each country needed a certain amount of finances to grow. If they didn't have it, they were given the difference in aid. After all, doesn't it make sense that the poorer the country, the more money they get?

Easterly presents us with statistics for eighty-eight countries that received aid in this fashion from the years 1965 to 1995. In order for us to consider the financing gap approach valid then there are two requirements that must be met. First, that there is a link between aid and investment. Secondly, assuming there is a connection between the two, does aid transfer to investment at a greater than one to one ratio?

According to Easterly and his statistics, there is no connection between aid and investment. Out of the eighty-eight countries that received aid, only seventeen showed a positive relationship between aid and investment. The other seventy-one experienced negative growth despite the amount of aid given to them. Out of the seventeen, only six showed growth at a greater than one to one ratio. Six out of eighty eight countries, then, satisfy both conditions. Two of those six countries received trivial amounts of aid (Hong Kong and China). The conclusion must be that the approach failed.