Classical Theories of Development

Theories of development

• Classical development theories: 1950s-80s

• Contemporary theories: late 1980s-present

• The classical theories are mostly optimistic: development will happen & we can promote it

• The contemporary theories are less confident: there can be poverty traps where low investment incentives keeps countries poor

Classical theories

• 1. Linear theories (Rostow, Harod-Domar)

• 2. The Lewis structural change model

• 3. The Solow model

• 4. Dependency theory

• 5. Market fundamentalism

--First 3 focus on capital accumulation. 4 focus on political and economic power relations. 5 focuses on letting markets work freely

--we’ll do H-D, Lewi & Solow on whiteboard

Classical theories

• 1. Linear theories: Rostow and Harrod-Domar.

• Developed 1940s-60s

• Based on historical experience of today’s developed countries.

• Focus on physical capital accumulation

The Rostow Theory

• “The Stages of Growth” book written in 1950s as “an anti-communist manifesto”

• Meant to encourage developing countries to follow capitalism over socialism

• Used by US/Western governments to justify large amounts of foreign aid (Rostow was an adviser to JFK and LBJ)

• http://www.cambridge.org/us/academic/subjects/economics/economic-development-and-growth/stages-economic-growth-non-communist-manifesto-3rd-edition?format=HB&isbn=9780521400701#HoBtxYtsRbDX5Xzr.97

Rostow’s five stages

• Economies go through five stages of growth

• - traditional society

• - preconditions for take-off (foreign and domestic savings mobilization)

• - take-off

• - drive to maturity

• - high mass consumption

Rostow

• Traditional

– Devote many resources to agriculture

– Hierarchical social structure

– Political power de-centralized

– Fatalism

– Technology and importance of science: low

Rostow

• Preconditions for takeoff

– Notion of progress

– Science, technology advance

– Education culturally more important

– Banks, financial institutions appear

– Centralized government/nationalism

– Increased investment and savings

Rostow

• Takeoff

– Technology and science continue to advance

– Political powers regard growth as important

– Entrepreneurial class emerges

– Savings/investment rise to 5-10% of the economy

– Agriculture: new techniques, sell to market

– Industry: a few key sectors

Rostow

• Drive to Maturity

– Increased participation in international markets

– Widespread use of new technology

– Broad industrial base

– Investment/savings rise to 10-20% of economy

Rostow

• Age of High Mass Consumption

– Masses, not just elites, cover more than basic needs (http://www.bbc.co.uk/history/british/victorians/bsurface_01.shtml)

– Large urban populations

– Work in offices, factories

– Systematic R&D

– Caring for least well-off

Critique of Rostow• The book makes it sound like development will

automatically happen and follow the Western path

• But many developing countries remain poor today

• They may need to follow their own path; for example, Japan, Singapore and South Korea used heavy government intervention to develop the countries

Critique of Rostow

• Assume you see a society that is stuck in Rostow’s “Traditional” stage and the government/aid donors want to help it advance.

• Can they somehow just “create the notion of progress, advance technology, make people value education , create banks, centralize the government, and increase savings?” to get to the take-off stage

• Imagine you want to do this in Afghanistan, Bolivia or Cambodia…it’s good if it works, but it’s not that easy to do

The Harrod-Domar mode

• See the course note on the HD model

• Y=(1/k)K, k=the capital-output ratio

• The change in capital=Investment:

• K= I

• Investment = Savings:

• I=S

• Savings=saving rate times income

• S=sY

• Since Y=(1/k)Y we have Y =(1/k)K

• Therefore Y =(1/k) K=(1/k) I=(1/k)sY

• So Y=(1/k)sY

• Y/Y = s(1/k)

• Y/Y = (s/k)

• “%growth of output =savings rate divided by capital-output ratio”

• Ex. Y/Y = (s/k)=0.2/4 = 0.05 = 5%

• GDP will grow at 5% per year

• To raise GDP growth, either increase the saving rate (s) or decrease the capital-output ratio (k)

• As in Rostow, capital accumultion /investment is key to growth

• Double the saving rate doubles output growth: Y/Y= s/k = 2Y/Y=2s/k

Implications

• If a country saves too little, it can borrow or use foreign aid

• Fill the “financing gap” to achieve the desired saving and growth rate

• Alternatively: lower the capital-output ratio -but this may be difficult.

Implications• Savings, investment, and physical capital

accumulation are key to growth

• International donors have used the prediction model to justify aid

• Y/Y = (s/k) = (0.2/4) = 5%

• Y/Y=(s’/k) = (0.3/4) = 7.5%

• If we supplement the 20% domestic saving rate with 10% of GDP in foreign aid, we will boosts GDP growth to 7.5%

Potential Limitations of the HD model• It assumes capital accumulation – investment- is

both necessary (we have to invest) and sufficient (if we invest, the country will grow) for economic growth

• In fact, it may be neither (Easterly Ch. 2)

• Many countries have grown because of technology –technology growth explains an estimated 2/3 of US GDP per worker growth since WW2

• Many countries invest a lot but fail to grow (the Soviet Union)

Put differently:

• Capital may require skilled labor, infrastructure, a legal framework, property rights, corruption control etc. to be productive

• Otherwise, capital gets diminishing returns

2010 data

United Arab Emirates

Afghanistan

Antigua and Barbuda

AlbaniaArmenia

Angola

Argentina

Austria Australia

Azerbaijan

Bosnia and HerzegovinaBarbados

Bangladesh

Belgium

Burkina Faso

Bulgaria

BahrainBurundiBenin

Bermuda

Brunei DarussalamBolivia

Brazil

Bahamas, The

BotswanaBelarus

Belize Canada

Congo, Dem. Rep.

Central African Republic

Congo, Rep.

SwitzerlandCote d'Ivoire

Chile

Cameroon

China

ColombiaCuba

Cabo VerdeCyprusCzech Republic

Germany

DenmarkDominica

Dominican Republic

AlgeriaEcuadorEstonia

Egypt, Arab Rep.

Eritrea

Spain

Ethiopia

FinlandFrance

Gabon

United Kingdom

Grenada

GeorgiaGhana

Gambia, The

Guinea

Equatorial Guinea

Greece

GuatemalaGuinea-Bissau Guyana

Hong Kong SAR, China

Honduras

Croatia

Haiti

Hungary

Indonesia

Ireland

Israel

India

Iraq Iran, Islamic Rep.

Iceland

Italy

Jamaica

Jordan

Japan

Kenya

Kyrgyz Republic

Cambodia

Comoros

St. Kitts and Nevis

Korea, Rep.

Kuwait

KazakhstanLao PDRLebanon

St. Lucia

Sri Lanka

Liberia Lesotho

Lithuania

Luxembourg

Latvia

Morocco

Moldova

Montenegro

Madagascar

Macedonia, FYR

MaliMongolia

Macao SAR, China

MauritaniaMalta

Mauritius

MalawiMexico

MalaysiaMozambiqueNamibia

NigerNigeria

Nicaragua

NetherlandsNorway

Nepal

New Zealand

OmanPanama

PeruPhilippines

Pakistan

Poland

Puerto Rico

West Bank and Gaza

Portugal

Paraguay

Qatar

RomaniaSerbia

Russian Federation

RwandaSmall statesOther small states

Saudi ArabiaSeychelles

Sudan

Sweden

Singapore

Slovenia

Slovak RepublicSierra LeoneSenegal

SurinameSouth Sudan

El Salvador

Swaziland

Chad

Togo

ThailandTajikistan

Timor-Leste

TunisiaTonga

Turkey

Trinidad and Tobago

Tanzania

UkraineUganda

United States

Uruguay Uzbekistan

St. Vincent and the Grenadines

Venezuela, RB

Vietnam

Vanuatu

Latin America & Caribbean (excluding high income)Yemen, Rep.

South Africa

Latin America & Caribbean

Zambia

Zimbabwe

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20

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P g

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0 10 20 30 40 50Gross capital formation (% of GDP)

n = 177 RMSE = 4.2747613

GDPgrowth = 2.763 + .06895 InvRate R2 = 1.6%

• The relationship between investment rates and GDP growth is pretty loose but positive

• 10% rise in investment rate linked to 10*(0.07)=0.7% more GDP growth

• This is something, if not everything; in 30 years your GDP level is (1+0.007)^30 - 1 = 23% higher than otherwise

• However:

• 1. Correlation does not imply causation –technology, education, demographic, legal-system, trade openness etc. differences might explain both GDP growth and investment differences and be the real growth driver

• 2. Low R-squared =1.6% implies that differences in investment rates only explain 1.6% of differences in GDP growth across countries – suggesting lots of other factors matter

• 2. The Lewis Structural change model

• Developed 1970s

• Alternative to simple linear progression view

• Assume two sectors:

• Agriculture or traditional sector A

• Manufacturing or modern sector M.

• Structural change means M grows relative to A.

• Every year people save part of income

• Invest the savings in capital for the M sector

• As capital grows workers in M get more productive.

• Then hire more workers in M

• These workers come from A.

• As capital grows over time M sector expands and A declines.

• Development=growing M, declining A.

• Again: capital accumulation is key

• Usually growth of M would push up wages

• (as food gets scarce and land per remaining worker in A is growing).

• But Lewis assumes initially many redundant workers in A – “surplus labor”

• Workers in A share what they produce and wage stays constant as long as M sector small compared to A sector

Do the Lewis model on the board…

Main results of the Lewis model

• 1. The manufacturing sector uses capital accumulation to “pull” the economy into modernity

• 2. The agricultural sector provides the labor supply by shedding its “surplus” labor

A possible example• An example may be China from ca. 1980-2005,

where hundreds of millions migrated from poor rural inland areas to work in the factories on the coast

• The labor supply was vast and wages stayed low despite the accelerating labor demand

• Eventually Chinese wages started to rise as it exhausted the surplus labor.

• India could benefit from the same transition process in the future

Policy implications• Since the modern sector is the economic

“engine” and depends on capital accumulation we can conclude that industrial capital accumulation will create GDP growth

• Policymakers used the Lewis model – and the idea that industrial capital accumulation is the economic engine - to justify supporting the modern sector

How did policy makers help the modern sector (esp. in the 1950s-60s in many countries)

• Public investment in industrial production

• Cheap loans to industry

• Build power plants, phone lines, ports, roads for urban industrialists

• Force exchange rates to be high to make it cheap to import machines (hurts agricultural exporters)

• Force farmers to sell to gov. for low prices (ensures cheap food/raw materials in cities)

• Export taxes on agriculture

Problems with the Lewis model and industry > ag focus

• Physical capital and labor are not the only inputs

• In practice, factors like infrastructure and skills remained too weak

• Industry startups like steel, radios, autos, chemicals never got internationally competitive

• Corruption problem and bureaucratic inefficiency hindered business as well

High wages

• The M sector wages could be high – much higher than the ag wages - due to unions, minimum wages, and the options to work for the gov. or foreign corporations

• High wages discourage owners from re-investing profits

Increasing returns• There may be “increasing returns” problems

• In order to create a high investment return, you may need a “critical mass” of investment/modern firms

• A single firm cannot get the modern production inputs (nuts and bolts for construction companies, tires for autos) it needs

• It depends on other firms to learn about modern production and marketing methods; to train workers; to get an urban consumer base

• [“Big Push Theory” later in class]

Capital can be a substitute – not a complement – to labor

• Capital could substitute for labor and destroy instead of create jobs

• Historically, many governments pushed for highly capital-intensive production, ex. subsidized interest rates

Urban migration and unemployment effects

• Due to few, but high-paying jobs, many people have migrated to cities and end in separated low-wage/high-risk informal labor market

• Countries get “dual” (formal vs informal labor market).

There may be no surplus labor • The ag. sector may have no surplus workers

• If the (subsidized) modern sector hires them,

• (a) food production falls, raising food prices,

• (b) rural labor gets scarce, raising wages

• (c) foreign exchange earnings from ag exports (main export earner) fall

• These factors limit the industry/urban potential

Lesson from history?

• Lewis model and “Modernization theory” may focus too much on the M sector.

• In the developed countries historically, new technology and ag. Institutions (like the enclosures movement) freed labor for industry

• This stabilized food supply and wages

• Improving ag productivity may be as important as improving M productivity

3.The Solow model

• The Solow model predicts limits to physical capital accumulation for long-run growth

• In the long run, the economy can only grow due to technological change.

• It can NOT grow due to investment alone

Do the Solow model on the board..

Why can investment not sustain growth in the Solow model?

• If you keep investing, so increasing the capital-per-worker (K/L) ratio, then

• 1. The marginal return to capital decreases: a worker with ten sowing machines is not ten times more productive than a worker with one

• 2. As the K/L increases, each worker gets• More depreciated capital to replace each year• A higher cost of supplying children w/ capital

Implications

• The Solow model implies that physical capital accumulation cannot sustain long-run growth

• Taking technology as given, boosting investment in poor countries may not help them

• In the long run, they need to improve their technology and efficiency

Potential Limitations of the Solow Model

• 1. If countries are far from their steady state, investment will still be helpful

• 2. Adding human as well as physical capital may help to advance technology

• 3. As incomes rise, countries may improve their public sector management and technology, which can again help growth

• Note: if K-accumulation can ultimately overcome diminishing returns, we say it has increasing – and not diminishing - returns…

• 4. Dependency theory

• 1950s (moderate) - 1970s (more radical)

• Inspired by leftist views of history, politics

• Focus on international power relationships, exploitation, dependency

• Thinks the international system keeps developing countries poor

• Fit with anti-colonial sentiments

Three variants of dependency theory

• Neo-colonial dependence model

• False-paradigm model

• Dualistic development thesis

Neo-colonial dependence model

• Poor countries are the periphery and rich countries the core in a core-periphery system

• Foreign trade and investment partners exploit developing countries

• DC elites – like landlords, business leaders, military leaders, public officials - collude with or depend on aid agencies, multinational corporations (MNCs), the IMF and World Bank, rich country leaders.

• Underdevelopment is not due to lack of capitalism but precisely due to international capitalism

False paradigm model

• Western “experts” think they understand poor countries

• Offer well intentioned but bad advice

• Even poor country experts are trained in western schools and modes of thought

• The prevailing development paradigm (analytical framework) is false

Dualistic development model

• A dual set of conditions prevail in poor countries and between poor and rich countries.

• Modern vs traditional economic sectors; modes of production; political systems; attitudes; health care; education systems..

• Wealthy, westernized, urban vs poor, traditional, rural

• - Bonfire of the Vanities, ‘how the other half lives’

Dualism (cont.)

• Dualism is not a transitory phenomenon, as in structural change model

• Hard to cross the barrier between the two worlds

• Superior elements do not pull up inferior elements

• May even perpetuate inferiority (US parallel).

Implications

• Dependency theories suggest development requires independence and control of own destiny.

• It was used to justify more government direction and barring or limiting foreign influence

• Led to inward-looking, gov. led development with regulations on foreign trade/investment, foreign currency, the financial system and production

• It promoted leftist revolutions against capitalist imperialism and domestic exploiters in Asia, Africa, Latin America

Implications• Political leaders (ex, in Ghana, Tanzania, Zambia

Senegal) intellectuals and political activists (Gandhi, Mao, Castro, Che Guevara, Idi Amin in Uganda) adapted socialist ideas, developed new economic schools of thought, sought to advance indigenous identity

• Like “African Socialism” Link 1 Link 2 to advance equity and development based on African traditions; ex tribal more than class community, tribal democracy & social responsibility; making soap from indigenous plants

Implications

• “Arab Socialism” revolutions in Egypt (GamelNasser coup, 1952-70), Algeria (first Pres. Ben Bella 1963-65), Libya (Qaddafi coup 1969-2011) with land expropriation, outlawing of political and religious opposition and state-owned enterprises Link Link2 (also Iraq, Syria)

• But all legitimized because they promoted the betterment of the people and pursued Islamic values like social justice and equality

Implications

• Gandhi’s philosophy to overcome poverty and backwardness via Indian self-sufficiency, harmonious spiritual development rather than class struggle and materialism; ex. homespun clothing and life in self-sufficient Ashrams for both communal production and spiritual development Link

Implications

• Mao’s philosophy (or more extremely Pol Pot’s in Cambodia) to conduct revolution and development via the countryside and peasants instead of urban workers Link Link2

• Revolution was a permanent process needed to prevent re-emergence of capitalism

• Ongoing revolution shaped how society worked, ex. Revolutionary Great Leap Forward and Cultural Revolution in china; Pol Pot’s executions and emptying of cities

Implications

• Import Substitution philosophy developed in Latin America, we’ll get to this..

Problems with dependency theories

• Government dominance of the economy came with political authoritarianism (gov. knows best)

• Closing off to outside influence closed off to competition and ideas

• Like Socialism had information, incentive and authoritarian problems in Eastern Europe, similarly in many developing countries

• Radical theories were untested and harder to implement in practice, costing lives

• Temptation to blame outsiders, domestic elites, even impure selfish thinking for problems and put ideology over pragmatism and reality may be dangerous

• 5. Market fundamentalism

• 1980s- 1990s

• Market fundamentalism argues that government intervention has worsened underdevelopment and not helped to solve it.

• We should let the market create incentives for people instead of regulate the market and destroy incentives with taxes, rules and regulations – use textbook (a.k.a. “neoclassical”) economic theory

Background for neoclassical thinking

• It is a reaction to the global trend of activist governments in the 1960s followed by slowing growth and inflation problems in the 1970s

• Western countries feel old system not working and elect new, pro-market, anti-gov leaders like Ronald Regan and Margaret Thatcher

• Developing countries too see slowing growth, inflation and then a major debt crisis in 1980s

Background for neoclassical thinking

• The view that the government is the problem and the market is the solution leads to a new aid donor and partly developing country philosophy, called the “Washington Consensus” in the 1990s

• It focuses on “stabilization, liberalization , privatization, and institutional reforms ”

“stabilization, privatization, liberalization and inst. reforms”

• Stabilization=stabilize the fiscal deficit and inflation, achieve a sound macroeconomic framework.

• Liberalization=let the market work freely rather than regulate it – ex. remove foreign trade/investment/ exchange rate controls, controls on the financial system

• Privatization=privatize state-owned companies and operations like electricity generation, water supply, garbage collection, banks, industries like steel &cement

• Institutional reforms=streamline the bureaucracy and address corruption

Did it help to take government out?

• Latin America is thought to have gone farthest in freeing up the economy

• Several countries had growth booms followed by financial crises in the 1990s

• The same happened in Asia

• People then called the neoclassical ideas too extreme and ideological over science-based

Did it help to take government out?

• The general problem with minimizing the government role is probably that

• (a) markets do not work perfectly on their own, tend to need some regulation (as maybe illustrated by the recent US recession)

• (b) Governments kept some regulations in place, but not necessarily the right ones.

• Market failure plus the wrong government interventions can have bad interactions

Example

• Both Asia and Latin America allowed free foreign investment in the 1990s

• They also deregulated their banking systems

• To encourage foreign investment and trade -and commit to low inflation and dollar-denominated debt repayment - they fixed the exchange rate (which basically prevented them from printing money)

Example• The freed-up banks now borrowed freely from

abroad, especially since there was little exchange rate and inflation risk

• If the exchange rate fix is credible and the banking system is sound, this ought to be okay

• Presumably foreign lenders would only lend and borrowers borrow as long as the MB > MC and the loan is repayable

Example• In reality banks were poorly regulated- perhaps by the

government, perhaps by their private owners – and over-borrowed for questionable investments & consumption loans. It ended in big financial crises.

• The fixed exchange rate probably acted as subsidy – in the free market, it would have fallen as bad debt built up, making it more expensive to borrow and signaling a problem

• Some banks may also have benefited from government connections and implicit bailout promises

Example

• (Note this all sounds pretty similar to the recent US crises, except that here more of the boom was foreign-financed and it ended with not only a financial crisis (like in the US) but with foreign debt and exchange rate crises (unlike in the US)

Other problems with minimizing the government’s role

• There may be heavy political resistance to market reforms

• If reforms are achieved, standard econ. theory predicts free markets are inefficient in economies of scale, externality, public goods and asymmetric information situations

• (in these cases, the free market can even cause a poverty trap, we’ll discuss this)

• Free markets may also raise inequality and leave out the poor

Overall lessons from classical development theories

• Capital accumulation

• Closing the economy/government direction

• Uncritical trust in free markets

• These ideas may have benefits but did not created development when they were tried

• New development theories developed from 1990s/2000s focus on how both markets and governments can have problems