Professional Documents
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Untitled
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Introductio n
Growth and Development
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is funded by the Overseas Development
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makes available low-priced, unabridged
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Macmillan Dictionary of Economics
Macmillan
Growth and Development
With Special Reference to
Developing Economies
Fifth Edition
A. P. THIRLWALL
Professor of Applied Economics, University of Kent at Canterbury
The Theory of Financial Liberalisation 278 The Total Net Flow of Financial
The Development of the Banking System 280 Resources to Developing Countries 331
Fiscal Policy 282 Official Development Assistance 331
Tax Reform in Developing Countries 286 Total Net Flow of Financial Resources by
Inflation, Saving and Growth 288 DAC Countries 332
The Keynesian Approach to the Finance United Kingdom Assistance to Developing
of Development 288 Countries 332
Reconciling the Prior-Saving vs Forced- OPEC Assistance 336
Saving Approaches to Development 293 Multilateral Assistance 336
The Quantity Theory Approach to the World Bank Activities 337
Finance of Development 293 Structural Adjustment Lending 338
Non-Inflationary Finance of Investment 295 The Recipients of External Assistance 339
Inflation and the Credit-Financed Growth Estimating the Aid Component of
Rate 296 International Assistance 340
The Dangers of Inflation 297 Aid-Tying 345
Inflation and Growth: The Empirical The Distribution of International
Evidence 298 Assistance 347
The Inflationary Experience 298 Schemes for Increasing the Flow of
The Structuralist-Monetarist Debate in Resources 349
Latin America 299
PART VI INTERNATIONAL TRADE,
Chapter 14: Foreign Assistance, Debt and THE BALANCE OF PAYMENTS
Development 302 AND DEVELOPMENT
Introduction 302 Chapter 15: Trade and Development 355
Dual-Gap Analysis and Foreign Introduction 355
Borrowing 304 The Gains from Trade 360
The Investment-Savings Gap 305 The Static Gains from Trade 361
The Import-Export, or Foreign Exchange, The Dynamic Gains from Trade 363
Gap 307 Trade as a Vent for Surplus 363
A Practical Case Study of Dual-Gap Export-Led Growth 364
Analysis 307 The Disadvantages of Free Trade for
The Assumptions of Dual-Gap Analysis 308 Development 366
Models of Capital Imports and Growth 309 Tariffs vs Subsidies as a Means of
Capital Imports, Domestic Saving and the Protection 367
Capital-Output Ratio 310 Import Substitution vs Export Promotion 369
The Balance of Payments, Foreign New Trade Theories for Developing
Borrowing and the Debt Burden 311 Countries: The Prebisch Doctrine 371
The Debt Service Problem 312 Technical Progress and the Terms of
The Debt Crisis of the 1980s 319 Trade 371
Solutions to Debt Difficulties 322 The Income Elasticity of Demand for
The Debate Over International Assistance Products and the Balance of Payments 372
to Developing Countries 326 Recent Trends in the Terms of Trade 373
The Motives for Official Assistance 326 Trade Theory and Dual-Gap Analysis 375
Private Investment and the Multinational Trade Policies 376
Corporation 328 Trade Preferences 377
The Types and Magnitude of Effective Protection 378
International Capital Flows 330 Trade Between Developing Countries 380
Contents XI
Since Growth and Development was first pub- low-income countries and that a separate econ-
lished in 1972 it has been widely used as a text for omic theory is needed. Models for this purpose
courses in economic growth and development in were widely acclaimed until it became evident that
both developed and developing countries. In 1978, they were at best intellectual curiosities. The reaction
1983 and 1989 new editions were published, and of some economists was to turn to cultural and
the book was taken into the Educational Low- social explanations for the alleged poor economic
Priced Books Scheme (formerly known as the performance of low income countries. Quite
English Language Book Society) for subsidised understandably, cultural and behavioural scho-
distribution in several developing countries. In lars are uneasy about this use of their studies.
this fifth edition, further revisions have been made Fortunately the intellectual tide has begun to
to add to, and update, statistics, to include new turn. Increasing numbers of economists have
institutional material, and to improve on the ex- come to realise that standard economic theory
position to aid students and teachers alike. is just as applicable to scarcity problems that
The purpose of the book remains the same: to confront low income countries as to the corres-
introduce students to the exciting and challenging ponding problems of high income countries. (T.
subject of development economics, which draws W. Schultz, 'The Economics of Being Poor',
on several branches of economics in order to eluci- Journal of Political Economy, August 1980.)
date and understand the development difficulties
facing the economies of the world's poor coun- This is not to say, of course, that all standard
tries. This does not mean that the book provides a theory is useful and relevant for an understanding
recipe or blue-print for development: far from it. of the development process. The relevance of static
There can be no general recipes of this nature, and equilibrium theory may be particularly ques-
even if there were there would have to be more tioned. Nor is it possible to ignore non-economic
than economic ingredients. factors in the growth and development process.
The book combines description and analysis, The fact is, however, that the desire for material
with an emphasis on the elaboration of simple improvement in developing countries is very strong,
and useful theoretical economic models for an and economics does have something positive to offer
understanding of the issues that comprise the by way of analysis unadulterated by political,
subject-matter of development economics. I make sociological and other non-economic variables. In
no apology for the use of conventional econ- the final analysis growth and development must be
omic theory. I concur with Theodore Schultz, the considered an economic process in the important
Nobel-Prize-winning economist, who has said of practical sense that it is unlikely to proceed very far
development economics: in the absence of an increase in the quantity and
quality of the resources available for production. The
This branch of economics has suffered from book lays particular emphasis on the economic
several intellectual mistakes. The major mistake obstacles to development and the economic means
has been the presumption that standard econ- by which developing countries may raise their rate of
omic theory is inadequate for understanding growth of output and living standards.
Xttt
XIV Preface to the Fifth Edition
For those new to the book, or for those now lowing on from Lewis, of the interaction and comp-
using the fourth edition, I outline below the main lementarity between agriculture and industry,
contents of each chapter and the changes intro- with a number of interesting insights concerning
duced into the fifth edition. the importance of demand expansion from agri-
Chapter 1 portrays various dimensions of the culture as a stimulus to industrial growth and of
development gap between rich and poor countries, achieving an equilibrium terms of trade between
and includes sections on income distribution, un- the two sectors. New studies are reported on the
employment, nutrition, health, education, and the supply response of agriculture.
basic needs approach to development pioneered Chapter 4 is on the role of capital accumulation
by the World Bank. There are new sections on the and technical progress in the development process,
measurement of poverty; on the attempt by the and remains unchanged.
United Nations Development Programme (UNDP) Chapter 5 is on dualism and Myrdal's concept
to construct a Human Welfare Index; and on re- of the process of circular and cumulative causa-
search as to whether the developing countries are tion. This chapter describes the various mechan-
catching up with the developed countries in terms isms by which economic divisions between regions
of productivity and levels of per capita income. and countries tend to be perpetuated and widened.
The mutual interdependence of the world eco- The chapter includes the early centre-periphery
nomy is emphasised, and there is discussion of the models of Prebisch and Seers, and the views of
call for a New International Economic Order. The Marxist writers, including Emmanuel's model of
latest statistics are given for all the main dimen- unequal exchange.
sions of the development gap. Chapter 6 is on population and development
Chapter 2 is on the production-function and attempts to evaluate the debate on whether
approach to the measurement of the sources of population expansion is a growth-inducing or re-
growth. This chapter stays unchanged except for tarding force. Particular attention is devoted to the
the reporting of new empirical studies, including work of Enke and to the recent work of Simon.
one from the World Bank. However, it is important Chapter 7 is on the case for planning and raises
to continue to stress that the approach cannot tell some of the broader issues of development
us why factor supplies and productivity grow at strategy, including early discussion of investment
different rates between countries. The pro- criteria.
duction-function approach is essentially a supply- Chapter 8 is devoted exclusively to social cost-
orientated approach to growth which treats the benefit analysis, and has been largely rewritten to
supply of factors of production as exogenous to an make a clearer distinction between the financial,
economic system. In practice, growth is likely to economic and social appraisal of projects. The
be demand-constrained, particularly by the bal- major emphasis is on comparing and contrasting
ance of payments in an open economy, and factor the approaches of Little and Mirrlees (using world
supplies are likely to be endogenous to an econ- prices) on the one hand and the United Nations
omic system. Given the growth of output permitted (using domestic prices and shadow exchange
by demand, however, it is interesting to apportion rates) on the other. More attention is given to the
this growth between quantity and quality im- relation between the shadow exchange rate and
provements in the various factors of production the standard conversion factor used by Little and
on the one hand and technical progress on the Mirrlees for the repricing of non-traded goods.
other. The chapter contains a lengthy discussion of the
Chapter 3 deals with the role of agriculture and determination of the shadow wage rate, and how
surplus labour in the development process. Par- to take account of the distributional effects of
ticular attention is paid to the influential Lewis project choice.
model of economic development with unlimited Chapter 9 is a new chapter written by my col-
supplies of labour. There is explicit treatment, fol- league Dr John Peirson on how environmental
Preface to the Fifth Edition xv
issues may be incorporated into social cost-benefit explored, as are the ways in which the present
analysis, and on the new and important concept of pattern of trade works to the relative disadvantage
sustainable development. of developing countries. The tendency for the
Chapter 10 is concerned with the choice of terms of trade to deteriorate, and for balance-of-
techniques and with the potential conflicts in- payments difficulties to arise, is stressed. The case
volved in moving towards the use of more labour- for protection, and the relative merits of import
intensive techniques: between employment and substitution and export promotion, are examined.
output on the one hand, and between employment New studies are reported on the relation between
and saving on the other. The role played by multi- trade performance and economic performance.
national corporations in dictating technological Chapter 16 is on the balance of payments and
choice is also examined. development and discusses the important concept
Chapter 11 introduces the student to the tech- of balance-of-payments constrained growth and
nique of input-output analysis and its role in plan- the various policy responses to this constraint at
ning and forecasting. It is shown how input- the national and international level. The latter in-
output analysis can be used for forecasting output, volves a consideration of the extensive facilities
import requirements, labour and capital require- afforded by the International Monetary Fund for
ments. There is a new section on linkage analysis balance-of-payments support. Some of the criti-
and on tests of the hypothesis that countries which cisms levelled at the IMF are also considered, in-
encourage activities with the highest backward cluding the relevance of devaluation. The chapter
and forward linkages grow the fastest. ends with a discussion of special drawing rights as
Chapter 12 gives an elementary exposition of a potential form of international assistance to de-
the technique of linear programming. veloping countries.
Chapter 13 turns to the finance of development By the time the sixth edition of this book
from domestic sources and includes extensive dis- becomes due in 1999, the facts pertaining to de-
cussion of the various means to raise the level of veloping countries will again be out of date, and
saving, including forced saving through inflation. no doubt there will have been new institutional
There is consideration of the role of monetary and changes and new innovations in thinking about
fiscal policy, including discussion of tax reform development strategy. To keep abreast with what
and a new section on the theory and practice of is going on students are encouraged to consult
financial liberalisation. such publications as the World Development Re-
Chapter 14 looks at the finance of development port and Finance and Development (published
from external sources, and the debt-servicing quarterly in several different languages by the IMF
problems created by foreign borrowing. The debt and World Bank), and journals such as World
crisis that arose in the 1980s, and which still Development, Journal of Development Studies,
lingers, is thoroughly surveyed, and there is a new Journal of Development Economics, Economic
section on solutions to the debt crisis and the Development and Cultural Change, and the
progress that has been made so far on the basis of World Bank Economic Review.
various initiatives. All the statistics relating to I am deeply grateful to Celine Noronha for
foreign resource inflows have been updated to preparing the manuscript for this new edition; to
1990/91. The whole aid debate is reviewed, plus Elizabeth Schachter for checking the proofs; to
the advantages and disadvantages of private Keith Povey, Stephen Rutt and Jane Powell for
foreign investment. There is a new section on editorial assistance; and to Jackie Butterley for
the activities of the World Bank, and on the compiling the index.
theory and practice of Structural Adjustment
Programmes. Canterbury, January 1993 A. P. THIRLWALL
Chapter 15 is devoted to the topic of trade and
development. The gains from trade are thoroughly
XVI
0 llllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllll 330
G) 1 1 820
0 ~~~I~~~~~~I~~~~~~I~~~~~IJ 2 .400
Population (billions)
XVII
• ®
.®
~0
0 Number of countries
(MATTHEW 25 :29)
Part I
Introductio n
II Chapter 1 II
Developm ent and
Underdeve lopment
3
4 Introduction
developed countries. Whatever the reason for areas of interest of the classical economists. Adam
neglect, the situation today is very different. The Smith, David Ricardo, Thomas Malthus, John
development of the Third World (the collective Stuart Mill and Karl Marx all dealt at some length
name for the developing countries), meaning (with divergent opinions on many issues) with the
above all the eradication of primary poverty, is causes and consequences of economic advance. It
now regarded as one of the greatest social and is entirely natural that thinkers of the day should
economic challenges facing mankind. comment on the contemporary scene, and there is
What accounts for this change in attitude and perhaps an analogy here between the preoccupa-
upsurge of interest in the economics of develop- tion of the classical economists at the time of
ment and in the economies of poor countries? A Britain's industrial revolution and the concern
number of factors can be pinpointed, which inter- of many economists today with the economics of
relate with each other. First, in the wake of the development and world poverty, the nature of
great depression and in the aftermath of war there which has been brought to the attention of the
was a renewed academic interest among pro- world so dramatically in recent decades. Develop-
fessional economists in the growth and develop- ment also represents a challenge equivalent to that
ment process and in the theory and practice of of depression and mass unemployment in the
planning. Second, the poor countries themselves 1930s which attracted so many brilliant minds to
have become increasingly aware of their own economics, Keynes among them. But the nature of
backwardness, which has led to a natural desire the challenge is of course very different. In the case
for more rapid economic progress. The absolute of unemployment in the 1930s, there was an or-
numbers of poor people are considerably greater thodox theory with which to grapple; the task was
now than in the past, which has struck a humani- to formulate a theory to fit the facts and to offer
tarian chord. Third, there has been a growing policy prescriptions. As it turned out, the solution
recognition by all concerned of the mutual inter- to the problem was to be costless: expand demand
dependence of the world economy. The political by creating credit and bring idle resources into
and military ramifications and dangers of a world play. Fancy, an economic problem solved costless-
divided into rich and poor countries are far more ly! The challenge of development is very different.
serious now than they were in the past; at the same There is no divorce between theory and the
time the old Cold War led the major developed observed facts. The mainsprings of growth and
countries to show a growing economic and politi- development are well known: increases in the
cal interest in poor and ideologically uncommitted quantity and quality of resources of all kinds.
nations. The recognition of interdependence has Countries are poor because they lack resources or
been heightened in recent years by fears of short- the willingness and ability to bring them into use.
ages of basic raw materials produced primarily in The problems posed by underdevelopment cannot
Third World countries, and by the rising price of be solved costlessly. It would be reassuring to
oil. think, however, that advances in growth theory,
coupled with more detailed knowledge of the
I Academic Interest in
Development
sources of growth, and the refinement of tech-
niques for planning and resource allocation, have
all increased the possibility of more rapid econ-
omic progress than hitherto. Certainly particular
Academic interest in the mechanics of growth ~nd theoretical models and techniques have been used
development is a renewed interest rather than a extensively in some countries, presumably in this
new preoccupation of economists. The progress belief. For example, models for calculating invest-
and material well-being of men and nations have ment requirements to achieve a target rate of
traditionally been at the centre of economic writ- growth invariably form an integral part of a devel-
ing and enquiry. It constituted one of the major opment plan, and in some countries there have
Development and Underdevelopment 5
been experiments in recent years with such tech- stage of development one hundred years ago. The
niques as input-output analysis, for the achieve- pool of technology on which to draw, and the
ment of sectoral balance and the avoidance of scope for its assimilation, is enormous. Used with
bottlenecks, and linear programming for the discretion, it must be considered as the main
achievement of efficient resource allocation. means of increasing welfare. The role of trade,
The question is often posed as to what lessons, however, is more problematic. A lot will depend
if any, the present developing countries can draw on how rapidly the developing countries can alter
from the first-hand observations of the classical their industrial structure and on movements in the
writers, or more directly from the development terms of trade. Currently the developing countries
experience of the present advanced nations. One are probably in an inferior position compared
obvious lesson is that while development can be with the present advanced countries at a compar-
regarded as a natural phenomenon, it is also a able stage of their economic history. The dynamic
lengthy process, at least left to itself. It is easy to gains from trade are present but the static ef-
forget that it took Europe the best part of three ficiency gains are less and the terms of trade in
centuries to progress from a subsistence state to most commodities are worse. The gains from trade
economic maturity. Much of development econ- accrue mainly to the rich industrialised countries,
omics is concerned with the time scale of devel- notwithstanding the rapid increase that period-
opment, and how to speed up the process of ically takes place in some commodity prices. The
development without causing problems as acute fact that the gains from trade are unequally dis-
and worrisome as the primary poverty it is desired tributed does not destroy, of course, the potential
to alleviate. In the next millennium, when primary link between trade and growth, or constitute an
poverty in most countries will, it is hoped, have argument against trade. Rather, it represents a
been eradicated, courses in development econ- challenge for altering the structure of trade and the
omics will undoubtedly take a different form. The terms on which it takes place.
emphasis will be on inter-country comparisons, The greater knowledge and acceptance of plan-
rather than on the process of development as such ning may also mean that the development experi-
and the growth pains accompanying the transition ence of the present developing countries will be
from a primarily agrarian to an industrial economy. less protracted and painful than in the past. Plan-
As far as classical theory is concerned, the gloomy ning can potentially mobilise the prerequisites of
prognostication of Ricardo, Malthus and Mill that development more expeditiously than the market
progress will end ultimately in stagnation would mechanism, which takes time to operate, and pro-
seem to be unfounded. It has certainly been con- vided attention is paid to income distribution, the
founded by experience. Population growth and sum total of sacrifice of present generations need
diminishing returns have not been uniformly de- be no more severe per individual. Classical econ-
pressive to the extent that Ricardo and Malthus omists were generally antithetical to interference
supposed. Rising productivity and per capita in- with the market mechanism, believing that the free
comes appear quite compatible with the growth play of market forces would maximise the social
of population and the extension of agriculture. good. But fashions change in economics, and after
Classical development economics greatly under- the Second World War, there was a much greater
estimated the beneficient role of technical progress acceptance of interference with the market mech-
and international trade in the development pro- anism, and planning in developing countries was
cess. It is these two factors above all which seem to seen by many as one of the main means by which
have confounded the pessimism of much of classi- development may be accelerated. The experience
cal theory. With access to superior technology of planning in many countries, however, has not
there is hope, and some evidence, that material been favourable, and planning has come into dis-
progress in today's developing countries will be repute, not the least because of the economic
much more rapid than in countries at a similar disarray of the rigidly planned economies of the
6 Introduction
old Soviet Union and Eastern Europe. It should oped nations, and has been strengthened from
never be forgotten, however, that no country in within by rising expectations as development has
the world made such swift economic advance in proceeded. Development is wanted to provide
such a short space of time as the Soviet Union after people with the basic necessities of life, for their
1918, through the planned allocation of resources own sake, and to provide a degree of self-esteem
which favoured investment at the expense of con- and freedom for people which is precluded by
sumption. The fact that planning may be operated poverty. Wealth and material possessions may not
too rigidly, or for too long and go wrong, should provide greater happiness but they widen the
not be allowed to obscure the fact that it also has choice of individuals, which is an important aspect
merits, and that unfettered free enterprise can also of freedom and welfare. The developing countries
lead to economic disaster and social deprivation. in recent years have shown a marked determina-
What is required in most developing countries is a tion to pull themselves up by theif own bootstraps
judicious mix of public and private enterprise, of assisted, in the words of Professor Hicks, 'by such
the use of markets combined with different types crumbs of aid as the richer countries are willing to
of planning, for the maximisation of social spare, and as they themselves are willing to accept'
welfare. (1966, p. 263). They have also called for a fairer
Planning requires a certain amount of model- deal from the functioning of the world economy
building and this, too, has been inspired by econ- which they view, with some justification, as biased
omists. The most common type of model, which in favour of countries already rich.
forms the basis of much of the model-building that The official call for a New International Econ-
developing countries indulge in, is to calculate the omic Order was originated by the Sixth Special
investment requirements necessary to achieve a Session of the United Nations General Assembly in
target rate of growth of per capita income - com- 1974. The United Nations pledged itself 'to work
monly referred to as a Harrod-Damar model. urgently for the establishment of a new inter-
Neither the models of Harrod (1948) or Domar national economic order based on equity, sovereign
(1947) were designed for the purpose to which equality, common interest and cooperation among
they are now put in developing countries, but their all States, irrespective of their economic and social
growth equations have proved to be an indispens- systems, which shall correct inequalities and re-
able component of macro-economic planning. We dress existing injustices, make it possible to elimin-
shall consider later the strengths and weaknesses ate the widening gap between the developed and
of using this type of aggregate model in develop- the developing countries and ensure steadily accel-
ment planning, and the pros and cons of planning erating economic and social development and
in general. peace and justice for present and future genera-
tions.' The programme of action called for such
things as: improved terms of trade for the exports
duced the Lima Declaration which set a target for trade and the balance of payments. There exists an
the developing countries to secure a 25 per cent interdependence in the world economy such that
share of world manufacturing production by the the malfunctioning of one set of economies im-
year 2000 compared with the share then of 10 per pairs the functioning of others. This was no more
cent (and a present share of 15 per cent). This evident than in the world economy in the 1980s
target will not be achieved since it requires a which, owing to the rising price of energy and the
growth of manufacturing of 10 per cent per an- debt crisis, displayed mounting economic chaos.
num in developing countries compared with 5 per The 1980 Brandt Report, entitled North-South: A
cent in developed countries, which is 3 per cent Programme for Survival (1980), and its sequel
more than achieved from 1965 to 1990. On the Common Crisis (1983), stressed the mutual be-
monetary front, in 1980 there was the Arusha nefit to all countries from a sustained programme
Declaration which demanded a UN Conference on of development in the Third World, and docu-
International Money and Finance to create a new mented the current adverse trends in the world
international monetary order 'capable of achiev- economy which pointed to a sombre future if not
ing monetary stability, restoring acceptable levels tackled co-operatively: growing poverty and hunger
of employment and sustainable growth' and 'sup- in the Third World; rising unemployment with infla-
portive of a process of global development'. And tion; international monetary disorder; chronic
at the 7th Session ofUNCTAD in Geneva in 1987, balance of payments deficits and mounting debts
policy approaches were called for in four major in most Third World countries; protectionism,
areas: debt and development resources; commodi- and tensions between countries competing for
ties; international trade; and the problems of the energy, food and raw materials. Development
least developed countries. economics addresses itself to many of the issues
contributing to disarray in the world economy.
There is not only a moral case for greater efforts
The Brandt Report called for a short-term emerg- economic and political harmony which cannot
ency programme as a prelude to longer-term ac- thrive in a world perpetually divided into rich and
tion, consisting of four major elements: a large poor. There has also been an affirmation by many
scale transfer of resources to developing countries; developed countries of a moral obligation towards
an international energy strategy to minimise the poorer nations. Not all aid and development as-
dislocation caused by sudden and rapid increases sistance is politically inspired. Particularly over the
in the price of oil; a global food programme; and a last three decades, the developed countries have
start on some major reforms in the international shown a genuine humanitarian concern over the
monetary system. Very little has been done. plight of Third World countries, which has
In the longer term, the Brandt Report called for: resulted in the establishment and support of sev-
a twenty-year programme to meet the basic needs eral institutions to assist developing countries, and
of poor countries, involving additional resource which led the period 1960-70 to be named the
transfers of $4 billion a year; a major effort to First Development Decade. We are now in the
improve agricultural productivity to end mass Fourth Development Decade, and the pledge to
hunger and malnutrition; commodity schemes to assist developing countries out of humanitarian
stabilise the terms of trade for primary commodi- concern has been reaffirmed. The goal of a greater
ties; easier access to world markets for the exports degree of income equality between the citizens of a
of developing countries; programmes for energy nation seems to be gaining support, albeit slowly,
conservation; the development of more appropri- as an objective among nations. Moreover, the
ate technologies for poor countries; an inter- propagation of this ideal is not confined to the
national progressive income tax, and levies on supranational institutions that have been es-
trade and arms production, to be used by a new pecially established to further it. Recent years have
World Development Fund (to fund development witnessed the spontaneous creation of several
programmes rather than projects); a link between national pressure groups, in different parts of the
the creation of new international money and aid to world, whose platform is the abolition of world
developing countries, and policies to recycle poverty; and the Church, which remained silent
balance-of-payments surpluses (as accumulated by and inactive for so long, periodically makes its
the Arab oil export countries since 1973, for voice heard. Aid from voluntary agencies to devel-
example) to deficit countries to remove balance- oping countries now amounts to over $3.5 billion
of-payments constraints on demand and to annually. But whatever the motive for concern, the
remove the risk of a slide into international protec- reality of world poverty and underdevelopment
tionism. Many of these issues we shall be discuss- cannot be ignored. Furthermore, primary poverty
ing in the course of this book. 1 Such a programme in developing countries is likely to persist for many
would be of mutual benefit to all parties, rich and years in the future. The economist has a special
poor. It would create investment confidence, responsibility to contribute to an understanding of
which is the crucial ingredient maintaining the the economic difficulties which poor countries face
dynamics of any economic system; it would and to point to possible solutions. This is a text-
stimulate trade and investment, and help the pros- book devoted to that end. Let us start by consider-
pects of sustained growth in the world economy. ing the meaning of development and establishing
It would be wrong to give the impression, how- the magnitude of poverty and of economic div-
ever, that the developed countries' concern with isions in the world as precisely as the data will
world poverty is motivated exclusively by the selfish allow. Then we shall focus on conditions within
realisation that their own survival depends on the developing countries, particularly the employ-
ment situation, the income distribution, the level
1 For a discussion and appraisal of the Brandt Report, see the
of nutrition, and other basic needs.
collection of articles in Third World Quarterly, October 1980,
and Kirkpatrick and Nixson (1981).
Development and Underdevelopment 9
the assumptions that underly conventional econ- foremost importance. It was, first of all, settled
omic models have to be abandoned if they are to agriculture that laid the basis for the great civilisa-
yield fruitful insights into the development pro- tions in the past, and it was the increase in agricul-
cess. Static equilibrium theory, for example, is tural productivity in England in the eighteenth
ill-suited for the analysis of growth and change century that laid the basis for, and sustained, the
and of growing inequalities in the distribution of first industrial revolution. If there is one overriding
income between individuals and countries. It is single factor which explains why some countries
probably also true, as Todaro (1989) strongly developed before others, and why some countries
argues, that economics needs to be viewed in the are still backward without a significant industrial
much broader perspective of the overall social sector, it lies in the condition of agriculture which
system of a country, which includes values, beliefs, in the early stages of development is the sector
attitudes to effort and risk taking, religion and the which must provide the purchasing power over
class system, if development mistakes are to be industrial goods.
avoided which stem from implementing policy The conditior. of agriculture depends on many
based on economic theory alone. factors, institutional as well as economic, and
physical conditions are also of key importance.
I The Perpetuation of
Underdevelopment
Climate, particularly, affects the conditions of pro-
duction. Heat debilitates individuals. Extremes
of heat and humidity also deteriorate the quality
of the soil and contribute to low productivity of
The study of economic development helps us to certain crops. It cannot be coincidence that almost
understand the nature and causes of poverty in all developing countries are situated in tropical or
low-income countries, and the transformation of subtropical climatic regions and that development
societies from being primarily rural to being pri- 'took off' in the temperate zones.
marily industrial, with the vast bulk of resources The condition of agriculture has not been helped
utilised in industrial activities and in service activi- by what Lipton (1977) has called urban bias
ties which serve the industrial sector. But why which has in many countries starved agriculture of
have some countries never participated in this resources. This has happened because ruling elites
process or got left behind? The first industrial generally originate from, or identify with, the
revolution gave the present developed countries an non-rural environment, and because policy-makers
initial advantage which they then sustained were led astray both by the empirical evidence
through the existence of various cumulative forces which shows a high correlation between levels of
at work against those left behind. In the last forty development and industrialisation, and by early
years there has been a second industrial revolution development models which stressed investment in
which has propelled another bloc of countries (the industry.
so-called newly industrialised countries of South Many other internal conditions have acted as
East Asia and Latin America) into a virtually barriers to progress in poor countries, which in-
industrialised state, and many others into a semi- teracted in a vicious circle. In some countries
industrialised state. But many countries are still population size presents a problem combined with
left behind in a semi-feudal state, including the low levels of human capital formation. The latter
very poorest which have now become the prime in turn perpetuates poverty which is associated
focus of concern of the Wodd Bank and other with high birth rates and large family size. This is a
development agencies. form of 'accommodation to poverty' (Galbraith,
There are many theories of the perpetuation (1980)) which then perpetuates low living stan-
of underdevelopment but none seem to have dards in a circular process. In other countries there
universal validity. The state of agriculture is of may not exist the psychological conditions re-
Development and Underdevelopment 11
Social indicators
Extremely poor Poor (including extremely poor)
Under 5 Net primary
Headcount Headcount mortality Life enrollment
Number index Poverty Number index Poverty (per expectancy rate
Region (millions) (percent) gap (millions) (percent) gap thousand) (years) (percent)
expenditure (with an allowance made for output regarded as an acceptable standard of living in the
produced for own consumption). The same level United Kingdom will be different (and higher)
of real income and expenditure in different coun- from that regarded as acceptable in Nigeria. In
tries, however, may be associated with different practice, however, for the measurement of poverty
levels of nutrition, life expectancy, infant mor- in the Third World, the World Bank takes just two
tality, levels of schooling etc. which must be con- figures for per capita income: one to classify the
sidered as an integral part of 'the standard of total poor, the other to measure the extremely
living'. Measures of living standards based on per poor. In 1990, the figures taken were $370 per
capita income, therefore, may need to be supple- annum and $275 per annum, respectively.
mented by other measures which include these Once the poverty line has been calculated, the
other variables. We discuss later the attempt by simplest way to measure poverty is by the head
the United Nations Development Programme count index which simply adds up the number of
(UNDP) to construct a Human Development In- people who fall below the poverty line (sometimes
dex which takes some of these factors into account. expressed as a proportion of the population). By
To separate the poor from the not so poor, an this measure, the W odd Bank calculated that the
arbitrary per capita income figure has to be taken number of poor people in the developing countries
which is sufficient to provide a minimum accept- is just over one billion, and the number of ex-
able level of consumption. In theory, a consump- tremely poor is just over 600 million. The numbers
tion-based poverty line can be thought of as by continent are shown in Table 1.1.
comprising two elements: firstly an objective One weakness of the headcount index, how-
measure of expenditure necessary to buy a mini- ever, is that it ignores the extent to which the poor
mum level of nutrition, and secondly a subjective fall below the poverty line, so that crude compari-
additional amount that varies from country to sons between countries, or over time, may be
country reflecting the cost of individuals partici- misleading. To overcome this weakness, the con-
pating in the everyday life of society. What is cept of the poverty gap may be used which
Development and Underdevelopment 13
" 40 -
sideration has implications for judging the claims ~
a.
of public policy because clearly if the headcount 30
index is taken as the measure of poverty, the
20
easiest way to reduce the head count index would
be to focus all attention on those just below the 10
poverty line, but this would not be socially just.
We need measures of poverty which also take 0 10 20 30 40 50 60 70 80 90 100
account of movements in the distribution of in- Per cent of population
come between the poor.
It is interesting to note that despite the massive
numbers of people in absolute poverty, the trans- tion and receive only 6 per cent of the world's
fer needed to leave everybody above the poverty income; the middle-income countries contain 15 per
line ($370) is relatively small- only 3 per cent of cent of the world's population and receive 17 per
total consumption in developing countries. cent of world income, and other rich industrialised
The focus of the World Bank is now very much countries contain 25 per cent of the world's popu-
on poverty eradication. In May 1992, the Presi- lation yet receive 77 per cent of world income.
dent of the World Bank, Mr Lewis Preston, Income distribution data of this type (for indi-
declared that poverty reduction will be 'the bench- vidual countries as well as for groups of countries)
mark by which our performances as a develop- can be represented graphically on a so-called
ment institution will be measured'. This represents Lorenz curve diagram as shown in Figure 1.1. The
a shift of emphasis away from the Bank's tra- 45° line represents a perfectly equal distribution of
ditional emphasis on project lending for economic income across the population. The bowed curve is
efficiency to secure an economic rate of return the Lorenz curve showing graphically the degree
from projects which may have done nothing to of inequality. To draw the curve, first rank coun-
improve the lot of the poor. tries or groups of countries in ascending order
according to the ratio of the percentage of income
they receive in relation to the percentage popula-
D Distribution of World Income tion they contain; then cumulate the observations,
and plot on the diagram. Taking the data given
Turning now to the consideration of the distribu- above, our ranking is obviously low-income,
tion of world income in relation to the population, middle-income and 'high' -income. The cumulative
and using the three-fold classification of low- distribution of income is 6/60 then 23/75 when the
income, middle-income and industrial countries, middle-income country figures are added to the
we find that the low-income countries contain first observation figures for the low-income coun-
approximately 60 per cent of the world's popula- tries, and 100/100 when the 'high' -income figures
14 Introduction
are added. Plotting these distributions gives the prices. If we regard $1200 as only barely above
Lorenz curve shown. If historical data are avail- subsistence, the major part of present income
able, changes in the distribution of income disparities between developed and developing
through time can be shown. It is possible, how- countries must have arisen over the last century.
ever, that two (or more) Lorenz curves may cross, Some countries, through a combination of fortune
precluding a definite conclusion on whether the and design, have managed to grow much faster
distribution has narrowed or widened from a than others. The overriding influence has been
visual inspection of the curves alone. In this case a industrialisation and the technological progress
more precise measure of distribution is required. associated with it. The close association between
One measure is to express the area enclosed be- industrialisation and living standards spells out
tween the Lorenz curve and the 45° line as a ratio the clear policy message that to base a develop-
of the total area under the 45° line. This is the Gini ment policy on agricultural activities alone would
coefficient of distribution which varies from 0 be misguided, however attractive such aphorisms
(complete equality) to 1 (complete inequality). as 'back to the land' and 'small is beautiful' may
Calculation of this ratio for the world economy sound to those disillusioned with the recent in-
would give a Gini coefficient of approximately dustrialisation experience of the developing coun-
0.6. tries. Sutcliffe (1971) is right when.he argues:
There is little evidence that the distribution of
world income has been narrowing over time. Ac- It is understandable that vague memories of the
cording to Kuznets (1965, pp. 142-75), if Lorenz oppression of the working class in 19th century
curves are plotted for the years 1894, 1938 and Britain, the contemporary horrors of American
1949 there is no indication that the curves have machine-age society, and the Stalinist attack on
been shifting closer to the 45° line. Andie and the Russian peasantry, should arouse feelings
Peacock (1961) reach the same conclusion in a which are hostile to industrialisation. Yet to
comparison of 1949 and 1957. Their estimate of oppose machines altogether, like Gandhi, or to
the Gini ratio, taking 62 countries, is approxi- argue that a long run rise in the standard of
mately the same for both years (0.637 and 0.636, living is possible without industrialisation,
respectively). What this suggests is that while per are no more than forms of sentimentalism, es-
capita income may have been growing in the low- pecially when the condition of most of the
income countries, it must have been growing population of the non-industrialised world is
almost as fast in the high-income countries. This is now both terrible and worsening. It is not senti-
certainly true of the period since 1965 as column 4 mentalism to demand that the process of in-
in Table 1.2 indicates. Average per capita in- dustrialisation should be made as humane and
come growth in the developing countries has been as painless as possible and that the long term
2.5 per cent, and 2.4 per cent in the developed aims of equality at a higher standard of living
countries. should be constantly borne in mind as the pro-
It is easily forgotten that the rich-poor country cess goes on.
divide is a relatively recent phenomenon. All coun-
tries were once at subsistence level, and as recently The concentrated impact of industrialisation on
as 200 years ago, at the advent of the British living standards in the Western world is dramati-
industrial revolution, absolute differences in living cally emphasised by Patel's illustration (Patel
standards between countries on average cannot (1964)) that if 6000 years of man's 'civilised'
have been great. The average per capita income of existence prior to 1850 is viewed as a day, the last
the developing countries today is approximately century or so represents little more than half an
$1200 per annum and this was about the average hour; yet in this 'half-hour' more real output has
level of real per capita income in Western Europe been produced in the developed countries than in
in the mid-nineteenth century measured at current the preceding period. It is true .that living stan-
Development and Underdevelopment 15
t means total.
w means weighted average.
Source: World Development Report, 1992.
dards in the developing countries have been rising biguous. Since living standards in all countries
faster since 1950 than at any time in the past; but tend to rise absolutely over time, it obviously
so, too, have the living standards in the developed refers to the comparative position of poor coun-
countries, and the gap between rich and poor tries, but is the comparative position being measured
countries continues to widen. Although develop- taking absolute or relative differences in per capita
ment consists of more than a rise in per capita income? How should the 'development gap' be
incomes, income disparities are the essence of the assessed? Unfortunately there is no easy answer to
so-called 'development gap'. Let us examine the this question, yet the answer given has a profound
nature and magnitude of this gap more closely. bearing on the growth of per capita income that
poor countries must achieve either to prevent a
deterioration of their present comparative position
• The Development Gap or for an improvement to be registered. Relative
differences will narrow as long as the per capita
The statement that 'the rich countries get richer income growth rate of the developing countries
and the poor countries get poorer' has become a exceeds that of the developed countries; and this
popular cliche in the literature on world poverty, excess of growth is a precondition for absolute
but without ro.uch discussion of the facts or the differences to narrow and disappear in the long
precise magnitude of the development task facing run. In the short run, however, a narrowing of
the developing countries if the per capita income relative differences may go hand in hand with a
gap between rich and poor nations is to be nar- widening absolute difference, given a wide ab-
rowed. Indeed, the statement itself is not unam- solute gap to start with, and thus the rate of
Development and Underdevelopment 19
growth necessary to keep the absolute per capita tries, the top 20 per cent of the richest people in
income gap from widening is likely to be substan- the rich countries had incomes 150 times higher
tially greater than that required to keep the rela- than the incomes of the poorest 20 per cent of
tive gap the same. But suppose the relative gap people in poor countries.
does narrow, and the absolute gap widens, are the Now let us turn to the future comparative posi-
poor countries comparatively better or worse off? tion of the poor countries, and the magnitude of
There is a tendency in economics to measure the development task as far as more equitable
phenomena, especially dispersions of income, in world living standards are concerned. To avoid
relative rather than absolute terms - to compare the issue of whether strategy and assessment
differences in the rates of change of variables, as should be concerned with absolute or relative per
with Lorenz curves, rather than absolute differ- capita income differences, and to facilitate quanti-
ences. In comparing rich and poor countries, how- fication, matters will be made simple by assuming
ever, it is not difficult to argue that even if a that the desirable goal is to narrow and eliminate
relative per capita income gap is narrowed, the both the absolute and the relative gap. We shall
comparative position of the poor may have take as a target the average per capita income of
worsened because the absolute gap has widened. the industrialised countries and attempt to answer
Take for illustration the case of the average Indian four specific questions as reliably as the data will
living on the equivalent of $350 per annum com- allow:
pared with the average American living on ap-
1 Given the recent growth experience of the
proximately $22 000. Suppose the Indian's income
poor countries, how long would it take for
rises by 20 per cent and the American's income by
them to reach the current average level of per
10 per cent. The Indian is now relatively better off,
capita income in the industrialised countries?
but is he not comparatively worse off? The Ameri-
2 Given the recent growth experience of the
can's increased command over goods and services
poor countries relative to the industrialised
(i.e. 10 per cent of $22 000) far exceeds that of the
countries, how many years would it take for
Indian (i.e. 20 per cent of $350), and unless mar-
the per capita income gap to be eliminated?
ginal utilities differ radically, divergences in total
3 Given the rate of growth of the industrialised
utility and welfare will widen in favour of the
countries from now until the year 2010 (say),
American. On welfare grounds there would seem
how fast would the poor countries have to
to be a case for paying as much attention to
grow for per capita incomes to be equalised by
absolute differences in per capita income between
that date?
rich and poor countries as to rates of growth of
4 Given the rate of growth of the industrialised
per capita income.
countries, how fast would the poor countries
As it happens, both the absolute and the relative
have to grow merely to prevent the absolute
gap between rich and poor countries has widened
per capita income gap between rich and poor
in the last thirty years. Research by Dowrick
countries from being any wider in the year
(1992) shows that between 1960/64 and 1984/88,
2010 than now?
average per capita income growth in the rich coun-
tries was 2.49 per cent per annum; in the middle- By asking the first two questions some idea can
income countries 2.16 per cent per annum, and in be obtained of the time scale of the catching up
the poor countries 1.36 per cent per annum. There process by the poor countries given their recent
is no evidence of living standards converging in the growth performance. The answers to the latter
world economy. In 1960, the richest 20 per cent of two questions give some idea of the growth task
the world's population had incomes 30 times greater facing the poor countries in their struggle not only
than the poorest 20 per cent of the world's popula- for parity of living standards, but also in simply
tion. In 1990, this ratio was 60 times greater. preventing the absolute gap from widening.
Taking account of income inequality within coun- Given the basic data, the answers to the ques-
20 Introduction
tions posed involve little more than simple ma- The solution to the second question is obtained
nipulation of the formula for compound interest: from the expression:
s= p (1 + r)n
where P is the principal sum and S is the sum to from which we can find how long it would take (n)
which the principal grows at an annual rate of for the per capita income gap to be eliminated
growth, r, over n years. For illustration: between rich and poor countries, as long as the
Let YDt be the current level of per capita in- rate of per capita income growth in poor countries
come in the industrialised countries = $20 000; is greater than in the industrialised countries -
Y Dct be the current level of per capita in- otherwise, of course, the absolute gap would
come in the poor countries = $1200; widen for ever.
rDbe the per capita income growth rate in
the industrialised countries from 1990 to the year 1o gYDt
2010 = 3 per cent (say); --
YDct
rDe be the actual per capita income growth n = ------~~----
log(1 + rDc) - log(1 + rD)
rate in the poor countries = 2 per cent;
Y~ be the assumed level of per capita in-
A calculation can be made for any individual
come in the industrialised countries in the year
country whose average per capita income growth
2010 = $36 000 at today's prices (assuming 3 per
was in excess of that of the industrialised
cent growth);
countries. Korea, for example, has a per capita
and r~c be the required per capita growth
income of approximately $5000 and per capita
rate of the poor countries.
income has been growing at approximately 7 per
The solution to the first question is then obtained
cent per annum. How long would it take Korea at
from the formula:
this rate to catch up the present industrialised
countries growing at 3 per cent? The answer is:
the poor countries between the base period (1990) the assumed 3 per cent average growth rate of the
and the year 2010(n = 20) to equalise per capita industrialised countries.
incomes. All the above calculations are sensitive to the
assumed future growth rate of the industrialised
countries, the choice of the target year in the fu-
ture, and the base year level of per capita income
Applying the assumed magnitudes of the variables taken for the poor countries. No one can possibly
gtves: know with precision what the future rate of ad-
vance of the industrialised countries will be, and 3
r';;c = 20Y(36 000/1200) - 1 per cent per capita income growth - the historical
average from 1950 to 1990- would seem to be as
= 18 per cent
reasonable an assumption as any. But the lower
The required growth rate is 18 per cent per annum the growth rate, the less formidable the growth
and hardly feasible. The magnitude of the develop- effort of the poor countries to achieve parity of
ment task is clearly colossal if defined in terms of living standards. No special significance should be
achieving roughly comparable living standards attached to the year 2010 as the choice of target
throughout the world by the beginning of the next year. Some year has to be taken to make these
century. For most of the poor countries per capita 'catching up' calculations - not too close to the
income growth would have to increase six-fold, present to give no hope and not too far away for
necessitating a ratio of investment to national in- the goal to be lost sight of. As far as the base year
come of 50 per cent or more. Investment ratios of level of per capita income in the poor countries is
this order are simply not feasible, and in any case concerned, a note of caution is in order. To the
the countries themselves could not absorb such extent that income statistics invariably understate
investment. the value of production in poor countries (see
The solution to the fourth question is obtained later), the calculations of the catching-up time and
from the expression: the growth rate required for parity of living stan-
dards will be exaggerated. The degree of over-
estimation, however, is not likely to be so great as
to invalidate the conclusion that the growth rates
where the left-hand side represents the base level required for parity of living standards by the year
per capita income gap and n is 20 years. Solving 2010 are not feasible, and that on current growth
for the growth rate that would have to be achieved performance some countries will never catch up.
to prevent the present gap from widening gives: It can be argued, of course, that world income
equality is an impracticable ideal, and that the
primary aim is not equality of living standards
throughout the world but 'tolerable' living stan-
dards in all countries, which is a very different
Applying the assumed magnitudes of the variables
matter. The problem is to define 'tolerable' living
gtves:
standards, and especially to guarantee a reason-
ably equitable distribution of that average level of
r0 c = 20Y[36 000 - (20 000 - 1200)]/1200
real income. The time scale involved to reach
- 1 = 14 per cent 'tolerable' living standards is clearly less than that
required to eliminate the gap entirely, but even so,
This again is a growth rate not feasible, with the if the average level of per capita income now en-
implication that the per capita income gap be- joyed in the industrial countries is regarded as the
tween rich and poor countries will almost cer- tolerable level, we estimate it will take almost a
tainly be wider in the year 2010 than now, given century for the average poor country on current
22 Introduction
performance to attain it. Can these countries wait different stages of development. Perhaps the most
that long? amusing set is attributable to the Brazilian econ-
omist, Roberto Campos, who distinguishes five
great development potential. But bearing in mind stage implying any causal relation between the
the arbitrariness of per capita income, it is still characteristics of low-income countries and the
very convenient to have one readily available, and extent of their poverty or underdevelopment. Low
easily understandable, criterion for classifying per capita incomes do seem to go hand in hand
countries, and perhaps per capita income is the with such characteristics as high birth rates and an
best single index we have. It also has one positive absence of industry, but it is always dangerous to
advantage, namely that it focuses on the raison equate association with causation, and in this con-
d'etre of development, which is the raising of liv- text what is cause and what is effect cannot be
ing standards and the eradication of poverty. And deduced without adequate theorising. As Kuznets
in the last resort per capita income is not a bad (1961, p. 9) reminds us, 'it is easy to translate close
proxy for the social and economic structure of statistical association into significant causal rela-
societies. If developing countries are defined on the tionships ... [but] in view of the continuous
basis of a per capita income level so as to include interplay of income levels and these associated
most of the countries of Asia, Africa and South characteristics this simple translation is a logical
America, striking similarities are found between trap that should be avoided lest it lead to intellec-
the characteristics and development obstacles of tual sterility and to a dangerously mechanistic
many of the countries in these continents. These approach to policy implications'. A simple mecha-
characteristics include a high proportion of the nical argument ascribing poverty to such factors as
labour force engaged in agriculture and low agri- low savings and primary product production
cultural productivity, a high proportion of domes- ignores the fact that countries may be at different
tic expenditure on food and necessities; an export stages of their economic history and may differ
trade dominated by primary products and an im- radically with respect to past history and future
port trade dominated by manufactured goods; a prospects. In this respect, four main categories of
low level of technology; high birth rates coupled low-income countries need distinguishing: first,
with falling death rates; and savings undertaken those countries with low per capita incomes but
by a small percentage of the population. There which are progressing rapidly and with enormous
may, of course, be some countries which on a per future potential based on indigenous resources;
capita income basis are classified as developed and second, those countries with rising per capita in-
which possess most of the above-mentioned char- comes but with less hope of rapid self-sustaining
acteristics, but the exceptions will be few, and the growth because of resource limitations; third,
reverse of this situation is almost inconceivable. those countries rich in resources but with per capi-
Also these countries have many social problems in ta income still relatively stagnant; and last, those
common, such as growing unemployment in countries with a stationary per capita income and
urban areas; inegalitarian income distributions, with little prospect of raising living standards ow-
and poor health and standards of education - ing to a sheer lack of resources. A low-income
about which we shall say more later. In general, country may fall into any one of these four broad
therefore, we conclude that per capita income may categories and it would clearly be misleading,
be used as a starting-point for classifying levels of without further information, to ascribe low per
development, and can certainly be used for iden- capita income in a particular country at any par-
tifying the need for development. The only major ticular point in time to characteristics it shares
reservation that we shall have to make later con- with other low-income countries. Association be-
cerns the case of geographically dual economies tween low incomes and certain development char-
where an aggregate per capita income figure can acteristics is all that one is really entitled to claim.
disguise the need for the development of a sizeable There is a difference, however, between using
region as great as the need for the development of per capita income as a guideline for classifying
a country itself, e.g. southern Italy. countries into developed and underdeveloped at a
It should be emphasised that we are not at this point in time and using the growth of per capita
24 Introduction
income as an index of development over time. The other hand, development is hardly possible with-
difficulty of using per capita income for the latter out growth; but development is possible, as we
purpose is the obvious one that if, in a particular have suggested, without per capita income rising.
period, per capita income did not grow because It would be a strange, rather purposeless, type of
population growth matched the growth of a coun- development, however, which left per capita in-
try's total income, one would be forced into the come unchanged, unless the stationary per capita
odd position of denying that a country had de- income was only temporary and a strong founda-
veloped even though its national product had in- tion was being laid for progress in the future. For
creased. This is an inherent weakness of linking the ultimate rationale of development must be to
the concept of development to a measure of living improve living standards and welfare, and while
standards. an increase in measured per capita income may
This leads on to the distinction between growth not be a sufficient condition for an increase in
and development. Development without growth is individual welfare, it is a necessary condition in
hardly conceivable, but is growth possible without the absence of radical institutional innovations,
development? If per capita income is rejected as an such as the distribution of 'free' goods.
index of development over time, an answer to this An increase in income is not a sufficient condi-
question is not possible without defining terms tion for an increase in welfare, because an increase
more precisely. in income can involve costs as well as benefits. It
The difficulty is defining 'development'. The may have been generated at the expense of leisure
meaning of 'growth' is fairly unambiguous; most or by the production of goods not immediately
economists would accept the definition of a rise in consumable. If development is looked upon as a
real national income, i.e. a rise in money income means of improving the welfare of present genera-
deflated by an index of prices. But 'development' tions, probably the best index to take would be
is an elusive term meaning different things to differ- consumption per man-hour worked. This index, in
ent groups of social scientists. 1 Most would agree contrast to an index of per capita income, focuses
that development implies more than just a rise in directly on the immediate utility derivable from
real national income; that it must be a sustained, consumption goods in relation to the disutility of
secular rise in real income accompanied by work effort involved in their production.
I
changes in social attitudes and customs which
have in the past impeded economic advance (see
our earlier discussion). But at this point agreement The Measurement and
on what constitutes development would probably
end. But whatever definition of development is Comparability of Per Capita
given, growth is clearly possible without the Incomes
broader societal changes referred to. The upswing
of the trade cycle is the most obvious example of We turn now to the difficulties of measuring real
the possibility of growth without development, per capita income and comparing living standards
and examples of abortive 'take-offs' are not hard between countries. These difficulties cannot be
to find where countries have grown rapidly for a ignored any longer and must be continually borne
short time and then reverted to relative stagnation. in mind in using per capita income figures both for
Historically, Argentina is a case in point. On the classification purposes and for comparing the rate
of development in different countries over time.
1 For semantic entertainment on the meaning of 'development'
The difficulties of obtaining meaningful and accu-
and 'underdevelopment', see Machlup (1967). Machlup him- rate measures of real per capita income relate
self defines economic development as 'those changes in the use more to the measurement of real income than to
of resources that result in potentially continuing growth of
national income per head in a society with increasing or stable
population, and we shall thus concentrate briefly
population'. on some of the problems of national income
Development and Underdevelopment 25
accounting and the uses of national income stat- illiteracy rife, and in which many goods produced
istics in developing countries. and consumed do not exchange for money. Differ-
The first point to bear in mind is that if no ences in the extent of the subsistence economy
allowance is made for the non-monetary sector in between developing countries, and differences in
the national income accounts of a developing the ease and difficulty of collecting data, may
country, any long-term growth estimates are markedly influence estimates of national income,
bound to have an upward bias owing to the grad- and therefore of per capita income differences,
ual extension of the money economy and the shift between these countries and the rest of the world.
of economic activities from the household to Some testimony to the role that the subsistence
the market-place. Furthermore, if no allowance is sector must play in the economies of most de-
made for the subsistence sector in some countries, veloping countries is illustrated by the inconceiv-
it may be misleading to compare periods in these ability that 60 per cent of the world's population
countries' history and to compare growth rates could remain alive on the equivalent of $1200 per
between countries, especially between the de- annum. But this is not the whole story.
veloped and the developing countries. The other part of the story, and probably the
Growth rates may also be biased upwards by major part, concerns the understatement of living
using prices as weights in compiling national in- standards in developing countries when their
come totals from the output statistics of different national incomes measured in local currencies are
sectors of the economy (unless the weights are converted into US dollars (as the common unit of
revised frequently), since goods with high prices, account) at the official rate of exchange. If the US
which subsequently fall, are usually the fastest dollar is used as the unit of account the national
growing. This is more of a danger in developing income per head of country X in US dollars 1s
countries than in developed countries because given by
of less sophisticated accounting techniques, the
greater difficulty in revising price weights, and the GNPx
more widespread introduction of new goods with . -;- Exchange rate
Popu1atwn
high initial prices.
A consideration of prices is also necessary in For example, if the GNP of country X is 100
deciding what price index to use as a deflator of million rupees, its population is 5 million, and
money national income in order to obtain an in- there are 10 rupees to the dollar, then per capita
dex of real income. The task of converting money income of country X in dollars is:
income statistics into real income raises all the
difficulties, not peculiar to developing countries, 100 -;- 10 = $2.
connected with the use of index numbers, such as 5
which base year should be taken, how to take
account of changes in the quality of products, But if living standards between two countries are
which weighting system to employ, and so on. to be compared by this method, it must be
These are conceptual issues to be sorted out by the assumed that 10 rupees in country X can buy the
national income statistician rather than by the de- same living standard as $1 in the United States. It
velopment economist, but it is important for the is well known, however, that official exchange
economist to know how figures for real national rates between two countries' currencies are not
income, or per capita income, have been arrived at very good measures of purchasing-power parity
prior to analysis. between countries, especially between countries at
But apart from the problem of bias and the different levels of development. The reason is this:
choice of price deflator there is the sheer practical exchange rates are largely determined by the
difficulty of measuring money national income in a supply and demand for currencies based on goods
rural economy where communications are bad, which are traded, the prices of which tend to be
26 Introduction
equalised internationally. Purchasing-power par- where Q; is the geometric mean of the quantities of
ity, however, depends not only on the price of each good consumed in the two countries.
traded goods, but also on the price of non-traded The purchasing-power-equivalent ratio can then
goods which is largely determined by unit labour be used to convert one country's national income
costs, which tend to be lower the poorer the country. measured in local currency into another country's
In general, therefore, the lower the level of de- currency as the unit of account (e.g. the US dollar).
velopment the lower the ratio of the price of non- For example, suppose that the official exchange
traded goods to traded goods and the more the rate between the Indian rupee and the US dollar is
use of the official exchange rate will understate 10 : 1, while the purchasing-power-equivalent
the living standards of the developing country ratio is 5 : 1. This means that converting the
measured in US dollars. The ratio of the price of Indian national income into US dollars at the
non-traded goods to traded-goods tends to rise purchasing-power parity rate will give double
with development as wage levels in the non-traded the income than the conversion at the official ex-
goods sector rise while productivity growth is change rate.
relatively slow, and slower than in the traded The method described above is only one poss-
goods sector. To make meaningful international ible approach to the construction of a binary
comparisons of income and living standards, purchasing-power parity ratio. Instead of the rela-
therefore, what is required is a measure of tive prices being applied to the geometric average
purchasing-power parity, or a real exchange rate, of the quantities of each good consumed in the
between countries. two countries, the quantity weights could be the
There are several methods of constructing quantities consumed in either the one country
purchasing-power parity ratios in order to make or the other. If the quantity weights of the poor
binary comparisons (one country with another) or country are used, the dollar valuation of the poor
'multilateral' comparisons in which the currency country's income would probably be even higher
of any one of a group of countries can act as the because relatively large weights would be given to
unit of account without altering the ratios of living those items which are widely consumed in those
standards between countries. countries with low relative prices, therefore im-
One approach to the construction of a proving the purchasing-power parity ratio.
purchasing-power parity ratio between two coun- Alternatively comparisons can be made from
tries is to revalue the national incomes of the two the output side by valuing output in both countries
countries by selecting a comparable basket of goods either at one country's prices or at the other's
and services in each country and estimating the pnces.
purchasing-power equivalent of each item in coun- The results of constructing and using pur-
try A relative to country B. Thus if P;a is the price of chasing-power parity ratios for making binary
item i in country A and P;b is the price of item i in comparisons have been quite dramatic. In an early
country B, the purchasing-power equivalent of study, Millikan suggested that the real incomes of
item i in country A relative to country B is P;aiP;b· many African and Asian countries in 1950 were of
By extending this calculation to all goods, and the order of 350 per cent larger than indicated by
applying the price ratios to the average quantities UN statistics in US dollars per capita (Kindleber-
consumed of each item in the two countries, we ger (1965), p. 9). Likewise, Usher (1966, pp. 10-
obtain a formula for the over-all purchasing- 17) estimated the ratio of British to Thai national
power equivalent in country A relative to country income per head to be 13.06 : 1 converting Thai
B: income in local currency into pounds at the
foreign exchange rate. However, by-passing the
exchange rate and valuing British and Thai income
directly at Thai prices the ratio fell to 6.27: 1, and
valuing both incomes at British prices the ratio fell
Development and Underdevelopment 27
Table 1.3 Per Capita GDP in 1970 in $US Using Official Exchange Rates and in International $s Using
International Prices
to 2.76 : 1. In making binary international com- rates increases the estimate of per capita income
parisons of per capita incomes, therefore, it makes more than two-fold (e.g. in the case of Colombia
a great deal of difference whether the official and India).
foreign-exchange rate is used as a measure of Purchasing power parities can be derived from
purchasing-power parity, or, if the use of ex- the table in the following manner. The purchasing
change rates is discarded, which quantity weights power parity rate (PPPR) is equal to the official
are applied to relative price indices or which price exchange rate divided by the extent to which the
weights are applied to relative quantities. official exchange rate conversion of per capita
More recently, Irving Kravis and collaborators income understates the true level of per capita
have developed a method of making multilateral income when measured at international prices.
comparisons of real per capita incomes across Suppose, for example, there are 7 Kenyan shillings
countries by constructing world price ratios based to one US dollar, and that the official exchange
on price and quantity data for over 100 com- rate conversion understates Kenyan per capita in-
modity categories in over 100 countries. The inter- come by 90 per cent (which it does according to
national prices are then used to value quantities in Table 1.3). The PPPR of Kenyan shillings to $US is
each of the countries. The international prices and therefore PPPR = 7/1.9 = 3.7. That is, to compare
product values are expressed in international dol- living standards between Kenya and the US, the
lars (1$). An international dollar has the same real exchange rate of 3.7 ought to be used, not the
overall purchasing power as a US dollar for official rate of 7 shillings to the dollar.
national income as a whole, but relative prices for The pioneer work of Kravis is now regularly
each country are relative to average world prices extended and updated by his collaborators, Sum-
rather than relative to US prices. This multilateral mers and Heston, who produce international com-
approach allows a direct comparison between any parisons of price levels and real per capita incomes
two countries using any country's currency as the at international prices for all major countries in
unit of account. The results of this exercise for ten the world since 1950, which can be compared
countries originally taken by Kravis et al. ((1975); with the World Bank estimates of per capita in-
see also Kravis et al. (1978)) are summarised in comes based on official rates of exchange with the
Table 1.3. It can be readily seen that converting US dollar (see, for example, Summers and Heston
some of the poor countries' incomes at inter- (1988)).
national prices rather than at official exchange Before ending this section it should be stressed
28 Introduction
that purchasing-power parity ratios, however de- head; annual number of domestic letters sent per
rived, should not be interpreted as equilibrium head; stock of radio receivers per head; stock of
exchange rates to be used as a standard for telephones per head; stock of road vehicles per
measuring the extent to which the official ex- head; and annual meat consumption per head.
change rate may be either under- or over-valued. Predictions are made by Beckerman and Bacon for
As we have said before, exchange rates are deter- eighty countries, and the countries ranked. Unfor-
mined by the supply of and demand for traded tunately there is no indication given of the extent
goods, while many goods not traded figure in the to which the ranking of countries by this method
purchasing-power parity ratios. differs from the ranking by published per capita
Apart from the construction of purchasing- income statistics. If the rankings differ substan-
power parity ratios there have been several other tially, it may be that the Beckerman-Bacon approach
attempts to overcome the problems of using sus- is the most appropriate to adopt for obtaining a
pect income statistics to compare living standards measure of comparative levels of welfare between
between countries and over time. One consists of countries as measured by consumption per head. If
the use of non-monetary indicators, such as levels the rankings do not differ markedly, income per head
of health and education, the number of cars per may still be regarded as a good proxy for the com-
head, steel production, etc., and to rank countries parison of living standards. (This is the conclusion of
according to an index of each indicator (United Hagen and Hawrylyshyn (1969).)
States = 100). The indices of all indicators are
then averaged. However, this approach suffers
from the drawback that there is no satisfactory
weighting system that can be used for combining
I Other Dimensions of the
Development Gap
the different indices. An alternative approach has
been suggested by Beckerman and Bacon (1966) The human problems of developing countries are
which they claim to be 'theoretically valid, poten- not confined to low levels of per capita income.
tially very accurate, and at the same time, almost Developing countries generally experience much
costless'. The approach is based on correlation higher levels of unemployment - open and dis-
and regression analysis. Their procedure is as fol- guised - than do developed countries; their
lows. First, they take reliable estimates of relative income distributions tend to be much more in-
(to the United States) real consumption per head egalitarian, and the levels of health, nutrition and
for thirteen countries. Then they take several non- education are often abysmally low. Policy in
monetary indicators and pick out those that corre- developing countries is becoming increasingly
late best with the reliable observations of real concerned with these other dimensions of the de-
consumption per head, experimenting with differ- velopment gap. The growth of per capita income
ent functional forms. Finally, with the aid of a has never been the sole objective of development
computer they find which combination of indica- policy but more attention is now being paid to
tors, and which forms of the equations linking other objectives which in some instances may con-
them to real consumption per head, give the best flict with growth of per capita income.
results in terms of the multiple correlation coef-
ficients and the standard errors of the regression
equations. From the best results, predictions can • Unemployment
be made of relative consumption per head for
countries, where data on income per head are Open unemployment in the urban areas of de-
thought to be unreliable, from the non-monetary veloping countries is another dimension of the
independent variables. The variables used as pre- development problem, and an increasingly serious
dictors were as follows: annual crude steel con- one. The reduction of unemployment has become
sumption per head; annual cement production per a major policy priority of governments and inter-
Development and Underdevelopment 29
Africa:
Egypt 1.9a 2.4 2.5 5.2
Middle East:
Syria 7.4 6.4 4.8 3.8b
Asia:
S. Korea 7.4 4.5 4.1 5.2 4.6 4.4
Philippines 8.2 6.0 4.4 4.8 5.1 5.3
Latin America and Caribbean:
Argentina 5.3 4.8 2.3 2.3 4.5 5.7
Chilec 5.4 4.1 15.0 10.4 11.3 20.0
Colombiad 8.9 8.2 10.5 9.9 8.1
Panama 7.6 7.1 6.4 8.8e
Peruf 4.7 4.9 7.0 6.8 7.0
Trinidad and Tobago 14.0 12.5 15.0 10.0 12.2
Uruguayg 7.2h 7.5 8.1i 7.3 6.6
Venezuelai 7.7k 6.3 7.6 1 6.0 6.2 7.1
• 1964, b 1979, c Gran Santiago, d Bogota, e 1979, 1 Lima Callao, 8 Montevideo, h 1967, ' 1974, i urban, k 1967, 1 1976.
Source: M. Godfrey, Global Unemployment: The New Challenge to Economic Theory (Brighton: Wheatsheaf Books, 1986).
national agencies concerned with developing lack of co-operating factors of production to work
countries. Poor countries for a long time, and par- with labour: capital in particular. As far as migra-
ticularly since the population explosion, have been tion is concerned, there are both push and pull
characterised by underemployment, or disguised factors at work. The push factors have to do with
unemployment (see Chapter 3), on the land. What the limited job opportunities in rural areas, and
has happened in recent years is that disguised un- the greater willingness and desire to move fostered
employment on the land has transferred itself into by education and the improvements in com-
open unemployment in the towns. The reasons for munications. The pull factors relate to the de-
this, and the rationale for migration, will be consi- velopment of industrial activities in the towns
dered later, but first let us outline the facts. Some offering jobs at a higher real wage than can be
idea of the seriousness of unemployment is given earned in rural areas, so that even if a migrant is
by the figures in Table 1.4 for a selection of de- unemployed for part of the year, he may still be
veloping countries. The figures are not so different better off migrating to the town than working in
from unemployment rates recorded in some de- the rural sector. If there is no work at all in the
veloped countries in the 1980s, but the recorded rural sector, the migrant loses nothing, except
figures measure only the tip of the iceberg. perhaps the security of the extended family sys-
There are a number of contributory factors to tem. The rate of growth of job opportunities in the
the emergence of unemployment in the towns on rural sector depends on the rate of growth of
an increasing scale. The problem is not so much demand for the output of the rural sector and
one of a deficiency of demand for labour in an the rate at which jobs are being 'destroyed' by pro-
aggregate demand sense. The causal factors relate ductivity growth. 1 The growth of demand for the
to the incentives to labour migration from the 1 i.e. since 0 = L(OIL), then dLIL = dOlO- d(OIL)I(OIL),
rural to the urban areas, and the incapacity of the where L is employment, 0 is output and OIL is labour pro-
urban areas to provide employment owing to a ductivity.
30 Introduction
output of the rural sector will be equal to the rate necessarily solved by a faster rate of capital ac-
of growth of total population plus the rate of cumulation in the urban sector, because migration
growth of per capita income multiplied by the is not simply a function of the actual difference in
income·elasticity of demand for rural output. Sup- real remuneration between the two sectors, but
pose population is growing at 2 per cent, that per also of the level of job opportunities in the urban
capita income is growing at 4 per cent and that the sector. If the rate of job creation increases, this
income elasticity of demand is 0.5, then the rate of may merely increase the flow of migrants with no
growth of demand for the rural sector's output reduction in unemployment. The solution would
will be 2.0 + 0.5 (4.0) = 4.0 per cent. Now seem to be to create more job opportunities in the
suppose that the rural sector's productivity is rural sector. This will require, however, not only
growing at 2 per cent. The rate of growth of the redirection of investment but also the exten-
demand for labour will then be the difference be- sion of education and transport facilities, which in
tween 4 per cent and 2 per cent, i.e. 2 per cent. If the past few years have themselves become power-
the rural-sector labour force is growing at 3 per ful push factors in the migration process. Whereas
cent, then 1 per cent of the labour force will be formerly redundant labour might have remained
becoming redundant annually. If the level of dis- underemployed on the family farm, nowadays
guised unemployment in the rural sector were not education and easy transportation provide the
to increase, this figure would constitute the poten- incentive and the means to seek alternative
tial volume of migrants. If the urban labour force employment opportunities. While education and
is only one-fifth of the size of the rural labour improved communications are desirable in them-
force, a 1 per cent migration of rural labour would selves, and facilitate development, their provision
represent a 5 per cent increase in the urban labour has augmented the flow of migrants from rural to
force due to migration. On average, this is about urban areas.
the extent of the influx from the rural sector into The pull factors behind migration are not hard
the urban areas of developing countries. On top of to identify. The opportunities for work and leisure
this there is the natural increase in the work-force provided by the industrial, urban environment
in the urban area to consider; this is of the order of contrast sharply with the conservatism and stul-
between 2 and 3 per cent. If job opportunities in tifying atmosphere of rural village life and act
the urban areas are only increasing at 5 per cent, naturally as a magnet for those on low incomes or
then 2 to 3 per cent of the urban labour force will without work, especially the young. Given the
become unemployed annually, thus raising the un- much higher wage in the urban sector, even the
employment percentage year by year. prospect of long spells of unemployment in
Historically, the process of development has the urban area does not detract from the incentive
always been associated with, and characterised by, to migrate. Moreover, the choice is not necessarily
an exodus from the land, continuing over centuries. between remaining in the rural sector and migrat-
The uniqueness of the present situation is not ing to the urban sector with the prospect of long
the migration itself but its magnitude and speed. periods of unemployment. The unemployed in the
And the problem is that the urban sector cannot urban sector can often find work, or create work
absorb the numbers involved. For any given tech- for themselves, on the fringes of the industrial
nology the rate at which the urban (industrial) sector - in particular in the informal service sector
sector can absorb migrants largely depends on the of the industrial economy. The wages may be low,
rate of capital formation. If labour and capital but some income is better than no income. In other
must be combined in fixed proportions, and the words, unemployment in urban areas may take the
rate of capital accumulation is only 5 per cent, form of underemployment, or become disguised,
then the rate of increase in job opportunities can just as in the case of the rural sector - its mani-
be only 5 per cent also. Unfortunately, however, as festation being low income. This has led to the
we shall show in Chapter 3, the problem is not notion of an income measure of unemployment
Development and Underdevelopment 31
which needs to be added to registered unemploy- gramme sponsoring missions to several countries
ment to obtain a true measure of unemployment to undertake detailed diagnosis of the employment
and the availability of labour supply. problem. Some of the major findings and conclu-
One way of measuring the extent of unemploy- sions have been surveyed by Thorbecke (1973).
ment disguised in the form of low-productivity/ The report on Colombia estimated that an em-
low-income jobs is to take the difference between ployment growth rate of 7 per cent per annum
the actual labour employed at the sub-standard would be required to absorb all increases in the
income and the labour that would be required to labour force. Since the projected rate of growth of
produce a given level of output or service at an labour productivity would make this impossible,
acceptable level of income per head. Before the report recommended a move to more labour-
measurement took place, of course, the acceptable intensive techniques, at least in the industrial sec-
(standard) level of income would have to be de- tor. The report on Kenya emphasised the income
fined. It could be that level set as the 'poverty line', measure of unemployment discussed above. It
below which health and welfare become seriously drew attention to the large number of people
impaired. The income measure of unemployment forced to work in the informal sector of the indus-
would thus be: trial sector with extremely low productivity, such
that income falls below an acceptable minimum.
0 0 Visible (open) unemployment was estimated at be-
U = L- L* tween 8 and 14 per cent. Adding low-income
OIL OIL*
workers in the manner described above, the per-
centage rises to 20 per cent for males and 50 per
where L is the actual labour employed, L * is the
cent for females. The report on Iran gave priority
labour consistent with an acceptable level of in-
to population control (which we discuss in Chap-
come per person employed, OIL is the actual level
ter 6) but, as it reputably said in the draft of the
of productivity, OIL* is the acceptable level of
report, the· population problem cannot be solved
income per employed person, and 0 is output.
overnight! The report on Sri Lanka is distinctive
Let us work an example. Suppose that the
for its thorough analysis of structural unemploy-
annual flow of output of an activity or service is £1
ment. There are three main types of structural
million and that the existing number employed is
imbalance in most developing countries which
10 000, giving a level of productivity of £100.
affect employment. One is between skills, attitudes
Now suppose that the acceptable level of pro-
and expectations on the one hand and oppor-
ductivity to produce an acceptable level of income
tunities on the other. This affects mainly educated
per person employed is £200. The income measure
people. Second, there is imbalance between re-
of unemployment is then:
gions. Third, there is the sheer lack of co-operating
factors for labour to work with, particularly capit-
u= 1 000 000 1 000 000 = 5000 al and skilled managerial enterprise. We take up
100 200 some of these difficulties in later chapters.
taken place has served largely to benefit the few - income. The data show fairly conclusively that
the richest 20 per cent of the population. Rural inequality increases up to a certain stage of de-
and urban poverty are still widespread, and if velopment and then declines, tracing out an in-
anything the degree of income inequality within verted U-shape similar to the pioneer work of
the developing countries has increased. It should Kuznets for the now developed countries. The
not come as a surprise, however, that the trans- average Gini coefficient for forty-three developing
formation of economies from a primitive subsist- countries is 0.467 compared with 0.392 for thir-
ence state into industrial societies, within a basically teen developed countries. The maximum equalisa-
capitalist framework, should be accompanied in the tion percentage is 35.8 for the developing countries
early stages by widening disparities in the personal compared with 28.4 for the developed countries.
distribution of income. Some people are more in- The greater degree of income inequality in the
dustrious than others, and more adept at accumu- developing countries appears largely due to the
lating wealth than others. Opportunities cannot, higher share of income received by the richest 5
in the very nature of things, be equal for all. In the per cent of income recipients. In developing coun-
absence of strong redistributive taxation, income tries this share is 28.7 per cent, compared with
inequality will inevitably accompany industrialisa- 19.9 per cent in developed countries. The share
tion because of the inequality of skills and wealth going to the poorest 20 per cent in developing
that differences in individual ability and initiative, countries is slightly higher than in the developed
and industrialisation, produce. countries, but there can be no comfort in this fact.
The evidence for individual countries suggests, The focus must be on absolute, as well as relative,
however, that income inequality ceases to increase poverty; and the poorest in countries with average
at quite low levels of per capita income - at about per capita incomes less than $1000 per annum
$300 per annum at 1965 prices, or at about $1500 must be very poor indeed. On average, the per
at 1992 prices. Beyond this level, income in- capita income of the poorest 20 per cent of the
equality tends to decrease as industrialisation pro- population in the typical developing country is
ceeds. Kuznets's work (1955, 1963) shows that in about 30 per cent of the national average. As we
many of the present developed countries, the ex- said earlier in the chapter, there are about 600
tent of inequality decreased in the later stages of million people living on per capita incomes of less
industrialisation, and certainly the degree of in- than $275 per annum at 1985 prices: 50 million in
equality in the developing countries is greater than Latin America; 450 million in Asia, and 100 mil-
in the present developed countries, largely as a lion in Africa.
result of the heavy concentration of income among Several formidable barriers exist to raising the
the top 5 to 10 per cent of income recipients. The living standards of the poorest, and to narrowing
work of Kravis (1960) also shows that the degree the income distribution overall. There is the dualistic
of inequality first increases within countries and nature of many economies (see Chapter 5), perpetu-
then declines. ated by feudal land-tenure systems and urban bias
The most comprehensive data assembled to in the allocation of investment resources. There is
date are those by Adelman and Morris (1971), and inequality in the distribution of education facilities
extended by Paukert (1973), which show the size to contend with, particularly the lack of facilities
distribution for fifty-six countries, developed and in rural areas where the poorest are concentrated.
developing (see Table 1.5). The table also shows Third, there is disguised unemployment on the
two measures of income concentration calculated land and underemployment and open unemploy-
from these figures - the Gini coefficient and the ment in urban areas created by rural-urban migra-
maximum equalisation percentage, which indi- tion, a shortage of investment resources, and
cates what percentage of total income would have inappropriate technological choices. Until de-
to be shifted between the quintiles of income reci- velopment policy comes to grips with these prob-
pients in order to achieve an equal distribution of lems, there will continue to be large pockets of
Development and Underdevelopment 33
Table 1.5 Size Distribution of Personal Income Before Tax in Fifty-Six Countries: Income Shares Received by
Quintiles of Recipients in the Neighbourhood of 1965
Under $100
Chad (1958) 8.0 11.6 15.4 22.0 20.0 23.0 0.35 25.0 68
Dahomey (1959) 8.0 10.0 12.0 20.0 18.0 32.0 0.42 30.0 73
Niger (1960) 7.8 11.6 15.6 23.0 19.0 23.0 0.34 25.0 81
Nigeria (1969) 7.0 7.0 9.0 16.1 22.5 38.4 0.51 40.9 74
Sudan (1969) 5.6 9.4 14.3 22.6 31.0 17.1 0.40 30.7 97
Tanzania (1964) 4.8 7.8 11.0 15.4 18.1 42.9 0.54 41.0 61
Burma (1958) 10.0 13.0 13.0 15.5 20.3 28.2 0.35 28.5 64
India (1956-7) 8.0 12.0 16.0 22.0 22.0 20.0 0.33 24.0 95
Madagascar (1960) 3.9 7.8 11.3 18.0 22.0 37.0 0.53 39.0 92
Group average 7.0 10.0 13.1 19.4 21.4 29.1 0.419 31.6 78.3
$101-200
Morocco (1965) 7.1 7.4 7.7 12.4 44.5 20.6 0.50 45.4 180
Senegal (1960) 3.0 7.0 10.0 16.0 28.0 36.0 0.56 44.0 192
Sierra Leone (1968) 3.8 6.3 9.1 16.7 30.3 33.8 0.56 44.1 142
Tunisia (1971) 5.0 5.7 10.0 14.4 42.6 22.4 0.53 44.9 187
Bolivia (1968) 3.5 8.0 12.0 15.5 25.3 35.7 0.53 41.0 132
Ceylon (Sri Lanka) (1963) 4.5 9.2 13.8 20.2 33.9 18.4 0.44 32.5 140
Pakistan (1963-4) 6.5 11.0 15.5 22.0 25.0 20.0 0.37 27.0 101
South Korea (1966) 9.0 14.0 18.0 23.0 23.5 12.5 0.26 19.0 107
Group average 5.3 8.6 12.0 17.5 31.6 24.9 0.468 37.2 147.6
$201-300
Malaya (1957-8) 6.5 11.2 15.7 22.6 26.2 17.8 0.36 26.6 278
Fiji (1968) 4.0 8.0 13.3 22.4 30.9 21.4 0.46 34.7 295
Ivory Coast (1959) 8.0 10.0 12.0 15.0 26.0 29.0 0.43 35.0 213
Zambia (1959) 6.3 9.6 11.1 15.9 19.6 37.5 0.48 37.1 207
Brazil (1960) 3.5 9.0 10.2 15.8 23.1 38.4 0.54 41.5 207
Ecuador (1968) 6.3 10.1 16.1 23.2 19.6 24.6 0.38 27.5 202
El Salvador (1965) 5.5 6.5 8.8 17.8 28.4 33.0 0.53 41.4 249
Peru (1961) 4.0 4.3 8.3 15.2 19.3 48.3 0.61 48.2 237
Iraq (1956) 2.0 6.0 8.0 16.0 34.0 34.0 0.60 48.0 285
Philippines (1961) 4.3 8.4 12.0 19.5 28.3 27.5 0.48 35.8 240
Colombia (1964) 2.2 4.7 9.0 16.1 27.7 40.4 0.62 48.0 275
Group average 4.8 8.0 11.3 18.1 25.7 32.0 0.499 38.5 244.4
$301-500
Gabon (1960) 2.0 6.0 7.0 14.0 24.0 47.0 0.64 51.0 368
Costa Rica (1969) 5.5 8.1 11.2 15.2 25.0 35.0 0.50 40.0 360
Jamaica (1958) 2.2 6.0 10.8 19.5 31.3 30.2 0.56 41.5 465
Surinam (1962) 10.7 11.6 14.7 20.6 27.0 15.4 0.30 23.0 424
Lebanon (1955-60) 3.0 4.2 15.8 16.0 27.0 34.0 0.55 41.0 440
Barbados (1951-2) 3.6 9.3 14.2 21.3 29.3 22.3 0.45 32.9 368
Chile (1968) 5.4 9.6 12.0 20.7 29.7 22.6 0.44 33.0 486
Mexico (1963) 3.5 6.6 11.1 19.3 30.7 28.8 0.53 39.5 441
Panama (1969) 4.9 9.4 13.8 15.2 22.2 34.5 0.48 36.7 490
Group average 4.5 7.9 12.3 18.0 27.4 30.0 0.494 37.6 426.9
34 Introduction
Table 1.5 Size Distribution of Personal Income Before Tax in Fifty-Six Countries: Income Shares Received by
Quintiles of Recipients in the Neighbourhood of 1965 (continued)
$501-1000
Republic of South Africa (1965) 1.9 4.2 10.2 26.4 18.0 39.4 0.58 43.7 521
Argentina 7.0 10.4 13.2 17.9 22.2 29.3 0.42 31.5 782
Trinidad and Tobago (1957-8) 3.4 9.1 14.6 24.3 26.1 22.5 0.44 32.9 704
Venezuela (1962) 4.4 9.0 16.0 22.9 23.9 23.2 0.42 30.6 904
Greece (1957) 9.0 10.3 13.3 17.9 26.5 23.0 0.38 29.5 591
Japan (1962) 4.7 10.6 15.8 22.9 31.2 14.8 0.39 28.9 838
Group average 5.1 8.9 13.9 22.1 24.7 25.4 0.438 32.9 723.3
$1001-2000
Israel (1957) 6.8 13.4 18.6 21.8 28.2 11.2 0.30 21.2 1243
United Kingdom (1964) 5.1 10.2 16.6 23.9 25.0 19.0 0.38 28.1 1590
Netherlands (1962) 4.0 10.0 16.0 21.6 24.8 23.6 0.42 30.0 1400
Federal Republic of
Germany (1964) 5.3 10.1 13.7 18.0 19.2 33.7 0.45 32.9 1667
France (1962) 1.9 7.6 14.0 22.8 28.7 25.0 0.50 36.5 1732
Finland (1962) 2.4 8.7 15.4 24.2 28.3 21.0 0.46 33.5 1568
Italy (1948) 6.1 10.5 14.6 20.4 24.3 24.1 0.40 28.8 1011
Puerto Rico (1963) 4.5 9.2 14.2 21.5 28.6 22.0 0.44 32.1 1101
Norway (1963) 4.5 12.1 18.5 24.4 25.1 15.4 0.35 24.9 1717
Australia (1966-7) 6.6 13.4 17.8 23.4 24.4 14.4 2.30 22.2 1823
Group average 4.7 10.5 15.9 22.2 25.7 20.9 0.401 29.0 1485.2
absolute poverty and a marked degree of inequal- countries have a comparatively equal income dis-
ity in income distribution. In deciding on the tribution while many of the slowest growing coun-
allocation of investment resources and the choice tries have a high degree of income inequality. It
of projects, a high weight needs to be given to appears that income inequality is not necessary for
projects which raise the income of the poorest in high levels of saving and investment or other fac-
the income distribution (see Chapter 8). Fortu- tors that contribute to fast growth.
nately, evidence from the World Bank does not
suggest that growth and equity necessarily con-
flict. If anything, countries with a greater degree of • Growth and Distribution
equality have grown fastest. This is shown in Fig-
ure 1.2 opposite where the growth of income per Progress towards achieving the twin objectives of
head is measured on the vertical axis, and income faster growth and a more equal distribution of
inequality is measured on the horizontal axis, and income can be examined simultaneously by con-
it can be seen that many of the fastest growing structing poverty-weighted indices of growth.
Development and Underdevelopment 35
Figure 1.2 Income Inequality and Economic Growth The idea of constructing poverty weighted in-
dices of growth is to give at least equal weight to
Percentage GOP growth per head, 1965-89
all income groups in society, if not a greater
8
weight to the poor, in order to obtain a better
7 measure of the growth of overall welfare combin-
ing the growth of income with its distribution.
6 In the above example, for instance, if each
group is given an equal weight of one-third, the
5 measured growth of welfare becomes:
4
% growth of 'welfare' = 1(0.33) + 1(0.33)
+ 10(0.33) = 4%
2 which is much less than the rate of growth shown
by the conventional measure of GNP growth when
distributional considerations are taken into
account.
0
A society could go further and say it places no
-1 value or weight on income growth for the richest
0 5 10 15 20 25 30 35 40 45 third of the population, and places all the weight
Income inequality on the lower income groups with, say, a 60 per
The mulliple of the income of the richest 20% cent weight to the bottom third and a 40 per cent
to the income of the poorest 20% weight to the middle third. The growth of 'wel-
Source: World Development Report 1991. fare' would then look derisory:
Agriculture Organisation that there are at least portant for brain development in the first three
one billion people in the world suffering from years of life, during which the brain grows to 90
various degrees of malnutrition, including two- per cent of its full size. Brain damage due to pro-
thirds of the world's one billion children. Mal- tein deficiency is irreversible.
nutrition among children is particularly serious
because it stunts growth and mental development,
and adds another element to the vicious circle of
poverty. Malnutrition is also a major cause of
I Poverty, Famine and
Entitlements
infant mortality, the rates of which are more than
twice as high in developing countries as in de- Malnutrition is caused by a lack of access to food,
veloped countries. The costs of treating various but this does not only depend on the availability of
forms of malnutrition are trivial relative to the food; it also depends on people's entitlement to
tangible benefits, and to the costs of treating the food. Vast sections of the population may go short
consequences. To prevent malnutrition in children of food, and experience famine conditions, not
from the age of six months to three years, which is primarily because food has become scarce, but
a child's most vulnerable period, can cost as little because their entitlement to food has been im-
as $50 at current prices. The annual cost of pre- paired. This is the powerful thesis put forward by
venting malnutrition is about the same as the daily Professor Sen (1984), who argues that to under-
cost of treating its effects. Vitamin A deficiency is a stand poverty and starvation, or malnutrition
cause of blindness. The annual cost of supporting associated with it, it is necessary to understand
a blind person is at least 1000 times the annual both ownership patterns and exchange entitle-
ingredient cost of the vitamin A needed for preven- ments, which requires in turn an understanding of
tion. Iodate deficiency is a cause of goitre, which modes of production and the class· structure. He
leads to cretinism and deaf-mutism. The cost of attempts to document the theory drawing on the
iodate to prevent goitre is one-sixth of a cent per experience of major famines such as the Great
person per year. And so one could go on. Preven- Bengal famine of 1943; the Ethiopian famine of
tion is better than cure not only for the individual 1973-5; the famine in the Sahel region of Africa in
but also in a very real economic sense for the the early 1970s, and the Bangladesh famine of
welfare of society as a whole. 1974. It seems that some of the worst famines
The relation between low-income and food in- occurred with no significant fall in food avail-
take is two-way. Low income is a cause of mal- ability per head.
nutrition. Malnutrition in turn is a cause of low What does the entitlement to food depend on?
income by impairing working efficiency and pro- Above all, it depends on the ability of individuals
ductivity. All too little is known about the second to exchange productive resources and goods for
relationship. But we do know that the food re- food. This depends in turn on such factors as the
quirements considered by nutritionists to be neces- ownership and employment status of individuals
sary for efficient working and healthy living are far (for example, whether they are owners of land,
greater than the levels achieved by a large minority labourers, peasant farmers, sharecroppers, etc.);
of the population in developing countries. Calorie productivity; non-working income in the form of
deficiency causes loss of body weight, tiredness, subsidies and transfer payments; and on the terms
listlessness, and a deterioration of mental faculties. of trade between food and other goods. Exchange
Calories are also required for the absorption of entitlements may deteriorate independently of a
protein which is otherwise used up for energy. general decline in the supply of food which raises
Protein deficiency causes such conditions as its price and worsens the terms of trade for other
kwashiorkor (the bloated stomachs and staring goods. Job opportunities may diminish; real wages
eyes we see on our television screens), which may or productivity may fall, and other people may
cause death in children. Protein is particularly im- become better off and demand more food. During
Development and Underdevelopment 3 7
the Great Bengal famine of 1943, 3 million people kept pace with population growth and there has
died, yet in terms of the total availability of food been no margin of safety or very little provision
grains, 1943 was not a subnormal year. Starvation for improving the distribution of food supplies. A
occurred because food entitlements shrunk as a dangerous dependence has grown up on North
result of first, a rise in the price of food due to America and the EEC. In 1972, for the first time
military procurement, secondly, because the price since the war, world food production actually fell.
of other commodities fell as more monetary de- In 1973 the world was threatened with a food
mand was switched to food, and thirdly, because crisis. Stocks of wheat amounted to only four
of a fall in the output of other goods. Because of weeks of world consumption. A crop failure in just
their ownership position, however, those in rural one major producing area would have spelt disas-
areas suffered less than the urban poor. The ab- ter. Disaster was averted by reasonably good
sence of famine in China and other socialist coun- weather and harvests. But the situation is still pre-
tries is not so much the result of increases in food carious and malnutrition persists. It is an intoler-
production per head, but the result of a shift in the able situation that year in and year out, at the end
entitlement system through guaranteed employ- of the twentieth century, millions of people should
ment and social security provisions. have their very lives threatened by the vagaries of
The policy message is that the alleviation of the weather, or by sudden political upheavals
famine requires the establishment and preserva- which impair their ability to import food. How
tion of adequate entitlements to food, not simply has this precarious situation arisen? The answer is
the provision of more food - important as that simple enough: through the neglect of agriculture.
may be. Public action requires programmes of If blame is to be apportioned it must lie jointly
food security which guarantee that people have with the international development agencies and
access to enough food at all times, and nutrition the developing countries themselves. In the early
programmes working through clinics targeted par- 1950s the developing countries saw industrialisa-
ticularly at children and pregnant women. 1 tion as the road to development and starved agri-
culture of resources. International development
agencies supported industrialisation plans and
• Food Production rarely lent money for agricultural projects. Tech-
nically, it is well within the world's grasp to in-
At the global level the problem of nutrition, and of crease agricultural production on an immense
food supply to those who need it, is also essentially scale. What is required is the initiative and politi-
a distribution problem. It is not a capacity prob- cal will, both within the international community
lem in the sense that the world is physically incap- and the developing countries, to make the radical
able of producing enough food to feed its changes necessary. As far as the international com-
inhabitants adequately. Since the Second World War munity is concerned, it could increase its foreign
global food production has generally kept pace aid for agricultural projects, especially where this
with population growth, and the world is prob- could lead to a significant breakthrough in agri-
ably capable of feeding itself ten times over if need cultural production. For example, the investment
be. The worrying factor that needs to be stressed, of $3 billion to eliminate the tsetse fly in infested
however, is that most of the increase in world food areas of tropical Africa could open up seven mil-
production that has taken place in recent years has lion square kilometres to livestock and crop pro-
been in the granary of North America. Food pro- duction. There must also be genuine international
duction in the developing countries has barely co-operation and agreement to guarantee world
food supplies. One possibility would be to have a
1 See the work of Dreze and Sen (1989) for the hunger and
system of granaries strategically placed across the
poverty project of the World Institute for Development Econ- world under international supervision, which
omics Research (WIDER). could store the food surpluses of the 'north' and
38 Introduction
release them at time of need. This in no way need to low life expectancy and a high incidence of
preclude or hinder the fundamental agricultural infant and child mortality. Tables 1.6 and 1.7
reforms that everyone recognises are necessary in present some selected statistics showing changes in
many of the poorer countries in Africa and else- the level of food production per head; daily per
where if there is to be self-sustaining growth. The capita calorie intake as a percentage of require-
desirability of a development policy based on ments, and various health-related indicators in-
a healthy agricultural sector is emphasised in cluding the number of people that share a doctor,
Chapter 3. the percentage of the population with access to
Lack of adequate food supply and nutrition, safe water, life expectancy at birth and rates of
combined with rudimentary health facilities, leads infant and child mortality.
Table 1.6 Health Related Indicators: Food Production, Calorie Intake and Doctors
Average index of
food production Daily calorie supply Population per
per capita (per capita) doctor
(1979-81 = 100)
1988-90 1965 1989 1984
Table 1.6 Health Related Indicators: Food Production, Calorie Intake and Doctors (continued)
Average index of
food production Daily calorie supply Population per
per capita (per capita) doctor
(1979-81 = 100)
1988-90 1965 1989 1984
Table 1.6 Health Related Indicators: Food Production, Calorie Intake and Doctors (continued)
Average index of
food production Daily calorie supply Population per
per capita (per capita) doctor
(1979-81 = 100)
1988-90 1965 1989 1984
Table 1.6 Health Related Indicators: Food Production, Calorie Intake and Doctors (continued)
Average index of
food production Daily calorie supply Population per
per capita (per capita) doctor
(1979-81 = 100)
1988-90 1965 1989 1984
Portugal 106 2 647 3 495 140
Korea, Rep. 106 2 178 2 852 1160
Greece 103 3 019 3 825 350
Saudi Arabia 189 1 850 2 874 730
Iraq 92 2150 2 887 1 740
Libya 78 1 875 3 324 690
Oman .. .. .. 1700
High-income economies 100 w 3 091 w 3 409w 470w
OECD members 101 w 3 099 w 3 417 w 460w
Other SOw 2546 w 3 072 w 880 w
Ireland 109 3 605 3 778 680
Israel 95 2 799 3 174 350
Spain 112 2 770 3 572 320
Singapore 69 2 285 3 198 1410
Hong Kong 80 2 486 2 853 1 070
New Zealand 102 3 238 3 362 580
Belgium 108 .. .. 330
United Kingdom 105 3 304 3 149 ..
Italy 94 3 097 3 504 230
Australia 95 3 053 3 216 440
Netherlands 111 3 024 3 151 450
Austria 106 3 244 3 495 390
France 103 3 355 3 465 320
United Arab Emirates .. 2 639 3 309 1 020
Canada 108 3 127 3 482 510
United States 92 3 234 3 671 470
Denmark 126 3 420 3 628 400
Germany 112 3 088 3 443 380
Norway 100 3 036 3 326 450
Sweden 99 2 930 2 960 390
Under-5
mortality rate Life expectancy at birth (years)
(per 1000 live births)
Female Male
Female Male
1990 1990 1965 1990 1965 1990
Under-5
mortality rate Life expectancy at birth (years)
(per 1000 live births)
Female Male
Female Male
1990 1990 1965 1990 1965 1990
Dominican Rep. 68 75 57 69 54 65
Papua New Guinea 70 84 44 56 44 54
Guatemala 76 91 50 66 48 61
Morocco 84 99 51 64 48 60
Cameroon 117 134 47 59 44 55
Ecuador 58 72 57 68 55 64
Syrian Arab Rep. 55 67 54 68 51 64
Congo 172 185 47 56 41 50
El Salvador 63 76 56 68 53 60
Paraguay 33 44 67 69 63 65
Peru 78 93 52 65 49 61
Jordan 62 68 52 69 49 66
Colombia 40 49 61 72 57 66
Thailand 28 38 58 68 54 63
Tunisia 50 63 52 68 51 66
Jamaica 16 22 67 75 64 71
Turkey 73 80 55 69 52 64
Romania 23 32 70 73 66 67
44 Introduction
Under-5
mortality rate Life expectancy at birth (years)
(per 1000 live births)
Female Male
Female Male
1990 1990 1965 1990 1965 1990
Poland 18 23 72 75 66 67
Panama 21 29 65 75 62 71
Costa Rica 18 22 66 78 63 73
Chile 18 23 63 76 57 69
Botswana 41 53 49 69 46 65
Algeria 83 91 51 66 49 65
Bulgaria 14 19 73 76 68 70
Mauritius 21 28 63 73 59 67
Malaysia 17 22 60 72 56 68
Argentina 30 40 69 75 63 68
Iran, Islamic Rep. 103 122 52 63 52 63
Albania 28 33 67 75 65 70
Angola 207 230 37 48 34 44
Lebanon 0 0 0 0 64 0 0 60 0 0
Mongolia 76 91 51 64 49 61
Namibia 119 140 47 59 44 56
Nicaragua 66 80 52 66 49 63
Yemen, Rep. 172 191 41 49 39 48
Upper-middle-income 49w 60w 62w 71w 58 w 65 w
Mexico 41 51 61 73 58 66
South Africa 81 98 54 65 49 59
Venezuela 36 45 65 73 61 67
Uruguay 22 28 72 77 65 70
Brazil 62 75 59 69 55 63
Hungary 16 22 72 75 67 67
Yugoslavia 25 30 68 76 64 69
Czechoslovakia 13 17 73 75 67 68
Gabon 148 167 44 55 41 52
Trinidad and Tobago 25 34 67 74 63 69
Portugal 14 17 68 78 62 72
Korea, Rep. 17 24 58 73 55 67
Greece 13 15 72 80 69 74
Saudi Arabia 72 87 50 66 47 63
Iraq 81 89 53 66 51 61
Libya 84 100 51 64 48 60
Oman 36 46 45 68 43 64
Development and Underdevelopment 45
Under-5
mortality rate Life expectancy at birth (years)
(per 1000 live births)
Female Male
Female Male
1990 1990 1965 1990 1965 1990
As far as food production per capita is con- poorest countries life expectancy is little more
cerned, it has risen on average by just over 1 per than 40 years. The infant and child mortality rates
cent per annum in the last ten years in the low- in poor countries are particularly high relative to
income countries, but hardly at all if China and the rich countries. Infant mortality is higher than
India are excluded from the sample. In the middle- 100 per 1000 in some poor countries compared
income countries progress has also been very slow with 8 per 1000 in rich countries. And while child
and in some low and middle-income countries per mortality averages ten per 1000 in the rich coun-
capita food production actually fell. tries, it averages 70 per 1000 in the low-income
Daily per capita calorie intake shows most of countries (excluding China and India).
the poorest countries below the required level of
2500, while the 'obese' industrial countries have an
average intake of 40 per cent above requirements. • Education
The average people to doctor ratio in developed
countries is 500 : 1, while in low-income and There has been an enormous growth in public
middle-income countries over 5000 people share expenditure on education in developing countries
one doctor. in recent years - some would say too much - but
In the light of the above facts, it is no surprise expenditure per capita is still only one-twelfth of
that life expectancy is low in developing countries that in developed countries. The statistics in Table
compared to the rich industrialised countries. In 1.8 indicate the relative underprovision of facili-
low- and middle-income countries we find that life ties and opportunities in poor countries, and the
expectancy at birth averages 63 years compared to still low rate of literacy in the poorest countries.
77 years in developed countries. In many of the The adult literacy rate in the low-income countries
Primt;try Secondary
Mozambique 37 68 3 5 0 0
Tanzania 32 63 2 4 0 0
Ethiopia 11 38 2 15 0 1
Somalia 10 .. 2 .. 0 ..
Nepal 20 86 5 30 1 6
Chad 34 57 1 7 .. 1
Bhutan 7 26 0 5 .. ..
Lao PDR 40 111 2 27 0 2
Malawi 44 67 2 4 0 1
Bangladesh 49 70 13 17 1 4
Development and Underdevelopment 4 7
Primary Secondary
Burundi 26 71 1 4 0 1
Zaire 70 78 5 24 0 2
Uganda 67 77 4 13 0 1
Madagascar 65 92 8 19 1 4
Sierra Leone 29 53 5 18 0 1
Mali 24 23 4 6 0 ..
Nigeria 32 70 5 19 0 3
Niger 11 28 1 6 .. 1
Rwanda 53 69 2 7 0 1
Burkina Faso 12 35 1 7 0 1
India 74 98 27 43 5 ..
Benin 34 65 3 .. 0 2
China 89 135 24 44 0 2
Haiti so 84 5 19 0 ..
Kenya 54 94 4 23 0 2
Pakistan 40 38 12 20 2 5
Ghana 69 75 13 39 1 2
Central African Rep. 56 64 2 11 .. 1
Togo 55 103 5 22 0 3
Zambia 53 95 7 20 .. 2
Guinea 31 34 5 9 0 1
Sri Lanka 93 107 35 74 2 4
Mauritania 13 51 1 16 .. 3
Lesotho 94 110 4 26 0 4
Indonesia 72 118 12 47 1 ..
Honduras 80 108 10 .. 1 10
Egypt, Arab Rep. 75 97 26 81 7 20
Afghanistan 16 24 2 8 0 1
Cambodia 77 .. 9 .. 1 ..
Liberia 41 .. 5 .. 1 3
Myanmar 71 103 15 24 1 5
Sudan 29 .. 4 .. 1 3
48 Introduction
Primary Secondary
Bolivia 73 81 18 34 5 23
Zimbabwe 110 125 6 52 0 6
Senegal 40 58 7 16 1 3
Philippines 113 111 41 73 19 28
Cote d'Ivoire 60 .. 6 20 0 ..
Dominican Rep. 87 95 12 .. 2 ..
Papua New Guinea 44 73 4 13 .. ..
Guatemala 50 79 8 21 2 ..
Morocco 57 68 11 36 1 11
Cameroon 94 101 5 26 0 3
Ecuador 91 118 17 56 3 25
Syrian Arab Rep. 78 108 28 54 8 20
Congo 114 .. 10 .. 1 6
El Salvador 82 78 17 26 2 17
Paraguay 102 106 13 29 4 8
Peru 99 123 25 67 8 32
Jordan 95 .. 38 .. 2 ..
Colombia 84 107 17 52 3 14
Thailand 78 86 14 28 2 16
Tunisia 91 115 16 44 2 8
Poland 104 99 69 81 18 20
Panama 102 107 34 59 7 22
Costa Rica 106 100 24 41 6 27
Chile 124 100 34 75 6 19
Botswana 65 111 3 37 .. 3
Algeria 68 94 7 61 1 11
Bulgaria 103 97 54 75 17 26
Mauritius 101 103 26 53 3 2
Malaysia 90 96 28 59 2 7
Argentina 101 111 28 74 14 41
Development and Underdevelopment 49
Primary Secondary
Upper-middle-income 99 w 104 w 26 w 56 w Sw 17 w
Mexico 92 114 17 53 4 15
South Africa 90 .. 15 .. 4 ..
Venezuela 94 105 27 56 7 28
Uruguay 106 106 44 77 8 50
Brazil 108 105 16 39 2 11
Hungary 101 94 .. 76 13 15
Yugoslavia 106 95 65 80 13 19
Czechoslovakia 99 92 29 87 14 18
Gabon 134 .. 11 .. .. 4
Trinidad and Tobago 93 97 36 83 2 6
Portugal 84 111 42 53 5 18
Korea, Rep. 101 108 35 86 6 38
Greece 110 102 49 97 10 28
Saudi Arabia 24 76 4 46 1 12
Iraq 74 96 28 47 4 14
Libya 78 .. 14 .. 1 ..
Oman .. 102 .. 48 .. 4
Primary Secondary
World 85 w 105 w 31 w 52 w 9w 16 w
w: means weighted average.
Source: World Development Report, 1992.
averages just 60 per cent compared to 78 per cent education, but the drop-out rate even from prim-
in the middle-income countries and 99 per cent in ary schools is often high. Secondary education is
rich countries. While there has been a major im- still a luxury in most developing countries, as is
provement in the literacy rate in most countries higher education. This is not to say the more edu-
over the last two decades, the absolute number of cational provision, the better. Education confers
those illiterate has actually increased. Except in undoubted benefits on individuals and societies,
the poorest countries, most children now have but it can also confer costs by exacerbating certain
access to some form of rudimentary primary development difficulties. Education inculcates
Development and Underdevelopment 51
knowledge and skills which raise productivity, but way as to make the structural transformation of
it can also perpetuate inequalities in societies and their economies in the direction of industrial de-
impart values, attitudes and aspirations which are velopment more difficult. There may be a genuine
inimical to development; for example, the adop- dilemma here, and a trade-off between growth and
tion of practices and institutional structures in- basic needs. It depends on whether the scale of
appropriate to the environment of the country. resource transfer increases as the allocation ·is
Societies need to look carefully at the nature and changed and on the degree of complementarity
allocation of educational provision in relation to between the two strategies. On the one hand it can
the needs and aspirations of the society. It would be argued that the provision of basic needs is a
be hard to argue, however, that a higher rate of form of consumption transfer- away from invest-
literacy and numeracy and more training in voca- ment - so that growth will be retarded and the
tional skills would not be in the private and social basic needs strategy will then not be sustainable in
interest. The problem again is one of competing the long run. On the other hand it can be argued
claims on limited resources. that the provision of basic needs is a form of
investment in human capital, which may be as
productive as investment in industry.
• Basic Needs Whatever the conflict here, it can also be
argued, as Singh (1979) does convincingly, that
The provision of health services, education, hous- there must be an important complementarity and
ing, sanitation, water supply and adequate nutri- interrelationship between meeting basic needs, in-
tion, came to be known in development circles in dustrialisation and accelerated structural change,
the 1970s (and supported by the World Bank) as and both strategies need to be, and can be, pur-
the basic needs approach to economic develop- sued side by side. Specifically, that to meet basic
ment. The rationale of the approach was that the needs on a sustainable basis it is necessary for
direct provision of such goods and services is likely productive structures to be transformed in favour
to relieve absolute poverty more immediately than of industry, and that a properly conceived basic
alternative strategies which simply attempt to needs strategy which achieves a more equitable
accelerate growth or which rely on raising the distribution of income should help industrialisa-
incomes and productivity of the poor. Arguments tion.
used in support of this change in strategy were as The International Labour Organisation (ILO)
follows: growth strategies usually fail to benefit has emphasised in its various publications (see, for
those intended; the productivity and incomes of example, Meeting Basic Needs) that the satisfac-
the poor depend in the first place on the direct tion of basic needs depends crucially on the estab-
provision of health and education facilities; it rna¥ lishment of a New International Economic Order,
take a long time to increase the incomes of the which according to the Lima Declaration of 1975
poor so that they can afford basic needs; in any has as its aim to increase the developing countries'
case, the poor tend not to spend their income share of world manufacturing output to 25 per
wisely and certain facilities such as water supply cent by the year 2000 (compared to 15 per cent
and sanitation can only be provided publicly; today). Singh shows that the provision of basic
lastly, it is difficult to help all the poor in a uniform needs on a sustainable basis requires accelerated
way in the absence of the provision of basic needs. growth of 7-8 per cent per annum, which in turn
While these arguments undoubtedly contained implies a growth of manufacturing output of 10 to
an element of truth, there was some suspicion 11 per cent. This is the rate of growth of manufac-
within the developing countries themselves that turing needed to reach the Lima target of a 25 per
the international propagation of this new doctrine cent share of world manufacturing output by the
was an attack on their sovereignty and would alter year 2000. Thus the basic needs strategy and
the nature of international assistance in such a structural transformation in the direction of indus-
52 Introduction
try lead to the same conclusion as far as industrial Development Report which gives alternative mea-
growth is concerned. Whether both objectives are sures of the economic well-being or progress of
achieved largely depends on the overall economic nations which do not necessarily accord with the
strategy pursued. The experience of several coun- usual measure of the level or growth of income per
tries shows that the rapid development of industry head. As the UNDP Report says 'although GNP
and the provision of basic needs are quite compat- growth is absolutely necessary to meet all essential
ible. China has achieved remarkable progress in human objectives, countries differ in the way that
both directions by recognising the importance of they translate growth into human development'.
gearing industrial development to the needs of The UNDP defines human development as a pro-
agriculture and the rural sector, by encouraging cess of 'enlarging people's choices'. This depends
the use of modern inputs into agriculture and by not only on income but also on social indicators
encouraging the development of small scale rural such as health provision, education, leisure time
industries. Other, non-socialist, countries have a and so on. The UNDP thus constructs a Human
good record in the provision of basic needs judged Development Index which combines a measure of
by the level of life-expectancy in relation to per income per head with measures of life expectancy
capita income. These tend to be societies where and adult literacy. Countries are then ranked by
income is more equitably distributed or which the index and compared with their income per
make special provision, such as Sri Lanka. Coun- head ranking. The results are shown in Table 1.9,
tries with a poor performance in the provision of ranking from lowest to highest. It can be seen that
basic needs illustrate that a basic needs strategy some countries that rank low by per capita income
needs to be comprehensive, otherwise failure in rank high by the human development index, and
one respect will nullify progress in others. 1 vice versa. In the former category of countries are:
World Bank lending for poverty alleviation Costa Rica, Cuba, Mexico, Venezuela, Jamaica,
programmes rose quite dramatically during the China, Chile, Uruguay and Sri-Lanka. In the latter
1970s and 1980s. The amount spent on poverty category of countries, note that the United States
alleviation programmes rose from US $500 mil- ranks only 19th on the human development index,
lion in 1970 to $3300 million in 1989, or from 8 but second according to the level of per capita
to 20 per cent of the total lending programme. Of income. Other rich countries which score low on
the total in 1989, $1800 million was spent on human development are Kuwait, United Arab
basic needs including education, health and water Emirates, Libya and Saudi Arabia.
supply compared to $340 million in 1970. The The Human Development Index (HOI) is con-
rest was spent on rural development and small- structed as follows. First a deprivation index is
scale industrial projects. Industry's share of total constructed for each of the three variables - per
lending remained at just over 30 per cent; while capita income, life expectancy and adult literacy.
the share of total lending going to infrastructure The deprivation index is measured as the differ-
fell from 58 per cent to 37 per cent between 1970 ence between the desirable (maximum) value of
and 1989. the index minus the actual value of the index
divided by the difference between the desirable
(maximum) and minimum values of the index
• Human Development Index (those actually observed across countries). The
bigger the difference between desirable and actual,
In 1990, the United Nations Development Pro- the higher the degree of deprivation. The depriva-
gramme (UNDP) produced its first annual Human tion indices are then averaged, and the human
1 For an evaluation of country experience, and of the com-
development index is taken as 1 -average depriva-
plementarities and trade-offs in the provision of basic needs, see tion index. To give an example: if the maximum
Streeten eta/. (1981), and Stewart (1985). (desirable) adult literacy index is 100 per cent, the
Development and Underdevelopment 53
"
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.
c~
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...
~
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c.,
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~ ~
~
~
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Niger 45 14 452 0.116 20 1 China 70 69 2 124 0.716 22 66
Mali 45 17 543 0.143 15 2 Libya 62 66 7 250 0.719 103 67
Burkina Faso 48 14 500 0.150 13 3 Sourh Africa 61 70 4 981 0.731 82 68
Sierra Leone 42 30 480 0.150 27 4 Lebanon 68 78 2 250 0.735 78 69
Chad 46 26 400 0.157 4 5 Mongolia 64 90 2 000 0.737 57 70
Guinea 43 29 500 0.162 31 6 Nicaragua 64 88 2 209 0.743 54 71
Somalia 46 12 1 000 0.200 23 7 Turkey 65 74 3 781 0.751 71 72
Mauritania 47 17 840 0.208 40 8 Jordan 67 75 3 161 0.752 76 73
Afghanistan 42 24 1 000 0.212 17 9 Peru 63 85 3 129 0.753 74 74
Benin 47 27 665 0.224 28 10 Ecuador 66 83 2 687 0.758 68 75
Burundi 50 35 450 0.235 18 11 Iraq 65 89 2 400 0.759 96 76
Bhutan 49 25 700 0.236 3 12 United Arab Emirates 71 60 12 191 0.782 127 77
Mozambique 47 39 500 0.239 10 13 Thailand 66 91 2 576 0.783 55 78
Malawi 48 42 476 0.250 7 14 Paraguay 67 88 2 603 0.784 65 79
Sudan 51 23 750 0.255 32 15 Brazil 65 78 4 307 0.784 85 80
Central African Republic 46 41 591 0.258 29 16 Mauritius 69 83 2 617 0.788 75 81
Nepal 52 26 722 0.273 8 17 Norrh Korea 70 90 2 000 0.789 67 82
Senegal 47 28 1 068 0.274 43 18 Sri Lanka 71 87 2 053 0.789 38 83
Ethiopia 42 66 454 0.282 1 19 Albania 72 85 2 000 0.790 61 84
Zaire 53 62 220 0.294 5 20 Malaysia 70 74 3 849 0.800 80 85
Rwanda 49 47 571 0.304 26 21 Colombia 65 88 3 524 0.801 72 86
Angola 45 41 1 000 0.304 58 22 Jamaica 74 82 2 506 0.824 62 87
Bangladesh 52 33 883 0.318 6 23 Kuwait 73 70 13 843 0.839 122 88
Nigeria 51 43 "668 0.322 36 24 Venezuela 70 87 4 306 0.861 95 89
Yemen Arab Rep. 52 25 1 250 0.328 47 25 Romania 71 96 3 000 0.863 84 90
Liberia 55 35 696 0.333 42 26 Mexico 69 90 4 624 0.876 81 91
Togo 54 41 670 0.337 24 27 Cuba 74 96 2 500 0.877 66 92
Uganda 52 58 511 0.354 21 28 Panama 72 89 4 009 0.883 88 93
Haiti 55 38 775 0.356 34 29 Trinidad and Tobago 71 96 3 664 0.885 100 94
Ghana 55 54 481 0.360 37 30 Portugal 74 85 5 597 0.899 94 95
Yemen, PDR 52 42 1 000 0.369 39 31 Singapore 73 86 12 790 0.899 110 96
Cote d'Ivoire 53 42 1 123 0.393 52 32 South Korea 70 95 4 832 0.903 92 97
Congo 49 63 756 0.395 59 33 Poland 72 98 4 000 0.910 83 98
Namibia 56 30 1500 0.404 60 34 Argentina 71 96 4 647 0.910 89 99
Tanzania 54 75 405 0.413 12 35 Yugoslavia 72 92 5 000 0.913 90 100
Pakistan 58 30 1 585 0.423 33 36 Hungary 71 98 4 500 0.915 87 101
India 59 43 1 053 0.439 25 37 Uruguay 71 95 5 063 0.916 86 102
Madagascar 54 68 634 0.440 14 38 Costa Rica 75 93 3 760 0.916 77 103
Papua New Guinea 55 45 1 843 0.471 50 39 Bulgaria 72 93 4 750 0.918 99 104
Kampuchea, Dem. 49 75 1 000 0.471 2 40 USSR 70 99 6 000 0.920 101 105
Cameroon 52 61 1 381 0.474 64 41 Czechoslovakia 72 98 7 750 0.931 102 106
Kenya 59 60 794 0.481 30 42 Chile 72 98 4 862 0.931 73 107
Zambia 54 76 717 0.481 19 43 Hongkong 76 88 13 906 0.936 111 108
Morocco 62 34 1 761 0.489 48 44 Greece 76 93 5 500 0.949 98 109
Egypt 62 45 1 357 0.501 49 45 East Germany 74 99 8 000 0.953 115 110
Laos 49 84 1 000 0.506 9 46 Israel 76 95 9 182 0.957 108 111
Gabon 52 62 2 068 0.525 93 47 USA 76 96 17 615 0.961 129 112
Oman 57 30 7 750 0.535 104 48 Austria 74 99 12 386 0.961 118 113
Bolivia 54 75 1 380 0.548 44 49 Ireland 74 99 8 566 0.961 106 114
54 Introduction
"
,.._!?0
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,.._!?0
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~...,
minimum is 50 per cent, and the actual is 70 per modities' with a high income elasticity of demand.
cent, then literacy deprivation is measured as Naturally enough in this schema, the develop-
(100 - 70) I (100 - 50) = 30/50 = 0.6. If this was ing countries get identified with primary produc-
the only index, the HDI would be 1 - 0.6 = 0.4. tion, the more developed countries with the
production of manufactured goods, and the ma-
ture developed economies with a high percentage
• The Stages of Development of their resources in the service sector. There can
be no dispute that resource shifts are an integral
It is often argued that countries pass through part of the development process, and that one of
phases during the course of development and that the main determinants of these shifts is a difference
by identifying these stages, according to certain in the income elasticity of demand for commod-
characteristics, a country can be deemed to have ities and changes in elasticity as development pro-
reached a certain stage of development. The sim- ceeds. But just as care must be taken to equate
plest stage theory is the sector thesis of Fisher (without qualification) development and welfare
((1933) and (1939)) and Clark (1940), who em- with the level of per capita income, so, too, cau-
ploy the distinction between primary, secondary tion must be exercised in identifying different de-
and tertiary production as a basis of a theory of grees of underdevelopment, industrialisation and
development. Countries are assumed to start as maturity with some fairly rigid proportion of re-
primary producers and then, as the basic necessi- sources engaged in different types of activity. Such
ties of life are met, resources shift into manufac- an association would ignore the doctrine of com-
turing or secondary activities. Finally, with rising parative advantage which holds that countries will
income, more leisure and an increasingly saturated specialise in the production of those commodities
market for manufactured goods, resources move in which they have a relative advantage as deter-
into service or tertiary activities producing 'com- mined by natural or acquired resource endow-
Development and Underdevelopment 55
ments. The fact that one country produces pre- very different levels of development.
dominantly agricultural products while another Ideally a criterion of development stages is re-
produces mainly manufactured goods need not quired which leaves the proportion of resources
imply that they are at different stages of develop- employed in different activities out of account.
ment on any of the conventional definitions of One possibility is to argue that a country has
development we gave earlier. Such an association reached a developed state when productivity in the
would also ignore the different types of service agricultural sector matches productivity in the in-
activities which may exist at different stages of a dustrial sector, and that it has reached a state of
country's history. There are three broad categories maturity when productivity in all sectors, includ-
of service activities, and the determinants of re- ing services, is approximately equal provided the
source allocation to service activities accompany- level is reasonably high. The alternative is simply
ing development may operate differently on each to classify countries as industrial, semi-industrial
in an offsetting manner. Newer service activities and non-industrial, using as a criterion for division
linked with the growth of leisure and high mass some level of the net value of manufacturing pro-
consumption tend to have a very high income duction per head of the total population combined
elasticity of demand; services linked to the growth perhaps with an indicator of the degree of indus-
of manufacturing also grow but at a declining rate, trialisation of exports (see Maizels, 1963).
and traditional services of pre-industrial times de- Having said all this, however, the fact remains
cline (Katouzian (1970)). In short, tertiary produc- that there is a good deal of empirical support for
tion is an aggregation of many dissimilar service the Fisher-Clark view that the pattern of develop-
activities some of which are related to low per ment across countries evidences many common
capita incomes and some to high per capita in- characteristics, especially the shift of resources
comes. Thus the same proportion of total re- from agriculture to industry. Figure 1.3 shows the
sources devoted to services may be associated with proportions of the labour force engaged in agricul-
Percentage
of labor
force
80
70
Services
60 /1980
50 Services
..--·'"1965
/
/
Industry
40 /
/
1965
Industry
1980
30
20
Ag ricu ltu re
1965
10 Agriculture
1980
QL-------~--~--------~~~--------~~---
Low income Middle income High income
$300 $1000 $1 0 000
Per capita income
56 Introduction
ture, industry and services between low-income, to make estimates of the income elasticity of de-
middle-income and industrialised countries, and mand for different commodities (given by b). An
over time. One sees the broad thesis of Fisher and income elasticity of demand for a good less than
Clark confirmed. In the low-income countries over unity would imply that its proportional import-
70 per cent of the labour force on average is em- ance in total output would decline as income
ployed in agriculture, while only 10 per cent is grows. Conversely, an income elasticity greater
employed in industry. By contrast in the industrial than unity means that its relative importance in
market economies only 7 per cent on average is total output will increase. Taking this basic equa-
employed in agriculture and 35 per cent in indus- tion (with some modifications), and applying it to
try. The proportion of the labour force in services a cross section of 51 countries, Chenery found that
is also relatively low in low-income countries com- the growth elasticity of the agricultural sector is
pared to more mature industrial countries, less than 0.5, while for industry it is over 1.3 and
although there is quite a wide variation between for services it is approximately unity. Within the
low-income countries. Over time, there is a notice- industrial sector, there will also be differences in
able reduction in the proportion of the labour the income elasticity of demand for products
force in agriculture in most countries, but particu- which will cause the pattern of industry to change
larly in the industrial market economies. There is a as development proceeds. The most notable de-
slight increase in the importance of industry in the mand shift is the relative switch from basic neces-
low- and middle-income countries, but not in the sities .like food, beverages and clothes to capital
industrial market economies where on average the and consumer durable goods.
shift of resources has been away from both agri-
culture and industry towards services, which em-
ploy on average over one half of the labour force. • Industrialisation and Growth
Generally speaking the lower the per capita in-
come, the higher the proportion of the labour The importance attached to industrialisation by
force in agriculture, and the higher the level of per developing countries lies in the close association
capita income, the higher the proportion in ser- that appears to exist between industrialisation and
vices. real income per head, and between the growth of
What is true of the sectoral distribution of the industry and the growth of output as a whole. This
labour force is also true of the sectoral distribution latter observed relationship is summed up in the
of output, although the magnitude of the propor- maxim 'manufacturing as the engine of growth'. If
tions differ because productivity differs markedly we relate the average growth of gross domestic
between sectors (see Table 1.10). Because pro- product (gcDP) to the average growth of manufac-
ductivity tends to be lower in agriculture than in turing industry (g1) over the period 1970-77 for 81
industry, except in some special cases such as Aus- countries, the following regression equation is
tralia and Canada, the proportion of total output obtained:
generated by agriculture tends to be lower than its
share of the labour force, and the proportion gGDP = 1.414 + 0.569 g1 r 2 = 0.610
generated by industry tends to be higher than its (0.051)
share of the labour force. (See also Cody, Hughes
and Wall (1980).) This is a highly significant relationship and is
Chenery and others (Chenery (1960) and (1979), confirmed by many other studies. 1 Since the re-
Chenery and Syrquin (1975)) have documented the gression coefficient is significantly less than unity,
changing sectoral share of output using regression
analysis. Using an estimating equation of the form 1 See the Symposium on Kaldor's growth laws edited by the
log V = log a + b log Y, where V is value-added present author in journal of Post-Keynesian Economics, Spring
per capita and Y is per capita income, it is possible 1983.
Development and Underdevelopment 57
Low-income economies 41 w 31 w 26 w 36 w 19 w 27 w 32 w 35 w
China and India 41 w 29 w 29 w 36 w 22 w 30 w 30 w 35 w
Other low-income 42 w 30 w 20 w 34 w Sw .. 38 w 38 w
Mozambique .. 65 .. 15 .. .. .. 21
Tanzania 46 59 14 12 8 10 40 29
Ethiopia 58 41 14 17 7 11 28 42
Somalia 71 65 6 9 3 5 24 26
Nepal 65 60 11 14 3 5 23 26
Chad 42 38 15 17 12 14 43 45
Bhutan .. 43 .. 27 .. 10 .. 29
Malawi 50 33 13 20 .. 14 37 46
Bangladesh 53 38 11 15 5 9 36 46
Burundi .. 56 .. 15 .. 10 .. 29
Zaire 20 30 32 33 .. 13 48 36
Uganda 52 67 13 7 8 4 35 26
Madagascar 25 33 14 13 .. 12 61 54
Sierra Leone 34 32 28 13 6 6 38 55
Mali 65 46 9 13 5 8 25 41
Nigeria 55 36 12 38 5 7 33 25
Niger 68 36 3 13 2 5 29 51
Rwanda 75 38 7 22 2 15 18 40
Burkina Faso 37 32 24 24 11 14 39 44
India 44 31 22 29 16 19 34 40
Benin 59 37 8 15 .. 7 33 48
China 38 27 35 42 28 38 27 31
Kenya 35 28 18 21 11 11 47 51
Pakistan 40 26 20 25 14 17 40 49
Ghana 44 48 19 16 10 9 38 37
Central African Rep. 46 42 16 17 4 .. 38 41
Togo 45 33 21 22 10 9 34 46
Zambia 14 17 54 55 6 43 32 29
Guinea .. 28 .. 33 .. 4 .. 39
Sri Lanka 28 26 21 26 17 15 51 48
Mauritania 32 26 36 29 4 .. 32 44
Lesotho 65 24 5 30 1 14 30 46
Indonesia 51 22 13 40 8 20 36 38
58 Introduction
Honduras 40 23 19 24 12 16 41 53
Egypt, Arab Rep. 29 17 27 29 .. 16 45 53
Bolivia 23 24 31 32 15 13 46 44
Zimbabwe 18 13 35 40 20 26 47 47
Senegal 25 21 18 18 14 13 56 61
Philippines 26 22 27 35 20 25 47 43
Cote d'Ivoire 47 47 19 27 11 .. 33 26
Dominican Rep. 23 17 22 27 16 13 55 56
Papua New Guinea 42 29 18 31 .. 12 41 40
Guatemala .. 26 .. 19 .. .. .. 55
Morocco 23 16 28 33 16 18 49 51
Cameroon 33 27 20 28 10 13 47 46
Ecuador 27 13 22 42 18 23 50 45
Syrian Arab. Rep. 29 28 22 22 .. .. 49 50
Congo 19 13 19 39 .. 7 62 48
El Salvador 29 11 22 21 18 19 49 67
Paraguay 37 28 19 23 16 23 45 49
Peru 18 7 30 37 17 27 53 57
Jordan .. 8 .. 26 .. 12 .. 66
Colombia 27 17 27 32 19 21 47 51
Thailand 32 12 23 39 14 26 45 48
Tunisia 22 16 24 32 9 17 54 52
Jamaica 10 5 37 46 17 20 53 49
Turkey 34 18 25 33 16 24 41 49
Romania .. 18 .. 48 .. .. .. 34
Poland .. 14 .. 36 .. .. .. 50
Panama 18 10 19 9 12 7 63 80
Costa Rica 24 16 23 26 .. 19 53 58
Chile 9 .. 40 .. 24 .. 52 ..
Botswana 34 3 19 57 12 6 47 40
Algeria .. 13 .. 47 .. 12 .. 41
Bulgaria .. 18 .. 52 .. .. .. 31
Mauritius 16 12 23 33 14 24 61 55
Malaysia 28 .. 25 .. 9 .. 47 ..
Argentina 17 13 42 41 33 .. 42 45
Development and Underdevelopment 59
Namibia .. 11 .. 38 .. 5 .. 50
Nicaragua 25 .. 24 .. 18 .. 51 ..
Yemen, Rep. .. 20 .. 28 .. 8 .. 47
Upper-middle-income 16 w 9w 36 w 40 w 19 w 25 w 47 w 51 w
Mexico 14 9 27 30 20 23 59 61
South Africa 10 5 41 44 24 26 48 51
Venezuela 6 6 40 50 .. 20 55 45
Uruguay 18 11 35 34 .. 28 47 55
Brazil 19 10 33 39 26 26 48 51
Hungary .. 12 .. 32 .. 27 .. 56
Yugoslavia 23 12 42 48 .. .. 35 40
Czechoslovakia .. 8 .. 56 .. .. .. 36
Gabon 26 9 34 49 7 7 40 42
Trinidad and Tobago 8 3 48 48 .. 13 44 49
Portugal .. .. .. .. .. .. .. ..
Korea, Rep. 38 9 25 45 18 31 37 46
Greece 24 17 26 27 16 14 49 56
Saudi Arabia 8 8 60 45 9 9 31 48
Iraq 18 .. 46 .. 8 .. 36 ..
Libya 5 .. 63 .. 3 .. 33 ..
Oman 61 3 23 80 0 4 16 18
High-income economies 5w .. 43 w .. 32 w .. 54 w ..
OECD members 5w .. 43 w .. 32 w .. 54 w ..
Other .. .. .. .. .. .. .. ..
Ireland .. .. .. .. .. .. .. ..
Israel .. .. .. .. .. .. .. ..
Spain .. .. .. .. .. .. .. ..
Singapore 3 0 24 37 15 29 74 63
Hong Kong 2 0 40 26 24 18 58 73
60 Introduction
New Zealand .. 9 .. 27 .. 19 .. 65
Belgium .. 2 .. 31 .. 23 .. 67
United Kingdom 3 .. 46 .. 34 .. 51 ..
Italy .. 4 .. 33 .. 23 .. 63
Australia 9 4 39 31 26 15 51 64
Netherlands .. 4 .. 31 .. 20 .. 65
Austria 9 3 46 37 33 27 45 60
France .. 4 .. 29 .. 21 .. 67
United Arab Emirates .. 2 .. 55 .. 9 .. 43
Canada 6 .. 40 .. 26 .. 54 ..
United States 3 .. 38 .. 28 .. 59 ..
Denmark 9 5 36 28 23 19 55 67
Germany 4 2 53 39 40 31 43 59
Norway .. .. .. .. .. .. .. ..
Sweden .. 3 .. 35 .. 24 .. 62
Japan 10 3 44 42 34 29 46 56
Finland 16 6 37 36 23 23 47 58
Switzerland .. .. .. .. .. .. .. ..
Kuwait 0 1 70 56 3 9 29 43
World 10 w .. 41 w .. 30 w .. 51 w ..
w means weighted averages.
Source: World Development Report 1992.
the equation also implies that the greater the ex- facturing output itself owing to the existence of
cess of manufacturing output growth over the rate increasing returns, both static and dynamic. Static
of growth of the economy as a whole, the faster returns relate to the size and scale of production
the overall growth rate will be. Setting gGDP = g 1 units and are a characteristic largely of manufac-
gives the growth rate which divides those coun- turing where in the process of doubling the linear
tries where industry is growing faster than overall dimensions of equipment, the surface increases by
output and those countries where industry is the square and the volume by the cube. Dynamic
growing slower. In the above sample, that growth economies refer to increasing returns brought
rate is 3.3 per cent (i.e. 1.414/(1 - 0.569)). about by 'induced' technical progress, learning by
There are two good reasons for expecting a doing, external economies in production and so
strong relation between the growth of manufac- on. Manufacturing seems to be the sector where
turing industry and the growth of the overall econ- major cost saving, technical advances take place.
omy. The first is that productivity growth in The relationship between the growth of pro-
industry is closely related to the growth of manu- ductivity and the growth of industry is sometimes
Development and Underdevelopment 61
referred to in the literature as Verdoorn's Law. strong negative correlation would be evidence of
This relationship can provide the basis of models convergence.
of geographic dualism (see Chapter 5). The second The results of testing the catch-up hypothesis
induced effect that manufacturing growth has on are mixed. A study by Baumol (1986) shows a
overall growth is that the faster manufacturing strong inverse correlation between a country's
grows, the faster the rate of transference of labour productivity level and its average growth of pro-
from other sectors of the economy where there is ductivity among industrialised countries and those
either diminishing returns or where no rela- at an intermediate stage of development, but there
tionship exists between employment growth and is no evidence of convergence as far as the poorer
output growth because there is already surplus countries are concerned. Another study of 113
labour. In both cases, a reduction in the amount of countries by Dowrick (1992) shows that while
labour in these sectors will raise productivity there is some evidence of catch-up in the sense that
growth outside manufacturing. growth rates are negatively related to initial levels
The question then is: what determines the rate of productivity, other differences have caused per
of growth of manufacturing? In the early stages of capita income growth to be faster the higher the
development the impetus to industrialisation must level of per capita income, producing a divergence
come from the agricultural sector which provides in living standards across the world (as we saw
the main source of autonomous demand for in- earlier in the chapter). Countries with higher levels
dustrial goods. In the later stages of development, of income have had higher investment ratios and a
the demand for industrial goods from outside the faster growth of the workforce which has con-
country becomes of prime importance for main- tributed to a faster growth of output.
taining the momentum of industrial growth. We Clearly a productivity gap itself is not a suf-
will develop and elaborate these points later when ficient condition for catch up. There have to be the
we consider the role of agriculture in development cooperating factors to enable poor countries to
in Chapter 3 and the idea of export-led growth in take advantage of the more advanced technology
Chapters 5 and 15. available, and they have to innovate as well.
traditional, transitional, take-off, maturity and the factory and the principle of the division of
high mass consumption. labour.
All we need say about traditional societies is On the social front a new elite must emerge to
that for Rostow the whole of the pre-Newtonian fabricate the industrial society and it must super-
world consisted of such societies; for example, the sede in authority the land-based elite of the
dynasties of China, the civilisations of the Middle traditional society. Surplus product must be chan-
East, the Mediterranean and medieval Europe, etc. nelled by the new elite from agriculture to indus-
Traditional societies are characterised by a ceiling try, and there must be a willingness to take risks
on productivity imposed by the limitations of and to respond to material incentives. And be-
science. Traditional societies are thus recognisable cause of the enormity of the task of transition, the
by a very high proportion of the work-force in establishment of an effective modern government
agriculture (greater than 75 per cent), coupled is vital. The length of the transition phase depends
with very little mobility or social change, great on the speed with which local talent, energy and
divisions of wealth and decentralised political resources are devoted to modernisation and the
power. Today there are very few, if any, societies overthrow of the old order, and in this respect
that one would class as traditional. Most societies political leadership will have an important part to
emerged from the traditional stage, as described play.
by Rostow, some time ago, mainly under the im- Then there is the stage of take-off. The charac-
pact of external challenge and aggression or national- teristics of take-off are sometimes difficult to dis-
ism. The exceptions to the pattern of emergence tinguish from the characteristics of the transition
from the traditional state are those countries stage, and this has been one bone of contention
which Rostow describes as having been 'born between Rostow and critics. None the less, let us
free', such as the United States and certain British describe the take-off stage as Rostow sees it - a
dominions. Here the preconditions of 'take-off' 'stage' to which reference is constantly made in the
were laid in more simple fashion by the construc- development literature. Since the pre-conditions of
tion of social overhead capital and the introduc- take-off have been met in the transitional stage,
tion of industry from abroad. But for the rest of the take-off stage is a short stage of development
the world, change was much more basic and fun- during which growth becomes self-sustaining. In-
damental, consisting not only of economic trans- vestment must rise to a level in excess of 10 per
formation but also a political and social transition cent of national income in order for per capita
from feudalism. income to rise sufficiently to guarantee adequate
The stage between feudalism and take-off Ros- future levels of saving and investment. Also im-
tow calls the transitional stage. The main econ- portant is the establishment of what Rostow calls
omic requirement in the transition phase is that the 'leading growth sectors'. Historically, domestic
level of investment should be raised to at least 10 finance for take-off seems to have come from two
per cent of national income to ensure self- main sources. The first has been from a diversion
sustaining growth. (On this particular point, as we of part of the product of agriculture by land re-
shall see, there seems to be very little difference form and other means. The examples of Tsarist
between the transition stage and the later stage of Russia and Meiji Japan are quoted, where govern-
take-off.) The main direction of investment must ment bonds were substituted for the landowner's
be in transport and other social overhead capital claim to the flow of rent payments. A second
to build up society's infrastructure. The precondi- source has been from enterprising landlords volun-
tions of a rise in the investment ratio consist of a tarily ploughing back rents into commerce and
willingness of people to lend risk capital, the avail- industry.
ability of men willing and able to be entrepreneurs In practice the development of major export
and to innovate, and the willingness of society at industries has sometimes led to take-off permitting
large to operate an economic system geared to substantial capital imports. Grain in the United
Development and Underdevelopment 63
States, Russia and Canada; timber in Sweden, and, ditional society had not been made. The dates
to a lesser extent textiles in Great Britain are cited of take-off for some of the present developed
as examples. Countries such as the United States, countries are given as follows: Great Britain,
Russia, Sweden and Canada also benefited during 1783-1802; France, 1840-60; the United States,
take-off from substantial inflows of foreign capi- 1843-60; Germany, 1850-73; Sweden, 1868-90;
tal. The sector or sectors which led to the take-off Japan, 1878-1900; Russia, 1890-1914.
seem to have varied from country to country, but Then there is the stage of maturity which Ros-
in many countries railway building seems to have tow defines as the period when society has effec-
been prominent. Certainly improvement of the tively applied the range of modern technology to
internal means of communication is crucial for an the bulk of its resources. During the period of
expansion of markets and to facilitate exports, maturity new leading sectors replace the old, and
apart from any direct impact on such industries as Rostow sees the development of the steel industry
coal, iron and engineering. But Rostow argues that as one of the symbols of maturity. In this respect
any industry can play the role of leading sector in America, Germany, France and Great Britain en-
the take-off stage provided four conditions are tered the stage of maturity roughly together.
met: first, that the market for the product should Accompanying changes in the industrial struc-
be expanding fast to provide a firm basis for the ture will be structural changes in society such as
growth of output; second, that the leading sector changes in the distribution of the work-force; the
generates secondary expansion; third, that the growth of an urban population; an increase in the
sector has an adequate and continual supply of proportion of white-collar workers; and a switch
capital from ploughed-back profits; and last, that in industrial leadership from the entrepreneur to
new production functions can be continually in- the manager.
troduced into the sector, meaning scope for in- Maturity also has important political features.
creased productivity. This is the period when nations grow confident
Rostow contends that the beginnings of take-off and exert themselves - witness Germany under
in most countries can be traced to a particular Bismarck and Russia under Stalin. This is also the
sharp stimulus which has taken many different period when fundamental political choices have to
forms, such as a technological innovation or more be made by society on the use to which greater
obviously a political revolution, e.g. Germany in wealth should be put. Should it be devoted to high
1848, the Meiji restoration in Japan in 1868, mass consumption, the building of a welfare state,
China in 1949 and Indian independence in 1947. or to imperialist ends? The balance between these
Rostow is at pains to emphasise, however, that possibilities has varied over time within countries,
there is no one single pattern or sequence for as well as varying between countries. Ultimately,
take-off. Thus there is no need for the developing however, every nation will presumably reach the
countries today to recapitulate the course of events stage of high mass consumption whatever the
in, say, Great Britain, Russia or America. The balance of choices at the stage of maturity. Since
crucial requirement is that the preconditions of the developing countries have no likelihood of
take-off are met, otherwise take-off, whatever reaching this stage in the foreseeable future, how-
form it takes, will be abortive. Investment must ever, and only a handful of countries have reached
rise to over 10 per cent of national income; one or it already, we shall not consider this fifth stage
more leading sectors must emerge; and there must here.
exist or emerge a political, social and institutional Instead, let us evaluate Rostow's thesis, and
framework which exploits the impulse to expan- consider the usefulness of this type of stage theory
sion. The examples are given of extensive railway apart from it providing a valuable description of
building in Argentina before 1914, and in India, the development process and pinpointing some of
China and Canada before 1895, failing to initiate the key growth variables. Most criticisms have
take-off because the full transition from a tra- hinged on whether a valid and operationally mean-
64 Introduction
ingful distinction can be made between stages of (1965), p. 227). And on the concept of the take-off
development, especially between the so-called stage in general Kuznets concludes that lack of
transitional phase and take-off, and between common experience typifying countries in the
take-off and maturity. Critics have attempted to take~off stage, in relation to investment, etc., 'casts
argue that the characteristics that Rostow dis- serious doubt on the validity of the definition of
tinguishes for his different stages are not unique to the take-off as a general stage of modern economic
those stages. Thus the demarcation between take- growth, distinct from what Professor Rostow calls
off and transition is blurred because the changes the precondition, or transition, stage preceding it
that take place in the transition phase also seem to and the self-sustaining growth stage following it'
take place in the take-off phase, and similarly with (Kuznets (1965)). Cairncross (1961) echoes these
the demarcation between take-off and maturity. remarks of Kuznets and appears to deliver a decis-
One of the most outspoken of Rostow's critics ive blow when he asks what, if the various stages
is Kuznets, and some of his criticisms may be overlap, is the meaning of a 'stage'?
quoted as representative of the criticisms that Ros- Are we to conclude from all this that Rostow's
tow has received in general. First, there is the contribution is of little value? The answer to this
difficulty of empirically testing the theory, which must be in the negative; at least, much can be
Rostow himself makes no attempt to do. For one salvaged. While growth stage theories may be
thing there is a general lack of quantitative evi- lacking in analytical power, the purpose of stage
dence for assertions made, and for another Ros- theory is not that the stages distinguished should
tow's description of the characteristics of some of necessarily have parallels in history, or be rigidly
the stages are not sufficiently specific to define the distinct, but to distinguish the situations in which
relevant empirical evidence even if data were avail- an economy may find itself- situations which may
able. With respect to the take-off stage, for merge into one another. While the concept of a
example, what is a 'political, social and insti- 'stage' may be quibbled with, and stage theory
tutional framework which exploits the impulses to dismissed as a blue-print for development, Rostow
expansion in the modern sector'? Kuznets argues: offers many extremely valuable insights into the
'it seems to me that Rostow . . . defines these development process. As we have seen from the
social phenomena as a complex that produces the work of Chenery and Maizels, development is not
effect he wishes to explain and then treats this entirely haphazard, and there are certain features
identification as if it were a meaningful identifica- of the development process which do follow a
tion' (Kuznets (1963), reprinted in Kuznets well-ordered sequence. Moreover, there are cer-
(1965), p. 219). Kuznets seems to be calling into tain development priorities which countries plan-
question the whole of Rostow's scientific method ning development may neglect at their peril. The
and is claiming as unscientific the practice of ob- importance of agriculture and the role of invest-
serving phenomena, developing hypotheses on the ment in raising the rate of growth are particularly
basis of the phenomena, and then using the stressed, as are certain political and sociological
phenomena to support the hypotheses! preconditions for development which economists
As regards quantitative evidence that is avail- are prone to forget, and which are ignored here.
able for testing hypotheses, Kuznets questions While emphasis on investment appears to be an
Rostow's figures of investment and the incremen- unfashionable doctrine in the developed countries
tal capital-output ratio during the take-off period at present, there exists no satisfactory counter-
in the countries studied. He says: 'Unless I have argument to the doctrine in developing countries if
completely misunderstood Professor Rostow's defi- capital is properly defined. If Rostow fails to pro-
nition of take-off, and its statistical characteristics, vide an analytical breakthrough, he has aroused
I can only conclude that the available evidence once again theoretical interest in the history and
lends no support to his suggestions' (Kuznets causes of the growth of the wealth of nations.
Development and Underdevelopment 65
66
Production-Function Approach to Growth 67
capital and labour in the productive process and growth rate into various constituent growth-
so on? Growth identities of the type outlined inducing sources and can 'explain' growth rate
cannot distinguish between such competing hy- differences in terms of these sources, it cannot
potheses. What is required is a testable model of answer the more fundamental question of why
the growth process. labour supply, capital accumulation and technical
The production-function approach to the measure- progress grow at different rates between countries.
ment of growth is a response to this challenge. It is The answer to this question must lie in differences
a method of approach to facilitate an understand- in the strength of demand for countries' products,
ing of the sources of growth, and to quantify the which in the early stages of development depends
contribution of these sources to any measured largely on the prosperity of agriculture (see Chap-
growth rate. The approach has been used exten- ter 3) and in the later stages of development de-
sively and usefully in developed countries, and pends largely on the country's export performance
some results and conclusions from these studies relative to its import propensity (see Chapter 16).
will be given later. It has more recently been Having said this, what problems does the pro-
employed in the context of developing countries, duction function approach pose? There are prob-
although some would say not very fruitfully be- lems of calculation and estimation but these are
cause the major sources of growth in developing not insuperable. Apart from the difficulties of spe-
countries are institutional and non-measurable. cifying the sources of growth precisely, and
The justification for introducing the approach here measuring accurately both the dependent and
is twofold. First, since it is now a widely used independent variables, the main problem is a
technique, students ought to be familiar with it, methodological one of fitting the appropriate pro-
and aware of its limitations. Second, and more duction function to the data; that is, specifying the
important, if discussions of development are to function relating output to inputs.
advance beyond the stage of anecdote, hunch and
opinion, growth and development must be placed • The Production Function
in an analytical framework so that hypotheses can
be advanced subject to the possibility of testing. One of the desirable properties of any macro-
The production-function approach is a first step in economic hypothesis, apart from being consistent
this direction. Even if growth consists of more with the observed facts, is that it should be consist-
than economic inputs, it is still useful to know the ent with, and derivable from, micro-economic theory.
rough contribution that the growth of, say, capital What we are calling the production-function ap-
and labour has made to measured growth in the proach to the analysis of growth in the aggregate
past, if only to put the growth debate in perspec- possesses, in part, this desirable property in that it
tive. It must be borne in mind throughout the borrows the concept of the production function
discussion, however, that this approach to the from the theory of the firm. Just as it can be said
analysis of growth does not tell us why the growth for a firm that output is a function of the factors of
of the factors of production, capital and labour, production- land, labour, capital and the level of
and technical progress differ between countries. technology (or factor efficiency) - so aggregate
The sources of growth are treated as exogenous. In output can be written as a function of factor
practice, however, the supply of most resources to inputs and the prevailing technology, i.e.
an economic system is endogenous responding to
the demand for them. Capital is a produced means 0 = f(R, K, L, T) (2.3)
of production and comes from the growth of where R is land, K is capital, L is labour and T is
output itself; labour is very elastic in supply, and technology. 1
technical progress is itself partly dependent on the
growth of output. Thus, while the production 1 For the time being, the formidable problems associated with
function approach can disaggregate any measured an aggregate measure of capital are ignored.
68 Introduction
Figure 2.3
K I The Cobb-Douglas Production
Function
~1~
The production function most commonly fitted to
aggregate data to distinguish empirically between
these three broad sources of growth has been the
unconstrained form of the Cobb-Douglas produc-
tion function, named after its two American orig-
0 L inators, Charles Cobb (a mathematician) and Paul
increase in combined inputs. If this is the case, Douglas (an economist), who pioneered research
output per unit of total inputs will increase and in the area of applied economic growth in the
the production functions representing equal ad- 1920s and 1930s (Cobb and Douglas (1928)). The
ditional amounts of production, e.g. 100, 200, Cobb-Douglas function may be written as
300, etc., must be drawn closer and closer together
as in Figure 2.3. (2.4)
In the opposite case of decreasing returns, the
functions would be drawn further and further where Otis real output at timet, Tt is an index of
apart. Finally, in the case of production subject to technology, or 'total' productivity, K tis an index
constant returns the functions would be drawn of the capital stock, or capital services, at constant
equidistant from one another. prices, L t is an index of labour input (preferably
Increasing returns may also result from ad- man-hours), a is the partial elasticity (responsive-
vances in technology, irrespective of increases in ness) of output with respect to capital (holding
factor supplies. These are called technological labour constant), and ~ is the partial elasticity of
economies of scale. In this case increases in output output with respect to labour (holding capital
per unit of input would have to be represented on constant).
a production-function diagram either by a relabel- It is assumed that changes in technology are
ling of the functions or a relabelling of the axes. exogenous and independent of changes in ·factor
That is, either the same amount of factor inputs, inputs, and that the effect of technical progress is
measured on the axes, would have to be shown to neutral on the factor intensity of production (see
be producing a higher output than before, or p. 118 for a definition of neutral technical pro-
alternatively the same output could be shown to gress). Tt, a and ~ are constants to be estimated
be produced by lesser amounts of inputs. If the empirically if the function is unconstrained. If a
functions are relabelled and not the axes, this is and ~ are assigned values in advance of the use of
tantamount to a shift in all the production func- the function for estimating purposes, the function
tions towards the origin. Shifts in the production is said to be constrained. Normally, a and ~ will
function towards the origin are implied by all be less than unity on the assumption of diminish-
forms of technical progress or any factor which ing marginal productivity of factors. The sum of
increases the productivity of the physical inputs. the partial elasticities of output with respect to
In short, there are three broad sources of the factors of production gives the scale of returns,
growth that can be distinguished using the produc- or the degree of homogeneity, of the function:
tion-function framework: first, increases in factor a + ~ = 1 represents constant returns, a + ~ > 1
supplies; second, increasing returns; and third, represents increasing returns, and a + ~ < 1 rep-
technical progress interpreted in the wide sense of resents decreasing returns, and the function is said
anything that increases the productivity of factors to be homogeneous of degree one, greater than
other than increasing returns. one, and less than one, respectively.
70 Introduction
The contribution of capital to measured growth is considered the result of measurement errors, is
0.25 (5 .0) = 1.25 percentage points; the contribu- likely to be the effect of resource shifts from less
tion of labour is 0.75 (1.0) = 0.75 percentage productive to more productive activities. Since the
points; and rT is left as a residual with a contribu- analysis is aggregative there is bound to be a
tion of 3.0 percentage points. If a and p were confounding of changes in actual output with
estimated empirically, and there happened to be changes in the composition of output unless the
increasing returns (a + p > 1), the significance of weights used for aggregating inputs are continu-
the factor contribution would be enhanced and rT ally revised. Resource shifts from agriculture
would be smaller. to industry can be expected to figure prominently
On the assumption of constant returns to scale, in any production-function study of developing
the production function can also be estimated in countries, as they do for studies of many advanced
its so-called labour-intensive form to analyse econom1es.
the growth of output per head. If we subtract rL Before considering some of the results of apply-
from both sides of equation (2.6) and assume ing the Cobb-Douglas function to empirical data,
a + p = 1, so that P = a - 1, we get: we must briefly mention some of its limitations. Its
use has come under attack on four main counts.
(2.8) The first criticism is that since only one combina-
tion of factor inputs can be observed at any one
In words, equation (2.8) says that the rate of time, there is an identification problem in attempt-
growth of output per head (or labour pro- ing to distinguish shifts in the function (technical
ductivity) is equal to the sum of the rate of growth progress) from movements along the function
of total productivity plus the rate of growth of (changes in factor intensity) unless the assumption
capital per head times the elasticity of output with of neutral technical progress is made. But technical
respect to capital. Taking the illustrative figures progress may not be neutral and therefore the
above, if r0 = 5 per cent and rL = 1 per cent, then effects of technical progress and changing factor
the rate of labour productivity growth is 4 per intensity become confused, biasing the results of
cent. Therefore: the contribution of factor inputs and technical
progress to growth. Secondly, the assumption that
4.0 = rT + 0.25 (5.0 - 1.0) (2.9) technical progress is independent of increases in
factor inputs has been questioned. This is not a
The contribution of capital per head (capital specification error of the function itself, however,
deepening) to productivity growth is 1 percentage and the Cobb-Douglas function can be used mak-
point, leaving r T with a contribution of 3 percent- ing technical progress a function of the rate of
age points (as before). growth of inputs - so-called endogenous models
Although r T has been variously called techni- of technical progress. Thirdly, the Cobb-Douglas
cal progress, advances in knowledge, etc., defi- function possesses the restrictive property of con-
nitionally it is that portion of the growth of output stant unitary elasticity of substitution between
not attributable to increases in the factors of pro- factors whatever the factor intensity. 1
duction, and includes the effects not only of the The assumption of a constant elasticity means
multifarious factors which go to increase the pro- that the function cannot represent a change in the
ductivity of labour and capital but also measure- ease of substitution between capital and labour.
ment errors in the capital and labour input series. The assumption of unitary elasticity may be serious
rT is perhaps best described as a residual, or,
perhaps more appropriately still, a 'coefficient of 1 The elasticity of substitution (cr) relates the proportional
ignorance' if the analysis proceeds no further. change in relative factor inputs to a proportional change in the
One important component of r D which can be marginal rate of substitution between labour and capital
72 Introduction
if the elasticity of substitution of factors differs heterogeneous items; in particular, what is the
significantly from unity and there are wide dis- meaning of an aggregation of capital goods built
crepancies in the growth rate of factors. For at different times, at different costs and with vary-
example, if the elasticity of substitution between ing productivities? How are such capital goods to
capital and labour is significantly less than unity be equated in an aggregate measure of capital?
and capital grows faster than labour, this will By and large, most of the above-mentioned
result in an overestimate of the contribution of criticisms are theoretical worries, the practical
capital to growth and an underestimate of the role significance of which is hard to determine. Studies
of other factors. The intuitive explanation of this of the nature of technical progress, at least in
bias is that the smaller the elasticity of substitution advanced countries, suggest that the assumption
the more difficult it is in practice to obtain in- of neutrality is a fair working hypothesis. The fact
creased output just by increasing one factor be- that technical progress may be dependent on fac-
cause diminishing returns set in strongly. By tor accumulation can be accommodated within
assuming the elasticity is higher than it is, the the Cobb-Douglas framework. Capital and
importance of the fastest-growing factor is exag- labour would have to grow at very different rates
gerated. If elasticity is high, diminishing returns for the elasticity of substitution to matter very
are not a problem, and if both capital and labour much, but in any case studies show that it is quite
expand at the same rate, growth is obviously close to unity. Finally, although the aggregation of
independent of the elasticity of substitution. 2 heterogeneous outputs and inputs can present
A final criticism relates to the measurement severe problems, especially the aggregation of
of output and inputs. What, argue some, is the capital which cannot be measured directly in
meaning of a function which aggregates so many physical units, there are techniques of aggregation
available which various studies have used with
(MRS) (or the proportional change in the relative factor-price some success.
ratio on the basis of marginal productivity theory). The elas-
ticity of substitution may therefore be written as What have been the results of applying the
Cobb-Douglas function to empirical data? First,
a = alog (LIK) let us consider its application in developed coun-
a log MRS tries and consider the conclusions that emerge. We
The proof that a = 1 is very simple: can start with the pioneer work of Cobb and
Douglas themselves. Ironically, the Cobb-Douglas
function as first conceived was not intended as a
device for distinguishing the sources of growth but
as a test of neo-classical marginal productivity
a
log MRS = log j3 + log KL theory; that is, to see whether elasticities corre-
sponded to factor shares. Douglas had observed
Differentiating with respect to log MRS gives
that the output curve for American manufacturing
1= alog (LIK) = 0 industry for the period 1899-1922 lay consist-
alog MRS ently between the two curves for the factors of
production, and he suggested to his mathema-
2 To overcome the restrictive property of the Cobb-Douglas
function when the growth rates of factors do differ, it is tician friend, Cobb, that they should seek to de-
possible to use the more general constant elasticity of substitu- velop a formula which could measure the relative
tion production function, of which the Cobb-Douglas is a effect of labour and capital on the growth of
special case. We cannot discuss the function here except to say
that it, too, is not without its specification errors. There is still output over the period in question. This story is
the assumption of constancy which has the drawback that one described by Douglas (1948) in his fascinating
may be ascribing changes in elasticity to changes in technology review article 'Are There Laws of Production?' As
which are really due to changes in factor proportions. This
limitation can only be overcome with a function possessing the an insight into inductive method the relevant pass-
property of variable elasticity of substitution. age is worth quoting in full:
Production-Function Approach to Growth 73
Having computed indexes for American manu- ance which it appears to give to productivity
facturing of the number of workers employed increase and it should be, in a sense, sobering, if
by years from 1899 to 1922 as well as indexes not discouraging to students of economic growth.
of the amounts of fixed capital in manufactur- Since we know little about the causes of pro-
ing deflated to dollars of approximately con- ductivity increase, the indicated importance
stant purchasing power, and then plotting these of this element may be taken to be some sort of
on a log scale, together with the Day index of measure of our ignorance about the causes of
physical production for manufacturing, I ob- economic growth in the United States, and
served that the product curve lay consistently some sort of indication of where we need to
between the two curves for the factors of pro- concentrate our attention (Abramovitz (1956),
duction and tended to be approximately one- p. 11).
quarter of the relative distance between the
curve of the index for labour, which showed Abramovitz's findings were supported by Solow,
the least increase in the period, and that of the who found, in examining the data for the non-
index of capital which showed the most. I sug- farm sector of the US economy for the period
gested to my friend Charles Cobb that we seek 1919-57, that approximately 90 per cent of the
to develop a formula which could measure the growth of output per head could not be accounted
relative effect of labour and capital upon pro- for by increases in capital per head; that is, using
duct during this period. At his suggestion the the notation in equation (2.8)
sum of the exponents was tentatively made
equal to unity in the formula 0 = TKa L 1 - a (2.10)
[our notation] .... The fact that on the basis of
fairly wide studies there is an appreciable de- The findings of Abramovitz and Solow dis-
gree of uniformity, and that the sum of the turbed economists brought up in the belief that
exponents approximates to unity, fairly clearly investment and capital accumulation played a cru-
suggests that there are laws of production which cial role in the growth process. Even allowing for
can be approximated by inductive studies and the statistical difficulties of computing a series of
that we are at least approaching them (Douglas the capital stock, and the limitations of the func-
(1948), p. 20). tion applied to the data (e.g. the assumptions of
constant returns and neutral technical progress,
The estimated function derived was 0' = 1.01 plus the high degree of aggregation), it was dif-
K0 ·25 U· 75 , which lent support to the neo-classical ficult to escape from the conclusion that the
model of constant returns and marginal product growth of the capital stock was of relatively minor
pricing. There was no discussion of the relative importance in accounting for the growth of total
importance of factors of production and the T output. It is true that Abramovitz had stressed that
variable in accounting for measured growth. It his findings did not imply that resources were un-
was not until Abramovitz in 1956 (Abramovitz important for growth, because of the interrelation
(1956)) and Solow in 1957 (Solow (1957)) between the growth of inputs and factors leading
showed that between 80 and 90 per cent of the to increases in output per unit of inputs, but this
growth of output per head in the US economy over caution was not sufficient to counter the initial
the century could not be accounted for by in- reaction that capital does not matter.
creases in capital per head that the production It would not be misleading to say that most of
function started to be used in earnest as a tech- the subsequent research effort in this field of
nique in the applied economics of growth. Abra- growth was designed to reverse this conclusion, or
movitz remarked: rather to 'assign back' to the factors of production
sources of growth which make up the residual
This result is surprising in the lop-sided import- factor but which are interrelated with, or depen-
74 Introduction
dent on, the growth of factor inputs. Work has fications to the Cobb-Douglas function which can
proceeded on two fronts. On the one hand, be made to allow for the quality changes discussed
attempts have been made to disaggregate the re- above, and then consider some of the empirical
sidual factor, measuring factor inputs in the con- evidence.
ventional way; on the other hand, attempts have
been made to adjust the labour and capital input
series for such things as changes in the quality of • Embodied Technical Progress
factors and their composition so that much more
measured growth is seen to be attributable to in- If capital is measured net at constant prices, and
creases in factor inputs in the first place. For exam- all ages or vintages of capital are treated alike,
ple, the labour input series has been adjusted for technical change associated with capital invest-
improvements in its quality due to the growth of ment becomes part of the residual factor in the
education, and for changes in its composition due growth equation. The ultimate effect of adjusting
to age/sex shifts. Likewise, the capital stock series the capital stock series for embodied or endoge-
has been adjusted to reflect changes in its composi- nous technical change is to raise the sensitivity of
tion and, more important, to allow for the fact the growth rate to changes in the rate of capital
that new additions to the capital stock in any line accumulation. The question is, how should the
of production are likely to be more productive adjustment take place, and how to assess the rela-
than the existing capital stock as a result of tech- tive importance of technical change that depends
nical advance. This is the notion of embodied or on the growth of capital compared to conven-
endogenous technical change as opposed to the tional hypotheses of the role of capital? Ex-
exogenous technical change assumption of the ori- perimenting with the embodied technical progress
ginal Cobb-Douglas function which assumes that hypothesis is, in fact, a complicated procedure
all vintages of capital share equally in technical because measures of the capital stock can only be
progress. A distinction is now made, therefore, properly corrected for the effect of technical
between embodied and disembodied technical change if the rate of progress is known. Since this
progress - embodied technical progress referring rate, in general, is unknown, it is necessary to
to technical improvements that can only be intro- work by a process of trial and error. Applied stu-
duced into the productive system by new invest- dies can be divided into those which attempt to
ment, and disembodied technical progress which is estimate a fairly precise rate of embodied technical
exogenous and not dependent on capital accumu- progress and those which simply try to assess its
lation. There are several ways in which embodied relative importance. As far as the latter approach
technical progress can be isolated from the re- is concerned, one device is to measure capital gross
sidual factor by appropriate adjustments to the at current prices rather than net at constant prices.
capital stock series to reflect the greater productiv- If capital is measured in this way, technical change
ity of the latest investments. The net result is to in capital should be implicit in the price variable
enhance the role of capital accumulation in the leaving disembodied technical change in the re-
growth process. sidual factor. Alternatively, an exponential time
Efforts have also been made towards overcom- trend can be added to the traditional form of the
ing one of the problems associated with the production function, representing a constant rate
aggregation of outputs by taking explicit account of productivity advance, and this may be called
of shifts of labour and capital from low-productivity disembodied technical progress. The residual
to high-productivity sectors. This, too, reduces the would then consist of the effects of embodied
significance of the residual factor and makes the progress. The difficulty here is that embodied tech-
role of labour and capital in the growth process nical progress may also grow exponentially if the
look correspondingly more important. growth of the capital stock itself is fairly constant.
Let us now look in greater detail at the modi- A third approach, and one which in theory
Production-Function Approach to Growth 75
allows a more precise measure of the rate of em- alter the age distribution of capital and this, too,
bodied technical progress, is the so-called vintage will affect the productivity of capital in that the
approach to the measurement of capital. The proc- gap between the average technology and the best-
edure here is more formal and involves a consid- practice techniques will be changing. A decrease in
eration of the model representing the embodiment the average age of capital will improve the pro-
hypothesis. The vintage approach to the consid- ductivity of capital by an amount equal to -/...K~A,
eration of embodied technical progress is most where ~A is the change in the average age of
associated with the name of Professor Solow. He capital (~A is negative if the capital stock is get-
was the first to present the economic theory upon ting younger owing to a faster accumulation of
which the vintage production function is based, capital).
and was among the first to modify the basic The rate of growth of the 'effective' capital
Cobb-Douglas function to allow for embodied stock may therefore be written as:
technical change and to estimate its growth. Basi-
cally, the approach consists of giving a separate ~K -
-+A.
K K
-A. K ~A (2.13)
valuation to each year's addition to the capital
stock, with a higher weight being assigned to the
most recent and presumably the more productive where ~KIK is the rate of growth of the actual
additions. The problem is deciding the weights. capital stock, A.K is the rate of growth of improve-
Solow's original model (1960) has estimation ment in the capital stock, and A.K~A is the effect of
complications, but Nelson (1964) has produced a changes in the average age of the capital stock,
similar model incorporating the same features which is a function of the investment ratio.
where the 'effective' capital stock is given as a The Cobb-Douglas function with embodied
function of the gross capital stock, its average age, technical progress may now be written in estimat-
and the rate of productivity improvement of new ing form as
capital goods. Denoting the 'effective' capital
stock as 1:, the Cobb-Douglas function as modified r 0 = rr + arK+ af...K- af...K~A
for changes in the quality of capital may be written (2.14)
as:
where r denotes the rate of growth of variables
(2.11) over time.
Equation (2.14) is derived in exactly the same
where 1: is the quality-weighted sum of capital way as equation (2.6) and can be interpreted in the
goods and T' is now an index of total productivity same way.
excluding the effect of technical progress em- But the question remains, how much of the
bodied in new capital. measured growth rate r 0 is due to embodied tech-
Assuming that technical progress improves the nical change, how much to disembodied, exogen-
quality of new machines at a constant rate per ous forces, and how much to changes in the age
annum (A.K), then: distribution of capital if the average age is chang-
t ing? If we know the rate of growth of total pro-
'tt = L Kvt(l + A.Kt (2.12) ductivity and the age distribution of capital, and
0
all technical progress is assumed to be embodied,
where Kvt is the amount of capital built in year V then A.K and the effects of changing age distribution
(of vintage V) which is still in use in timet. (Kvt is can be calculated. But it is clearly unrealistic to
gross capital of vintage V, and the variable it is assume that all technical progress is embodied.
thus an integral value of capital with different How, then, is the rate of embodied progress to be
vintages). estimated using the vintage approach? The method
If the rate of growth of capital changes, this will commonly employed is to experiment with differ-
76 Introduction
ent rates of embodied technical progress and, on To what extent may the role of labour in the
a trial-and-error basis, choose that rate which growth process be underestimated, and the
gives the best statistical fit when the function is amount of 'unexplained' growth exaggerated, by
estimated using empirical data for the other vari- ignoring changes in the quality of labour? A model
ables. Needless to say, the technique is arbitrary, analogous to that embodying technical progress in
but given values for A.K and A.KdA, the sensitivity of capital can be developed which embodies quality
output with respect to capital is increased. Im- improvements in labour, although it is not strictly
provements in the quality of capital can be re- necessary for new additions to the labour force to
garded as equivalent to physical increases in the be more productive than the average for the aver-
quantity of capital of a few extra per cent. The age quality to increase. The sorts of factors that
contribution of capital to growth is enhanced. increase the personal efficiency of labour, and
As far as the empirical evidence is concerned, labour productivity, operate, in general, in a dis-
however, there seems to be some difference of embodied way.
opinion among investigators as to the importance If we denote the improved quality of labour as
of the embodiment hypothesis. Nelson (1964) qL, where q stands for the improvement in the
found that virtually all of the variation in growth productive efficiency of labour, changes in the
of labour productivity in the American economy quality of labour are accommodated by writing
in the first half of the twentieth century can be the Cobb-Douglas function as:
accounted for by variations in the average age of
the capital stock, as opposed to variations in A.K (2.15)
even if full embodiment is assumed. On this
where T* is an even narrower concept than T' by
finding the proportion of the total output of a
country that is invested is crucial to growth, since excluding from the residual improvements in the
the average age of capital is inversely related to the quality of labour as well as capital. q can stand
both for an improvement in the average quality of
investment ratio. On the other hand, Denison
(1964) has argued on several occasions that the labour, and an improvement in the productive
embodiment effect operates solely through the age efficiency of new workers due to such things as
distribution of capital, which is subject to very education or training. If q expresses an improve-
small variation and cannot be important in prac- ment in the productive efficiency of new workers,
it is here that there is an analogy with the vintage
tice. But it is not only changes in the average age of
the capital stock that distinguish the 'new view' of model of capital, and it becomes necessary to ex-
investment from the traditional assumption that press the production function not only in a form
all progress is disembodied. The average age of recognising an improvement in the average quality
of labour but in a form which also takes account
capital may remain the same, but at the same time
more productive machines may be replacing those of changes in the age composition of labour. Let A.L
that are wearing out. Several studies for America, be the yearly rate of improvement in the average
efficiency of labour and dE the change in the
which have attempted to estimate embodied tech-
nical progress by the trial-and-error procedure average age of the work-force. We can then write:
mentioned, arrive at annual improvement rates of
d(qL)
between 2 and 5 per cent. (2.16)
(qL)
The Cobb-Douglas function, adjusted for labour and capital separately, is to take the differ-
changes in the quality of both capital and labour, ence between the marginal product in the two
now becomes (in estimating form): sectors considered and to multiply this difference
by the product of the increase in the proportional
r0 = ry* + arK+ aA.K- aA.KilA importance of the factor in the sector with the
highest marginal product and the share of the
(2.17)
factor in total income. Thus, suppose labour is
moving from agriculture, which is a low-pro-
The residual term, rT *, is now the rate of growth ductivity sector, to industry, which is a high-
of total productivity or technical progress inde- productivity sector, then the contribution of the
pendent of increases in factor inputs. The effect of transfer of labour to measured growth can be esti-
making allowance for improvements in the quality mated as:
of labour and changes in its average age is exactly
the same as in the case of capital - to increase the
sensitivity of output growth to the growth of the
labour force and to reduce the size of the residual
factor. The two most important factors affecting where MRPLr is the marginal revenue product of
the quality of labour in any economy are work labour in industry, MRPLA is the marginal revenue
experience (or learning), which primarily im- product of labour in agriculture, ilSLr is the
proves the average quality of labour, and formal change in the proportional importance of labour
education and training, which may exert their in the industrial sector, and L/Y is labour's share
effect both through changes in the average quality of income.
of labour and its 'age' distribution if education The same procedure can be adopted for estimat-
and training expand, and primarily affect new ing the contribution of capital shifts to growth.
workers. We shall discuss education and learning Robinson (1971) has estimated for the period
more fully when we consider again capital and 1958-66 that the average contribution for 39
technical progress in Chapter 4. 1 countries of capital and labour transfers between
agriculture and industry to measured annual
growth was 0.20 and 0.57 percentage points, re-
• Resource Shifts spectively, giving a joint percentage contribution
to the average annual growth rate of 16 per cent.
In addition to improvements in the quality of in- A second method is to take a weighted average
puts, an important source of productivity growth of the rates of 'technical progress' within different
may be resource shifts from less productive to individual activities and to subtract this from the
more productive activities. Unless the weights for aggregate measure of technical advance, leaving
aggregating capital and labour are continually re- the difference as a measure of productivity ad-
vised to reflect their changing productivities in vance due to shifts of resources between activities.
different occupations, the effects of resource re- This is not an ideal measure because the difference
allocation will appear independent of the factors is bound to contain the effects of other 'errors' and
of production whereas, in practice, growth from omissions, but is does give some idea of the effects
this source is intimately bound up with factor of aggregation. When Massell (1961) adopted this
endowments and the sectors in which the growth procedure in a study of nineteen American manu-
of factors of production takes place. There are two facturing industries over the post-war years, he
main methods of calculating the effect of resource found that approximately 30 per cent of the aggre-
shifts on measured growth. One method, taking gate rate of technical advance was the result of
1 For a survey of many of the issues discussed here, see Ken- aggregation. Approximately 0.1 percentage point
nedy and Thirlwall (1972). of growth was due to labour shifts and 0.8 percen-
78 Introduction
tage points to capital shifts. Denison (1967) has developed countries. The price of labour almost
made estimates of a similar order of magnitude for certainly exceeds its marginal product, while the
some countries of Western Europe considering price of capital falls short of it so that the share of
only shifts of resources from agriculture to indus- income going to labour exceeds the elasticity of
try. From 1950 to 1962 resource shifts from agri- output with respect to labour and the share of
culture to industry contributed 1.04 percentage income going to capital understates the elasticity
points per annum to the growth rate of Italy, 0.76 of output with respect to capital. Second, the
percentage points in Germany and 0.65 percent- aggregation of inputs and outputs is generally
age points in France. Indeed, it is these shifts more difficult, and there are greater problems of
which account in large part for the difference in resource under-utilisation to contend with. The recent
the post-war growth performance of continental past, however, has witnessed a sprinkling of produc-
Europe on the one hand and the United States and tion-function studies for developing countries, and there
Great Britain on the other. The potential scope for are undoubtedly many more to come as more data be-
growth from this source in developing countries must come available. Moreover, the production function, de-
be considerable as Robinson's work suggests. Given spite its drawbacks, does yield verifiable hypotheses.
the size of the agricultural sector in developing coun- The studies for advanced countries tend to
tries, resource shifts into industry will be a source confirm the relative unimportance of capital com-
of growth for a considerable period in the future. pared with other growth-inducing variables. Even
allowing for changes in the composition of capital
and embodiment, capital growth rarely accounts
• Empirical Evidence for more than one-half of the measured growth of
output. Denison, who adjusts the capital stock for
Since Abramovitz and Solow reported their findings changes in its composition, estimates a contribu-
in 1956 and 1957, a substantial body of empirical tion of approximately 25 per cent in the United
evidence relating to the sources of growth has States over the period 1950-62 and just under 20
accumulated experimenting with different spe- per cent in North-West Europe over the same
cifications of the aggregate production function. period (Denison (1967)). Solow, using an em-
Unfortunately, it is not systematic. The time bodied model, finds the weighted contribution of
periods taken, the data used, the sectors of the embodied technical progress for plant and machin-
economy examined, and the methodology em- ery less than that of disembodied progress (Solow
ployed, all vary within and between countries. All (1962)). One notable exception to this general rule
that can be done here is to draw attention to some is the case of Israel, where Gaathon (1961) finds
of the major findings and let readers check for that the growth of capital per head accounted for
themselves the nature of the work. Until recently 60 per cent of the annual average growth of in-
most of the evidence available pertained to fairly come per head over the period 1950-9. Perhaps
advanced economies and it is largely from this this is a good example of the type of country that
evidence, wisely or not, that conclusions have been Hicks had in mind when he said that 'it is very
drawn on development strategy for developing wrong to give the impression to a [developing]
countries. Research in developing countries has country, which is very far from equilibrium even
been hampered by a lack of researchers, a shortage on past technology, that capital accumulation
of reliable empirical data, and perhaps an even is a matter of minor importance' (Hicks (1965),
greater suspicion of the aggregate production p. 304). We shall discuss later good economic
function, and its implicit assumptions, than in de- reasons why the growth of capital may be more
veloped countries. The assumption that factor important for growth in developing countries than
shares can be used as weights to measure the rela- in more mature economies.
tive contribution of labour and capital to growth If a country experiences a rapid rate of capital
is probably more dubious in developing than in accumulation this will undoubtedly offset some of
Production-Function Approach to Growth 79
the biases against capital inherent in the produc- cussed later in Chapter 6 in considering the so-
tion-function framework. For equal additional in- called 'population problem'. The importance of
creases in capital and labour the factor of produc- labour is considerably enhanced when the growth
tion showing the biggest contribution to growth of education is taken into account. In the United
will be the one with the largest partial elasticity. If States over the period 1929-58 Denison (1962)
labour and capital grow at the same rate, and a has estimated that increases in education raised
and ~ are decided on the basis of shares of the the quality of the labour force by the equivalent of
national income, the contribution of capital a 0.93 per cent per annum increase in the quantity
growth will always appear less important than of labour. Weighting by labour's share of the
labour simply because its share of the national national income gives a contribution of education
income is smaller. This bias is greater the greater to measured growth of 0.68 percentage points, or
the degree of structural disequilibrium in the 23 per cent. The corresponding contribution of
labour market with wages in excess of marginal education to the rise in output per person em-
product. Furthermore, when a and ~ are estimated ployed is 42 per cent.
empirically, there is also a tendency for the partial
elasticity of output with respect to capital to be
biased downwards compared with the elasticity
for labour. The reason is that in estimating a by
I Production-Functi.on Studies of
Developing Countries
regression techniques, output is normally related
to the capital stock or capacity rather than capital In recent years several production-function studies
utilisation. Output is obviously less sensitive to of the sources of growth in developing countries
actual capacity (which is relatively fixed) than to have been attempted, notably by Maddison (1970),
the utilisation of capacity. The elasticity of output Bruton (1967), Robinson (1971), Hagen and Haw-
with respect to labour, on the other hand, can be rylyshyn (1969), Correa (1970), Gaathon (1961),
more easily related to a measure of labour utilisa- Lampman (1967) (the last three studies, and others,
tion by taking statistics of man-hours worked. It is surveyed by Nadiri (1972)), Shaaeldin (1989) and
interesting to note that a study by Brown and de the World Bank (1991). Let us consider these studies
Cani (1962), which took the utilisation of capital and bring out their major conclusions, especially any
as the measure of capital input, estimated an elas- important contrasts with the conclusions from stu-
ticity of output with respect to capital of 0.739, dies of developed countries.
which is much higher than normally estimated or Maddison studies 22 developing countries over
employed in production-function studies. In future the period 1950-65. His approach is conventional
production-function studies much more attention except for the adjustment of employment growth
needs to be paid to capacity utilisation, and also to for such factors as the migration of labour from
possible discrepancies between factor prices and agriculture to industry and improvements in
marginal products, before making estimates of health and education to obtain a measure of the
elasticities on the basis of factor shares. growth of the 'effective' labour force. Allowing for
In general, the growth of the labour force has these improvements, Maddison estimates an aver-
contributed as much to growth in developed coun- age growth of the effective labour supply for all
tries as capital accumulation and probably more in countries of 3.9 per cent per annum, compared
the developing countries if embodied technical with actual employment growth of 2.1 per cent
progress is ignored. Labour-force growth is neu- per annum. Labour migration is estimated to have
tral, of course, on the growth of income per head raised the growth rate of the 'effective' labour
except to the extent that there is a relation be- supply by the equivalent of a 1.1 per cent increase
tween the growth of the work-force and the in employment. Likewise better health and educa-
growth of labour productivity. There are con- tion are estimated to have raised the growth rate
flicting views on this matter and these are dis- of the 'effective' labour supply by 0. 7 per cent. The
80 Introduction
Table 2.1 The Contribution of Factor Inputs and Increased EHiciency to Economic Growth, 1950-65 (measured
in percentage points)
The contribution of
Source: Maddison, Economic Progress and Policy in Developing Countries, table 11.11, p. 53.
average growth rate of the capital stock for the allocation. The weights applied to labour and
countries is estimated as 6.1 per cent per annum. capital of 0.5 to obtain the above results may seem
Applying weights of 0.5 to both the growth of arbitrary but they have some support from Robin-
capital in each country and the growth of labour son's later cross-section study of the sources of
makes the rate of growth of capital the most im- growth in developing countries which suggests
portant source of growth in most countries. Mad- that at least the elasticity of output with respect to
dison concludes in fact that the acceleration of labour is of the order of 0.5. This weight is prob-
investment has been the most important engine of ably lower than labour's share of income in the
growth in the post-war developing world. Over average developing country. The contribution of
all, the growth of the 'effective' labour force is factor inputs and increased efficiency to measured
estimated to have contributed about 35 per cent to growth in each of the individual countries is
average measured growth, and capital about 55 shown in Table 2.1.
per cent, leaving a residual contribution of 10 per Maddison also makes the novel distinction in
cent attributable to increased efficiency in resource his analysis between growth that has been induced
Production-Function Approach to Growth 81
by policy changes and growth that would have most countries the same division has been made
occurred spontaneously. It appears, according to between the contribution of factor inputs to
Maddison's calculations, that, on average, policy- measured growth, after allowance for improve-
induced growth in the form of investment and ments in the health, nutrition and education of the
improved health and education facilities accounted labour force, and the contribution of total factor
for 40 per cent of measured growth. Other policy productivity growth (i.e. improvements in efficien-
changes, however, apparently reduced growth in cy). The only major difference between the studies
some countries by impairing efficiency. The nega- surveyed by Nadiri and Maddison's study is that
tive growth due to changes in 'efficiency' shown in the studies covered by Nadiri the contribution
for some countries in column 4 of Table 2.1 is of resource shifts from agriculture to industry is
attributed by Maddison to such factors as import separately identified, having been subtracted from
restrictions, misguided subsidisation and excessive the. contribution of total productivity growth, as
inflation. opposed to being included in the contribution of
Nadiri (1972) has brought together and sur- labour-force growth to measured growth as in
veyed a number of other production-function stud- Maddison's study. The detailed results of the stu-
ies for developing countries: in some cases the dies surveyed by Nadiri are shown in Table 2.2.
same countries as those taken by Maddison. For The major conclusions are as follows: except for
Table 2.2 The Contribution of Factor Inputs, Improvements in the Quality of Labour and Resource Shifts to
Economic Growth in a Selection of Developing Countries
Argentina 195()-62 3.19 1.58 0.93 0.12 0.53 1.43 0.18 0.18
Brazil 195()-62 5.49 2.44 1.83 0.43 0.18 1.66 1.39 0.39
Chile 195()-62 4.20 1.05 0.65 0.20 0.20 0.32 2.83 0.11
Colombia 195()-62 4.79 2.35 1.66 0.49 0.20 1.04 1.40 0.33
Ecuador 195<J-62 4.72 1.47 0.92 0.32 0.23 1.07 2.18 -0.35
Honduras 195()-62 4.52 2.17 1.06 0.82 0.29 0.95 1.40 1.38
Mexico 195()-62 5.97 2.41 1.43 0.93 0.05 2.82 0.74 0.44
Peru 195()-62 5.63 1.40 0.67 0.57 0.16 1.40 2.83 0.36
Venezuela 195()-62 7.74 2.59 2.19 0.21 0.19 2.04 3.11 0.56
Greece 1951-61 5.29 2.80 1.63 0.86 0.60
India 195()-60 4.47 1.86 1.55 1.06
Israel 195()-65 11.01 3.50 4.11 3.40
Japan 1952-67 8.97 2.45 4.49 2.03 0.91
Philippines 1947-65 5.75 2.24 1.01 2.50
Notes: The rate of growth of income in column 1 is the sum of columns 2, 4 and 5. All 'contributions' are measured in percentage points.
Source: Compiled from Nadiri, 'International Studies of Factor Inputs and Total Productivity: A Brief Survey', Review of Income and Wealth, June
1972.
Country sources: Latin American countries: Correa, 'Sources of Economic Growth in Latin America'.
Greece: E. Voloudakis, 'Major Sources of the Postwar Growth of the Greek Economy', mimeo (Athens, 1970).
India: G. Psacharopoulos, The Anatomy of a Rate of Growth: The Case of Hawaii 195 0-60, Economic Research Centre, University
of Hawaii (March 1969).
Israel: A Gaathon, Economic Productivity in Israel (New York: Praeger, 1971).
Japan: W. Chung, 'A Study of Economic Growth in Postwar Japan for the Period 1952-67: An Application of Total Productivity
Analysis, mimeo (Denison University, 1970).
Philippines: R. Lampman, 'The Sources of Post-War Growth in the Philippines'.
82 Introduction
the fast-growing countries of Japan, Israel and developing countries. The contribution of resource
Mexico, the contribution to measured growth of shifts from agriculture to industry also looks smal-
total labour-input growth is shown to be greater ler than might have been expected, perhaps due to
than the contribution of capital-input growth, in the general surplus of labour in developing coun-
contrast to the results of Maddison's study. This is tries and the low capacity to absorb labour into
mainly due to the fact that in the studit:s surveyed productive employment in the industrial sector.
by Nadiri capital is given a smaller weight than Bruton's study concentrates entirely on the five
labour, reflecting capital's lower share of national Latin American countries of Argentina, Brazil,
income. This only serves to emphasise the point Colombia, Chile and Mexico over the period
that if the contribution of factor inputs to growth 1940-64. Bruton's main interest is to explain dif-
is to be assessed separately it is of prime import- ferences in productivity growth between the coun-
ance that the estimates of the weights should be tries. His major conclusion is that the main cause
reliable indicators of the elasticity of output with of differences in productivity growth has been the
respect to the factor inputs. Bearing in mind the ability to exploit unused resources. Total produc-
point made earlier that labour's share probably tivity growth (the residual) averages 1.4 per cent
exaggerates the elasticity of output with respect to per annum for the five countries, which represents
labour, and that capital's share underestimates the a contribution to measured growth of approx-
responsiveness of output to capital accumulation, imately 25 per cent. This is lower than the average
the equal weights used by Maddison are probably contribution of total productivity growth to mea-
to be preferred. However, the studies surveyed by sured growth in advanced countries. Maddison's
Nadiri support Maddison's finding that capital study and the studies surveyed by N adiri are
accumulation is a much more important source of further corroborated by Bruton's finding that total
growth in developing countries than it appears to productivity growth is of less importance as an
be in developed countries. Total factor productiv- explanation of growth in developing countries
ity growth is also shown to be of less importance than in developed countries. The major source of
in developing countries than in developed coun- growth in developing countries is the growth of
tries, which also corroborates Maddison. Accord- factor inputs themselves.
ing to Nadiri, this is probably because a large part Robinson's study is a cross-section study based
of investment expenditure is on infrastructure pro- on data from 39 countries averaged over the
jects which do not yield productivity gains im- period 1958-66. Robinson distinguishes four ma-
mediately, and also because the skills and quality jor sources of growth and the inevitable residual:
of human resources to work with capital are still the contribution of labour; the contribution of
so low. A few other features of the results may also capital; the effect of resource transfers from agri-
be noted. The gains to growth from improved culture; and the effect of foreign borrowing. The
health conditions are considerable. Their effect on parameters from the cross-section equation allow
growth comes via a reduction in the death rate and estimation of the average contribution of these
a reduction in the number of work days lost factors to measured growth across countries. From
through illness. As long as the initial conditions the equations which exclude foreign borrowing,
are poor, there will continue to be high returns to the contribution of labour to measured growth is
investment in health facilities. On the other hand, estimated as 20 per cent, the contribution of capi-
it appears that the contribution of education to tal 52 per cent, and the contribution of resource
growth is relatively small, and also small com- shifts 16 per cent, leaving a residual accounting for
pared to the contribution in developed countries. 12 per cent of measured growth. From the equa-
This may be the result of a number of factors tions including foreign borrowing, labour's con-
concerned with the emphasis on education at the tribution falls to 19 per cent and capital's to 32 per
primary level; unemployment among the edu- cent. The contribution of resource shifts rises
cated, and the predominant class basis of most slightly to 18 per cent and the contribution of
Production-Function Approach to Growth 83
Table 2.3 The Contribution of Factor Inputs and Total Productivity Growth to Industrial Growth in Kenya,
Tanzania, Zambia and Zimbabwe
Table 2.4 The Contribution of Factor Inputs and Total Productivity Growth to Economic Growth in 68
Developing Countries 1960-87
foreign borrowing is estimated at 14 per cent, productivity to the growth of output in various
leaving a residual contribution of 17 per cent. continents. Once more, the overall conclusion is
These results, in their estimates of the relative reached that the major source of growth is not
contribution of the factors of production and total productivity growth, but the growth of inputs
productivity growth, are very similar to Maddi- themselves.
son's. The results of Hagen and Hawrylyshyn are It is satisfying that the conclusions from a wide
similar to Robinson's and, in addition, show some number of studies using different techniques and
positive and lagged response to the growth of dubious data should all point in roughly the same
education. direction. First, the major source of growth in
The recent interesting case study of Shaaeldin, developing countries is increases in factor inputs,
which fits equation (2.6) to four African countries, aided by improvements in the quality of labour
shows that over the period of the 1960s and 1970s through health improvement and education. Second,
and into the 1980s, total factor productivity the growth of 'total' productivity is relatively slow
growth was negative in three of the countries. The compared to developed countries, which may be
results are given in Table 2.3 and confirm again partly a reflection of the different stage of develop-
the overwhelming importance of the contribution ment reached. Third, resource transfers from agri-
of capital formation to the growth process. culture to industry are quite important as a source
Finally, we present in Table 2.4 the latest of growth but not so important as one might have
World Bank results for the period 1960-87 show- expected. They will become more important as the
ing the <;ontribution of factor inputs and total ability of the industrial sector to absorb surplus
84 Introduction
labour increases. Robinson also finds foreign bor- 3. What is the difference between exogenous and
rowing a separate identifiable source of growth endogenous technical progress?
suggesting that foreign exchange can be consi- 4. Why may the income shares of factors of pro-
dered as a scarce factor limiting growth (see duction in developing countries give a mis-
Chapter 14). leading indication of the elasticity of output
Before ending it should be said again that these with respect to increases in the factors?
aggregate models which have produced the results 5. What factors does the growth of 'total factor
above are rough tools. They do, however, give an productivity' depend on?
important idea of the forces at work and a rough 6. Why is the contribution of capital to growth
idea of the likely quantitative significance of differ- likely to be more important in poor countries
ent factors. If one overriding conclusion emerges it than in rich countries?
is probably that developing countries ignore capi- 7. How can the production function be modified
tal accumulation at their peril if they are to increase to measure the effects of changes in the quality
their rate of growth significantly. of factors of production on output growth?
8. What methods can be employed to estimate
I
the effect of resource shifts on output growth?
Questions for Discussion and 9. What have been the major findings of produc-
Review tion function studies of the sources of growth
in developing countries?
1. What is a production function? 10. Why do factors of production and technical
2. What are the special properties of the Cobb- progress grow at different rates between coun-
Douglas production function? tries?
Part II
Factors in the
Developn1 ent Process
II Chapter 3 II
Land, Labour and Agriculture
In the production-function approach to the analy- labour to land and the extent of natural resource
sis of the sources of growth, land as a separate endowments are likely to exert a major influence
factor of production tends to be assumed away or on the speed of development as determinants of
subsumed into capital. There are two main the pace of agricultural advance and the pace of
reasons for this. The first is the traditional classical industrialisation based on a healthy agricultural
notion of land as a fixed factor of production, sector or the exploitation of indigenous resources.
which in the long run is undoubtedly true. The Geographical factors, including the nature of the
second is the practical fact that land without the land, and God-given factors such as weather and
application of capital is of little use, justifying the terrain, must be included in any list of reasons
treatment of land and capital as one factor. drawn up in answer to such questions as: why
This is not to deny, however, the importance of have some countries developed earlier than others,
land and natural resource endowments as factors or why have some countries remained in a tradi-
in the growth process. The quality of land can tional or transitional state longer than others?
markedly affect the level of agricultural pro- This is the concept of geographic determinism,
ductivity in the early stages of economic develop- which can be advanced as a hypothesis of under-
ment, and the importance of agricultural devel- development in its own right.
opment, in turn, can be clearly seen within the
production-function framework. Rising agricul-
tural productivity permits the release of labour
from agriculture to industry, which in turn leads
I The Role of Agriculture
in Development 1
to increasing returns, rising income per head and
greater capital accumulation. Given the domi- In this section we shall consider land in relation to
nance of the agricultural sector in the economic agriculture, and discuss in a general way the role
structure of developing countries, such factors as 1 For a good, rigorous, theoretical treatment of the role of
the physical attributes of land (topography, fer- agriculture in economic development see Ghatak and lngersent
tility, etc.), the land-tenure system, the ratio of (1984).
87
88 Factors in the Development Process
of the agricultural sector in the development pro- to country, but it must be remembered that every-
cess. In the course of the discussion we shall elab- where peasant subsistence farming is a traditional
orate on the emergence of an economy from its way of life and attempts to raise productivity will
traditional subsistence state into Rostow's tran- alter the way of life. Schultz (1980) remarks per-
sitional stage in which the seeds are sown for ceptively:
'take-off' into self-sustaining growth. The approach Most of the people in the world are poor, so if
to be adopted has a common-sense, pragmatic we knew the economics of being poor we would
appeal since land primarily affects the productivity know much of the economics that really mat-
of agriculture, and second, the development of ters. Most of the world's poor people earn their
agriculture, owing to its initial importance in a living from agriculture so if we knew the econ-
country's economic structure, must play a crucial omics of agriculture we would know much of
role in establishing the framework for indus- the economics of being poor. People who are rich
trialisation. The agricultural sector, for instance, find it hard to understand the behaviour of poor
must provide, in large measure, the factor supplies people. Economists are no exception, for they,
for industry; it must provide food for an urban too, find it difficult to comprehend the prefer-
industrial population, and it must contribute to ences and scarcity constraints that determine
the market for industrial goods if the demand for the choices that poor people make. We all know
goods is to be sufficient to justify their production that most of the world's people are poor, that
domestically. For the agricultural sector to release they earn a pittance for their labour, that half
labour, to provide savings, to supply food and to and more of their meagre income is spent on
contribute to the market for industrial goods, it food, that they reside predominantly in low
must generate a steadily rising surplus of produc- income countries and that most of them are
tion in excess of subsistence needs. Since land is earning their livelihood in agriculture. What
relatively fixed in supply, this requires rising agri- many economists fail to understand is that poor
cultural productivity. The 'grass-roots' school of people are no less concerned about improving
economic development, which came into fashion their lot and that of their children than rich
as a reaction against the emphasis on industrialisa- people are.
tion at any cost, lays stress on policies to raise the
level of productivity in agriculture as the most So what holds productivity back? In some cases
crucial development priority and an indispensable it is an inappropriate labour to land ratio combined
element of a long-run development strategy. Over- with a lack of appropriate and complementary
all, agricultural productivity in developing coun- inputs; in other cases, it is the structure and organ-
tries is less than one-tenth of the level in devel- isation of agriculture, and in many cases it is a
oped countries, and in many countries output per combination of both coupled with unfavourable
head is barely enough to meet subsistence needs. natural factors. Low productivity may be associ-
Some progress has been made in recent years with ated, for example, with a high population density
particular crops in particular countries, but the and a high ratio of labour to land. In this case,
performance of the agricultural sector is still dis- productivity might be increased substantially with
appointing. In the 1950s and 1960s food produc- small applications of capital in the form of drain-
tion per head hardly rose. In the 1970s and 1980s age schemes, fertilisers, etc. On the other hand,
there was some improvement, but the availability low productivity may be associated with the oppo-
of food still gives cause for concern, and the lack site situation of a high ratio of land to labour, in
of a marketable surplus holds back development which case the solution to low productivity is like-
on a wide front. ly to involve much larger doses of capital for
The quickest and cheapest way to raise pro- labour to work with. Most countries in Asia have
ductivity will depend on the reasons for low high ratios of labour to land, while in Africa the
productivity. The reasons will vary from country reverse is true, as was the case in many of'today's
Land, Labour and Agriculture 89
richest countries at an equivalent stage in their who may have to relinquish to the landowner a
economic history, e.g. America, Canada and large fraction of their output. In these circum-
Australia. stances, there is little incentive to efficiency and im-
Differences in the land to labour ratio through- p~oved productivity. Land reform, involving the
out the developing countries, however, can only subdivision of estates, and security of tenure for
explain a fraction of differences in productivity the tenants, might contribute both to an increased
and in income per head. There must be more fun- intensity of land use and to increased efficiency
damental factors at work concerned with geogra- and initiative on the part of the tenant farmer,
phy; the organisation of agriculture; the incentives particularly where he is allowed to reap fully the
to produce and the supply of inputs. As far as rewards of his own labour. The scope for land
natural, geographical factors are concerned, cli- reform remains enormous in Latin America. Still 1
mate and terrain determine to a large degree what per cent of the largest landowners own 70 per cent
goods a country can produce, the amount of culti- of the land, while 10 per cent of the largest farms
vatable land available per inhabitant and the occupy 80 per cent of the land. Only Cuba, Mex-
land's fertility. To some extent the application of ico and Bolivia have undertaken extensive land
capital to land can compensate for unfavourable reform among the countries of Latin America.
natural forces, but there are obvious limits. Moun- Elsewhere, there have been major land reforms in
tains cannot easily be flattened or deserts readily Japan, Egypt, Israel, South Korea and China.
watered. Having said this, however, differences in There is impressive evidence that where a change
natural conditions and in the productivity of the in the tenure system has permitted the producers
soil can be no more than another partial explana- themselves to reap the rewards of new techniques,
tion of poverty and low productivity. Poor people peasant farmers have been ready to break with
are to be found along the highly productive alluv- custom and tradition. The task of persuading pro-
ial banks of the Nile, as well as on the barren ducers to adopt more modern methods of produc-
plateaus of Asia and South America. The organisa- tion and to purchase improved seed and fertiliser
tion of agriculture and the structure of incentives has been much less difficult. While latifundios are
and opportunities for improvement would seem to too big, the minifundios are often too small to be
be of paramount importance. productive, and change is required here too towards
family farms of intermediate size with security of
tenure, sufficient to support a family and with the
varies in response to changes in the prices of agri- Table 3.1 Elasticities of Supply of Farm Products
cultural goods relative to the price of other goods (Acreage) in Developing Countries
in the economy.
The evidence shows that aggregate supply elas- Elasticities
Area and Time
ticities of agricultural output range from 0.3 to commodity period Short-run Long-run
0.9 (Chhibber (1988)). The long-run elasticity is
obviously higher than the short-run elasticity, and Punjab, rice 1914-45 0.31 0.59
the elasticity tends to be higher in the more ad- Philippines, rice 1954-64 0.13-0.22 0.15-0.62
vanced and land-abundant developing countries. Indonesia, rice 1951-62 0.30
The supply response of farmers to price changes Punjab, wheat 1914-43 0.08 0.14
India, cotton 1922-3 0.59 1.08
depends crucially on the ability of farmers to re- India, cotton 1948-61 0.64 1.33
spond to price signals which depends, in turn, on India, jute 1911-38 0.46 0.73
transport and infrastructure, and access to agri- Punjab, sugar cane 1915-43 0.34 0.60
cultural inputs. In poorer countries with inadequ- Egypt, cotton 1913-37 0.40
ate infrastructure, the supply elasticity is low
Source: Krishna, 'Agricultural Price Policy and Economic De-
(0.2-0.5). In fact, the supply elasticity of agricul- velopment' (1967); based on summary made by Krishna of
ture with respect to non-price factors (e.g. the pro- research done by him and others.
vision of public goods and services) is much higher
than with respect to price, especially in poorer
developing countries with inadequate infrastruc- fore, of raising producer prices is that government
ture and marketing facilities. revenue may fall. This then has implications for
Surveys of the supply elasticity of crops in dif- government expenditure if there is a budget con-
ferent countries have been done by Behrman straint. Only if the elasticity of the supply of out-
(1968), Krishna (1967), and Askari and Cummings put with respect to producer prices is greater than
(1976). That by Krishna is more condensed and is unity will government revenue not fall, but as we
reported here in Table 3.1. In all cases the measure saw above, the supply elasticity is typically less
of supply response is acreage under cultivation than unity.
rather than output yield because of the various To achieve efficiency within agriculture, the
seasonal and other factors that can influence yield IMF concentrates on such factors as: improving
from year to year. storage and transport facilities; increasing the
The International Monetary Fund (IMF) and availability of agricultural inputs and improving
World Bank are naturally concerned with the per- extension services; and enhancing the efficiency of
formance of the agricultural sector in countries to public enterprises in agriculture by insisting on the
which they lend under various adjustment pro- economic pricing of output and inputs, and by
grammes (see Chapters 14 and 16). Three inter- privatising marketing and extension services.
related issues are typically addressed: the terms of We saw earlier that the supply response of
trade between agriculture and the rest of the econ- farmers to price changes depends a great deal on
omy; the efficiency of the agricultural sector; and the the ability to respond which depends on infra-
supply response of agriculture to price changes. structure, transport, access to inputs and so on.
with regard to the agricultural terms of trade, Governments may be in a dilemma here because
the IMF normally insist that the prices paid by raising producer prices and reducing their own
State Marketing Boards to producers be increased. revenue may impair their ability to spend on in-
Traditionally, governments have 'taxed' the agri- frastructure etc. Given that the elasticity of supply
cultural sector through agricultural Marketing with respect to non-price factors is higher than
Boards driving a large wedge between the prices with respect to price, it would seem unwise to cut
paid to producers and the market prices of the public expenditure as far as it affects the agricul-
commodities concerned. One implication, there- tural sector.
92 Factors in the Development Process
I Transforming Traditional
Agriculture
of 'technical progress' that are taken for granted in
the developed countries; for example, the applica-
tion of fertilisers and the selection and cultivation
of high-yield crops. With the so-called 'green re-
The task of transforming traditional agriculture is volution', the scope for yield increases has become
not simply a question of land reform or price widespread in developing countries, and rates of
policy, however. The transformation of traditional return on investment in new technologies and
agriculture is also dependent on new inputs. The varieties of seed can be very high. Mexican 'dwarf'
policy issue is to determine the form that the new wheat is a prime example of the impact that tech-
inputs should take if agriculture is to attract an nology can have on the productivity of agriculture.
adequate share of investment resources. The task What matters most, then, are the incentives and
is not exclusively a question of the supply of associated opportunities that farm people have to
capital. augment production by means of investments that
Schultz (1964) has argued that the low pro- include the contribution of agricultural research
ductivity of farm labour is due more to an ab- and the improvement of human skills. 'An integral
sence of specific factor inputs, such as research and part of the modernisation of the economies of high
education, than to a shortage of reproducible and low income countries is the decline in the
capital as such. He contends that the most practic- economic importance of farmland and a rise in
al and economical approach to achieving sizeable that of human capital - skills and knowledge'
increases in agricultural productivity lies in en- (Schultz (1980); see also Griffin (1979)).
hancing the efficiency of the existing agricultural It must also be recognised that subsistence agri-
economy through improvements in the quality of culture is an uncertain activity and therefore risky,
inputs, and by the application of advances in particularly when survival is at stake, and this is
knowledge and modern technology on a broad another factor that breeds conservatism and makes
front. Additional quantities of existing inputs will change difficult even in the face of opportunities. 1
achieve nothing because of very low rates of re- Poor people prefer to be safe than sorry; they will
turn. Indeed, contrary to the conventional view tend to prefer an inferior outcome that is relatively
that a stagnant agricultural sector is the result of certain to the prospect of a higher average return
the reluctance of peasant producers to respond to with a greater degree of risk attached. They are
incentives, Schultz argues that it is traditional agri- risk averse. This is clearly not irrational behaviour
culture which is the cause of the seeming antipathy for poor people living on the margin of subsist-
to work and investment because of low returns at ence, even if the greater risk is imagined rather
the margin to existing inputs. The way to trans- than real. To overcome inertia on this score, an in-
form traditional agriculture into a relatively cheap tegral element of agrarian reform must be policies
source of growth is by investment to produce a designed to minimise risk and uncertainty through
supply of new agricultural inputs that will be prof- the provision of various types of insurance.
itable for farmers to adopt. Schultz suggests that
what has been lacking in the past is not an unwill-
ingness on the part of the agricultural sector to
accept new ideas but public expenditure and the
I The Growth of the Money
Economy
organisation of particular public activities to serve
the agricultural sector. Agricultural research, and The question of the willingness to change customs
investment in man to improve human capabilities and traditions leads naturally to a consideration of
in agriculture, have been too readily neglected. He how peasant subsistence economies, producing
points to the rapid rise of agricultural productivity goods for consumption only, typically transform
in Japan and Taiwan in the late nineteenth and
early twentieth centuries which was due to forms 1 This is particularly stressed by Galbraith (1980).
Land, Labour and Agriculture 93
themselves into money economies with an export Both the ability to export and the ability to
and industrial sector. From historical experience market internally imply surplus production over
two factors would appear to be crucial for the subsistence needs, and it is the size of this surplus
expansion of the agricultural sector and the event- that will largely determine the speed with which
ual production of goods for exchange at home the subsistence sector can be drawn into the
and abroad. One is the expansion of communica- money economy. Again we come to the point that
tions to create outlets and markets for surplus unless productivity in agriculture increases, the
production (and to encourage the production of expansion of the monetised sector will tend to
the surplus itself). The other is the emergence of a decelerate as the land for cultivation dries up.
class of middlemen or export-import merchants When land has been exploited to the full it acts as
acting as agents between world markets and the a constraint on development unless agricultural
domestic agricultural sector. If these conditions productivity increases or non-agricultural activi-
prevail, purely subsistence farming can develop ties can be established.
first into mixed agriculture, where part of the crop The emergence of an export sector provides a
is retained for subsistence and part is sold in the powerful stimulus to development and the exten-
market, and finally into modern agriculture with sion of the money economy. Exports create the
production entirely for the market, very often capacity to import and the very purchase of
based on one crop. In the transition from subsist- foreign products can encourage further export
ence agriculture, cash crops can utilise slack specialisation. A population which acquires a taste
labour and land when the subsistence crops are for imported goods provides the impetus to pro-
finished; but the transition into mixed farming is ducers to export more. In the case of new goods,
only possible if the farmer has the inputs to raise as well as new techniques, there is strong evidence
productivity and credit to purchase the inputs, as that peasant producers respond to incentives, and
well as the marketing facilities. -Modern agricul- are not so dissimilar to Western economic man as
ture, run on strictly commercial lines for profit and is sometimes claimed. Imports also provide a sti-
based on one crop, must rely on exports since the mulus to industrialisation. If a market for a
size of the domestic market will generally be too foreign-manufactured good becomes established it
small. The system of modern commercialised agri- becomes easier, and less risky, with the aid of tariff
culture, on which so many less developed coun- protection, for a domestic manufacturer to set up
tries are now dependent for their export earnings, in business because the market is assured. Imports
is often termed Agribusiness. This is a catch-all can also substitute for domestic capital and raise
phrase referring not only to the production of the the growth rate directly.
commodity in question, but also to the backward When farmers start to specialise in goods for
and forward linkages associated with the produc- export, and rely on other producers for goods which
tion process; the provision of finance, machinery, they previously produced themselves, the money
fertilisers, seed, etc. at the input end and the pro- economy will spread from the foreign trade sector to
cessing, manufacturing and marketing of the pro- the rest of the domestic economy. This is nothing
duct at the output end. Today, the multinational more than the international division of labour giving
corporations have a powerful position and a rise to the need for a means of exchange within a
strong hold over the production and export of country as well as between countries.
major agricultural commodities produced in the The transition from a state of total dependence
developing countries. To give just a few examples: on the production of agricultural goods to a state
three US firms control over one-half of the global of dualism, with the coexistence of a subsistence
banana trade; five European companies control 90 agricultural sector and a commercialised industrial
per cent of tea sold in the West, and the two sector, is a significant landmark in the develop-
largest coffee companies control 20 per cent of the ment of an economy. The dual economy sets up
world market. incentives which are absent in the purely agrarian
94 Factors in the Development Process
cultural extension is another important aspect of producing only what it needs for itself and no
the Bank's assistance to the rural sector. In India more, everyone is a Robinson Crusoe supplying
where 'contact' farmers disseminate knowledge to his own capital by refraining from present con-
their neighbours of improved techniques learnt sumption. With specialisation in the production of
from field agents, over 10 million farm families goods for export, and the producer's need for
have been helped. The rural poor now have more capital to expand productive capacity, mechan-
extensive and easier access to credit financed by isms grow up spontaneously to meet the need for
the Bank. In India much of the credit has been credit. It is a good market maxim that demand will
used by small farmers to provide supplementary create a supplier at a price. The suppliers are gen-
irrigation. Finally the Bank operates various multi- erally village money-lenders, shopkeepers, landlords
purpose projects that combine a wide range of and not infrequently the Church - especially in
activities normally in conjunction with a regional South America - charging (ates of interest often in
development programme. In Mexico, some excess of 50 per cent.
75 000 low-income families have benefited from
such a project in some thirty localities through
investments in irrigation, soil conservation, elec-
trification, schools, health care, water supplies and
marketing services. Each dollar the Bank invests in
rural development is supplemented by local invest-
I The Interdependence of
Agriculture and Industry
ment, and the Bank rightly stresses that its con-
tribution to the total flow of resources can only be Once agriculture emerges from its stagnatory, sub-
effective if appropriate national policies are also sistence state and starts to specialise and produce
pursued on pricing, taxation, land reform and so goods for export, and industry develops under the
on. The major part of the Bank's programme to impact of growth in the agricultural sector, the
reach the rural poor is still in the process of imple- two sectors of agriculture and industry become
mentation, and is therefore difficult to assess re- very much interdependent. The industrial sector
liably, but indications suggest that a combination adds to the demand for goods produced by agri-
of additional resources combined with institu- culture, and absorbs surplus labour which may
tional reform and national government commit- raise productivity in agriculture. The agricultural
ment to improvement in the rural sector, can have sector, in turn, provides a market for industrial
a major impact. goods out of rising real income, and makes a fac-
Apart from the World Bank, other multilateral tor contribution to development through the re-
institutions exist to help traditional agriculture, lease of resources if productivity rises faster than
notably the United Nations' International Fund the demand for commodities. We discuss more
for Agricultural Development (IF AD), which seeks fully this interaction later in the chapter.
to integrate small farmers and landless people into The transfer of resources from agriculture to
the development process. The Fund states that its industry may be capital or labour or both. Since
priority is for 'projects which will have a signifi- labour is in abundant supply in most low-income
cant impact on improving food production in de- countries, there is generally no difficulty involved
veloping countries, particularly for the benefit of in releasing labour for industry except at harvest
the poorest sections of the rural population'. Up to periods. Labour, in any case, will tend to migrate
1990, over one billion dollars had been dispersed. naturally in response to seemingly better opportu-
In the absence of external institutional invest- nities in the industrial sector and higher real incomes.
ment, the sources of capital for the expansion of The real earnings of labour in the industrial sector
both agriculture and industry are relatively limited may be over twice as much as the agricultural
in the early stages of development. In a truly sub- wage. If the industrial sector is to be guaranteed an
sistence economy, in the sense of an economy adequate supply of labour, some wage differential
96 Factors in the Development Process
because they are so poor but because their capital- but Lewis himself recognised that the failure of
ist sector is so small.' Accepting the strict classical peasant agriculture to increase its productivity has
assumptions that all wages are consumed and that probably been the chief factor holding back the
all profits are saved, the savings ratio depends not expansion of the industrial sector in many de-
only on the share of profits in the capitalist sector veloping countries. If this is so, argue Lewis's
but on the size of the capitalist sector as well. critics, the growth of non-farm employment can
The process outlined by Lewis comes to an end be said to depend on the growth of the agricultural
when capital accumulation has caught up with surplus. This, in fact, is the starting point of neo-
population so that there is no longer surplus classical models of development (see Jorgenson
labour in the subsistence sector left to absorb. (1966) ), in contrast to classical models with their
When all the surplus labour is absorbed, the exclusive stress on the supply of capital. The
supply of labour to the industrial sector becomes second effect arising from the expansion of the
less than perfectly elastic. It is now in the interests capitalist sector if there is a shortage of food is that
of producers in the subsistence sector to compete the real wage may have to rise in industry further
for labour, since the marginal product of labour is squeezing the capitalist surplus. If labour is needed
no longer below the institutional wage. When this in agriculture to meet the demand for food, unli-
point is reached, the agricultural sector can be said mited supplies of labour at a constant real wage
to have become commercialised. This change in may be very limited indeed. The assumption of
producer behaviour in the subsistence sector has unlimited supplies of labour is the central proposi-
also been defined as the end of the take-off stage tion underlying the classical approach to the
(Ranis and Fei (1961)). theory of development, and Jorgenson (1966,
Implicit in the Lewis model is the assumption p. 54) has argued that the classical approach stands
that employment growth in the capitalist sector or falls by this hypothesis. Historically, of course,
will be proportional to the rate of capital forma- real wages have risen in agriculture and industry,
tion. If profits are reinvested in labour-saving tech- and the capitalist sector has also expanded rap-
nology, however, this will not be so, and the rate idly, which lends support to a middle view between
of growth of employment in the industrial sector, the classical and neoclassical approaches. Lewis
and the rate of absorption from the agricultural himself recognised the importance of both capital
sector, may be very low. accumulation and food supply, and it is this con-
It is also possible that the process of absorption sideration which forms the basis of his argument
may end prematurely before surplus labour in the for the balanced growth of the agricultural and
subsistence sector is fully exhausted, owing to industrial sectors.
checks to the expansion of the capitalist surplus. Capital accumulation in the industrial sector
First, capital accumulation and labour absorption may also be checked for reasons unrelated to the
may be checked for reasons which are related to expansion of the capitalist sector and its demand
the expansion of the capitalist sector itself. For for food. For example, real wages may be forced
example, as the capitalist sector expands, the up directly by labour unions, or indirectly through
terms of trade may turn against it. If the demand rising real wages in the subsistence sector due to
for food expands faster than agricultural pro- increased agricultural productivity. Lewis himself
ductivity, the capitalist sector will be forced to pay states 'anything which raises the productivity of
higher prices for food in exchange for industrial the subsistence sector (average product per per-
goods, reducing the size of the capitalist surplus. son) will raise real wages in the capitalist sector,
This will have two effects. First, if the capitalists and will therefore reduce the capitalist surplus and
are forced to pay higher prices for the goods they the rate of capital accumulation, unless it at the
buy relative to those that they sell, this means less same time more than correspondingly moves the
saving for investment. The problem does not arise terms of trade against the subsistence sector'.
if productivity in agriculture is expanding rapidly, Lewis reaches this conclusion because one of
100 Factors in the Development Process
the simplifying assumptions of his classical two- ing a marketable surplus. The greater the surplus,
sector model is that the expansion of the capitalist the cheaper industry can obtain food and the more
sector is limited only by a shortage of capital, so saving and capital accumulation can be under-
that any increase in prices and purchasing power taken. This is the supply side. But industry also
for farmers is not a stimulus to industrialisation needs a market for its industrial goods, which in
but an obstacle to the expansion of the capitalist the early stages of development must largely come
sector. How does this square with the idea of the from agriculture. This is the demand side, and the
agricultural/ sector providing a market for indus- higher the price of agricultural goods the greater
trial goods, and the view of the World Bank (World agricultural purchasing power will be. Given this
Development Report, 1979) that 'a stagnant rural conflict between low food prices being good for
economy with low purchasing power holds back industrial supply and high food prices being good
industrial growth in many developing countries'? for industrial demand, what is required is a simple
The answer is that there does seem to be a contra- model which brings together agriculture and in-
diction, because the classical approach emphasises dustry in an equilibrium framework, where the
supply to the exclusion of demand, or rather takes terms of trade between agriculture and industry
for granted that there will always be a market provides the equilibrating mechanism ensuring
clearing price for industrial goods. In fact, there that supply and demand grow at the same rate in
will be a minimum below which the price of in- each sector.
dustrial goods cannot fall, set by the subsistence Let us first model growth in the agricultural
wage in industry. Johnston and Mellor (1961) rec- sector in relation to the terms of trade; then
ognised this worrying feature of the Lewis model growth in the industrial sector, and then bring the
many years ago when they perceptively remarked two sectors together. Agriculture's growth rate
'there is clearly a conflict between emphasis on will be a function of how much it invests relative
agriculture's essential contribution to the capital to output and of the productivity of investment.
requirements for overall development, and empha- How much investment goods it obtains from in-
sis on increased farm purchasing power as a stimu- dustry in exchange for food that it 'saves' depends
lus to industrialisation. Nor is there any easy on the price of industrial goods relative to food,
reconciliation of the conflict.' The challenge of re- i.e. on the terms of trade between industry and
conciliation has never been taken up in a simple agriculture. The higher the price of investment
way, but there is a resolution of the conflict if the goods, the less investment possible for a given
complementarity between the two sectors is amount of food and the lower the growth of
recognised from the outset, and it is remembered supply capacity. The inverse relation between the
that there must be an equilibrium terms of trade industrial terms of trade (the price of industrial
that balances supply and demand in both sectors. goods relative to the price of food) and the agri-
The basis of the model comes from Kaldor (1979). cultural growth rate (gA) is shown in Figure 3.5.
I
Figure 3.5
A Model of the Industrial
Complementarity Between terms of
trade
Agriculture and Industry .1
We have seen that agriculture provides the poten-
tial for capital accumulation in industry by provid- gA
P,
Minimum
terms of 1------~
trade
0 Maximum Growtn
growth rate
0 Growth
Industry's growth rate will also be a function of equilibrium terms of trade (p*), as shown in
its investment ratio and the productivity of invest- Figure 3.7. 1
ment. But there is a certain minimum terms of In this model of the complementarity between
trade below which industry would not be able to agriculture and industry, we can see the implica-
invest anything because all output would be re- tions of what happens if the terms of trade are not
quired to pay workers' wage goods (food). If all in equilibrium, and the checks to the expansion of
wages are consumed the cost of food input per industry that Lewis mentions.
unit of output in industry will depend on the real If the terms of trade are not in equilibrium - if
wage rate in industry divided by the productivity the price of food is 'too low' or 'too high' in
of labour, i.e. w/(0/L) = W/0, where w is the real relation to industrial goods - then industrial
wage and W is the wage bill. Industrial prices must growth is either demand constrained or supply
cover W/0, and this sets the lower limit to indus- constrained. For example, if in Figure 3.7 the
trial prices relative to food prices. At the other terms of trade were at PB because the price of food
extreme, industrial growth cannot exceed a certain was 'too low', industrial growth would be demand
maximum where the price of industrial goods is so constrained to g 1 by a lack of agricultural purchas-
high relative to the price of food that agriculture ing power over industrial goods. Industry could
buys no industrial goods and all industrial goods accumulate capital, but it could not sell its goods.
are retained for reinvestment in industry. The in- Alternatively, if the terms of trade were below
vestment ratio approaches, in effect, 100 per cent, eqwilibrium at P2 , industrial growth would be
and the upper limit to growth is given by the supply constrained to g2 because the price of food
productivity of investment. The positive relation was 'too high' impairing capital accumulation in
between the industrial terms of trade and the in- industry. Agriculture could buy, but industry
dustrial growth rate (g1) is shown in Figure 3.6. could not supply. Growth is maximised at P*.
If we now assume for simplicity (although with- We can now examine what happens if there are
out loss of generality) that the income elasticity of shifts in the curves. Clearly shifts in the curves will
demand for agricultural and industrial goods is cause both the growth rates and the equilibrium
unity, then at a given terms of trade, the rate of terms of trade to vary. An improvement in agri-
growth of agricultural output represents the rate cultural productivity which shifts gA outwards will
of growth of demand for industrial goods, and the
rate of growth of industrial output represents the
1 If the income elasticity of demand for industrial goods is
rate of growth of demand for agricultural output,
greater than unity, and for agricultural goods less than unity,
and where gA and g1 cross there will be balanced then the equilibrium growth rate for industry will exceed that
growth of agriculture and industry (g*) at an for agriculture.
102 Factors in the Development Process
mean both higher industrial growth and an im- as described in Chapter 1. The informal economy
provement in the industrial terms of trade. The of the urban sector harbours the bulk of this
importance of agricultural productivity improve- labour in transition from the rural sector into in-
ment could not be better illustrated. An improve- dustrial employment. The conclusion to be drawn
ment in industrial productivity will shift g1 outwards in that the expected value of the urban wage,
which will also mean higher industrial growth but notwithstanding the probability of long spells of
at the expense of a worse terms of trade for indus- unemployment, still exceeds the wage in the rural
try. If there is a tendency for real wages in industry sector, and as long as it does the process of migra-
to rise commensurately with productivity in- tion will continue. In these changed circumstances,
creases, however, the g1 curve will remain stable development theory has focused its attention in
and the terms of trade will never move against recent years on urban unemployment and on poli-
industry in favour of agriculture unless agricul- cies to combat it. Most of the models of the rural-
tural productivity falls and the gA curve shifts urban migration process are pessimistic about re-
inwards. ducing the level of urban unemployment by con-
The checks to industrial expansion in Lewis's ventional means such as subsidies to labour or
model are easily illustrated. A rise in the real wage public-works programmes in the urban areas. The
in industry will shift the g1 curve inwards which reason is that migration from the land is made to
will choke industrial expansion unless there is an be a function not only of the actual urban-rural
equivalent increase in agricultural productivity wage differential but also of the level of employ-
shifting the gA curve outwards (see the quote from ment opportunity. More employment oppor-
Lewis on p. 99). tunities reduce unemplo'yment immediately but
A final implication of the model is that if encourage more migration. It thus becomes an
through time agriculture is subject to diminishing empirical question whether increasing the rate of
returns, productivity in agriculture will fall, shift- growth of employment in urban areas will actually
ing inwards the gA curve and reducing the rate of reduce unemployment. The very real possibility
industrial growth. If the g1 curve is relatively exists, however, that urban areas may be caught in
stable, industrial growth depends fundamentally a 'high level unemployment equilibrium trap' as
on the rate of land saving innovations (technical long as surplus labour on the land remains and
progress) in agriculture to offset the effect of development policy concentrates new activity in
diminishing returns. established urban (industrial) centres.
One of the earliest and simplest models of the
rural-urban migration process, which is also oper-
Now cancelling Nand ()y/da from both sides and (UIS) is much higher than UIW, the elasticity of
multiplying both sides by d/w and UIW, the condi- migration itself would have to be higher than the
tion for unemployment to increase becomes: elasticity of labour supply for unemployment to
increase following a job expansion programme. If,
as1w d u as before, we assume w/r = 2 and Jt = 0.8 and,
-->- (3.11) say, U/S = 2, the migration elasticity would have
adJd w w
to exceed 0.6 for unemployment to rise. In prin
or substituting (3.2) into (3.11): ciple, this elasticity is easy to estimate by specify-
ing a migration function in which migration is a
asJW WJt- r u function of the expected urban-rural wage dif-
-->--- (3.12) ferential holding constant other factors affecting
()dfd w w migration. For an interesting case study, see the
study of Tanzania by Barnum and Sabot who esti-
In words, equation (3.12) says that unemployment mate an elasticity of migration with respect to the
will increase in the urban sector as a result of a urban wage itself, holding other things constant,
policy change to increase employment if the elas- of between 0.7 and 2.0. 2
ticity of the urban labour supply (by migration)
I
with respect to the urban-rural wage differential
exceeds the expected urban-rural wage differential Disguised Unemployment:
as a proportion of the urban wage times the unem- Types and Measurement
ployment rate. Equation (3.12) is obviously test-
able. It transpires, in fact, that equation (3.12) is The higher the marginal product of labour in agri-
satisfied with a very low elasticity. For example, culture, the greater the force of the neoclassical
suppose that the actual urban wage is twice the argument that it is the growth of the agricultural
rural wage, 1 that the probability of obtaining a job surplus that determines the growth of non-farm
in the urban sector is 0.8 and that the unemploy- employment. We must now examine more criti-
ment rate is 10 per cent, then the level of unem- cally the classical assumption of unlimited supplies
ployment will increase if the elasticity of the urban of labour, defined as marginal product below the
labour supply with respect to the expected urban- subsistence wage.
rural wage differential is 0.03. If the marginal product of labour in the rural
Note that the growth of total labour supply as a sector is positive (which is not precluded in Lew-
result of migration (aSJW) is not the same thing as is's model as long as it is below the subsistence
the rate of growth of migration (aSJS), so that the wage), the withdrawal of labour from the subsist-
elasticity of supply with respect to a change in job ence sector will reduce total output. To argue that
opportunities is not the same thing as the elasticity development via unlimited supplies of labour is
of migration with respect to a change in job feasible and relatively painless must implicitly
opportunities. We could, however, convert equa-
tion (3.12) into the elasticity of migration with
respect to adld by multiplying both sides of (3.10) 2 Barnum and Sabot (1977). Other recent studies of the rural-
by UIS instead of U/W. This would give: urban migration process include Knight (1972). For a survey of
studies, see Todaro (1976). Todaro gives an alternative way of
evaluating whether urban unemployment will rise or not. It can
()SIS wn- r U be shown that the level of unemployment will rise if T] > g X
-->--- (3.13) NIS, where T] is the period elasticity of induced migration with
ad/d w s respect to the change in modern sector job probabilities; g is the
growth of urban employment prior to the increase in job
opportunities; N is the level of urban employment and S is the
Since the ratio of unemployment to migration existing level of rural-urban migration. It can also be shown
that the rate of urban unemployment will rise if T] > g x WIS,
1 Any values can be substituted as long as w/r = 2. where W is the urban workforce.
Land, Labour and Agriculture 105
however, it could exist today in India and else- As far as the distinction between harvest and
w~~re in the changed circumstances of rapid non-harvest labour is concerned, Nath (1974) sug-
pop:Ulation growth, especially since 1940. gests that busy-season and slack-season labour in-
~ second method of estimating the static sur- puts should be included as separate arguments in
plus' is to take the difference between labour avail- the production function. He adopts this approach
able and the labour required to produce the cur- in a cross-section analysis of 150 farms in the
rent level of agricultural output with given techni- Ferozepur district (Punjab) in India for the period
ques, making due allowance for the seasonality of 1967-8, relating annual output to busy-season
production. The estimate of the magnitude of sur- labour, slack-season labour and other inputs, us-
plus labour in this case will vary with local condi- ing a Cobb-Douglas production function (see
tions, and what is regarded as a normal working p. 69). Nath finds not unexpectedly, that the mar-
day. ginal product of busy-season labour is indeed posi-
A third method of approach is to estimate agri- tive, but that the marginal product of slack-season
cultural production functions (see Chapter 2) to labour is not significantly different from zero.
test whether the elasticity of output with respect to The conclusion from all these studies is that the
labour input is significantly different from zero or marginal product of labour on family farms with
not. This approach indicates whether there is sur- no hired labour in the slack season may well be
plus labour or not, but does not measure its zero. In this sense, a static surplus exists. But
magnitude. where agriculture is partly commercialised, and in
In discussing labour's marginal product in agri- the harvest season, the marginal product of labour
culture and the extent of disguised unemployment, is positive, and reductions in the agricultural
two important distinctions need making: between labour force would impair agricultural output.
harvest and non-harvest time; and between farms Defenders of the classical model of development
which hire labour and those which do not. Within (e.g. Marglin (1966)) claim, however, that no one
the production-function approach this distinction has ever argued that the withdrawal of labour
is easily made explicitly and is a very fruitful under all circumstances will not affect output. The
approach for that reason. As far as the distinction purpose of the classical model is to draw attention
between hired and non-hired labour is concerned, to the fact that the marginal product in industry
the marginal product of family labour can hardly far exceeds the opportunity cost of labour in agri-
be zero if workers are hired, nor can the marginal culture, and those who use the classical model
product of the hired workers themselves be zero if normally stipulate some dynamic change as migra-
they are paid. Desai and Mazumbar (1970) have tion takes place.
taken a sample of Indian farms and divided it into This leads to the question of the measurement
those using hired labour and those not. Differences of the dynamic surplus, which is the difference
between the two groups are striking. The marginal between the actual labour employed and the
product of labour on the farms hiring labour is labour required given some small change in tech-
significantly different from zero; on farms not hir- nique (including an increase in the number of
ing labour the marginal product is not significantly hours worked per day).
different from zero. 'It should be remembered, Unfortunately, investigators who have measured
however, that zero marginal product per man- the dynamic surplus have not generally dis-
hour or per man-day is not a necessary condition tinguished between the causes of the surplus, or
for surplus labour. Surplus labour can take the made explicit the assumptions on which their esti-
form of a small number of hours or days worked. mates of labour requirements are based, and this is
On the other hand, if the marginal product per a major reason why estimates and opinions differ
man-hour or man-days is zero, there must be some on the extent and existence of disguised unem-
surplus labour, and presumably it is the tip of the ployment. If the surplus is measured simply by the
iceberg. difference between the amount of labour that, in
Land, Labour and Agriculture 107
The Role of Capital in Development 112 How Societies Progress Technologically 119
The Capital-Output Ratio 114 Learning 120
Technical Progress 116 Education 121
Capital- and Labour-Saving Technical
Progress 117
112
Capital and Technical Progress 113
technical progress in the capital-goods sector itself concept than some of these studies admit. Second,
is also important because this will determine the even if capital is relatively unimportant in de-
price of capital relative to labour. veloped countries, there may be a fundamental
Developing economies themselves lay great em- difference between countries which already have
phasis on the importance of capital accumulation, large quantities of capital per head and those
and stress the need to raise the level of investment which do not. In countries where specialisation
in relation to output. A glance at any national and the division of labour is minimal, the scope for
development plan will testify to this. Development capital to permit more roundabout methods of
is associated with industrialisation and indus- production, and to increase productivity, may be
trialisation with capital accumulation. Many de- greater than where specialisation has already
velopment economists also see investment as the reached a high level of sophistication. Moreover,
most important single factor in the growth pro- in technologically backward countries the rate of
cess. Professor Rostow (1960) defines the process growth of capttal required to absorb new tech-
of 'take-off' into sustained growth in terms· of a nology is likely to be greater than in advanced
critical ratio of investment to national product, countries. By definition, technologically backward
and Professor Arthur Lewis (1955) has described countries also have a backlog of technology to
the process of development as one of transforming make up. Furthermore, in a labour-abundant econ-
a country from being a 5 per cent saver and inves- omy, with a low capital-labour ratio, the very
tor to a 12 per cent saver and investor. It is com- act of capital deepening - giving each worker a
mon, in fact, for countries to calculate fairly little more capital to work with - may make a
precise ratios of investment to national income substantial difference to total product - much
that will be required either to achieve a particular more so than in countries where the process of
rate of growth or to prevent capital per head or capital deepening has been a continuing process
income per head from falling. These calculations for some length of time. All these factors represent
involve assumptions about the normal relation be- important contributions that capital can make to
tween capital and output, a relation which is for- economic progress, which may be relatively more
mally expressed in the concept of the capital- important the smaller is the initial capital stock of
output ratio (which we shall consider later). Pro- a country relative to its population. It is a familiar
fessor Johnson (1969, p. 9) singles out capital economic proposition that the scarcer is one 'factor
accumulation in its widest sense as the disting- of production in relation to another, the higher is
uishing characteristic of development, and has de- its productivity, other things being equal.
scribed the structural transformation of economies Capital accumulation is also seen as the escape
as a generalised process of capital accumulation: from the so-called 'vicious circle of poverty' - a
'The con.dition of being "developed" consists of circle of low productivity, leading to low per capi-
having accumulated, and having established, ta income, leading to a low level of saving per
efficient social and economic mechanisms for head, leading to a low level of capital accumula-
maintaining and increasing large stocks of capital tion per head, leading to low productivity. Low
per head in the various forms. Similarly the condi- productivity is seen as the source of the 'vicious
tion of being "underdeveloped" is characterised circle of poverty', and the point where the circle
by the possession of relatively small stocks of the must be broken by capital accumulation.
various kinds of capital.' Since productivity can be raised by other means
The emphasis on investment in developing as well, there is implicit in the argument the pes-
countries may not be without foundation despite simism that no further reorganisation of the
the findings for advanced countries that capital existing factors of production could have much
accumulation seems to have made only a relatively impact on output, and that technical progress is
minor contribution to measured growth in the mainly embodied, requiring net additions to the
present century. For one thing, capital is a broader capital stock. Whether this pessimism is justified is
114 Factors in the Development Process
an empirical question in the final analysis, but the imate to treat the capital-output ratio as an inde-
emphasis placed by developing countries on capi- pendent variable in the economic system, and to
tal accumulation is very real. 1 use the ratio as a parameter in investment plan-
ning. Is not the ratio the dependent variable in the
system determined by the level of investment and
• The Capital-Output Ratio the rate of growth? This is a fairly crucial question
to consider, because it is common for countries to
The link between capital and output is embodied use an aggregate ICOR, and also incremental
in the concept of the capital-output ratio, which capital-output ratios for sectors of the economy,
can measure in physical units, or in value terms, for deciding on the rate of investment necessary to
either the average or the marginal relation be- achieve a particular target rate of growth of in-
tween capital and output. The average capital- come. Yet if the ratio itself is determined by the
output ratio of an economy is the stock of capital rate of growth, is this permissible? As we shall
divided by the annual flow of output (K/0), while come to see, a lot depends on the length of the time
the marginal or incremental capital-output ratio period over which investment is being planned.
(ICOR) measures the relation between increments Taking both time-series and cross-section data,
to the capital stock and increases in output (l:iKI there is substantial empirical evidence of a strong
l:iO or Ill:iO). If the gross value of a country's inverse relation between growth and the value of
stock of capital is £100 million and its gross the ICOR2 and good theoretical reasons for believ-
annual income is £25 million, the average capital- ing that the ICOR is the dependent variable in the
output ratio would be 4 : 1. If the economy grows relation. Two main reasons can be advanced.
smoothly at full capacity, the incremental capital- First, the investment rate tends to be more stable
output ratio will approximate to the average, so than other factors, so that growth may increase or
that in this example four extra units of capital decrease while the rate of capital accumulation
would be required to produce an additional unit remains virtually unchanged. The inverse relation
flow of output (in £s). would be less marked if capital-output ratios were
With fluctuations in income, however, the aver- computed by taking a measure of capital services,
age capital-output ratio may differ substantially rather than the stock of capital, but this is not
from the ICOR. In periods of recession the average normally the case. Second, if the significance of non-
capital-output ratio will tend to be higher than its capital inputs in the growth process is greater than
'normal' value since output will be depressed in that of capital, there will be an inverse relation be-
relation to the size of the capital stock, which is tween the investment rate and the capital-output
relatively fixed. But while the average ratio is still ratio. This means that if the relation between growth
high at the start of the upturn of the business cycle, and the investment rate is positive (which no one
the incremental ratio will appear low. If the econ- disputes), the relation between growth and the
omy is working below capacity, very little extra capital-output ratio will be negative.
capital will be needed to increase output and sub- Let us illustrate these points by making use of
stantial growth may be associated with a relatively the Cobb-Douglas production function. From the
small ICOR. In attempting to calculate ICORs, the equation in its estimating form, r0 = rT + arK
stage of the business cycle must always be borne in + ~rL> the ICOR is given by:
mind.
The dependence of the ICOR on the level of l:iK l:iK/0
activity raises the question of whether it is legit- l:iO rT + arK+ ~rL
where ll.K/0 is the investment ratio. Now if ll.K/0 suggests. Similarly, it is highly misleading to calcu-
is stable and rT and rL vary more than rK, ll.Kill.O late c by dividing the savings or investment ratio
and r 0 will vary in opposite directions. Likewise, if by the rate of growth of output. Apart from the
the growth of the labour-force and technical prog- fact that the economy may not be working at full
ress contribute more to growth than capital ac- capacity, the assumption is being made that all
cumulation, ll.KI ll. 0 and r 0 will vary in opposite increases in output are attributable to increases in
directions. In the short run, therefore, a low capital, which is untrue. The productivity of capi-
measured ICOR more probably implies that growth tal (ll.O/I) is overstated, and, since the ICOR
has been rapid, and not that relatively rapid growth (I/ll.O) is the reciprocal of the productivity of
will be associated with a low ratio of investment to capital, the ICOR is understated.
output because the ICOR is low. This latter problem can be overcome by making
The use of the incremental capital-output ratio the distinction between the actual ICOR, as
for estimating the amount of investment required measured above, and the adjusted ICOR, which is
to increase output by a given amount was inspired the ICOR adjusted for increases in the supply of
by the work of Harrod and Domar (see p. 6 and other factors (e.g. a 5 per cent increase in the
references). Although their work was originally de- labour force). The concept of the adjusted capital-
signed to establish the conditions for equilibrium output ratio takes care of what otherwise appears
growth, their fundamental equations have been to be a conflict between the observed productivity
put to various alternative uses. Harrod's basic of capital and that implied by the value of the
growth equation is Gc = s, where G is the rate of actual ICOR. For example, suppose that a coun-
growth (ll.0/0), cis the ICOR (I/ll.O) and sis the try's investment rate is 15 per cent and its growth
savings ratio (S/0). By substituting terms it can be rate is 5 per cent, giving an actual c·apital-output
seen that the equation merely expresses the ex post ratio of 3 : 1. This would suggest a productivity of
identity that saving equals investment, which fol- capital of 33.3 per cent. But, typically, the rate of
lows from the accounting identities that income return on capital is much less than this. The reason
equals consumption plus investment and income is that other factors contribute to growth. Suppose
equals consumption plus saving. None the less, it that the growth of the labour force is such that it
is this equation that has been endlessly manipu- contributes 3.5 percentage points to the 5 per cent
lated to give the savings (or investment) ratio (s) growth rate, leaving 1.5 percentage points to be
necessary to achieve a particular target rate of 'explained' by capital (assuming no technical
growth (G), given the value of c, and to calculate progress). In this case, with a 15 per cent invest-
the value of c, given G and s. This is in spite of the ment ratio, the adjusted capital-output ratio is
fact that no causality is implied by the equation. 10 : 1, giving a rate of return on capital of 10 per
The Harrod equation certainly predicts an in- cent. The actual capital-output ratio is 3 : 1, but if
verse relation between growth and the ICOR, but there was no growth of the labour force, the ad-
since c is assumed constant in Harrod's original justed capital-output ratio tells us that an invest-
model, it is the ICOR that determines growth and ment ratio of 50 per cent would be required to
not the other way round. grow at 5 per cent. In short, if other factors remain
It is not difficult to demonstrate that the exer- unchanged, much more investment is required to
cise of calculating the savings and investment re- achieve a target rate of growth than is implied by
quired to achieve a target rate of growth, given c, calculations of c from the Harrod equation. The
and the exercise of calculating c, givens and G, are adjusted ICOR is sometimes referred to as the net
fraught with danger. If the economy has been incremental capital-output ratio; that is, the
operating below capacity, there is no telling what ICOR on the assumption that other factors do not
is the 'true' value of c, and the investment needed change. Net or adjusted ICORs are difficult to
in the short run to produce a given G cannot be estimate, but clearly the variability of the factors
calculated with the precision that the equation that co-operate with capital in the productive sys-
116 Factors in the Development Process
tern can play havoc with calculations of the actual a ten- to fifteen-year period, but planning in-
ICOR from data on past growth and the invest- vestment requirements for anything less than a
ment ratio alone. five-year period on the assumption of a stable
When calculations are made of saving and in- capital-output ratio may be asking for trouble.
vestment requirements to achieve target rates of Finally and briefly, other more obvious dangers
growth for, say, a five- to ten-year planning may be mentioned of using the capital-output
period, the normal assumption is that the in- ratio as a basis for investment planning. First,
cremental capital-output ratio will approximate exclusive attention to the capital-output ratio may
to the average and that over the long term the exaggerate the need for investment when output
factors to co-operate with capital will be forth- may be increased by other, simpler means. On the
coming as in the past. For a planning period in basis of Indian experience, Professor Reddaway
excess of five years this assumption may not be (1962) suggests that before calculating the addi-
unreasonable. Criticisms of the use of the in- tional capital required to produce a target output,
cremental capital-output ratio in investment plan- it would be wiser for a developing economy to
ning relate more to its use in the short run. think first of the output that might reasonably be
On the other hand, as a result of technical prog- expected from increased utilisation of existing fac-
ress, and shifts in the pattern of demand and the tors and better methods applied to old capital.
distribution of resources between sectors with Second, the accuracy of any calculations of the
different productivities, the ICOR may also be capital-output ratio may be called into question in
subject to secular change. In principle, this should backward economies lacking comprehensive and
be easier to allow for in investment planning. In reliable statistics. Third, it must be remembered that
practice, in the absence of extensive time series, the aggregate ICOR is bound to disguise sectoral
there may be some dispute as to the direction of differences, and in calculating overall investment
the trend. Some economists argue that it is likely requirements some allowance should be made for
to fall as per capita incomes rise owing to greater the changing sectoral distribution of resources.
economies of scale, external economies, improve-
ments in the quality of labour and shifts in de-
mand towards service activities requiring less • Technical Progress
capital. Others argue, however, that it can be ex-
pected to rise owing to diminishing returns if The term 'technical progress' is used in several differ-
capital grows faster than labour, which is nor- ent senses to describe a variety of phenomena; but
mally the case as countries get richer. The only re- three, especially, can be singled out. First, it is a
liable evidence we have relates to advanced coun- term used by economists to refer to the effects of
tries, which suggests that, in practice, long-run changes in technology, or more specifically to the
changes in the capital-output ratio are quite small, role of technical change in the growth process. It is
with the factors leading to increases and decreases in in this sense that we used the term in Chapter 2;
the ratio presumably tending to offset one another. that is, as an umbrella head to cover all those
In the short run, though, as we have said, the factors which contribute to the growth of 'total'
ratio may be subject to serious variability either as productivity. Second, technical progress is used by
a result of variations in the supply of co-operating economists in a narrow specialist sense to describe
factors or variations in capacity utilisation. In the character of technical improvements, and is
planning the level of investment the issue that often prefaced for this purpose by the adjectives
must be faced is whether the planning period is 'labour-saving', 'capital-saving' or 'neutral'.
long enough for the short-run variability of the Third, technical progress is used more literally to
ratio not to matter. If the ratio does stay fairly refer to changes in technology itself, defining tech-
constant over long periods, capital requirements nology as useful knowledge pertaining to the art of
can perhaps be estimated with some accuracy for production. Used in this sense, the emphasis is on
Capital and Technical Progress 117
describing improvements in the design, sophistica- proceeds. The difficulty stems from the perennial
tion and performance of plant and machinery, and problem of defining capital. If certain expendi-
the economic activities through which improve- tures, which ought properly to be regarded as
ments come about - research, invention, develop- adding to the capital stock, are excluded from the
ment and innovation. measurement of capital, and these expenditures
Having already discussed technical progress in have grown faster than measured capital, the
the first sense in Chapter 2, we shall concentrate capital-output ratio will be biased downwards.
here on the narrow specialist descriptions of tech- While technical progress may appear neutral or
nical progress, and on how societies progress capital-saving because of a stable or declining
technologically. capital-output ratio, it may nevertheless be
capital-using and would appear so if the capital
CAPITAL-SAVING
Labour
L
Figure 4.2
Labour
to the right of the old expansion path. At Pu activities which apply new knowledge to the task
where the new production function cuts the old of production. These are all basically economic
expansion path, the ratio of the marginal product activities. But the study of the way in which
of labour to capital is higher than at P. Again, P 1 is societies progress technologically, and the speed of
not an equilibrium point and it will pay producers progress, is not only the preserve of the economist.
to move to point Q, substituting labour for capi- The economist can identify the mainsprings of
tal. The ratio of marginal products has not re- progress, but their pervasiveness and acceptance in
mained unchanged at a constant labour to capital societies is not a purely economic matter. The
ratio, and in this case K2 K3 capital is saved. spread of new knowledge, for example, depends
As with Harrod technical progress, it is difficult on its rate of adoption and diffusion and this raises
to know what form Hicks technical progress takes questions of individual motivation, the willingness
in practice, largely because of identification prob- to assimilate new ideas and to break with custom
lems. While the classification is analytically dis- and tradition, which impinge heavily on territory
tinct, how does one distinguish empirically be- occupied by development sociologists. The relative
tween a change in factor proportions due to a shift importance of different factors contributing to
in the production function and a change in factor progress, and the speed of progress itself, will vary
proportions due to a change in relative prices? from country to country according to its stage of
Hicks himself seemed to be of the view that tech- development and a whole complex of social and
nical progress is relatively labour-saving, but the economic forces. Moreover, many of the main-
indirect evidence we have for this is slight. For springs of technological progress are not mutually
example, given the magnitude of the rise in the exclusive. At the risk of excessive simplification,
price of labour relative to capital and an elasticity attention here will be confined to four main
of substitution of close to unity, labour could not sources of progress which are of potential sig-
have maintained or increased its share of the nificance to any society.
national income (as it has done slightly in some One major source of improvement in tech-
advanced countries) if technical progress was nology, and progress, is the inventive and innova-
markedly biased in the labour-saving direction. If tive activity of the native population. All societies
technical progress is biased in one direction or are endowed to some degree with a potential supp-
another, its major impact will be on factor utilisa- ly of inventors, innovators and risk-takers and, in
tion if the price of factors is not flexible. The type the absence of imported technology and person-
of technology employed, and the factor propor- nel, it is on the emergence of this class of person
tions it entails, must bear a major responsibility that technological progress will primarily depend
for the growing level of unemployment in develop- in the early stages of development. Economic
ing countries, as described in Chapter 1. The case backwardness in many countries may quite legiti-
for the use of more labour-intensive techniques is mately be traced back to a relative shortage of
discussed in Chapter 10. inventors, innovators and risk-takers. It is fairly
well established that some cultures and some en-
entrepreneur and innovation in the development the receptiveness of all sections of the community
process. Ultimately, however, it is the lag between to change. The absorption of technology from
the creation of knowledge and its adoption, and abroad is referred to as the 'cultural diffusion pro-
the rate of dissemination of new knowledge, that cess', and again its study involves sociological
most directly affects the rate of measured technical analysis as well as economics.
progress between countries; and these two facets
of innovation are intimately connected with the
attitudes of society at large. For Schumpeter, prog- • Learning
ress results from what he calls the 'process of
creative destruction', which is bound up with in- A third means by which societies progress tech-
novation, and instigated by competition. Innova- nologically, gradually raising their efficiency and
tion, in turn, is the driving force behind competi- productivity, is through the process of 'learning by
tion. But innovation requires decision-takers and doing', which refers to the accumulatio~ of experi-
hence his complementary stress on the role of the ence by workers, managers and owners of capital
entrepreneur. A characteristic of many poor coun- in the course of production which enables pro-
tries is a shortage of decision-takers, a relative lack ductive efficiency to be improved in the future. It is
of competitive spirit and a general aversion to a learning process that Adam Smith referred to in
risk-taking. These may be partly cultural traits and discussing the division of labour. Smith stressed
also partly, if not mainly, a function of the stage of the importance of the division of labour for three
development itself. The characteristics commonly main reasons: first, as a means of improving the
associated with business dynamism are themselves dexterity of workers; second, to save time which is
a function of business, and more particularly the lost in the absence of specialisation; and third, to
form of organisation we call 'capitalism'. In a encourage the invention of machines which facili-
closed economy, it might be said that invention is tate and abridge labour to improve the pro-
a necessary but not a sufficient condition for prog- ductivity of labour. All these advantages of the
ress. In an open economy, it is not even a necessary division of labour are part of a learning process.
condition because technology embodying new Labour improves its skill through specialisation
knowledge can be imported from abroad, from and work experience, and becomes more adept at
societies more technically advanced. If backward the job in hand. Managers see deficiencies in orga-
economies lack inventors they can still innovate by nisation, which can subsequently be remedied;
applying appropriate technology developed and on the basis of accumulated knowledge they
abroad. Technical assistance programmes in de- are also able to embody more productive tech-
veloping countries, organised by the developed niques in the capital stock.
countries, are designed to foster innovation, par- Learning may be regarded as either endogenous
ticularly the adoption of new techniques and new or exogenous, or both, depending on the factor of
goods. Societies' exposure to new goods may be a production considered. If existing labour and
powerful factor in economic development by existing capital are subject to a learning process,
acting as an incentive to producers and workers to then learning by doing can be regarded as exogen-
increase their surplus for exchange. The spread of ous and as part of disembodied technical prog-
technology and ideas may also be expected to ress. If, however, it is assumed that learning enters
come about naturally in the general process of the productive system only through the addition of
commercial intercourse, and the exchange of in- new factors, then learning by doing must be re-
formation through trade. The speed with which garded as endogenous. This is the basis of Arrow's
modern technology is absorbed by economically capital model (1962), from which the term 'learn-
backward countries will depend on the same class ing by doing' originates. His hypothesis with re-
of factors as the diffusion of knowledge within spect to capital is that at any moment of time new
countries - which in the final analysis amounts to capital goods incorporate all the knowledge then
Capital and Technical Progress 121
available based on accumulated expenence, but vanced technology applied to production. The
once built their productive efficiencies cannot be capacity to absorb physical capital may be limited,
altered by subsequent learning. among other things, by investment in human
The endogenous model may be more appropri- capital. It is in this respect that there is likely to be
ate in the case of capital but is much less relevant a close interrelationship between the mainsprings
in the case of labour. It is in relation to labour that of technological progress.
most research into the learning process has been Detailed empirical work on the relation be-
conducted. The notion of the learning curve, or tween education and growth relates largely to ad-
progress function, which has been found in many vanced countries. We gave some of the results of
industries, relates direct labour input per unit of such studies in Chapter 2. We can now elaborate
output to cumulative output as the measure of in a little more detail. Professor Schultz, in his
experience. Typically, labour input per unit of out- Presidential Address to the American Economic
put is found to decline by between 10 and 20 per Association in 1961 (see Schultz (1961)), was one
cent for each doubling of cumulative output, with of the first to suggest that growth in the United
a corresponding rise in the productivity of labour. States 'unexplained' by conventional factor inputs
For any one product, of course, learning cannot go might be due to the rapid increase in the quality of
on at the same rate for ever, but since product labour through education. Similarly, it may be the
types are constantly changing it is probably safe to increase in education in the twentieth century that
conclude that in the aggregate there is no limit to accounts for the substantial rise in earnings per
the learning process. For economies as a whole the worker. According to Schultz the stock of educa-
residual factor in the growth equation must partly tion in the United States rose by approximately
reflect the process of learning by doing. There is no 850 per cent between 1900 and 1956 compared
easy way of adjusting the labour-input series for with an increase in reproducible capital of 450 per
learning to include it as part of the contribution of cent (at constant 1956 prices). Schultz acknowl-
labour to growth. edged the difficulties in estimating the rate of
return to education, but argued that even when
every conceivable cost is considered, and all ex-
• Education penditure is treated as investment and none as
consumption, 1 the return to investment in educa-
Finally, we come to the relation between tech- tion is at least as high as, if not higher than, the
nological progress and improvements in the return on non-human capital. Becker's lower esti-
health, education and skills of the labour-force, or mate (Becker (1964)) of the social return on male
what is commonly called investment in human college graduates in the United States, excluding
capital. Investment in human capital takes many 'spillovers', is 12.5 per cent, which is the same as
different forms, including expenditure on health Blaug's estimate for Britain for the last three years
facilities, on-the-job and institutional training and of secondary schooling (Blaug (1965)). Taking 60
re-training, formally organised education, study per cent as the measure of 'unexplained' growth
programmes and adult education, etc. Investment between 1929 and 1956, Schultz concluded that
in human capital can overcome many of the char- between 30 and 50 per cent of this residual can be
acteristics of the labour force that act as impedi- taken as representing a return to the increased
ments to greater productivity, such as poor health, education of the labour force. Bowman (1964)
illiteracy, unreceptiveness to new knowledge, fear reaches similar conclusions. Using Schultz's data
of change, a lack of incentive and immobility.
Improvements in the health, education and skill of 1 The greater the proportion of expenditure treated as pure
labour can increase considerably the productivity consumption, the higher the rate of return on the investment
and earnings of labour and may be preconditions component.
for the introduction of more sophisticated, ad-
122 Factors in the Development Process
on the stock of education, and applying rates of the labour force; second, no allowance is made for
return of 9, 11 and 17.3 per cent, Bowman has improvements in the quality of education; and
calculated corresponding percentage contributions third, there are all the 'spillovers' from education
of the growth of education to national income of to consider, such as the contribution of education
21, 26 and 40 per cent respectively. Denison to knowledge and its diffusion throughout society.
(1962) also reaches roughly the same conclusion, Becker wants to attribute the whole of Denison's
using a more direct approach which has now be- residual to these 'spillovers' and to double his own
come fairly standard for estimating the contribu- estimate of the social rate of return to college
tion of education to growth. The method involves education as a result.
two steps. The first involves gathering information An alternative procedure for estimating the
on the distribution of the labour force by amounts contribution of education to growth, and the rate
of schooling at different dates. The second step of return on education expenditure, is to use the
involves collecting information on income differ- production-function approach outlined in Chapter
ences between education cohorts with different 2. All that is required is a measure of education
amounts of schooling embodied in them, which expansion ('education deepening' following De-
are then used as weights to derive an index of the nison) to be included in the production function.
improvement in the quality of labour due to The contribution of education to measured
education on the assumption that a certain percent- growth is then the rate of growth of the education
age of differences in earnings is due to differences variable multiplied by the elasticity of output with
in the amount of education. Suppose, for instance, respect to the education variable. In estimating
that the earnings differential between those with form, the production function with the growth of
eight years' schooling and those with ten years' education included would be written:
schooling is 20 per cent, that one-half of the differ-
ence is assumed to be due to the extra two years' (4.1)
schooling, and that a person with eight years'
schooling is treated as one unit; then the person where rE is the rate of growth of education, and y
with ten years' education is counted as 1 + (0.5 X is the elasticity of output with respect to educa-
0.2) = 1.1 units. On this basis, but assuming that tion. The rate of return to education would then
60 per cent of income differences are due to educa- be measured as:
tion, Denison estimates that the expansion of
education in the United States over the period L\0 0
- = Y-=- (4.2)
1929-57 raised the quality of labour by the L\E E
quantity equivalent of 29.6 per cent or 0.93 per
cent per annum. Taking the annual growth rate of where 0 and E are the mean levels of output and
output of 2.93 per cent and assuming an elasticity the education variable, respectively.
of output with respect to labour of 0. 73, this gives It is the apparent importance of education in
a contribution of education to measured growth of the growth process in developed countries that has
23 per cent (i.e. (0.73 X 0.93)/2.93 = 0.23). The invoked the response that investment in human
effect of education on the growth of per capita capital may be as important as investment in
income is even more striking. Denison gives the physical capital in developing countries. Assuming
contribution as 42 per cent, and Schultz puts the the analyses of developed countries to be sound,
contribution at between 25 and 45 per cent for the the question is whether it is legitimate to draw
same period. These results are very impressive, policy conclusions for developing countries from
and furthermore there are good reasons why the the experience of developed countries. Can pre-
calculations may be underestimates. For one thing dominantly Western experience be used to fore-
the methodology employed ignores the role of cast the returns to education in the poorer nations
education in maintaining the average quality of of the world? The potential dangers of doing so
Capital and Technical Progress 123
Developing countries
Brazil (1970) 24 13 25 14
Chile (1959) 24 17 12
Colombia (1973) 15 15 21
Ethiopia (1972) 20 19 10 35 23 27
Ghana (1967) 18 13 17 25 17 37
Kenya (1971) 22 19 9 28 33 31
India (1978) 29 14 11 33 20 13
Indonesia (1978) 22 16 15 26 16
Pakistan (1975) 13 9 8 21 11 27
South Korea (1971) 15 9 16 16
Developed countries
Japan (1976) 10 9 7 13 10 9
United Kingdom (1978) 9 7 11 23
United States (1%9) 11 11 19 15
Source: G. Psacharopoulos, 'Returns to Education: A Further International Update and Implications', Journal of Human
Resources, April 1985.
have been forcefully set out by Balogh and vate return is invariably higher than the social
Streeten (1963). How convenient, they say, to elev- return because many of the costs of education are
ate a statistical residual to the engine of develop- not borne by the private individual and the extra
ment and by doing so convert ignorance into return to society does not compensate. Secondly,
'knowledge'! On the other hand, a recent World the social return declines the higher the level of
Bank survey concludes that 'studies have shown education. The returns to primary education are
that economic returns on investment in education very high, while the returns to tertiary (higher)
seem, in most instances, to exceed returns on education are quite low.
alternative kinds of investment, and that develop- In considering investment, and rates of return,
ing countries obtain higher returns than the de- in education, what needs to be remembered is
veloped ones' (World Bank, Education Sector that education is not a homogenous commodity.
Policy Paper (1980)). Some estimates of the rate of The returns to different types of education may
return to education in developing countries com- differ radically between backward and advanced
pared with developed countries are given in Table countries owing to differences in supply (cost) and
4.1, distinguishing between the return to the indi- demand conditions. A high return to training in
vidual (the private return) and the return to the physics in America, say, does not imply the same
economy at large (the social return). high return in Zambia. The returns to different
It will be noticed from the summary table that, types of education and training for different age
in general, both the private and the social return to groups and types of institution must be worked
education is higher in developing countries than in out in individual countries before policy con-
the three developed countries. Two other interest- clusions are reached. Education for education's
ing observations can also be made. Firstly the pri- sake, except perhaps at the primary level, would
124 Factors in the Development Process
inexcusable resource waste. The greatest need is to both types of capital formation need to be con-
decide on the type of educated manpower required sidered together in the planning process and car-
and to plan accordingly with the aid of manpower ried on simultaneously. Ultimately, the amount of
budgets. In this way skill bottlenecks can be eased resources devoted to investment in human capital
and unemployment among the educated avoided. is an allocative problem that each country must
An unemployed intelligentsia, which is already a solve itself, on which no hard-and-fast rules can be
reality in some poor countries, is not only an laid down a priori. All that can be done in general
avoidable waste but may also undermine the de- is to point to the potential benefits of education,
velopment process. and investment in human beings in the widest
One of the strongest associations in developing sense.
countries is between levels of per capita income
and the proportion of the population in primary
education, and the evidence is that educational
expansion at the elementary level has led growth.
Sustained growth seems to be more strongly
I Questions for Discussion and
Review
associated with the proportion of children en-
rolled in primary schools than any other factor 1. What is meant by the process of capital ac-
connected with human capital. Lewis (1966, p. cumulation?
1 09) has remarked that 'allowing for some 2. Distinguish between the various forms of in-
absorption into farming and for the expansion of vestment and capital accumulation that can
non-agricultural employment, a developing econ- raise income per head.
omy needs to have at least 50 per cent of its 3. Why do developing countries, and many de-
children in primary schools'. The hypothesis is velopment economists, lay great stress on the
that traditional customs and attitudes cannot be role of capital accumulation in the develop-
changed significantly until a large section of the ment process?
community at a fairly young age is exposed to new 4. Define the concept of the incremental capital-
ideas and ways of doing things. The relevance of output ratio. What is the use of the concept in
primary education in this regard may partly ex- development planning?
plain why traditional agriculture has been trans- 5. How will technical progress affect the capital-
formed in some countries but not in others. The output ratio?
percentage of the age group enrolled in primary 6. What is meant by the terms: neutral, capital-
and secondary education in developing countries saving, and labour-saving technical progress?
is given in Table 1.8 (p. 46). A survey of 17 7. What are the main means by which societies
developing countries by Psacharopoulos (1973) progress technologically?
found an average rate of return of 25 per cent to 8. In what sense does expenditure on education
expenditure on primary education. represent an addition to the capital stock?
The fact that the capacity of a country to 9. What is 'learning by doing'?
absorb physical capital and technological progress 10. Why did Rostow define 'take-off into sus-
may be constrained by the availability of human tained growth' in terms of a critical ratio of
capital, however, is not a sufficient reason for giv- investment to national income? (See also
ing it preferential treatment. As a general rule, Chapter 1.)
Part III
Obstacles to Development
II Chapter 5 II
Dualisn1, Centre-Periphery
Models
and the Process of
Cun1ulative Causation
It is easy to argue that poverty and backwardness which unequal advantage between developed and
are due to a general shortage and inefficient use of developing countries is perpetuated.
the key factors of production; it is much harder to First, the dualistic structure of developing coun-
determine precisely why there should be a dearth tries will be considered. Secondly we shall examine
of some factors and an abundance of others, and Myrdal's model of the process of circular and
why development may be a slow and lengthy pro- cumulative causation which can be applied to re-
cess. It is certainly impossible to explain present- gions and countries alike (Myrdal (1957) ). We
day international discrepancies in the level of shall see that Myrdal's model is one of many that
development with reference to initial differences in can be used to understand the perpetuation of the
factor endowments. The present development gap development gap and divergencies between North
has arisen largely through industrial development and South or between the 'centre' (industrialised)
in certain selected areas of the world which has, in countries and the 'periphery' (primary producing)
turn, generated its own factor endowments. The countries. The models of Prebisch and Seers will
purpose here, however, is not to consider why be examined in this context, and their similarities
some countries were able to industrialise sooner emphasised. Finally we shall briefly discuss models
than others, but rather to consider some of the of unequal exchange and dependency which
potential obstacles to growth in the present de- emphasise alternative mechanisms making for in-
veloping countries, and the mechanisms through ternational inequality in the world economy. In
127
128 Obstacles to Development
the next chapter in this section we shall elaborate here social and technological dualism, leaving geo-
on the so-called population 'problem' in develop- graphic dualism until later when we consider
ing countries. Myrdal's hypothesis of cumulative causation.
The first question is, what development prob-
lems does the existence of dualism pose for an
• Dualism economy, and how can dualism impede and retard
development? As far as social dualism is con-
Dualism is a description of a condition in which cerned, the obstacles appear to be similar to those
developing countries may find themselves in the presented by a traditional society with no modern
early stages of development, the extent of which exchange sector at all. The task is one of providing
may have implications for the future pattern and incentives in the subsistence sector and drawing
pace of development. There are a number of poss- the subsistence sector into the money economy.
ible definitions and interpretations of the term The fact that the indigenous subsistence sector
'dualism', but in the main it refers to economic may be reluctant to alter its traditional way of life
and social divisions in an economy, such as differ- and to respond to incentives is not peculiar to a
ences in the level of technology between sectors or dual economy. It is true, therefore, that underde-
regions, differences in the degree of geographic velopment tends to be associated with social dual-
development and differences in social customs and ism, but it is perhaps a little misleading to regard
attitudes between an indigenous and an imported social dualism as an underlying cause of back-
social system. Dualism in all its aspects is a con- wardness and poverty. It would be difficult to argue
comitant of the growth of a money economy that development would be more rapid in the ab-
which, as we saw in Chapter 3, may either arise sence of a monetary sector, from which the existence
naturally as a result of specialisation or be im- of dualism stems. Even if the growth of the exchange
posed from outside by the importation of an alien sector makes little impact on attitudes in the indigen-
economic system- typically capitalism. Basically, ous sector, it is bound to make some contribution
therefore, a dual economy is one characterised by to development by employing labour from the sub-
a difference in social customs between the subsist- sistence sector and disseminating knowledge. With-
ence and exchange sectors of an economy, by a out the growth of the money economy it is difficult
gap in the level of technology between the rural to envisage much progress at all. In short, it seems
subsistence sector and the industrial monetised more realistic to regard social dualism as an inevi-
sector, and possibly by a gap in the level of per table consequence of development rather than as a
capita income between regions of a country if the basic cause of underdevelopment.
money economy and industrial development are This is not to say that social dualism does not
geographically concentrated. In fact, it is not un- create problems of its own. For example, different
usual for geographic, social and technological development strategies will be required to cope
dualism to occur together, with each type of dual- with dissimilar conditions in the two sectors, and
ism tending to reinforce the other. Also, the more this may involve real resource costs not encoun-
'progressive' sectors typically have favourable ac- tered by the developed economy. It is in this sense
cess to scarce factors of production, which is a that the dual economy is at a comparative dis-
major cause of the persistence of dualism. Urban advantage.
bias plays an important part in this process (Lip- Similar reservations can be raised over whether
ton (1977) ). it is accurate to describe technological dualism as a
If the basic origin of dualism is the introduction of cause of underdevelopment. As with social dual-
money into a subsistence barter economy, and de- ism, it is probably more realistic to regard it as an
velopment depends on the extension of the money inevitable feature of the development process.
economy, development must contend with the exist- Again, though, the difficulties that may ensue from
ence of dualism in all its aspects. We shall consider gaps in technology between the rural and indus-
Dualism, Centre-Periphery Models and Cumulative Causation 129
trial sectors of the economy must be recognised. tion and rapid assimilation of technical progress
Two disadvantages are commonly associated with throughout all sectors of the economy, and second
technological dualism. The first we mentioned ear- to ensure the 'proper' pricing of factors of produc-
lier: where technological dualism is the result of a tion to prevent in the first place the introduction of
foreign enclave, a proportion of the profits gener- a technology which may be profitable to private
ated in the industrial sector will be remitted to the individuals but which does not maximise the re-
home country, reducing the level of saving and turns to society at large because factor prices do
investment below what it might have been. The not adequately reflect relative factor endowments.
second disadvantage is more fundamental, but dif- But even a technology which is socially optimal in
ficult to avoid. If in the rural, or non-monetised, this sense may not be the technology which pro-
sector of the economy production processes are vides the soundest basis for sustained growth in
characterised by labour-intensive techniques and the long run. The question of the choice of tech-
variable technical coefficients of production, while niques is discussed in detail in Chapter 10.
production processes in the industrial, technologi-
cally advanced sector are capital-intensive and
possess relatively fixed technical coefficients, it is
possible that the technology of the industrial sec-
I The Process of Cumulative
Causation
tor may impede progress in the agricultural sector
on which the rapid development of the total The hypothesis of cumulative causation as an ex-
economy, in part, depends. First, relatively fixed planation of the backwardness of developing
technical coefficients (i.e. a low elasticity of sub- nations is associated with the name of Gunnar Myr-
stitution between factors) means that labour can dal (Myrdal (1957) ). Basically, it is a hypothesis of
only be absorbed from agriculture into industry as geographic dualism, applicable to nations and re-
fast as the growth of capital, and second, capital gions within nations, which can be advanced to
intensity itself will restrict employment oppor- account for the persistence of spatial differences in a
tunities in the industrial sector, contributing to wide variety of development indices including per
urban unemployment and perpetuating under- capita income, rates of growth of industrialisation
development in the rural sector. Hence, productiv- and trade, employment growth rates and levels of
ity growth in the agricultural sector, which is unemployment. As such, the process of cumulative
recognised as being necessary to establish a secure causation is a direct challenge to static equilibrium
basis for take-off into sustained growth, may be theory, which predicts that the working of econo-
slowed down. mic forces will cause spatial differences to narrow.
It is true that if the technology of the modern Myrdal contends that in the context of develop-
sector (imported or otherwise) does embody fixed ment both economic and social forces produce
technological coefficients, it may be difficult for an tendencies towards disequilibrium, and that the
economy to use the socially optimum combination assumption in economic theory that disequilib-
of factors, but this short-run disadvantage must be rium situations tend towards equilibrium is false.
weighed against the favourable repercussions on If this were not so, how could the tendency for
productivity stemming from the advanced technol- international differences in living standards to
ogy. If capital accumulation and technical prog- widen be explained? Thus Myrdal replaces the
ress, and the development of an industrial sector - assumption of stable equilibrium with what he
in addition to agricultural development - are calls the hypothesis of circular and cumulative
essential prerequisites to raising the level of per causation, arguing that the use of this hypothesis
capita income, it is difficult to see how tech- can go a long way towards explaining why inter-
nological dualism can be avoided, at least in the national differences in levels of development, and
early stages of development. The best that can be interregional differences in development within
done is first to encourage the widespread applica- nations, may persist and even widen over time.
130 Obstacles to Development
tend to stimulate enterprise and the demand for causation, that Professor Hirschman (1958) has
products, adding to the demand for factors of suggested that the lagging regions may possibly be
production. In short, migration from region B will better off if they became sovereign political states.
cause the demand curve for labour to shift to the If a lagging area was an independent 'country', the
.left, say to D 1 DI> and migration into region A will mobility of factors of production could be more
cause the demand curve for labour to shift further easily controlled, competition between the leading
to the right, say to D 2 D 2 , causing the initial wage and lagging regions could be lessened, each region
discrepancy at least to persist, if not widen (if the could more easily concentrate on producing goods
shifts in demand are greater than those assumed). in which it possessed the comparative cost advan-
Thus once development differences appear, there tage, separate exchange rates could be fixed for the
is set in motion a chain of cumulative expansion in two regions, and resort could be more easily made
the favoured region which has what Myrdal calls to protection.
'backwash' effects on other regions, causing de- Despite these potential advantages of nation-
velopment differences in general to persist or even hood for a backward region, however, Hirschman
diverge. argues against sovereignty because he believes that
Capital movements and trade also play a part in the forces making for the interregional transmis-
the process of cumulative causation. In a free mar- sion of growth are likely to be more powerful than
ket, capital, like labour, will tend to move to those making for 'international' transmission.
where the prospective return is highest and this This presupposes, however, that the forces making
will be to the region where demand is buoyant. for the interregional transmission of growth are
Capital, labour and enterpreneurship will tend to lost, and begs the question of whether the differen-
migrate together. The benefits of trade will also tial advantages of being a region within a nation,
accrue to the host region. Regions within a nation as distinct from a separate 'nation', offset the
using a common currency cannot have balance- 'backwash' effects that still remain. Hirschman
of-payments difficulties in the normal sense, but recognises the continued existence of 'backwash'
the maintenance of employment depends on the effects and argues that, to offset them, a nation
ability to export, otherwise unemployment will which is concerned with developing its backward
appear. If production is subject to increasing re- regions should provide certain equivalents of
turns, the region experiencing the rapid growth of sovereignty, such as a separate tax system and the
factor supplies will be able to increase its competi- right to protect certain activities. Policies must be
tive advantage over the relatively lagging regions designed to reduce what he calls the 'polarisation'
containing smaller-scale industries, and increase effects of interregional differences in development
its real income accordingly. In the same way, the and to strengthen the 'trickling down' effects. The
general freeing and widening of international mar- 'trickling down' effects are the favourable reper-
kets and the expansion of world trade will tend to cussions on backward regions emanating from ex-
favour the more rapidly growing regions within panding regions, which Myrdal calls 'spread'
nation-states. effects. These 'trickling down' or 'spread' effects
The impact of immigration into the expanding consist mainly of an increased demand for the
region is also likely to induce improvements in backward areas' products and the diffusion of
transport and communications, education and technology and knowledge. In Myrdal's view, the
health facilities, etc., improving efficiency and pro- 'spread' effects are weaker than the 'backwash'
ductivity and widening still further the competitive effects, and if interregional differences are to be
advantage of the growing region over the lagging narrowed, nations must rely on state intervention.
regions experiencing out-migration of the factors The alternative is to wait for a natural end to the
of production. process of cumulative causation, which may be a
Such is the potential strength of the 'backwash' long time coming.
effects of the process of circular and cumulative But a time must eventually come when increas-
132 Obstacles to Development
ing costs in the expanding region will halt expan- for the richest group of countries conststmg of
sion. The higher costs of living, and the external Australia, New Zealand, Canada, the United
diseconomies produced by congestion, will ulti- Kingdom, the United States and Sweden, and the
mately outweigh the benefits of greater efficiency highest coefficient of variation for a group of
and higher money returns to the factors of produc- countries undergoing rapid structural change in-
tion. The process of migration will then be halted, cluding Brazil, Italy, Spain, Colombia and Greece.
and possibly reversed. In some developed coun- India shows a much lower coefficient of variation,
tries this stage is now beginning to be reached. The suggesting that very poor countries tend to be
question for governments with certain growth and uniformly poor. The short run time-series evidence
welfare objectives is whether they can afford to let for sixteen countries showed the coefficient of
the process take its natural course, and to tolerate variation to be stable or falling in all the developed
the inequalities that may arise before the process countries, and increasing in the developing coun-
ends. In practice, governments in many advanced tries of Japan, Yugoslavia and India (but not Bra-
countries have taken active steps for many years to zil). The longer historical time-series evidence
redress regional imbalances, and this is one reason shows that the experience of regional inequality in
why regional disparities tend to be less in ad- the United States, Italy, Brazil, Sweden and France
vanced countries than in developing countries. seems to follow the inverted 'U' shape of initially
In the developing countries, however, Myrdal is increased inequality followed by a decrease in ine-
of the view that, far from lessening regional in- quality. Finally, the US cross-section evidence in
equalities, the state has been a positive force mak- 1950 and 1960 shows that regional per capita
ing for their persistence: 'In many of the poorer income variations within individual States decline
countries the natural drift towards inequalities has significantly with the level of State per capita
been supported and magnified by built-in feudal mcome.
and other inegalitarian institutions and power The pattern found is not hard to explain. Differ-
structures which aid the rich in exploiting the ences must first emerge as a result of some 'shock'
poor' (Myrdal (1963 edn), p. 40). or stimulus in one region or set of regions. Histori-
cally, in an international context, the initial shock
was the industrial revolution in Western Europe,
• Regional Inequalities which gave Europe an initial advantage in the
production and trade of industrial commodities.
The evidence collected by Williamson (1965) Once a difference has emerged, it will tend to be
shows fairly conclusively that regional disparities perpetuated by the processes already described.
in per capita income tend to widen in the early Migration from poor to rich regions will tend to
stages of the development process and then nar- be selective in the early stages of development
row. Williamson examines three types of evidence: because only those with skills and education will
the international cross-section data, short and be able to afford to migrate. 'Spread' effects ema-
long run time-series data for individual countries, nating from prosperous regions will be weak owing
and cross-section data for the United States, treat- to a general lack of political and economic integra-
ing the individual States as 'countries' and the tion. The factors which accentuate differences in
counties within the States as regions. The measure the early stages of development will tend to
of regional inequality taken is the coefficient of weaken with time, however. Migration will be-
variation of regional per capita income, with each come less selective; 'spread' effects will become
region's observation weighted by its relative share more powerful; external diseconomies of expan-
of the total population. As far as the international sion and congestion in expanding regions will
cross-section evidence is concerned, a sample of 24 grow, curbing capital migration from poor to rich
developed and developing countries in the 1950s regions; and then governments may attempt to
gives the lowest weighted coefficient of variation rectify imbalance.
Dualism, Centre-Periphery Models and Cumulative Causation 133
Williamson finds regional differences in per Myrdal argues in the same vein in the case of
capita income partly a function of differences in capital movements. If it were not for exchange
work-force participation rates, and partly a func- controls and generous incentives for indigenous
tion of regional differences in productivity due to and foreign capitalists to earn high profits, the
differences in the industrial mix. Regional dualism natural tendency would be for the developing
in the industrial sector alone is not found to be countries to be net exporters of capital. Risks
very marked. The major difference lies in produc- associated with investment tend to be much higher
tivity differences between industry and agriculture. in developing countries, and safety is as much a
Since the biggest geographical income differences factor determining capital movements as rates of
are likely to be between urban and rural areas, and return. As it happens, owing to the favourable tax
since development is associated with the spread of treatment of profits, market guarantees, and the
urbanisation and a reduction in the size of the large volume of capital from international lending
rural sector, again it is not surprising that regional organisations, the developing countries are gener-
disparities should narrow somewhat in the later ally net importers of long term capital, although
stages of development. the short-term account tends to be adverse.
The potential weakness of Myrdal's hypothesis
however, but permits the immigration of skilled Chapter 2, relating to how societies progress tech-
labour, the developing countries undoubtedly suf- nologically.
I
fer. While in theory, therefore, certain types of
international labour migration could help to nar-
row international differences in levels of develop- Models of 'Regional' Growth-
ment, in practice the assumptions of such a model
are rarely fulfilled.
Rate Differences: Prebisch, Seers
Even so, any potential gain from unrestricted and Kaldor
labour mobility is unlikely to offset the interna-
tional 'backwash' effects arising from trade and While the Myrdal model of centre and periphery
international capital movements. Even with unres- emphasises the process of cumulative causation work-
tricted migration, therefore, there would still be a ing through increasing returns and competitiveness in
tendency for international differences in the level favoured regions, other centre-periphery models
of development to widen through trade and the stress the balance of payments implications of the
free movement of capital. And the existence of particular pattern of production and trade between
international 'spread' effects gives no cause for rich and poor countries which arise from the fact that
modifying this conclusion. International 'spread' industrial goods produced and traded by rich countries
effects are fairly weak - certainly weaker than have a higher income elasticity of demand than goods
'spread' effects within nations. produced and traded by poor countries. One of the
What, then, should be our verdict on the earliest models, powerful in its simplicity, is that of
hypothesis of cumulative causation? Given that Prebisch.
the hypothesis assumes free trade and free mo-
bility of the factors of production, it perhaps con-
tains more force with respect to interregional • The Prebisch Model 1
differences in development than international dif-
ferences. On the other hand, it cannot be dismissed Consider a two-country, two-commodity model in
lightly in discussing the development gap. In view which the advanced centre produces and exports
of the fact that there has been no tendency in the manufactured goods with an income elasticity of
recent past for international per capita income demand 2 greater than unity, and the backward
levels to converge, the hypothesis is not refuted by periphery produces and exports primary commod-
the evidence. In particular, the present internation- ities with an income elasticity of demand less than
al trading and payments position of developing unity. Let us suppose that the income elasticity
countries does not inspire confidence that the total of demand for manufactures (em) is 1.3, and
gains from trade between the developed and de- the income elasticity of demand for primary
veloping countries are distributed equitably. commodities (ep) is 0.8. Assume to start with that
The contribution of the hypothesis of cumula- the growth rates of income of both centre and
tive causation to an understanding of development periphery are equal to 3 per cent, i.e. gc = gP =
and underdevelopment is its emphasis on develop- 3.0. What will be the growth of exports (x) and
ment as a cumulative phenomenon and, more im- imports (m) in the centre and periphery? For the
portant still, its challenge to static equilibrium centre we have:
theory, i.e. that regions or nations which gain an 1 First hinted at in The Economic Development of Latin Amer·
initial advantage may maintain that advantage in ica and its Principal Problems (1950), and developed in 'Com-
perpetuity to the detriment of development else- mercial Policy in the Underdeveloped Countries', American
where. At its root is the phenomenon of increasing Economic Review, Papers and Proceedings, May 1959.
2 The income elasticity of demand for goods measures the
returns defined broadly as the accumulation of proportionate change in demand for a good with respect to a
productive advantages of the type discussed in proportionate change in income, holding other things constant.
Dualism, Centre-Periphery Models and Cumulative Causation 135
XC= gp X em = 3.0 X 1.3 = 3.9 per cent periphery and centre will equal the ratio of the
income elasticity of demand for the two countries'
me = gc X ep = 3.0 X 0.8 = 2.4 per cent
commodities:
and dividing through by gc, we reach the interest- 1 D. Seers, 'A Model of Comparative Rates of Growth of the
ing result that the relative growth rates of the World Economy', Economic journal March (1962).
136 Obstacles to Development
I An Export-Growth Model of
Regional Growth-Rate
Differences
It is possible to combine the ideas of Myrdal with
d Ypt the insights of Prebisch and Seers in a single
Yet -r(A- a) model, which focuses on the role of export growth
(5.6)
dt bYcoert in the development process in an open economy
and in which the Prebisch result emerges as a
Since the denominator is positive we notice that special case if relative prices are fixed and trade is
the relative income gap will widen through time balanced. The model is applicable to regions and
(i.e. the level of income in the periphery will fall open developing economies alike. 4 It takes as its
relative to that in the centre) if (A - a) > 0. Now a starting point the not unreasonable assumption
is the constant term in the import demand func- that the output of an open economy is demand-
tion for the periphery, which will be negative if the determined, not supply-constrained, and that it is
income elasticity of demand for imports from the the long-run growth of autonomous demand that
centre is greater than unity. 1 The constant term, A, governs the long-run rate of growth of output. The
in the centre's import demand function will be main component of autonomous demand in an
positive if the income elasticity of demand for open economy, in turn, is demand emanating from
imports from the periphery is less than unity. 2 outside the region, i.e. the demand for a region's
Therefore (A - a) > 0. Seers notes that the grow- exports. The model is a variant of export-base
ing disparity will be even greater as far as per models of development which stress the import-
capita income is concerned if population growth is ance of exports as a leading sector. The hypothesis
faster in the periphery than the centre. This would is that once a region obtains a growth advantage it
will tend to sustain it at the 'expense' of other
1 In other words, with a linear import demand function, the
intercept of the function must be negative for the ratio of 3 A fuller discussion of balance-of-payments constrained
imports to income to increase as income rises, which is what is growth, and the role of various adjustment mechanisms, is
implied if the income elasticity of demand for imports exceeds ~iven in Chapter 16.
unity. The model is discussed more fully in Dixon and Thirlwall
2 By analogous reasoning to the above. (1975).
Dualism, Centre-Periphery Models and Cumulative Causation 137
regions because faster growth leads to faster pro- demand and the form of the export demand func-
ductivity growth (the so-called 'Verdoom effect') tion. It is conventional to specify exports as a
which keeps the region competitive in the export multiplicative function of home prices, foreign
of goods which gave the region its growth advan- prices and foreign income implying constant price
tage in the first place. 'Success' breeds success, and and income elasticities. Thus:
'failure' breeds failure! In this section attention
will be confined to outlining the model. An ex- (5.8)
amination of the international evidence of the rela-
tion between the growth of exports and the where X is the quantity of exports in time t, Pd is
growth of output in developing countries will be the domestic price in time t, Pf is the foreign price
left until Chapter 15. in time t, Z is foreign income in time t, T] is the
Let: price elasticity of demand for exports (< 0), 0 is
the cross elasticity of demand for exports (> 0),
(5.7) and E is the income elasticity of demand for ex-
ports (> 0). Taking discrete rates of change of the
where gt is the rate of growth of output in time t, xt variables gives the approximation:
is the rate of growth of exports in time t, y is the
(constant) elasticity of output with respect to ex- (5.9)
port growth (= 1 if exports are a constant propor-
tion of output), and t is discrete time. Apart from where lower case letters represent rates of growth
the theoretical considerations underlying the spe- of the variables.
cification of equation (5. 7), that the rate of growth The rate of growth of income outside the region
of the economy as a whole will be governed by the (z) and the rate of change of competitors' prices
rate of growth of autonomous demand, there are a (Pr) may both be taken as exogenous to the region.
number of practical considerations that make ex- The rate of growth of domestic (export) prices will
port demand for highly specialised regions (or be endogenous, however. Let us assume that prices
countries) extremely important for both demand are formed on the basis of a constant 'mark-up' on
and supply. In most industries in a region, local unit labour costs so that:
demand is likely to be trivial compared with the
optimum production capacity of the industries.
The viability of regional enterprise must largely (5.10)
depend on the strength of demand from outside
the region. There are also a number of important
reasons why export demand may be a more potent where Pd is the domestic price, W is the level of
growth-inducing force than other elements of de- money wages, R is the average product of labour,
mand, especially in open, backward areas - re- and T is 1 + percentage mark-up on unit labour
gions or countries. The first is that exports allow costs. From equation (5.10) we can write:
regional specialisation, which may bring dynamic
as well as static gains. Second, exports permit (5.11)
imports, and imports may be important in de-
veloping areas which lack the capacity to produce where lower-case letters stand for the discrete
development goods themselves. Third, if the ex- rates of change of the variables.
change of information and technical knowledge is The model becomes 'circular and cumulative'
linked to trade, exporting facilitates the flow of by specifying the growth of labour productivity as
technical knowledge which can improve the area's partly a function of the growth output itself (Ver-
supply capacity. doorn's Law). If the function is linear we may
Now let us consider the determinants of export write:
138 Obstacles to Development
g = f,(x)
X
placed by developing countries on industrialisa- sions to the argument, e.g. the dependence of the
tion and the restructuring of world trade to allow periphery on foreign capital and the expropriation
their manufactured goods easier access to world of the surplus by the centre; the dependence on
markets (see Chapter 15). Notice also from the foreign technology; terms-of-trade deterioration;
model that if relative prices in international trade mechanisms which reduce real wages in develop-
do not change, equation (5.13) would reduce to: ing countries below what they would otherwise
be, and various socio-cultural aspects of neo-
(5.14) colonialism which thwart the drive to indepen-
dence and self-reliance. Writers in this tradition
and if balanced trade is a requirement (m = x): include Dos Santos, Baran, Gunder Frank, Amin,
and Emmanuel. It should be emphasised at the
(5.15) outset that dependency theory cannot easily be
tested empirically; rather it is designed to provide
where Jt is the income elasticity of demand for a framework of ideas, to accommodate the many
imports. Thus with relative prices fixed, the aspects and features of the functioning of the
growth elasticity with respect to exports (y) must world capitalist economy and the many types of
equal the reciprocal of the income elasticity of dominance and dependency.
demand for imports (Jt) in the balanced trade DosSantos (1970) defines dependence thus: 'by
models of Prebisch and Seers. Again we end up dependence we mean a situation in which the econ-
with the simple rule that one country's growth rate omy of certain countries is conditioned by the
(g) relative to others (z) depends on the ratio of the development and expansion of another economy
income elasticity of demand for the country's ex- to which the former is subjected'. The relation is
ports relative to its imports (or the other country's such that 'some countries (the dominant ones) can
exports in a two-country model), i.e. from (5.15): expand and can be self-sustaining, while others
(the dependent ones) can do this only as a reflec-
E
tion of expansion, which can have either a positive
(5 .16) or a negative effect on their intermediate develop-
ment'. Unequal development must be seen as an
integral part of the world capitalist system. In-
emerged in the post-war era since 1945 based on porations are seen as the modern instrument for
multinational corporations which began to invest the expropriation of surplus value. Neo-marxists
in industries geared to the internal market of de- allow for a residue of surplus, but argue that if it is
veloping countries. This is a technological- reinvested in the periphery or left in the hands of
industrial dependence. Santos argues that each of local elites, it will not be used appropriately for
these forms of dependence has so conditioned the development purposes. As in Dos Santos's model,
internal structure of peripheral countries, that this the system hinges on the collaboration of the gov-
itself has become part of the dependency relation; erning elite who live in the capital city, who think
for example, the highly dualistic structure, the in- like, and identify with, their ex-colonial masters.
come inequality and conspicuous consumption of So poor countries, despite formal political inde-
the wealthy classes; a dependency mentality and pendence, remain locked into an old system of
the ingrained habit of seeking outside help, and economic dependence which perpetuates under-
the unholy alliance between the domestic ruling development.
elite and foreign interests, all conspire to impede For Frank, like Santos, underdevelopment is a
internal development. Thus Santos (1973) main- natural outcome of the world capitalist system
tains that dependency is not simply an external since the development of some countries inevitably
phenomenon; it also has to do with the supportive means the distorted development or underde-
power groups within the poor countries them- velopment of others. Development itself perpetu-
selves who find the status quo profitable: ates underdevelopment, a process which Frank has
coined 'the development of underdevelopment'.
if dependency defines the internal situation and Frank sees the origins of the process in colonisa-
is structurally linked to it, a country cannot tion, which started as a form of economic ex-
break out of it simply by isolating herself from ploitation, and which has distorted the economic
external influence; such action would simply structure of third world countries ever since. The
provoke chaos in a society which is of its es- developing countries were forced into the position
sence dependent. The only solution therefore of suppliers of raw materials for industrial
would be to change its internal structure; a countries, thus effectively blocking industrial de-
course which necessarily leads to confrontation velopment in the primary producing countries
with the existing international structure. themselves. The whole export orientation and
foreign dominance of these countries has limited
Baran (1957), Frank (1967) and Amin (1974) the growth of the domestic market and the estab-
focus their attention more squarely on the tradi- lishment of basic national industries for wide-
tional Marxist mechanisms by which capitalism in spread development throughout the whole
general, and international capitalism in particular, economy. The international, national and local
aid the rich in exploiting the poor. Emphasis is capitalist system alike generates economic de-
placed on the expropriation and transfer of the velopment for the few and underdevelopment for
surplus produced by labour to the owners of capi- the many. The solution would appear to be no-
tal, which operates at different levels. Think of a thing short of social and political revolution.
cone, the base of which represents the rural poor
producing a surplus from their labours in the fields
or down the mines. This surplus is first siphoned • Unequal Exchange
off by those in the provincial towns, by small
employers and merchants. The wealth of these The theory of unequal exchange owes its name to
towns, in turn, is sapped by the capital cities, and Emmanuel (1972). Exchange is unequal between
finally, part of this wealth is siphoned away by rich and poor countries because wages are lower
foreign investors who repatriate it to the apex of in poor countries, and lower than if the rate of
the cone - the rich world. The multinational cor- profit in poor countries was not as high as in rich
Dualism, Centre-Periphery Models and Cumulative Causation 141
countries. In other words, exchange is unequal in wage rate (we) gives a constant price (Pel which
relation to a situation where wages would be acts as numeraire (hence the horizontal line, we).
equalised. 'Inequality of wages as such, all other In the periphery, at a given wage (wp), there is a
things being equal, is alone the cause of the ine- positive relation between the rate of profit and
quality of exchange.' Let us illustrate the model terms of trade ( P) given by the upward-sloping
diagrammatically and show its affinity with the line wP. The equilibrium terms of trade is given at
ideas of those who stress the terms of trade as the P 1 • An increase in periphery wages shifts the
main mechanism through which the gains from periphery curve rightwards to w~ giving a new
exchange are unequally distributed. Take two terms of trade P2 at the same rate of profit. Un-
countries, and call them 'centre' (c) and 'periphery' equal exchange is measured as the difference be-
(p). Assume that prices in the two countries are tween the actual terms of trade (P 1 ) and what it
based on a percentage mark-up (r) on unit labour would be if wages were higher in the periphery
costs, so that: and the rate of profit was lower at r 1 • The 'ex-
planation' of unequal exchange is unequal wage
rates.
The model does not get us very far, however,
without understanding why there are wage
and differences between centre and periphery. In
Emmanuel's model, the wage differences are insti-
tutionally determined outside the model, whereas
in practice there are many factors that impinge on
wage differences within the model itself which
need consideration. Moreover, money wage differ-
where w is the money wage rate, and wL/0 is
ences may not be the only factor leading to
wage costs per unit of output. Now assume that
unequal exchange. If money wage differences be-
for institutional reasons we > wP and that the
tween centre and periphery reflect differences in
mark-up or rate of profit equalises between the
labour productivity, the terms of trade between
two countries. The theory of unequal exchange
periphery and centre will not be nearly as bad as
then says that because of this, the terms of trade
suggested by money wage differences alone. In-
will be worse for the periphery than if wages in the
deed, if differences in money wages are exactly
periphery were higher and the rate of profit lower.
matched by differences in productivity, there
This can be illustrated diagrammatically, taking
would be no difference in money wage costs per
the price of the centre's goods as numeraire so that
unit of output and no difference in relative prices
Pc = 1. See Figure 5.4.
'caused' by differences in money wages. There can
In the centre, the given rate of profit (f) and
still be unequal exchange in the Emmanuel sense
by virtue of the way Emmanuel defines the con-
Figure 5.4 cept, but if the cause of low wages is low produc-
tivity it is not a simple institutional matter to raise
wP (periphery)
Rate of them. 1
profit (r) /w' p
,,
/
/
1 Within this framework, movements in the terms of trade can
On the other side of the coin if there is no good 2. Is dualism avoidable in the development
reason why the rate of profit should equalise be- process?
tween the two countries, a higher rate of profit in 3. In what ways might dualism impede the func-
the centre could be an independent source of un- tioning of the total economy?
equal exchange between centre and periphery, and 4. In what senses is Myrdal's theory of circular
also an explanation of why wages are depressed in and cumulative causation a challenge to static
the periphery. If account is taken of the character- equilibrium theory?
istics of the goods produced by the centre and 5. What are the media through which the process
periphery- manufactured goods in the centre sub- of circular and cumulative causation work?
ject to decreasing costs, and primary commodities 6. If backward regions suffer 'backwash' effects
in the periphery subject to increasing costs - we from regions of expansion, would they be bet-
can predict that oligopolistic structures will de- ter off as sovereign states?
velop in the centre, while competitive structures 7. What is the so-called 'Verdoorn effect' and its
prevail in the periphery, with a tendency, there- importance in the process of circular and
fore, for the rate of profit to be higher in the cumulative causation?
centre. The lower rate of profit in the periphery, 8. What do you understand by the theory of
and the attempt by capitalists to keep up the rate unequal exchange?
of profit in the face of competition, leads to the 9. What do the centre-periphery (or North-
depression of wages in classic Marxist style. South) models of Prebisch, Seers, Dixon and
Thirlwall, and Kaldor all have in common?
143
144 Obstacles to Development
perverse to call this an improvement in welfare argued that it is a basic human right to be able to
simply because the number of people 'enjoying' choose freely and responsibly the number and
such an impoverished state had risen. As Cassen spacing of children. This indeed was the resolution
(1976) has put it: 'concern for the never born (as endorsed by Bucharest World Population Confer-
opposed to those actually born, past and future) ence in 1974 which laid the foundation for the
may be something of a luxury'. Rawls (1972), in A World Bank's increased support for population
Theory of Justice, invites us to think of a rational control programmes throughout the Third World.
observer having to choose membership of one or Now let us outline the facts on world popula-
other society from behind a veil of ignorance as to tion and then consider in more detail the conflict-
where in each society he would find himself placed. ing role of population growth in the development
With a moderate degree of self-interest, Rawls process.
argues, he would probably choose the society which
rejects utilitarianism and adheres to the per capita
criterion. And yet a population policy based on max- • Facts About World Population
imising per capita income has frightening implica-
tions (not entirely fanciful) for all sub-marginal The pertinent facts about the growth of world
groups in society that may be deemed to be depress- population, and predictions concerning what the
ing the average standard of life (see later the discus- future holds in store, are given in Table 6.1. Col-
sion of optimum population). umn 1 shows the crude birth rate per 1000 of the
Where does all this leave the welfare basis for population and the relative decline in the rate since
population control programmes? A surer basis lies 1965. Column 2 shows the crude death rates
not in diminishing returns to population (indeed which have declined dramatically in many coun-
there may be increasing returns, in which case the tries. The average annual growth in population is
utilitarian debate becomes irrelevant), but in the the outcome of the average difference between the
divergencies between the private and social benefit average birth and death rate over the period consi-
from large numbers of children. For example, each dered. Column 4 shows the future projected
individual family may prefer to have fewer chil- annual growth of population to the year 2000,
dren if it knew all other families would have fewer and the projected level of population in the year
children, but it is not willing to limit the number of 2000. Column 3 gives the fertility rate, which is
children in isolation. This is an example of what is the number of children who would be born per
known in welfare economics as 'the isolation para- woman if she were to live to the end of her child-
dox', and establishes a case for public interven- bearing years and bear children at each age in
tion. It is the young who suffer from more children accord with prevailing age-specific fertility rates.
because most of the costs arise in the future. Pre- The fertility rate, and the number of girls born per
sent parents may enjoy their children, but their woman (the net reproduction rate), strongly in-
children may wish their parents had had less, and fluences the future level of population.
they probably would have had less if they could At the present time the world's population is
have been sure that everybody else would have just over 5 000 million, of which more than two-
had less too. A further reason for public interven- thirds live in the developing countries, and over
tion in the field of population control may be one-third resides in Asia. This level compares with
market failure if it can be shown that families have approximately 250 million at the time of Christ,
more children than they actually want and that and less than 1000 million as recently as 1800 AD.
there is an unmet need for family planning The current rate of growth of world population is
services. It is interesting to note that surveys of just under 2 per cent per annum, which has no
desired family size in developing countries consist- precedent historically. From AD 1 to 1750 the rate
ently put the figure at one or two lower than the was no more than 0.05 per cent per annum; from
actual family size. Apart from this, it could be 1750 to 1850, 0.5 per cent annum; and even be-
Population and Development 145
Population
(billions)
r------------------------------------,12
40 Developed-, 1-
countries
- -- :
30
Births
20 I I
I'-- ---,--t I
10
!
- I -
Deaths I
o~~~~~--~~- 0
195019601970198019902ooo 195019601970198019902000
Total world
population
Developed
countries'
population
tween 1900 and 1950 it was only 0.8 per cent per The rates of population growth in developing
annum. The present rate of increase will double countries in the recent past have been substantially
world population every thirty-five years, and it can in excess of the rate of growth for the world as a
be fairly confidently predicted that, unless there is whole, and look like continuing so in the foresee-
a very rapid decline in the birth rate or some able future. The average rate of growth for the
catastrophe such as a nuclear holocaust, the low- and middle-income countries over the period
world's population will be over six billions by the 1965-90 was 2.2 per cent per annum, compared
year 2000. The explosive growth of world popula- with 0.8 per cent in the developed countries. By
tion is illustrated in Figure 6.1, which also shows continents, Latin America has experienced the
the actual and projected crude birth and death most rapid growth (2.6 per cent), followed by
rates for the developed and developing countries. Africa (2.3 per cent) and Asia (1.9 per cent).
The gap between the two rates gives the rate of The country with the largest population is Chi-
population growth. na, with an estimated current population of 1100
150 Obstacles to Development
million, followed by India, USA, Indonesia, Japan, there is increasing evidence that it can occur with
Brazil, Bangladesh, Nigeria and Pakistan, all with improvement in a wide range of socio-economic
populations of over 100 million. China and India conditions: for instance, education and improved
alone currently add 25 million people to the opportunities for women which delays marriage
world's population every year. In the last minute, and makes women more receptive to contraceptive
approximately 300 babies have been born and 150 knowledge; the provision of health services and
people have died, increasing the world's popula- improved life expectancy; the level of literacy, and
tion by 150 persons, giving a yearly increase of 80 access to family planning services. In Figure 6.2,
million. the negative association between the level of per
The rate of growth of population is the differ- capita income and fertility is clearly seen, but the
ence between the number of live births per thousand downward drift in the curve over time can also be
of the population and the number of deaths per clearly discerned, as well as big differences in the
thousand. In a country where the birth rate is 40 fertility rate between countries at the same level of
per 1000 and the death rate is 20 per 1000, the income, reflecting the influence of the factors men-
rate of population growth will therefore be (40 - tioned above.
20)/1000 = 20 per thousand, or 2 per cent per Japan provides a dramatic post-war case study
annum. If (in normal circumstances) a birth rate of where the birth rate has fallen from 34 per 1000 in
60 per 1000 is considered to be a 'biological' 1947 to 11 per 1000 at the present day. It would
maximum, and a death rate of 10 per 1000 is not be legitimate to generalise from the experience
considered a 'medical' minimum, the maximum of Japan, but even this case history would suggest
possible growth rate of population, ignoring im- a minimum of another twenty years before birth
migration, would be about 5 per cent per annum. rates are brought into a closer relation with death
These birth and death rates are, in fact, extremes, rates.
and are rarely found in practice. The current maxi- The projections of the United Nations predict a
mum birth rates recorded are 50 per 1000 in some much longer time span of adjustment for most
African countries. For the developing countries as countries as indicated in Table 6.2, which shows
a whole the average birth rate is about 30 per the forecasts for various continents. Even by the
1000 and the average death rate is now about 10 year 2000, it is predicted that in Africa and Latin
per 1000, giving an average rate of population America, birth rates will still be of the order of 30
increase of approximately 2 per cent annum. This per 1000. Only in China is it projected that the
rapid rate of population growth, compared with birth rate might fall close to the level of the de-
advanced countries (and also in relation to the veloped countries. Part of the reason is due to the
growth of national income), can be seen to be the young age structure of the population produced by
result of relatively high birth rates coupled with past and current high fertility levels which means
death rates almost as low as in advanced coun- that the number of young people greatly outnum-
tries. If population growth is a 'problem' in de- bers the number of parents, and thus the number
veloping countries, this is the simple source of the of potential parents in the future far exceeds the
difficulty and the long-run solution is plain. existing level. Thus, even if measures are taken to
The vital questions are: can high birth rates be control births, and fertility declines substantially,
expected to fall naturally with development, and, it can still take decades for the level of population
if so, what is the crucial level of development and to stabilise because the number of couples having
per capita income at which the adjustment takes more limited families is greater than the number of
place, and how long does the process take? The couples having larger families. It is estimated that
conventional wisdom used to be that fertility de- even if fertility rates were reduced immediately to
cline would come only with rising levels of per the level of replacement (namely, one girl per
capita income, urbanisation, and industrialisation. woman, which means approximately two children
This is the theory of demographic transition. But per family), the population of the developing
Population and Development 151
Figure 6.2 Fertility in Relation to Income in Developing Countries, 1972 and 1982
0 1972
•1982
Yugoslavia
1~-----------L----------~------------~-----------L----------~----------~~
$6000
0 $1000 $2000 $3000 $4000 $5000
Income per capita (1980 dollars)
Table 6.2 Recent and Forecast Crude Birth and Death Rates
Source: United Nations, World Population Trends and Prospects 1950-2000 (New York, 1979).
152 Obstacles to Development
I
levels of the rate of births and deaths. This pro-
position is best illustrated by means of a simple
diagram (Figure 6.3). The curves RB and RD re- The Conflicting Role of
present the time paths of the birth rate and death
rate respectively. Population growth is determined Population Growth in the
by the gap between the two curves. To save draw- Development Process
ing more diagrams, let us suppose that points X
and Y in Figure 6.3 represent two countries with Population growth plays a conflicting role in the
the same current rate of population growth ( Pq = development process. It can act both as a stimulus
St). In the case of country Y, population growth and an impediment to growth and development.
will soon slow down since the death rate has The question, to which there is no easy answer, is
reached its minimum and the birth rate is falling. at what point do the economic disadvantages be-
In the case of country X, however, which has the gin to outweigh the advantages? Where does the
same current population growth, the population balance lie?
growth rate can be expected to increase in the The commmi view as far as the developing
future as the gap between the birth and death rate countries are concerned is that rapid population
widens. The death rate is falling but the birth rate growth presents an obstacle to the growth of living
remains constant to the point V; only after this standards. The argument in a nutshell is that rapid
point will population growth decrease. Here, then, population growth acts as a barrier to capital
are two countries with the same observed popula- accumulation and capital deepening, retards the
tion growth in the present but with radically differ- rate of productivity growth and, in general, adds
ent future prospects. In comparing countries, and more to the numbers to be supported than to the
Population and Development 153
level of output. A fairly typical remark, repre- population growth and total factor productivity
sentative of the pessimistic school of population growth are positively correlated.
economists, is that of Enke (1971): The effect of population growth on savings is
also a good deal more theoretically complex than
The economic danger of rapid population growth the above arguments suggest. The traditional
lies in the consequent inability of a country argument is that population growth reduces the
both to increase its stock of capital and to im- community's savings ratio by leading to a high
prove its state of art rapidly enough for its per dependency ratio of children who consume but do
capita income not to be less than it otherwise not produce. Ignoring the fact that many young
would be. If the rate of technological innova- children do, in fact, work in developing countries,
tion cannot be forced, and is not advanced by the implication of the argument would seem to be
faster population growth, a rapid proportionate that a reduction in population growth would in-
growth in population can cause an actual re- crease the savings ratio by 'raising' the age struc-
duction in income per capita. Rapid population ture of the population. In the process, however, it
growth inhibits an increase in capital per worker, must be remembered that many older members of
especially if associated with high crude birth the community also consume without producing
rates that make for a young age distribution. and that the proportion of retired members of the
community to the total population will rise as
Hoover and Coale (1958), in a study of popula- population growth slows. Thus what happens to
tion growth and development based on Indian the aggregate savings ratio as the population
experience, also remark: growth rate changes will depend on how the com-
position of the total dependency ratio alters, and
While greater numbers in the labour force add on the propensity to save (dissave) of the two
to the total product, faster growth of the labour groups of dependents. For example, if the propen-
force implies a lower output per worker than sity to dissave of the retired was greater than that
slower growth. The reason for this result is that of the inactive young, the aggregate savings ratio
with a faster growing labour force more capital might fall with a reduction in the birth rate as the
must be directed to provide tools and equip- retired dependency ratio rose. Thus while it is
ment for the extra workers so that they will be certainly true that both groups of dependants
as productive as the existing labour force, and dissave, 1 it would be wrong to conclude that coun-
thus less will be available, ceteris paribus, for tries with high rates of population growth will
increasing output per worker. necessarily have lower savings ratios, other things
The arguments made do not sound unreason- 1 The evidence from Leff, taking a cross-section of seventy-four
able but they are rarely backed by direct empirical developed and developing countries, is as follows (t values in
evidence, nor do they recognise the findings in parentheses):
some countries (as pointed out in Chapter 2) that In SlY= 7.34 + 0.16 In YIN+ 0.03 In g
increases in capital per worker account for only a (5.72) (2.88) (3.28)
small proportion of increases in output per work-
- 1.35 In D 1 - 0.40 In D 2
er, and that the major part of increases in output (4.64) (2.56)
per worker appears to be due to increases in out-
put per unit of total inputs. There are simulation where In denotes logarithm of the variables; SlY is the savings
ratio; YIN is per capita income; g is the growth of per capita
studies for individual countries (see Enke (1971), income; D 1 is the proportion of the population under 14; and
(1966)) showing a negative relation between D 2 is the proportion of the population over 65. Analysing the
population growth and capital accumulation but samples of developed and developing countries separately gives
the same negative signs on D 1 and D 2 but in the developed
these studies invariably hold total factor produc- countries the magnitude of the coefficient on D 2 is higher than
tivity growth constant, which may be mistaken if that on D 1 • See Leff (1969).
154 Obstacles to Development
equal, than countries with lower rates of popula- growth of the population, employment and output
tion growth. On the contrary, in fact, in the very on the one hand and the growth of production per
long term the savings ratio will tend to rise with head on the other. The possible explanations for
the rate of population growth owing to the in- such a relation are numerous. It has been argued
crease in the ratio of active to non-active house- (see Chapter 4, p. 120) that an economy with a
holds. This is one of the predictions of the life- faster rate of growth of employment and output
cycle hypothesis of saving (see Modigliani (1970)). may be able to learn more quickly and hence raise
In the long term, when the population is in bal- its rate of technical progress. Second, if there are
anced growth, the age structure of the population internal and external economies of scale in pro-
will be uniquely related to the rate of population duction, increased employment and output will
growth, and the same effect on the savings ratio lead to a faster rate of growth of labour productiv-
can be expected from population growth as from ity. Third, there are likely to be economies of scale
the increase in income due to productivity growth. in the use of capital. Capital requirements, in most
It should also be remembered that the effect of cases, do not increase in the same proportion as
children on a society's total savings works pri- population. There are many important indivisibili-
marily through the family as a unit and depends ties in the provision of capital, especially in the
on how the family reacts to the increase in the field of transport and other social-overhead capit-
number of children. There may just be a substitu- al. There may even be capital deepening if the
tion of one form of expenditure (on children) for life-cycle hypothesis of saving holds - which pre-
another. Alternatively, the family may work har- dicts a positive relation between the savings ratio
der to provide for the children, in which case there and population growth provided population is in
would be no adverse effect on saving at all. Saving balanced growth.
in some families may even increase if there is a It would be misleading to give the impression,
sufficient increase in output and a high degree of however, that all population economists are
substitution. The degree of substitution between pessimistic about the influence of population
one form of expenditure and another will depend growth on living standards. Clark ((1967) and
on the ability to substitute determined by living (1969)) argues that a classification of the develop-
standards and the level of saving already achieved. ing countries shows that those with the highest
The question of an output response from popula- rates of population growth have the highest rate of
tion pressure comes back to the point made earlier increase of production per head, and that his-
of the possibility of a positive relation between torically periods of population growth usually
population growth and total productivity growth. precede and provoke economic growth. Easterlin
The argument that a slow-down of population (1967) suggests that population pressure can
growth would raise the savings ratio assumes that favourably affect individual motivation and lead
the factors that determine output are independent to changes in production techniques which over-
of the number of dependents for whom provision come the consequences of population pressure. In
has to be made. But it may well be that the sheer this connection it has been argued by Boserup
increase in numbers creates work and production (1965) that a major stimulus to the 'green revolu-
incentives which affect output and productivity tion' has come from the pressure of population on
favourably. In fact there is a good deal of theory food supply. Easterlin also claims that the young
and empirical evidence suggesting a positive rela- age structure of a country makes it more amenable
tion between population growth and the growth to change, more receptive to new ideas, more will-
of output per unit of labour, especially in the ing to shift resources from low-productivity to
manufacturing sector, assuming some growth in high-productivity sectors, and so on, all of which
the labour force as population expands. This is may raise income per head. In Hirschman's model
Verdoorn's Law, which we discussed in Chapter 5, (see Chapter 7), population growth increases the
which hypothesises a positive relation between the supply of potential decision-makers, expands mar-
Population and Development 155
kets and leads to development via shortages. evidence as there is, based on international
The potentially conflicting role of population comparison, seems to show that there is no
growth in the development process is highlighted pronounced .'relationship between the rate of
by the difference in attitude towards population productivity growth and the annual increase in
increase between the developed and developing the supply of labour. Whether the rate of
countries, and between the developing countries growth of national product keeps ahead of that
themselves. In many advanced countries popula- of population depends largely on the balance of
tion growth is welcomed, at least by govern- other factors.
ments. In some countries it has been actively en-
couraged by generous family-allowance provisions All that has really been said so far is that
(e.g. France) and liberal immigration policies (e.g. population growth presents a paradox. On the one
Canada). In the developing countries there is a hand increases in population may reduce living
view, held within and outside, that population standards owing to the adverse effect of popula-
growth and abundant supplies of labour are tion growth on savings and capital per head. On
serious obstacles to development, but it is by no the other hand increases in population and the
means unanimously held. In a UN inquiry into the labour force can raise living standards through
attitudes of countries towards population growth, learning, specialisation and scale economies which
several countries cited the strain on investible re- larger numbers, wider markets and a higher vol-
sources that population growth imposes, but other ume of output make possible. What may be
countries did not mention economic drawbacks called the 'paradox of labour' can be seen more
at all, and pointed to positive advantages of easily by taking the identity 0 = P( OIP), or in dif-
population expansion (United Nations (1964)). ferential form !::..(010) = !::..(PIP) + t::..(OIP)I(OIP),
Malaysia, for example, mentioned the possibility where 0 is output and P is population (and a
of substantial external economies of scale in the constant fraction of the population is assumed to
long run. The Cameroons expressed the view that work). Decreasing amounts of capital per worker
a lower population growth rate would not contain (and possibly diminishing returns to land) imply a
the pressure to urbanisation and industrialisation negative relation between the terms on the right-
which it regarded as an essential ingredient of hand side of the equations so that output per head
economic development. Venezuela stressed human is lower than it would otherwise be as the popula-
resources as the most valuable asset of a country, tion increases. On the other hand, the possibility
while Liberia expressed concern over adequate of increasing returns, due to the factors men-
supplies of labour to industry if population growth tioned, implies a positive relation between the two
was curtailed. Among the more developed coun- terms so that living standards rise as the popula-
tries, Ireland and Czechoslovakia both regarded tion increases. The question is, which forces pre-
their populations as too low, and detrimental to dominate? The debate as to whether population
development. Australia emphasised the import- growth is a stimulus or an impediment to the
ance of population growth for enlarging domestic growth of living standards is largely a question of
markets on which her expanding export industries whether the relation between !::..(PIP) and !::..(OIP)I
are based. The most non-commital statement can (OIP) is significantly positive or negative. If the
be found in the British reply, but it sums up well relationship is negative, then population growth is
the conflict of opinions: an impediment to rising living standards, and the
growth of output itself may also be impaired. If
There is nothing either in experience or in econ- the relationship is positive then the effect of
omic theory to indicate that a rapidly growing population growth on the growth of output and
population makes it easier or more difficult to output per head is unambiguously favourable.
keep the rate of growth of the national product
ahead of that of population. Such empirical
156 Obstacles to Development
on the values of a and p, and on the relationship Figure 6.4 The Relationship Between the Average
between population growth and capital accumula- Rate of Growth of Per Capita Income and Population
tion on the one hand and between population Growth in Developing Countries, 1960-1980.
growth and technical progress on the other. Sup-
pose for illustration that production is assumed to X
developing countries which led him to conclude sources used to retard population growth can con-
that 'the implication is that the rate of population tribute perhaps one hundred times more to higher
growth among underdeveloped countries has no incomes per head than resources used to accelerate
uniform effect on growth in per capita product - a output growth'. The core of the argument is a
denial of the hypotheses [which assume] that high simple numerical example comparing the impact
rates of population growth would be particularly on average income of equal expenditures either on
limiting on the growth of per capita product in the conventional development projects intended to
underdeveloped countries with their lower re- raise the national income, or on a birth reduction
serves and increased pressure of population on programme. For example, suppose $0.5 million is
economic resources' (Kuznets (1967)). invested each year in conventional capital projects
The fact that the international cross-section evi- yielding a rate of return of 15 per cent per annum.
dence lends very little support to the notion that This would give an annual output increase of
curbing population growth will have much impact, $0.075 million. After ten years, $5 million will
if any, on the growth of income per head is not to have been invested yielding an annual income flow
deny, of course, that curbing population growth of $0.75 million. If the initial level of income was,
may be desirable for other reasons, such as to say, $500 million, the flow from the new invest-
relieve overcrowding, to relieve pressure on food ment represents a proportionate change of 0.0015.
supplies, and, in general, to improve the distribu- Now suppose $0.5 million is invested each year in
tion of income. To be sceptical of an inverse rela- a birth-control programme fitting intra-uterine de-
tion between population growth and per capita vices. If the cost per participant is $1, there would
income growth is not to pour cold water on be 500 000 participants on average each year.
population-control programmes. On the contrary, Assuming that the live-birth fertility of a typical
given the uncertainty of the population-growth! woman participant is 0.15 infants a year, the re-
living-standards relationship, and the force of other duction in births over ten years is (500 000) (0.15)
arguments for limiting numbers, the most sensible (10) = 750 000. If the initial population is say, five
strategy is to pursue programmes on the hypothesis million (which combined with the assumption of
that population control increases per capita income. $500 million income gives a per capita income of
In simulation studies of the gains from population $100), the proportionate change in population
control, however, which use the effect on per capita due to the annual investment in the birth control
income as the criterion for success, it is important programme is 0.15. Thus if investment of $5
that explicit account should be taken of the positive million in physical capital over ten years gives a
relation between population growth and total pro- growth rate of income of 0.0015, and $5 million
ductivity growth if the gains are not to be exagger- invested over ten years in population control gives
ated. This point is particularly important to bear in a proportionate reduction in population of 0.15,
mind in evaluating the work of Enke and collabor- then investment to control births is 100 times
ators, who have tried to estimate the returns from more effective in raising the rate of growth of per
expenditure on population control compared with capita income than investment in physical capital.
alternative forms of investment, and to calculate Enke comments: 'it is staggering to encounter such
whether investment on birth prevention is more ratios when comparing different economic poli-
effective than investment in physical capital in raising cies'. General amazement could be reduced if it is
income per head. noticed that this particular ratio is crucially depen-
dent on the values taken for the initial levels of
population and income. The lower the population
• Enke's Work and the higher the income (i.e. the higher the level
of per capita income) the greater the relative re-
To take up the latter issue first, Enke's work and turn to birth control programmes, suggesting that
views (1966) led him to the conclusion that 're- rich countries underinvest in birth control pro-
Population and Development 159
grammes - a conclusion opposite to the one Enke of a saved birth of $263. The cost of preventing a
presumably wanted to reach (see Curtin (1969)). birth is estimated to be only $5, giving a very high
If the approach is sensible it also implies that the net present value and a high social rate of return
more investment in birth control programmes, the on capital invested. Within the framework of the
higher the ratio of effectiveness will become; a model the most suspect feature of Enke's pro-
form of increasing returns to population control. cedure is that the whole of a child's consumption
One weakness of the approach is that while Enke up to the age of 15 is treated as a reduction in so~
concedes that substantial bonuses may have to be ciety's saving whereas, in fact, the child may work;
paid to encourage the adoption of birth control the family to which it belongs may reduce their
practices, he does not recalculate the basic numer- consumption on other things, or the family itself
ical example to take account of these additional may work harder and produce more to support
expenditures. The excuse is that bonuses are the child. When these considerations are taken
simply transfer payments, but transfer payments into account, the net gain in saving or saved con-
have alternative investment uses. But the major, sumption from the prevention of a birth may be
serious objection to the whole approach is that it very much less. Also forgotten are the positive
treats changes in population and income as inde- externalities that people may confer on one
pendent whereas they are interdependent. When another, not to mention that great leaders, inven-
population growth is reduced, output growth will tors and artists must come from the human stock.
also be reduced directly if the marginal product Who can say what the long run consequences of
of labour is positive, and also indirectly if pro- saving births will be with such intangible con-
ductivity growth in the economy falls as the siderations involved? Moreover, to measure the
population growth rate falls. A reduction in benefits of a lower population simply in terms of
population growth may yield no long-run increase additions to saving is extremely narrow in concep-
in income per head. It is possible, of course, that tion. Societies have never placed an infinite valua-
an increase in income from investment in physical tion on saving, not even Stalinist Russia. The
capital may induce population growth, nullifying analysis would suggest, taking it to its logical con-
also the gains from investment in physical capital clusion, that the social optimum would be
in some crude Malthusian manner. But this is achieved when consumption per head fell to zero,
much less likely than the former possibility. If yielding maximum savings but at the cost of
anything, direct increases in income seem to have a national suicide!
depressing effect on the birth rate. Indeed many
would argue that a precondition for any birth
control scheme to be effective is that the level of ·• Simon's Challenge
income is first raised - a view summed up by the
aphorism that affluence is the best contraceptive. The most recent concerted challenge to the think-
Enke (1971) also undertakes traditional cost- ing and work of Enke, and to the view that
benefit analysis to estimate the rate of return to population growth is uniformly depressing for the
expenditure on birth control programmes. The ben- material well-being of mankind, has come from
efit of a birth prevented is measured by the dis- Professor Julian Simon ((1977) (1981) and (1986)).
counted value of the saved consumption (i.e. by Simon's major thesis is that 'the ultimate re-
increased saving). Up to the age of 15, when an source is people - skilled, spirited and hopeful
addition to the population is not productive, Enke people - who will exert their wills and imagina-
calculates a net gain in saving, discounting at 15 tions for their own benefit, and so, inevitably, for
per cent, of $280 (at 1960s prices); and between the benefit of us all'. Simon brings together both
the ages of 15 and 55, when the addition to the theoretical arguments and empirical evidence
population is productive, he calculates a net loss of on both sides of the population debate and pre-
saving of $17, giving a total net benefit to society sents his own simulation results on the relation
160 Obstacles to Development
between population growth and living standards. new methods in agriculture; the supply response
He finds that the initial effects of population in- of families; the provision of social infrastructure
crease on per capita income are negative, but that (particularly transport); scale economies and demand-
in the longer term the positive feedback effects that induced investment. Let us briefly consider some
result from the stimulus of population growth to of these factors.
technological progress and other factors which im- A society under pressure from population
"prove the rate of growth of productivity outweigh growth may be expected to respond by finding
the negative effects. Simulations suggest that for new and more efficient ways of meeting given
countries already industrialised the initial negative needs. In agriculture, the Malthusian view would
effect of population is offset within fifty years. For be that improvement in agricultural techniques is
less developed countries the conclusion is that independent of population and that improvements
moderate population growth is more favourable simply induce more population. Others would
to the growth of living standards than either a argue that even if population pressure does not
stationary population or very fast population induce the production of new techniques it cer-
growth. An overall judgement on population tainly induces the adoption of new techniques. It is
growth, and whether it is beneficial or not, there- difficult to see how the green revolution would
fore depends very much on a weighing of the have occurred without the pressure of numbers on
balance between the present and the future. In food supply.
economics the present and the future are made Agricultural families may respond to the needs
comparable using the concept of a discount rate. of additional children by changing methods, work-
Whether the positive long-run benefits of popula- ing harder and producing more. Studies suggest
tion growth are considered to outweigh the short- that the elasticity of output to increases in the
run negative effects depends very much on the number of children is about 0.5; that is, an in-
discount rate and the time period taken. The less crease in family size, say, from four to five (25 per
future benefits are discounted and the longer the cent) would result in a 12.5 per cent increase in
time period taken, the more beneficial (less det- output. Simon argues that population growth also
rimental) population growth appears, and the has a large positive effect on agricultural saving,
shorter the time period considered and the more which tends to be overlooked because a large frac-
future benefits are discounted the less beneficial tion is non-monetised.
(more detrimental) population growth appears. Population pressure provides a stimulus to
There will be some time period and some discount develop social infrastructure, transport and com-
rate at which additional population now is exactly munication facilities, which have far-reaching
on the borderline of having a negative or positive external repercussions, extending beyond the addi-
value. tional numbers they were designed to serve. Popu-
What are the positive feedback effects that lation growth also makes these facilities more econ-
population increase can have on economic prog- omical to provide because of the scale economies
ress which vitiates the classical prediction that involved in their provision. Simon argues 'if there
population growth is uniformly depressing on is a single key element in economic development
living standards? In his simulation model of the other than culture and institutions and psycho-
relationship between population growth and per logical make-up, that single key element is trans-
capita income in advanced countries, Simon portation together with communications'. Adam
attempts to capture the effect of additional chil- Smith, an early contemporary of Malthus and
dren on such factors as the savings ratio; labour much more optimistic about the development pro-
supplied by the parents; scale economies and tech- cess, was impressed by the benefits of communica-
nical progress. In his simulation model for de- tions: 'good roads, canals and navigable rivers, by
veloping countries Simon considers the following diminishing the expense of carriage, put the re-
important feedback mechanisms: the stimulus to mote parts of the country more nearly upon a level
Population and Development 161
with those in the neighbourhood of the town. short-term costs. Indeed, only when the benefits
They are upon that account the greatest of all are considered is it possible to comprehend why
improvements - they break down monopolies ... societies are infinitely wealthier today than cen-
they open new markets.' To the extent that turies ago despite population expansion.
population growth exerts pressure for these facili-
ties to be provided, a significant output response is
to be expected. • The 'Optimum' Population
Increased population also has many other types
of productivity effects which are subtle and in- What is the 'optimum' population? The term
direct, yet nonetheless very important. It is very 'optimum population' is used in several different
difficult, for example, to improve health and senses, but four, particularly, are commonly em-
sanitation in sparsely populated areas, but once ployed. First, it is sometimes used to refer to the
sanitation and health improvement become size of population which maximises the average
feasible and economical with greater numbers product or income per head. It is in this situation
enormous benefits may result - more than in that a society's savings ratio is likely to be maxi-
proportion to the increase in population. A mised. Thus if the total product curve for an econ-
growing population also facilitates change with- omy is drawn as in Figure 6.5, the optimum
out disrupting the organisation and positions of population is OP, where a ray from the origin is
those already established. Thus government and tangential to the total product curve. AtOP, total
administration may be expected to improve and product (OY) divided by population (OP), or
become more in keeping with the needs of de- average product per head of population, is at its
velopment. Youth itself has positive advantages. maximum. The condition for maximum average
Young people are more receptive to change and product per head is that the marginal and average
modernisation than older people. The younger a product per head should be equal. If the marginal
population the more education (or human capi- product of an addition to the population is above
tal) per head of the population. Young people the average, average product could be increased by
tend to be more mobile which is an asset when an expansion of the population. Contrariwise,
structural change is required. With a growing if the marginal product is below the average, a
population, investment is less risky. Many econ- further increase in population will reduce the aver-
omists are of the view that one of the major ob- age product and the population would exceed the
stacles to development is not a shortage of savings optimum level in the way defined. If there was no
but a lack of willingness to invest. An expanding saving, the maximisation of product per head
market resulting from population growth provides would maximise welfare per head because con-
an incentive to investment. sumption per head would then be at a maximum.
The great difference between the results of On the surface this concept of optimum popula-
Simon and the results of Enke (and of Hoover and tion seems an attractive one on which to base a
Coale cited earlier) is that all the beneficial feed-
back effects of population on output mentioned Figure 6.5
above are omitted from the latter analyses. But
any of the feedback factors referred to may par-
tially or fully offset the capital-dilution effect of tJ
::l
greater numbers in the short run which is the 'tl
~ y 1--------,~
factor that the predictions of conventional models iii
reflect. A complete analysis of the relation between ~
population and living standards must have due
regard to the longer term benefits that population
expansion can confer on societies, as well as the
162 Obstacles to Development
Q.
Yet a population policy based on maximising ;;;
c
per capita income has frightening implications -~
population, for any given ratio of population to which is able to explain the pattern of population
resources. In view of the variety of interpretations growth during the course of development. What
of the concept of optimum population, the claim happens to population as per capita income rises,
that a country is 'overpopulated' or 'underpopu- and what happens to national income, and there-
lated' needs to be viewed with some scepticism fore per capita income, as population rises?
unless a precise definition of terms is given. Models of the low-level equilibrium trap attempt
to integrate population and development theory
by recognising the interdependence between popu-
I Equilibrium Trap
A Model of the Low-Level
lation growth, per capita income, and national
income growth. This type of model, which orig-
inated in the 1950s, is designed firstly to demons-
trate the difficulties that developing countries may
To repeat, there are two main interrelated reasons face in achieving a self-sustaining rise in living
why rapid population growth may be regarded as standards, and secondly to provide pointers to
a retarding influence on development. First, rapid policy action. One such model by Nelson (1956),
population growth may not permit a rise in per on which we shall concentrate, contains three
capita incomes sufficient to provide savings necess- basic equations dealing with the determination of
ary for the required amount of capital formation net capital formation, population growth and
for growth. Second, if population growth outstrips income growth. Let us consider these equations
the capacity of industry to absorb new labour, separately before examining the simple workings
either urban unemployment will develop or rural of the model.
underemployment will be exacerbated, depressing
productivity in the agricultural sector. It is not
inconceivable, moreover, that rises in per capita D Capital Formation
income in the early stages of development may be
accompanied by, or even induce, population Capital formation takes place through saving
growth in excess of income growth, holding down and new land brought into cultivation, i.e.
per capita incomes to a subsistence level. Today dk = dk' + dR, where k is capital, k' is savings-
we witness falling death rates (associated with de- created capital and R is land. We shall ignore new
velopment), contributing to population pressure; land as a part of capital and concentrate on
and presumably for centuries past the population savings-created capital. It is assumed that all sav-
of most countries has been oscillating around the ing is invested.
subsistence level, with small gains in living stan- The rate of savings per capita (dk' IP) is related
dards (due to 'technical progress') being wiped out to income per capita (0/P) in the way shown in
either by higher birth rates or such factors as dis- Figure 6.7. In equation form:
ease, famine and war. One vital question that a
theory of economic development must answer is, dk'
at what level of per capita income can income p b [ (~)-X],
growth be expected to exceed population growth
permanently, thus sustaining further rises in per
capita income indefinitely? This question cannot where -p>
0
(-p)
0'
(6.7)
be answered at a point in time by casual observa-
tion that income growth exceeds population and
growth, because the very rise in per capita income
may induce population growth greater than in- 0 0'
come growth in the future. A full behavioural -C, where-~(-)
p p
model is required, and a theory of population
164 Obstacles to Development
dk'
p dP
p
dk'
p p
dP
,dP*
p
0
0 0 -p
p
Per capita income is so low up to the level (0/P)' per capita income levels below S, dP!P is negative
that there is disinvestment (dissaving), assumed to since the death rate would exceed the birth rate.
be at a constant rate, C. Beyond (0/P)' the rate of
savings per capita rises linearly with per capita
income. D Growth of National Income
Income (or output) is assumed to be a linear homo-
D Population Growth geneous function of factor inputs, 0 = Tf(K, L)
where K is capital, L is labour (as a constant
With rising per capita income, population growth proportion of the population) and Tis an index of
(dPIP) is first assumed to increase owing to falling 'total' productivity. Technology and the social
death rates. Then at a critical level of per capita structure are assumed constant. From the assump-
income (0/P)" population growth reaches a maxi- tions of the model, the income growth curve can
mum (dPIP)* where the death rate has fallen to a be drawn as in Figure 6.9. Where S = X (taken
minimum. Since Nelson's model is short run, the from Figures 6. 7 and 6.8, population is stationary;
effect of per capita income on the birth rate is the rate of savings-created capital per head is
ignored, but the relation can easily be accommo- zero, and therefore income will be stationary
dated if desired. The relation between population (dOlO = 0). With rising per capita income beyond
growth and per capita income can be represented this stationary equilibrium, growth increases
as in Figure 6.8. In equation form:
dP Figure 6.9
p P[(~)-s], dO
0
where ( ~ ) < (~ )" (6.8)
and
owing to increases in the labour force and capital theories of development (see Chapter 7 and be-
per head. As population growth reaches a maxi- low), and the concept of a 'critical minimum
mum, however, and savings as a percentage of effort', was the belief that to escape from the 'trap'
national income approach a constant, income it would be necessary to raise per capita income to
growth will level off. In the absence of technical Oa in one go. If countries are in a trap situation,
progress, growth will ultimately decrease owing to however, much greater hope probably lies in the
the law of variable proportions, in this case due to dOlO curve drifting upwards over time, through
a fall in the capital-labour ratio. technical progress, or in a sudden drop in the dPIP
Combining Figures 6.8 and 6.9, we have a dia- curve from a reduction in the birth rate. Capital
grammatic representation of the possibility of a from abroad, raising the dOlO curve, and emigra-
low-level equilibrium trap situation in which per tion, lowering the dPIP curve, could also free an
capita income is permanently depressed. Figure economy from such a trap.
6.10 shows this. Any level of per capita income To take account of factors other than popula-
between the subsistence point (S = X) and Oa will tion growth which may depress per capita income,
be accompanied by a growth of population faster and factors other than increases in capital per head
than the growth of income, forcing per capita that may raise per capita income, the low-level
income down. The equilibrium level of per capita equilibrium trap model can be extended and
income will be where the population growth curve generalised by adopting Leibenstein's terminology
cuts the income curve from below. One such point of income-depressing forces and income-raising
is to the left of Oa, where S = X, and this point forces (Leibenstein (1957)). Leibenstein's approach
represents the low-level equilibrium trap. Any is illustrated in Figure 6.11. The curve represent-
level of per capita income below Oa will force per ing income-depressing forces, zt, is measured hori-
capita income down to this subsistence level. Con- zontally from the 45° line, and the curve represent-
trariwise, any per capita income level beyond Oa ing income-raising forces, xt, is measured verti-
will mean a sustained rise in per capita income cally from the 45° line. Per capita income level Oa
until the two curves cross again at Oq. This would is the only point of stable equilibrium. Between
be a new stable equilibrium with the population Oa and Oq income-depressing forces are greater
growth curve again cutting the income growth than income-raising forces and per capita income
curve from below. To escape from the low-level will slip back to Oa. Only beyond Oq are income-
equilibrium trap, per capita income must either be raising forces greater than income-depressing
raised to Oa, or the dOlO and dPIP curves must forces such that a sustained increase in per capita
be shifted favourably. The origin of 'big push' income becomes possible. Oq is the critical per
dO dP
o'T
...
"0
c: ·-
Oiu
OI"O
E .,
~
X,
gg
·- "
!9 ·=
.." .."
·a "0
'- :I
~]
..__ _ _ _ _ _ _ _ _ _ _ _ _ Per capita
income, and
induced income
growth
166 Obstacles to Development
171
172 Planning, Resource Allocation, Development and Techniques
to interfere with the market mechanism and to evidence of structural disequilibrium and a very
adopt various forms of planning for the allocation imperfect market system which may not operate to
of resources. In the former Soviet Union and the the benefit of society at large.
countries of Eastern Europe, planning superseded Third, because of externalities, many projects
the market mechanism entirely. There has in that developing countries need, and which would
recent years, however, been disillusion with plan- be profitable to society, may not appear profitable
ning, and the formerly planned economies of under a pure market system in which all invest-
Eastern Europe have swung to the other extreme, ment decisions are left to private individuals. The
embracing the market mechanism almost uncon- level of investment may fall below the social opti-
ditionally. Is there a middle way for developing mum first because private investors ignore the ex-
countries to follow? Are the conditions required ternal economies and supplementary benefits of
for the market mechanism to operate efficiently projects in calculating prospective returns, and
met in developing countries, and if not, what is the second because the element of risk will be higher
role of planning? The bad experience of planning for a series of unco-ordinated individual projects
in Eastern Europe should not blind us to the fact that than for a co-ordinated investment programme
the market mechanism also suffers grave deficiencies, systematically undertaken through some central
and that the way forward in most developing coun- direction. A further disadvantage of the market
tries must be a judicious mix of market capitalism mechanism is that by itself it is unlikely to produce
combined with state intervention. 1 the rapid structural changes which development
The traditional case for interference with the requires. There is no guarantee in a free-market
market mechanism and some degree of planning setting that the supply of 'development' goods and
rests on several grounds, all of which continue to factors of production will be forthcoming in the
remain valid. quantities required. Supply may be completely
First, given the natural preference of people for price inelastic, in which case there is little alterna-
present rather than future satisfaction, resources tive to the public provision of the goods or factors
in a free market will tend to be allocated for the in question. The market mechanism as an efficient
production of goods for immediate consumption allocative device assumes that resources are
rather than for building up the means of produc- mobile and producers and owners of factors of
tion, i.e. for the production of capital goods. Left production respond to incentives and strive to
to itself, the operation of the market is likely to maximise gains. Part of the reason for bottlenecks
lead to a much slower pace of development and a and supply inelasticities may be that this assump-
much lower level of future welfare than if re- tion does not always hold good in the context of
sources, via some form of interference with the backward economies.
market mechanism, can be diverted to the produc- For a variety of reasons, therefore, it is argued
tion of capital goods. that interference with the market mechanism is a
Second, as we shall see later, market prices may necessary prerequisite of a more rapid pace of
provide a very imperfect guide to the social opti- development. The belief of those that advocate
mum allocation of resources because they do not some form of planning or central direction is that
reflect the opportunity cost or value to society of positive action of this type will help to achieve
the use of factors of production or the production more expeditiously and more reliably the goals
of certain commodities. A perpetual shortage of that developing countries set themselves. The
capital and foreign exchange, and a surplus of overriding object of a planned development pro-
labour, at existing market prices is prima facie gramme is to incorporate society's choice of goals
and to allocate resources to meet these goals. The
vital question, to which there is no easy answer, is,
1 For a comprehensive discussion of the role of the State in what form should planning take? Should the mar-
economic affairs, see Crabtree and Thirlwall (1993). ket mechanism be superseded altogether, and the
Planning and Resource Allocation in Developing Countries 173
state assume total responsibility for resource mechanism, and that goals will be set which far
allocation? Or should planning take place within exceed the country's capacity to achieve them,
the framework of the market mechanism with leading to widespread disillusion with the plan-
market prices adjusted to reflect social values, and ning process. One attraction· of the market
with taxes and subsidies to eliminate divergences mechanism, which classical economists continual-
between private and social costs and benefits? In ly emphasised, is that it decentralises decision-
short, should a command economy be established, making and, if it functions smoothly, can stimu-
or should the government merely give incentives, late efficiency and growth without any elaborate
and tax to provide certain goods and services it- administrative apparatus. Those who see dangers
self? Moreover, who should decide on the weight in assigning decision-making to possibly inexperi-
to be given to the choice between present and enced and inept administrators may well accord
future consumption, between labour- and capital- with Adam Smith's view that 'governments are
intensive technology, and between goods and ser- rarely more effective than when they are negative'.
vices and leisure? Should the state be authoritarian It is fashionable now to defend the market
in the interests of future generations, or should the mechanism for resource allocation on these tradi-
government submit to the will of the present gen- tional 'classical' grounds. It is argued that if the
eration? No objective economic answer exists to market does not function properly in the interests
these questions. In the final analysis they must be of society, there is a stronger case for making the
decided politically. It is the political system and market more perfect, and for improving its func-
the ideology of those in power that ultimately tioning, than there is for planning. Market im-
determine the type of economic organisation. perfections and price distortions, in particular, are
Whatever form interference with the market not themselves arguments for planning, but rather
mechanism takes, however, it will inevitably in- arguments for ensuring that the price mechanism
volve some degree of state intervention and con- functions better. There is, perhaps, a stronger case
trol over the means of production, distribution for planning in the event of market failure, due to
and exchange, and the partial replacement of the divergences between private and social costs and
market mechanism. But it should be remembered benefits, but even here market prices can be
that planning is not incompatible with the use of brought more into line with opportunity costs
the price mechanism. The abandonment of the through policies to promote competition, and sub-
market mechanism need not necessarily involve sidies could be given to private producers in cases
dispensing with the use of prices for resource where the private return from socially desirable
allocation. The abandonment of the market projects falls short of the social return. The prob-
mechanism merely involves replacing one set of lem is more intractable if producers and factors of
decision-makers with another. But planners can, production do not respond to incentives, but de-
and do, use prices (or profits determined by prices) fenders of the market mechanism would question
as an aid to decision-making. Price movements can whether producers and workers in developing
still be used as signals for resource allocation even countries do have the aversion to risk-taking and
in a totally planned economy in which there is no effort that is sometimes supposed.
private ownership. The success of planning de- But in reality, of course, the choice for the vast
pends crucially on the existence of an ample sup- majority of countries is not between complete
ply of able and technically qualified administrators laissez-faire and total state planning of the means
who are committed to development and not to the of production, but rather: what combination of
furtherance of a political ideology at all costs or to private and public enterprise; to what extent
their own aggrandisement. The dangers of plan- should the public sector be extended; to what
ning are that unqualified and corrupt admin- extent should there be interference with private
istrators will assume responsibility for resource decision-making; to what degree should the pri-
allocation and perform 'worse' than the market vate sector be integrated into a national develop-
174 Planning, Resource Allocation, Development and Techniques
ment plan? These are the questions on which most there are inter-industry models which show trans-
developing countries must reach decisions. actions and interrelationships between producing
sectors of an economy, normally in the form of an
input-output matrix. Finally there are models and
• Development Plans techniques for project appraisal and the allocation
of resources between industries.
Whatever a country's political ideology, a de- Models of these types serve a twofold purpose.
velopment plan is an ideal way for a government In the first place they enable planners to reach
to set out its development objectives and to de- decisions on how to achieve specified goals. They
monstrate initiative in tackling the country's de- highlight the strategic choices open to the policy-
velopment problems. A development plan can maker in the knowledge that not all desirable
serve as a stimulant to effort throughout the goals are achievable simultaneously. Only with an
country, and also act as a catalyst for foreign understanding of the interrelationships between
investment and agency capital from international different parts of the economy, and a knowledge
institutions. of the parameters of the economic system, is it
Depending on the politics of a country, and its possible for meaningful and consistent policy deci-
available expertise, a development plan will vary sions to be reached. Without detailed information
in its ambitiousness from a mere statement of aims on which to base planning (or what has been
and pious hopes to detailed calculations (and called 'planning without facts'), the case for decen-
proposals for action) of the resources needed, and tralised decision-making becomes overwhelming.
the amount of output that each sector of the Second, models of the type described above can
economy must generate, in order to achieve a perform an equally valuable function from the
stipulated rate of gro~th of output or per capita point of view of enabling the future to be projected
income. 1 Anything more than a statement of aims with a greater degree of certainty than would
inevitably involves some form of model-building, otherwise be possible, thereby providing some
if only to delineate the relationships between sec- knowledge of what resources are likely to be avail-
tors of the economy and between the key variables able in relation to requirements within a stipulated
in the growth process. planning period. Various types of model may be
Four basic types of model are typically used in classified, therefore, according to whether they are
development planning. First, there are macro or required for policy or decision purposes or for the
aggregate models of the economy which may purpose of projection and forecasting. The neces-
either be of the simple Harrod-Damar type, or of sary constituents of a plan containing both types
a more econometric nature, consisting of a series of model are a statement of economic goals; the
of n equations in n unknown variables which rep- specification of policy instruments or instrumental
resent the basic structural relations in an economy variables; the estimation of structural rela-
between, say, factor inputs and product outputs, tionships; the availability of historical data; the
saving and income, imports and expenditure, etc. recognition of exogenous variables; and last, but
Second, there are sector models which isolate the not least, a set of national accounts for national
major sectors of an economy and give the structu- income and expenditure, foreign trade and even
ral relations within each sector, and perhaps also manpower to ensure consistency between demand
specify the interrelationships between sectors, e.g. and the supply of resources available.
between agriculture and industry, between capital
and consumer-goods industries, and between the
government and the rest of the economy. Third, • Policy Models
1 Students should familiarise themselves with a plan for a coun- The essence of a policy model is that a certain set
try of their choosing. Almost all developing countries have one. of objectives is specified and the model is then used
Planning and Resource Allocation in Developing Countries 175
to determine the most appropriate measures to of structural equations for the economy, this exer-
achieve those objectives within certain constraints. cise should not be too difficult.
In most development plans the primary objective The structural relationships given by the
is the achievement of a target rate of· growth of structural equations are the restrictions on the in-
output or per capita income within the planning strumental variables which the policy-makers
period, or some terminal level of consumption, must consider as datum. They represent, as we
subject to constraints on the composition of out- have said already, such things as technological
put, the distribution of income and the availability relationships in industry, income-consumption re-
of factor supplies. Given the time horizon of the lationships, foreign-trade relationships and other
plan, and the objective function, the optimum behavioural and institutional relationships which,
strategy can be worked out from the initial con- in the short run at any rate, are outside the sphere
ditions. One of the big dangers of planning in of the policy-maker to influence. In the long run,
developing countries is that planners and policy- certain structural relations may of course change
makers are prone to choose targets based on needs with changes in the economy induced by the plan-
and aspirations rather than on the basis of avail- ning process itself. The capital-output ratio, for
able resources, with the inevitable consequence example, may change under the influence of
that the targets are not achieved. It is incumbent education expansion and the development of a
on the planner to specify the constraints as accu- country's infrastructure. Other, more basic,
rately and honestly as possible to avoid disillusion structural relationships, however, must be con-
with the planning process. tended with in the planning process, even in the
The solution to a policy model of this kind is long run. Some of the important questions that
somewhat different from one designed to find the need to be answered with the help of the structural
value of certain instrumental variables that will equations are: Can capital be guaranteed in the
achieve a particular target rate of growth. The quantities required? Will exports and foreign
difference can be illustrated with reference to the assistance keep pace with the imports required?
simple Harrod model of growth which gives the Will the future demand for consumption goods,
level of savings necessary to achieve a particular out of increases in per capita income, exceed the
growth rate assuming some value of the capital- supply and cause inflation? Can the required inter-
output ratio. The level of savings required to relationships between industries be maintained so
achieve a target rate of growth may be very differ- that bottlenecks do not arise? If the objective func-
ent from the level of savings available when the tion or goals of a plan require a certain degree of
problem is posed as one of maximising growth balance between supply and demand in various
subject to constraints. The level of savings neces- markets and sectors of the economy, then clearly
sary to achieve the target rate of growth may the objective function must be maximised subject
conflict with society's wish for present rather than to this general requirement of avoiding shortages
future consumption; it may be incompatible with of capital, labour and foreign exchange. The basic
the supplies of skilled labour necessary to work structural relationships required can be found or
with capital, and the level of savings may not even determined by drawing on economic theory and
be achievable because of a limit to the capacity to econometric research, or by intuitive 'feel' in the
tax or to 'force' saving through inflation. case of behavioural and institutional relationships.
It is clear from what we have said so far that the Next, the instrumental variables must be speci-
first step in the formulation of a policy model must fied. These are the variables that the planners
be the construction of an aggregate model of the intend to influence in some way in order to achieve
economy (incorporating, if need be, a sector model the objectives specified within the constraints laid
and an inter-industry model) to highlight and down. If the basic objective is a higher rate of
check the implications of the target rate of growth. growth, one obvious instrumental variable is the
If it is possible to formulate a reasonably sound set level of savings and investment in relation to
176 Planning, Resource Allocation, Development and Techniques
national income. This can be influenced by tax come, consumption, investment, employment and
policy, inflation and assistance from abroad. If the foreign trade, etc., is also likely to run into the
structural relationships are given, and the con- problem of sectoral differences in structural rela-
straints are outlined, a solution to a policy model tionships such that if the structure or pattern of
will give a set of values for the instrumental vari- production changes over time within the plan
ables that satisfies all the structural (and behaviou- period, the use of average structural coefficients
ral) equations in the model consistent with the may give rise to misleading results. This is where
constraints imposed. In the case of savings, for sectoral models become important. If the economy
example, the solution to a policy model would can be conveniently divided into two or three sec-
give the level of saving possible compatible with tors, the average coefficients can be adjusted for
balance between the agricultural and industrial expected changes in the expansion or contraction
sectors of the economy, foreign borrowing of no of the different sectors over the period of the plan.
more than a certain amount, consumers' desires Ultimately, any macro model must be consistent
for present rather than future consumption, with the models and predictions for various sec-
and so on. tors of the total economy.
It should be emphasised at this point that the Despite the potential use of decision models,
planners ought not to lay down rigid policy pre- they are not so widely used as might be expected in
scriptions for more than a very short length of developing countries, especially decision models
time. Planning itself may alter circumstances in the which attempt to optimise one thing or another. In
future in an unforeseen way and planners must be practice, planning tends to be much more ad hoc.
ready to adapt to the new situation. The means by The reason is very often the difficulty in arriving at
which to achieve plan goals must be flexible, and agreement over the objective function. It is ex-
so too must the planning period. The term 'rolling tremely difficult to balance the conflicting aims of
plan' is used to describe planning of a flexible different parts of the community and to reach a
nature where plans are continually being reviewed consensus over conflicting economic objectives.
and revised in the light of new developments. If
plans need to be revised, however, it is important
that they are modified cautiously to avoid erosion • Projection Models
of confidence. One of the purposes of planning is
to imbue confidence, especially among the private Any of the first three of the basic types of model
decision-making class who are most susceptible to mentioned at the outset may be used for projection
uncertainty, and it is vital that this confidence is or forecasting purposes. Typically, aggregate mod-
not upset and uncertainty increased by sudden els for projection are of the Harrod-Domar type
changes in policy. There are three typical planning and are used to indicate the amount of capital
horizons: one-year plans corresponding to a nor- required in the future, either to achieve a particu-
mal budget and accounting period; medium-term lar target rate of growth or to keep the labour
plans stretching over four to seven years; and ten- force fully employed (or both), assuming the
to twenty-year plans (which is probably the max- labour force is exogenously determined. Sector
imum length of time for which it is possible to models, on the other hand, are designed to project
make meaningful projections). the output of various sectors and, if balanced
Because of computational limitations, separate growth is required, to allocate resources ac-
decision models will probably have to be con- cordingly. Last, inter-industry models are designed
structed for distinct policy purposes, e.g. the to estimate the output requirements of industries
choice of techniques, the structure of trade, the as a result of a projection of expansion of the final
pattern of final demand, the allocation of re- demand for goods and services over a future
sources, etc. The application of aggregate macro period of time (see Chapter 11).
models based on interconnections between in- It would be wrong, of course, to think of fore-
Planning and Resource Allocation in Developing Countries 177
casting models as entirely distinct and divorced choice of technology, in turn, will be particularly
from decision models. Forecasting models, es- influenced by the way in which resources are
pecially of the econometric type, are often used, valued, and by the relative valuation given to pre-
and are designed to be used, as decision models, sent versus future consumption and welfare.
with current choices and decisions depending on Because of the interdependence between the
the future the models portray. Indeed, there is little choice of goods and the choice of technology, a
use for pure forecasting models as such without country which decides to use relatively labour-
using them as a guide to policy. intensive techniques within the framework of
goods chosen may none the less have a greater
Table 7.1 Consumption Benefits with DiHerent Investment Ratios Over DiHerent Planning Horizons
K y 1 c K y 1 c K y I c
1 200 100 0 100 200.00 100.00 10.00 90.00 200.00 100.00 50.00 50.00
2 200 100 0 100 210.00 105.00 10.50 94.50 250.00 125.00 62.50 62.50
3 200 100 0 100 220.50 110.25 11.03 99.22 312.50 156.25 78.12 78.12
4 200 100 0 100 231.53 115.76 11.57 104.19 390.62 195.31 97.65 97.65
5 200 100 0 100 243.10 121.55 12.15 109.40 488.27 244.13 122.07 122.07
6 200 100 0 100 255.25 127.62 12.76 114.86 610.34 305.17 152.58 152.58
7 200 100 0 100 268.01 134.00 13.40 120.60 762.92 381.46 190.73 190.73
8 200 100 0 100 281.41 140.70 14.07 126.61 953.65 476.82 238.41 238.41
9 200 100 0 100 295.48 147.74 14.77 132.97 1192.06 596.03 298.01 298.01
10 200 100 0 100 310.25 155.12 15.51 139.61 1490.07 745.03 372.51 372.51
Key: K is the capital stock; Y is output; I is the level of investment; and C is consumption.
put and consumption (or welfare)- between con- vestment ratios of 0, 10 and 50 per cent, and three
sumption today and consumption tomorrow. different planning periods of three, six and ten
Efficiency in resource allocation will maximise years. Further assume that the capital-output
present output and consumption from a given ratio is 2, and that, for simplicity, there is no
amount of resources, but may impair growth and depreciation and no discounting. Let the initial
future consumption. Striving for growth may low- capital stock equal 200, producing 100 units of
er present welfare but will provide greater output output. The time paths of output, consumption,
in the future. investment and the capital stock for the three dif-
ferent investment strategies and three different plan-
ning horizons can now be shown, as in Table 7.1.
• Present vs Future Consumption Over the three-year planning period, the first
policy of no investment maximises consumption.
The choice between present and future consump- Over the six-year planning period, the second pol-
tion is the same as the choice between consump- icy of a 10 per cent investment ratio maximises
tion and investment in the present. How much consumption, and over the ten-year planning
investment should be undertaken in the present period the third policy of a 50 per cent investment
depends on the time interval over which society ratio maximises consumption.
wants to maximise consumption and what value it The calculations in Table 7.1, and the conclu-
places on consumption in the future compared sions drawn from them about the time period over
with consumption in the present; that is, on the which consumption will be maximised, will be
rate at which it discounts future consumption affected by discounting, and the discount rate
gains. Time affects both the accumulation of con- chosen, because the present value of future con-
sumption gains and the effect that discounting has. sumption gains are worth less and less the further
Investment should take place so as to maximise into the future they accrue, and their value is also
consumption over the planning period. The invest- less the higher the discount rate chosen. What we
ment ratio which maximises consumption will illustrate, then, is that the answer to the question
vary according to the planning period, with and of how much to invest depends crucially on the
without discounting. Let us illustrate with a planning horizon taken and the discount rate
numerical example. Consider three different in- chosen. The longer the planning horizon, and the
180 Planning, Resource Allocation, Development and Techniques
less the stream of future consumption benefits is the other hand, the more capital-intensive the
discounted, the more investment. The shorter the technology, the lower the level of consumption
planning horizon taken, and the higher the dis- and employment in the present. 1
count rate, the less investment there will be. In general, we reach the conclusion that the
We also illustrate that countries with low initial higher the valuation placed on raising the present
stocks of capital and low levels of consumption level of employment and consumption as com-
must invest heavily if high future living standards pared to future output, the more labour-intensive
are to be attained. But to invest heavily they must techniques should be favoured. On the other hand,
take long planning horizons. One of the argu- the greater the valuation placed on future output
ments for planning is, in fact, to lengthen the in relation to present welfare, the more capital-
planning horizon beyond that chosen by indi- intensive methods of production should be
viduals maximising privately. Any finite planning favoured. It is capital-intensive techniques that are
horizon, however, only takes care of the people capable of yielding the largest surplus of income
living within the planning period. To take account over wage costs for a given capital outlay, making
of generations living beyond the horizon, certain possible a higher rate of reinvestment for the fu-
constraints must be built into the investment mod- ture. The choice between projects of different de-
el such that, for example, the level of consumption grees of capital intensity, therefore - in so far as
at the end of the period should not be above a there is a choice - boils down to the relative
specified level, otherwise maximisation of con- weights to be attached to an additional increment
sumption within the horizon would mean consum- of investment compared to an additional incre-
ing all income at the end of the horizon leaving no ment of consumption. If saving is regarded as
saving for future investment and consumption. 'sub-optimal', then at the margin an extra unit of
investment must be regarded as more valuable than
an extra unit of consumption and there is a case
• Choice of Techniques for more capital-intensive techniques which will
generate this extra investment potential at the
In a planning framework, the valuation of present margin. As we said earlier in Chapter 3, the fact
versus future welfare is also the central issue re- that the social opportunity cost of labour is zero
garding the choice of technology - whether tech- makes no difference to the argument because even
niques should be capital- or labour-intensive. At first 'costless' labour will consume if employed in in-
sight it would seem sensible, in a labour-abundant dustry, and the object is to minimise consumption.
economy, to use labour-intensive techniques of As long as the wage in industry is higher than the
production, and to encourage activities that use marginal product in alternative uses, there will be
factors of production which are in abundance. an increase in consumption with the employment
Doing so, however, may lead to a conflict between of more labour in industry. This has important
efficiency and growth; a clash between the maxi- implications for the valuation of labour in re-
misation of present consumption and the level of source allocation, which we take up when we dis-
consumption in the future. The problem is that if cuss social cost-benefit analysis and shadow
the wage rate is given, and invariant with respect wages in Chapter 8.
to the technique of production, the more labour- There is not only a potential conflict between
intensive the technique the less saving that is likely
to be generated for future reinvestment. Specifi- 1 This conclusion depends, among other things, on the wage
cally, if the propensity to consume of the workers is rate being invariant with respect to the technique of produc-
higher than that of the owners of capital, the total tion. If the wage is higher the more capital-intensive the tech-
surplus, and the surplus per unit of capital in- nique, this conclusion would have to be modified. For a
discussion of this point, and other considerations which may
vested, left for reinvestment will be smaller than if lessen the conflict between employment and saving in the
the technology were more capital-intensive. On choice of techniques, see Chapter 10.
Planning and Resource Allocation in Developing Countries 181
employment and saving in the choice of techniques different senses, but the original exponents of the
but also a conflict between employment and out- balanced growth doctrine had in mind the scale of
put. The conflict arises not in the utilisation of investment necessary to overcome indivisibilities
existing equipment but in the choice of new tech- on both the supply and demand side of the de-
niques. Techniques of production which are velopment process (see, for example, Rosenstein-
labour-intensive may have higher capital-output Rodan (1943)). Indivisibilities on the supply side
ratios than techniques which are more capital- refer to the 'lumpiness' of capital (especially
intensive. A simple example will illustrate the social-overhead capital); and the fact that only
point. Assume a fixed amount of capital to be investment in a large number of activities simul-
invested of £1000. One technique of production taneously can take advantage of various external
could employ 100 units of labour with £1000 of economies of scale. Indivisibilities on the demand
capital, but the capital-output ratio is 5. This side refer to the limitations imposed by the size of
would give an output of 200 with the employment the market on the profitability, and hence feasibil-
of 100 men. A second technique of production ity, of economic activities. This was the original
employs 50 units of labour but has a capital- interpretation of the doctrine of balanced growth:
output ratio of 4. This would give an output of the large-scale expansion of activities to overcome
250 with employment of 50 men. Thus maximis- divergencies between the private and social return.
ing both the current level of employment and The doctrine has since been extended, however,
output are only consistent if the more labour- to refer to the path of economic development, and
intensive techniques also have the lowest capital- the pattern of investment, necessary to keep the
output ratios. We discuss these conflicts more different sectors of the economy in balance so that
fully, and the choice of techniques in practice, in lack of development in one sector does not impede
Chapter 10. development in others. This does not mean, of
course, that output in all sectors should grow at
I Balanced vs Unbalanced
Growth
the same rate, but rather in accordance with the
income elasticity of demand for products so that
supply equals demand. The notion of equilibrium
is implied, and an absence of shortages and bottle-
Another broad choice of development strategy is necks. A definition of balanced growth em-
between so-called balanced and unbalanced bracing the several different interpretations and
growth. Whether or not there exists a low-level emphases that have been placed on the term has been
equilibrium trap, which needs a 'critical minimum attempted by Paul Streeten (1959): 'Wherever
effort' to overcome it, sound economic reasons can several non-infinitesimal investment decisions (or
be advanced in support of a 'big push', taking the decisions generally) depend for their success on
form of a planned large-scale expansion of a wide each other, simultaneous investment in a series of
range of economic activities. The economic industries (or firms or plants), in conformity with
rationale for a 'big push' forms part of what has the pattern of consumers' demand and of different
come to be known as the doctrine of balanced industries' demand for each other's products, is
growth. Opposed to this thesis, however, is a required.' Balanced growth, therefore, has a hori-
school of thought which argues that a 'big push' is zontal and vertical aspect. On the one hand it
not feasible, and that in any case development is recognises indivisibilities in supply and com-
best stimulated in developing countries by the de- plementarities of demand, and on the other it
liberate creation of imbalance. In this respect stresses the importance of achieving balance be-
balanced versus unbalanced growth is an issue of tween such sectors as agriculture and industry,
development strategy which may constrain the ap- between the capital-goods and consumer-goods
plication of investment criteria. industries, and between social capital and directly
The term 'balanced growth' is used in many productive activities.
182 Planning, Resource Allocation, Development and Techniques
Thus there are two fairly distinct versions of the Moreover, there are several alternative ways in
balanced growth doctrine that need considering: which markets can be widened. The improvement
one referring to the path of development and the of transport facilities in developing countries, and
pattern of investment necessary for the smooth of communications in general, offers tremendous
functioning of the economy, and the other refer- scope for the expansion of markets. Also the doc-
ring to the scale of investment necessary to over- trine of balanced growth for demand reasons may
come indivisibilities in the productive process on lose much of its force in the context of an open
both sides of the market. Nurkse's views (1953) economy. Restrictions on imported commodities
on balanced growth tend to embrace both versions could immediately expand the market for home-
of the theory of balanced growth, while Rosenstein- produced substitutes, and export promotion can
Rodan concentrates on the necessity for a 'big also be resorted to. No one would deny that there
push' to overcome the existence of indivisibilities. are development difficulties connected with a lim-
We shall first consider the economic arguments for ited home market for commodities, but a 'big
a large-scale investment programme and then dis- push' is not the only way, and not necessarily the
cuss the desirability of achieving balance between most expeditious or economical, in which these
different sectors of the economy. difficulties can be overcome.
On the demand side, the argument amounts to On the supply side, the argument for a 'big
little more than Adam Smith's famous dictum that push' is bound up with the assumed existence of
specialisation, or the division of labour, is limited external economies of scale. The external econ-
by the extent of the market, and that if the market omies referred to in this context go beyond the
is limited certain activities may not be economi- external economies of the traditional theory of the
cally viable. If, however, several activities are estab- firm. Whereas in traditional equilibrium theory
lished simultaneously, each could provide a market external economies refer to the fact that the nature
for each other's products, so that activities that of the production function in one activity may be
are not profitable considered in isolation would altered by the existence of other activities (e.g.
become profitable considered in the context of a those in close proximity), in the context of de-
large-scale development programme. The onus velopment theory they refer mainly to the impact
would presumably be on the government to or- of a large investment programme on the profit
ganise such a programme, and planning would super- functions of participating firms. If there exist ex-
sede the market system for the programme to ternal economies in either sense, the social return
be initiated. It is true that industrial enterprises of an activity will exceed the private return. It is
may have to be of a certain minimum size to be argued that the way to eliminate this divergence is
profitable, if only to compete in international mar- to make each activity part of an overall programme
kets, but the argument begs certain questions and of investment expansion. Enterprises which are
leaves others unanswered. For example, there may not, or do not appear to be, profitable in isolation
be latent demand for certain commodities which become profitable when considered as part of a
would obviate the need to establish other activities comprehensive plan for industrial expansion
to generate the income and purchasing power embracing several activities. As several commenta-
necessary for those commodities to be bought. 1 tors have pointed out (e.g. Fleming (1955)),
however, while the expansion of several activities
1 It is for this reason that the example of the shoe factory has may improve the profitability of each activity -
always seemed to me to be singularly inappropriate for illus- assuming there are inter-industry linkages - the
trating the problem posed by a limited market; the proposition
being that a shoe factory would never be viable unless it was cost of factor inputs may rise, offsetting the benefit
part of a large investment package since shoe workers will want of these external economies. Under the impact of a
to spend their income on commodities other than shoes. Unless 'big push' the price of capital goods and the cost of
an economy is totally devoid of other activities, there should be
enough people working e;sewhere to justify at least one isolated capital may rise substantially, and so too may the
shoe factory! wage rate. If factors of production are not in elas-
Planning and Resource Allocation in Developing Countries 183
tic supply, the case for a 'big push' to eliminate lays emphasis on the path of development and the
discrepancies between the private and social re- pattern of investment. This version of the balanced
turns of an activity is weakened- at least it would growth doctrine stresses the necessity of balance
be a question of weighing the benefits of the exter- between sectors of the economy to prevent bottle-
nal economies against the increased cost of factor necks developing in some sectors, which may be
inputs. One advantage of gradual expansion as a hindrance to development, and excess' capacity
opposed to a 'big push' is that the supply of factors in others, which would be wasteful. Among the
would have some time to adjust to the increased foremost proponents of this version of the bal-
demand. anced growth doctrine are Nurkse (1953) and
It was in the light of these demand and supply Professor Arthur Lewis (1955). Particular emphasis
considerations, however, that Rosenstein-Rodan is placed by these two economists on achiev-
in his pioneer article recommended a massive in- ing a balance between the agricultural and indus-
vestment programme for the industrialisation of trial sectors of developing economies. This is for
East and South-East Europe extending over a ten- two main reasons, both of which recognise the
year period. His idea was for an Eastern European interdependence between the two sectors and the
Industrial Trust to be established to instigate a 'big mutual assistance and stimulus that each can give
push' sufficient to absorb ten million workers re- the other. The first is that if agricultural productiv-
garded as surplus in the agricultural sector. Calcu- ity is to improve, there must be incentives for
lating on the basis that each worker would require farmers to expand their marketable surplus, and
between £300 and £350 of capital, he estimated this requires a balance between the agricultural
that the investment ratio would have to be raised and consumer-goods sectors of the economy. The
to 18 per cent of national product for the ten-year second is that agriculture requires capital inputs
period, or double its prevailing level. Rosenstein- and this requires a balance between agriculture
Rodan was not optimistic that this could be and the production of capital goods and the provi-
achieved, and it is true to say that in the case of the sion of social-overhead capital. This is in addition
present developing countries there are few today to the fact that agricultural output can provide a
who believe that a 'big push' is feasible, even if basis for the development of local industries and
desirable. The prevailing view would seem to be that the industrial sector relies on the agricultural
that if developing countries do possess the re- sector for food. Furthermore, in the absence of
sources for a 'big push', they ought hardly to be increasing exports the agricultural sector must rely
described as developing in the first place. on the industrial sector for a substantial propor-
The fact remains, however, that certain invest- tion of the increased demand for its products. The
ments must be of a minimum size to be economi- doctrine of balanced growth in this form, es-
cally worthwhile. It may be uneconomical to build pecially the stress on the balance between agricul-
roads, railways and power stations merely to meet ture and industry, steers a middle course between
current demand. Ideally, social-overhead capital the traditional comparative cost doctrine that de-
of this type must be planned and built on a large veloping countries should confine themselves to
scale to achieve long-run economy in the use of the production of primary commodities, and the
resources. But this argument hardly qualifies for view that developing countries ought to industrial-
the special label 'balanced growth'. The case for a ise as intensively and quickly as possible.
'big push' for supply reasons seems to be quite
weak in the absence of resources to attempt such a
strategy and without detailed knowledge of the • Unbalanced Growth
precise magnitude of the net economies that are
likely to accrue. A major criticism of the balanced growth doctrine
We turn very briefly, therefore, to the second is that it fails to come to grips with one of the
version of the balanced growth doctrine which fundamental obstacles to development in develop-
184 Planning, Resource Allocation, Development and Techniques
:J
0 X
Their argument is that in the absence of sufficient <i.
resources, especially capital, entrepreneurs and 0.:
ci
decision-makers, the striving for balanced growth
may not provide a sufficient stimulus to the spon-
taneous mobilisation of resources or the induce-
-
0
"0'
"
'iO
0
ment to invest, and will certainly not economise 1- 0 ..,;___...:....__ _ _ _ _ _ _ _ _ Availability and
on decision-taking if planning is required. s, cost of S.C.
this criterion. The line OX connects the optimal velopment. Italy discovered this in its attempt to
points on the different curves and this represents develop the Mezzogiorno, and policy was changed
the most 'efficient' expansion path, or 'balanced' as a result. On the other hand, Hirschman's analy-
growth path, between SC and DPA. sis leaves several questions unanswered. He
But suppose that 'optimal' amounts of SC and concedes that the objective must be to obtain in-
DPA cannot be expanded simultaneously to keep creasing outputs of directly productive activities at
in balance with one another. On what criteria is minimum cost in terms of resources devoted to
that postponement choice made? One possibility is both DPA and SC, and that the cost of producing
the sequence AA 1 BB 2 C where the initial expan- any given output of DPA will be higher the more
sionary step is always taken by social capital. This inadequate is SC, but what is the minimum
is the sequence that is called 'development via amount of SC required in a developing economy?
excess capacity'. The other (opposite) possibility is Is this minimum so high as to contradict the argu-
the sequence AB 1 BC1 C where the initial expan- ment that DPA should precede SC, at least in the
sionary step is taken by DPA. This is the sequence earliest stages of development? Furthermore, what
that is called 'development via shortages'. Accord- is the guarantee that SC will subsequently be pro-
ing to Hirschman, the preference should go to the vided once DPA have been established? Indivisi-
sequence of expansion that maximises 'induced' bilities with respect to social capital may be so large
decision-making. It is difficult to tell a priori which that private investors are not induced to supply at
sequence this is likely to be. If SC is expanded, any price: Reliance would then be on the govern-
existing D PA becomes less costly, encouraging ment. Hirschman neglects to pay adequate atten-
further DPA. If DPA are expanded first, costs will tion to the government's crucial responsibility in
rise but pressures will arise for SC facilities to be this connection. It looks suspiciously as if unbal-
provided. Both sequences set up incentives and anced growth via shortages, like the 'big push',
pressures and ultimately, in Hirschman's view, the may not be economically feasible (albeit for differ-
sequence chosen must depend on the relative ent reasons).
strength of entrepreneurial motivations on the one Hirschman would apply the same criterion of
hand and on the response to public pressure of the 'induced decision-making' to the choice and se-
authorities responsible for social capital on the other. quence of projects within the directly productive
In general, however, Hirschman has some harsh sector. Here inducements stem from interdepen-
things to say about the traditional view that SC dencies between activities, or what Hirschman
must precede, or even be kept in balance with, calls 'backward' and 'forward' linkage effects.
DPA if development is to progress smoothly. Backward linkages measure the proportion of an
While he admits that a certain minimum of social activity's output that represents purchases from
capital is a prerequisite to the establishment of other domestic activities. Forward linkages
DPA, he argues that development via excess measure the proportion of an activity's output
capacity is purely permissive, and that to strive for that does not go to meet final demand but is used
balance is equally dangerous because there will be as inputs into other activities. With knowledge of
no incentive to induced investment (or induced inter-industry flows in an economy, from an
decision-making). On the other hand, develop- input-output table (see Chapter 11), it should be
ment via shortages will compel further investment, possible to rank activities according to the magni-
and hence the most 'efficient' sequence as far as tude of their combined linkage effects. Hirschman
'induced' decision-making is concerned is likely to is suggesting that within the directly productive
be that where DPA precedes SC. sector a useful development strategy would be to
It is true that where there is strong social and encourage those activities with the potentially
economic resistance to change, 'permissive' acts, highest combined linkages, because this will pro-
such as the construction of social-overhead capi- vide the greatest inducement and incentive to
tal, are not likely to provide much impetus to de- other activities to develop.
186 Planning, Resource Allocation, Development and Techniques
Unfortunately, one of the typical characteristics countries which lack an honest and competent
of developing countries is a lack of interdepen- administration. While unbalanced growth econ-
dence between activities. Primary product produc- omises on decision-making, however, decisions
tion has very limited backward linkages with other must still be taken and the need for managerial
activities, and forward linkages, although poten- ability and administrative expertise is in no way
tially greater, also tend to be small in practice. diminished. A further advantage of unbalanced
Agriculture's demands on other sectors are mini- growth, as opposed to balance between sectors, is
mal, and only a comparatively small fraction of total that there may also be a certain degree of econ-
agricultural output in developing countries is pro- omy in the use of physical resources. If capital is
cessed domestically; most is exported. The fact scarce, and indivisibilities do exist, it is probably
that manufacturing activities possess greater back- more economical to produce a few products in
ward and forward linkages, strengthening the optimum-size plants rather than a whole range of
cumulative nature of development, is another products in sub-optimal plants. There may be a
powerful reason for industrialisation. Hirschman trade-off, in other words, between balance and
advocates the expansion of industry through the technical efficiency.
transformation of semi-manufactures into goods The inherent danger of unbalanced growth is
required for final demand, or what he calls 'en- that it leaves too much to chance. With the unba-
clave import' industries. In general he lays great lanced growth model one has the uncomfortable
stress on the role of imports in the development feeling that the pace of development rests solely on
process seeing imports as part of the inducement the whims of entrepreneurs and whether indi-
mechanism. For not only can semi-manufactured viduals are induced to invest or not. There is little
imports be processed into goods for final demand, discussion of how to overcome discrepancies be-
but final-demand imports themselves can then be tween the private and social profitability of de-
readily produced at home once the market has velopment projects, and the possibility of waste
attained a certain size (or production threshold). If and excess capacity through actions being abortive
one of the major obstacles to development is a must also be faced. Supposing imbalances are de-
shortage of decision-makers, coupled with uncer- liberately created, or arise naturally, but supply is
tainty and a limited market, the existence of im- totally inelastic, what then? Is the simultaneous
ports provides conclusive proof that the market is existence of excess capacity in some sectors and
there. As imports increase, so too do the chances shortages in others allowed to persist, or is the
that domestic production will one day be profit- onus on the public authorities to produce some
able. Hirschman criticises developing countries for semblance of co-ordination? The role of shortages
restricting imports prematurely, and argues that in promoting development is probably overrated.
infant industry protection should only be given after At least a distinction needs to be made between
imports have reached such a level as to guarantee types of shortage: those that can be filled by re-
domestic producers a market for their goods. sponse from the market mechanism and those
Rather like the operation of the price mechan- which cannot, and those which induce expansion
ism, Hirschman seems to be arguing for develop- of capacity and those which do not. Unbalanced
ment through a process of 'successive adaptation', growth may further lead to the concentration of
with the system itself pointing to the shortages or production on one or two commodities, with
bottlenecks and overcoming them accordingly. In possible harmful effects on the balance of pay-
fact, one of the major appeals of unbalanced ments if the goods are price inelastic and income
growth is that it does not imply the abandonment inelastic in demand. Last, imbalances can be a
of the market mechanism. Like the market powerful source of inflationary pressure, with cost
mechanism, unbalanced growth also decentralises and price increases emanating from the bottleneck
decision-making (as well as economising its use), sectors spreading throughout the economy.
which may be an advantage in some developing Methods of controlling this type of inflation, other
Planning and Resource Allocation in Developing Countries 187
than by restoring balance, have severe limitations: points of both doctrines so that an optimum
first, if price controls are imposed, the supply strategy of development combines some elements
situation may be made worse in the shortage sec- of balance as well as imbalance. The gain of real
tors by discouraging production; second, general resources from concentration and specialisation
demand deflation will be wasteful by creating un- must be weighed against the potential disadvan-
employed resources in the non-bottleneck sectors; tages, and perhaps a saving of resources through
and third, currency depreciation which may be maintaining balance between sectors. Historically,
necessary to maintain a balance of payments is growth has been unbalanced, and this is implicit in
itself inflationary by raising the domestic price of classical trade theory, with balance being restored
imports. There is evidence that in some South through imports. By and large, the present de-
American countries one of the major sources of veloping countries are following the same route
rising prices is sector inflation coupled with ex- and pursuing a combination of strategies. Re-
change rate depreciation. We shall have more to sources tend to be concentrated in a limited
say about sector inflation in Chapter 13. number of sectors, but within these sectors the
It is not easy to evaluate the balanced versus investment programme attempts to maintain ver-
unbalanced growth debate. For one thing, the tical balance. Concentration of effort is feasible in
theories cannot easily be tested empirically, and an open economy with the capacity to buy im-
for another the strategies are politically conten- ports, and at the same time investment is on a
tious. From the purely economic point of view, large enough scale for complementary activities to
however, there is really no reason at all why ba- be established recognising interdependencies in
lanced and unbalanced growth should be pre- production and consumption.
sented as alternatives in the first place. Several It is the association of balanced growth with
attempts have been made, in fact, to present ·a planning which has tended to polarise opinion on
reconciliatory view, notably by Mathur (1966). the two strategies; but unbalanced growth does
One step towards this reconciliatory approach, not preclude planning. With a mixed strategy of
which both Hirschman and Nurkse mention them- concentration on particular sectors but balance
selves, is to treat unbalanced growth as a means of within them, a decision has first to be made on
achieving the ultimate objective of balanced which sectors to concentrate and then resources
growth. A further step is to look for compatibili- allocated accordingly.
ties in the two approaches. Since balanced growth If unbalanced growth precludes planning - in-
is consistent with sectors growing at different deed, if that is its appeal - the issue is largely one
rates, provided supply and demand are in balance, of the distribution of the gains from development.
the distinctive feature of the alternative strategies With balanced growth there is the opportunity to
must be the imbalance between supply and de- distribute the benefits of development more evenly
mand. Unbalanced growth would concentrate re- throughout society, to remedy inequality, to con-
sources in a few selected areas, creating shortages trol inflation and to avoid the unemployment of
elsewhere. But this is quite consistent with the 'big resources. With unplanned unbalanced growth
push' version of the balanced growth doctrine pro- there is no guarantee against unemployment, infla-
vided the scale of investment is sufficient to over- tion and an unequal income distribution. Left to
come indivisibilities and complementarities. If itself, unbalanced growth is essentially a doctrine
unbalanced growth is defined not so much in of laissez-faire, with no safeguards against the
terms of shortages as in terms of concentration on socially divisive repercussions of change. At the
certain activities, according to comparative purely economic level the two doctrines can be
advantage or the existence of increasing returns, complementary rather than alternative strategies.
balanced and unbalanced growth can be com- But if unbalanced growth excludes planning and
plementary strategies. There is no reason why de- the co-ordination of decision-making, the implica-
velopment strategy should not draw on the strong tions of the two strategies may be very different.
188 Planning, Resource Allocation, Development and Techniques
not. Only the conditions for Pareto optimality hence the so-called minimum capital-output ratio
would deny it! 1 criterion (or 'highest rate of turnover criterion', as
For all the above reasons, there has been a it is sometimes called (see Kahn (1951)). Under
prolonged debate in recent years over the most this criterion the object of the allocation exercise is
appropriate criterion for resource allocation in the to minimise 1/l::iO and maximise !:l.0/1, where II
light of the development obstacles of developing l::i 0 is the incremental capital-output ratio and
countries and their aspirations. The different !:l.0/1 is the productivity of capital. Appealing as
criteria that have been suggested reflect, by and this criterion may seem, its use is open to a number
large, differences of opinion as to what developing of objections and suffers from all the deficiencies
countries ought to attempt to maximise, the broad of static criteria just discussed. Apart from the
choice being between present and future levels of very real difficulty of measuring the capital-output
output and consumption. Most of the criteria dis- ratio, the criterion ignores the important factor of
cussed by early writers in this field refer to the time. The capital-output ratio is measured by the
allocation of capital, reflecting the view of domes- amount of investment divided by the flow of out-
tic capital as the primary scarce resource. Increas- put from that investment over an accounting
ingly, however, attention has been paid to the effects period, normally one year. Since the lives of pro-
of resource allocation decisions on the balance-of- jects differ, however, it is quite possible for a pro-
payments in recognition of foreign exchange as an ject with a high capital-output ratio to produce a
equally scarce resource. We shall consider chrono- total output over its lifetime far greater than the
logically some of the more important ideas and same amount of investment in a project with a
criteria that have been put forward, before devot- lower capital-output ratio but with a shorter life.
ing a separate chapter to social cost-benefit analy- It may be possible to overcome this weakness of
sis which has come to dominate ~he literature. the capital-output ratio criterion by choosing the
Before we start, it should be stressed again that the project with the lowest ratio of capital to lifetime
investment criteria to be discussed refer to the output, but care must be taken in doing this be-
pattern of investment, i.e. to what projects to cause the present (discounted) value of future out-
choose, not to the choice of technology. This is not put is a function of the time pattern of that output.
to say that the choice of projects may not have The power of discounting increases the further one
implications for the choice of techniques, but con- goes into the future so that even if a twenty-year
ceptually the two choices must not be confused. project yields a higher total output than a ten-year
project, if most of the output gain of the twenty-
DThe
argued in this way in a classic article in 1955. In a
Social Marginal Product sense they go to the other extreme, arguing that
Criterion developing countries ought to strive for growth
and the maximisation of future welfare, and allo-
The social marginal product criterion for resource cate resources accordingly. Within a growth frame-
allocation would only give the same result as the work, the maximand becomes the accumulation of
minimum capital-output ratio criterion on the capital over time and the Galenson-Leibenstein
assumptions of no divergence between the market criterion for resource allocation is the maximisa-
and social prices of goods and that the social cost tion of what they call the 'marginal per capita
of labour is zero. To see this, consider Figure 7.2, reinvestment quotient'.
where the production functions, 1, 2, 3, represent
successively higher levels of 'social output' that
can be produced with different combinations of
labour and capital. To minimise the capital-
DReinvestment
The Marginal Per Capita
Quotient Criterion
output ratio requires the maximisation of the
output-capital ratio. With a fixed amount of The basis of the Galenson-Leibenstein argument
capital, OA, the output-capital ratio is maximised is that resources ought to be allocated to maximise
when society is on its highest isoquant. Higher 'per capita output, or average income, either over
levels of output can be reached until the marginal time, or at some time in the future'. This requires
product of labour is zero; that is, until the slope of maximising the investible surplus in the present to
the production function (or isoquartt) is horizon- provide each additional unit of labour with as
tal. When the marginal product of labour is zero, much capital as possible, since capital per head is
the social (or opportunity) cost of labour is zero. the major determinant of output per head. If all
Planning and Resource Allocation in Developing Countries 191
projects have the same production functions, this The marginal per capita 1 reinvestment quotient
would imply the allocation of capital to projects is defined as:
with a much higher capital intensity than if the
objective was to maximise total consumption out- p-ew
put in the present. If the objective of development r= (7.1)
k
is to maximise total output per capita at some
future point in time, therefore, investment re- where p is the (net) output (value-added) from the
sources should be allocated to give each worker in investment, e is the number of workers attached to
the future as much additional capital as possible. the investment, w is the real wage, and k is the cost
Galenson and Leibenstein call this allocation rule of the investment. r is also the growth rate because
the marginal per capita reinvestment quotient on the assumption that all wages are consumed,
(MPCRQ) criterion, and the objective becomes to and in addition that all profits are reinvested; the
allocate investment resources such that the reinvestment formula is equal to the Harrod
MPCRQ is equalised in all uses. Seven basic fac- growth formula sic, where s is the savings ratio
tors will determine the size of the marginal per and c is the incremental capital-output ratio.
capita reinvestment quotient: (1) the gross produc- That is:
tivity per worker; (2) the amount of wage goods
consumed per worker; (3) the replacement and r = P -k ew = ( ~ ) ( 1 - e;) = sic (7.2)
repair of capital; (4) improvements in the skills
and efficiency of workers which are unrelated to
capital accumulation; (5) decline in mortality where s = (p - ew)lp and c = kip.
rates; (6) decline in fertility rates; and (7) the The growth rate is maximised but at the ex-
direction of reinvestment. pense of the present level of consumption and
The Galenson-Leibenstein approach is de- employment. Hence the MPCRQ criterion would
signed to take account of the influence of projects appear to go to the other extreme from the static
on the rate of capital accumulation, or, to put it marginal criterion by neglecting present consump-
another way, to take account of the choice of tion and welfare, concentrating instead on build-
projects on the distribution of income between ing up the means of production for a greater
savers and spenders. The economic basis of the volume of output and consumption in the future.
approach is the belief that the level of per capita The criterion suggested by Galenson and Leiben-
output is largely determined by the capital-labour stein has been criticised on the grounds that its use
ratio, and the amount of capital per worker must would lead to excessively capital-intensive projects
largely depend on the level of profits (the and the sacrifice of present employment. It is true
surplus over wages) stemming from the original that the adoption of the criterion may lead to more
investment. capital-intensive projects and less employment
This view is very much in line with Lewis's than if the objective function was to maximise the
argument that the saving and investment ratio in level of present consumption. Having conceded
developing countries is dependent on the size of this, however, a number of considerations need to
the capitalist surplus. Without question, the im- be borne in mind. First, it should be noted that the
plication of the application of the MPCRQ crite- point of maximum surplus using the Galenson-
rion would be relatively capital-intensive projects Leibenstein criterion is the point where the mar-
which minimise the use of labour and the payment ginal product of labour is equal to the wage. In
of wages, leaving the maximum possible surplus this sense, the criterion is no different from the
for future reinvestment. The present level of em-
ployment and output would be sacrificed for the 1 Note: per capita does not refer to reinvestment per
sake of more investment tb raise the level of out- unit of the existing labour-force but of the future
put per head in the future. labour-force.
192 Planning, Resource Allocation, Development and Techniques
static neoclassical optimising criterion of the pri- dered. There are a number of reasons why total
vate firm. The fact that the Galenson-Leibenstein output may be important, not the least of which is
criterion apparently leads to a greater capital in- that the less the amount of employment offered,
tensity than the earlier investment criteria is be- the greater the level of unemployment and the
cause the Galenson-Leibenstein criterion takes the greater the probability of consumption in excess of
market wage as the cost of labour, whereas the production, and therefore dissaving. If total saving
other criteria implicitly assume a shadow wage of is a function of total income, as well as its distri-
zero. If the market wage is low, however, pursuing bution, a compromise must be reached between
the Galenson-Leibenstein criterion will still lead maximising the surplus choosing capital-intensive
to relatively labour-intensive projects in the indus- projects, and maximising total output choosing
tries in which the developing countries choose to less capital-intensive projects.
specialise. It is not correct to interpret the Moreover, should not some allowance be made
Galenson-Leibenstein criterion, as some writers for the fact that society is bound to value present
have done, as aiming to maximise the capital- consumption more than future consumption by
labour ratio, though Galenson and Leibenstein lay some margin, however small, if only because if
themselves open to this interpretation by talking present consumption is less than future consump-
of maximising 'the amount of capital per worker'. tion its marginal utility is higher? If so, an invest-
What they mean is maximising the surplus per ment criterion is required which reflects both the
future worker. Second, it is worth pointing out immediate contribution of projects to consumer
that the criterion is not so extreme as other plausi- welfare and the future welfare made possible by
ble investment criteria that might be applied, such additions to the capital stock from saving gener-
as the allocation of investment resources to maxi- ated by the current investment. A partial solution
mise output and savings per head of the popula- to the problem of the relative valuation of present
tion so as to maximise society's savings ratio. and future consumption, and hence the choice of
Third, it can be shown that the clash between projects, is to fix a time horizon, acceptable to
employment and saving may disappear entirely if society, within which future welfare gains must
the wage rate and the capital intensity of produc- offset welfare losses in the present. 1 If this time
tion are positively related. Fourth, the conflict is horizon exceeds the actual length of time it takes
minimised the smaller the difference between the for welfare gains to match welfare losses, rela-
propensity to save of workers and capitalists. The tively capital-intensive projects may be fav:oured
conflict may also be minimised by appropriate tax with some sacrifice of present consumption. If,
and subsidy policies. These last three points and however, the period over which future welfare
others are considered in more detail in Chapter 10 gains just compensate for welfare losses in the
on the choice of techniques. present exceeds the acceptable time horizon,
Galenson and Leibenstein's analysis is useful in relatively labour-intensive projects should be
stressing the relationship between the choice of favoured. Needless to say, this approach is very
projects, the distribution of income and the rate of arbitrary depending on the time horizon chosen.
saving, but their precise conclusions rest on the If, however, some democratic consensus can be
assumption that saving and investment are solely reached, this would appear to be a better solution
functions of the distribution of income, and to the inevitable clash between present and future
nothing else. But suppose that saving depends on consumption than a straight choice between one
the total level of income as well (which will not be or other of the investment criteria discussed above
maximised if labour as the abundant factor is not which in their basic form ignore the trade-off be-
employed up to the point where its marginal pro- tween present and future welfare.
duct is equal to its opportunity cost). If so, it may
not be wise simply to aim at maximising the total 1This is suggested by Professor A. K. Sen in Choice of
surplus. The level of output must also be consi- Techniques (1968).
Planning and Resource Allocation in Developing Countries 193
hence
t=O benefits in units of Bt- We can then divide every-
thing by W 1 so that the new weights attached to B2
The first part of the expression in equation (7.3)
and B 3 represent the amounts of B2 and B3 that are
measures the direct contribution of the project to
equivalent to one unit of B1 • Equation (7.4) be-
consumption. The second part takes account of comes:
the cumulative future benefit made possible by the
increased rate of capital accumulation from the
w2B2 w3B3
project's reinvested savings. Expressing equation B = B1 + - - + - - (7.5)
(7.3) as a proportion of the capital invested would wt wt
give a calculation of the social marginal product
which incorporates Galenson and Leibenstein's For n different benefits:
fundamental point that project selection ought not n
to be considered independently of the effect of a B = ~ kB·
"" I I
i=O
project on the level of saving and future output.
Now a project which looks 'efficient' on the ordi- where k; are the weights representing the rates at
nary SMP criterion may look inferior to another if which society is willing to substitute one benefit
its reinvestment ratio is low because it is making for another (k 1 = 1; k 2 = w 2 1w 1 ; etc). The weights
no contribution to raising the level of future output. attached to different benefits may of course change
194 Planning, Resource Allocation, Development and Techniques
through time, depending on how the objectives of it, and diverse benefits measured, provided the
the development policy change with time. relative worth of one objective, or benefit, relative
Let us illustrate with a simple numerical to another is specified.
example. Suppose that an extra unit of consump-
tion (B 1 ) is worth 10 times an extra unit of em-
ployment (B 2 ) and 5 times a 1 per cent reduction in
the Gini ratio measuring the degree of income
inequality (B 3 ). If we take consumption as numer-
I Questions for Discussion and
Review
aire, equation (7.5) becomes:
1. In what ways may the market mechanism fail
1 1 to provide a socially desirable allocation of
B=B 1 +-B
10 2 +-B
5 3 (7.6) resources in developing countries?
2. What are the major causes of divergences be-
tween the market price of goods and their
Thus, a project yielding 100 units of consumption,
social valuation?
20 extra jobs, and a reduction in the Gini ratio of
3. What are the major causes of divergences be-
1 per cent would yield a benefit of
tween the market price of factors of produc-
tion and their cost to society?
20 1 4. Does the replacement of the market mechan-
B = 100 +-+-= 102.2
10 5 ism by planning necessarily imply abandon-
ment of the price system?
Provided the weights attached to different benefits 5. Why do developing countries construct de-
are specified, projects yielding different combina- velopment plans?
tions of benefits measured in different units can be 6. What do you understand by the concept of
compared. 'balanced growth'?
To use the social welfare function for project 7. What is Hirschman's major criticism of the
appraisal, the sum of benefits measured in a com- doctrine of balanced growth?
mon unit of account, and properly discounted, 8. What major factor distinguishes static from
must then be expressed as a ratio of some scarce dynamic investment criteria for the allocation
factor that goes into the project, e.g. capital or of resources?
foreign exchange, if the scarce factor is to be allo- 9. What is the purpose of constructing a social
cated to maximise social benefit. welfare function?
In conception the social welfare function is very 10. Should countries be guided by the law of com-
similar to the notion of social product. Its appeal is parative advantage in the allocation of invest-
that every goal and aspiration can be included in ment resources?
II Chapter 8 II
Project Appraisal, Social
Cost-Benefit Analysis and
Shadow Wages
The literature and discussion about project choice level of current saving may be sub-optimal. In a
and the allocation of resources has been domi- sense, social cost-benefit analysis tries to incor-
nated in recent years (since 1970) by social cost- porate all the considerations that previous criteria
benefit analysis. Social cost-benefit analysis is have stressed as important to consider, and thus
really the public analogue or equivalent of the may be said to have superseded them.
present value method of private investment ap-
praisal, but it has to take many things into account
which adds to its complexity. The technique is • Project Appraisal
recommended for the appraisal of publicly
financed investment projects in order to allocate When we are talking about public investment we
resources in a way most profitable to society, are talking mainly about public infrastructure pro-
recognising that the market prices of goods and jects (such as roads and water supplies) and public
factors of production do not necessarily reflect enterprise projects (such as steel mills, power
their social value and costs, respectively, and, plants etc.). In addition, there are other categories
given that society is concerned with the future of state-supported investment where social cost-
level of consumption as well as the present, the benefit analysis may be applied such as private
195
196 Planning, Resource Allocation, Development and Techniques
0 -5 - 5.00
1 2 X 0.926 + 1.85
2 2 X 0.857 + 1.71
3 2 X 0.794 + 1.59
4 2 X 0.735 + 1.47
5 2 X 0.681 + 1.36
present value. The project yields a net present duces supply costs will reduce the price of
value of £2.98 million. local supplies and will represent an indirect
benefit of the road.
3 Third, there are the consequences of a project
• Economic Appraisal for other sectors that supply inputs to the
project. If a project demands more inputs, this
First of all, let us consider the secondary (or in-
is income to the supplier. For example, a new
direct) costs and benefits that may arise from
dam will require local materials; a new factory
public projects, and then consider how to adjust
will demand steel and so on. These reper-
the market prices of goods and services and factors
cussions need taking account of.
of production in order to take account of their
economic value to society at large. There are three Beyond the secondary (or indirect) effects of
major indirect effects to consider: projects, the market prices of goods produced, and
the factors of production used, may not reflect
1 First there is the economic impact of the pro-
their value to the economy as a whole. The prices
ject on the immediate vicinity of the project.
need adjusting to reflect their true economic value
Some projects, of course, such as an irrigation
to society.
scheme, are designed to have an impact on the
In economic appraisal (as opposed to financial
immediate vicinity, and their benefits would
appraisal), we now have to redefine the variables
be counted as direct benefits, but other pro-
in the net present value formula in equation (8.1)
jects will have incidental indirect effects, both
to ascertain whether a project is profitable to
positive and negative. A new road, for
society at large.
example, which is designed to cut travel time
may raise output in the immediate vicinity. Vt is the flow of social benefit measured at
This is a positive benefit. On the other hand, a economic (or efficiency) prices
new dam to generate electricity may flood ct is the social cost of inputs (measured by
arable land and reduce agricultural produc- opportunity cost)
tion. This is a negative indirect effect. r is the social rate of discount
2 Second, there are the price effects upon local Ko is the social cost of the investment
markets. If, for example, prices fall as a result
of a project, this represents a gain in consumer A project will be profitable to society if the
surplus, and this needs to be added to the social benefits of the project exceed the social
value of the project. A new road which re- costs, or, to put it another way, if the net present
198 Planning, Resource Allocation, Development and Techniques
value of the project to society is greater than 1 First, the government imposition of taxes,
zero. subsidies, tariffs and controls of various kinds
The question is: how should a project's social distort free market prices. Opportunity cost
benefits and costs be measured, and what common must be measured net of taxes and subsidies.
unit of account (or numeraire) should the benefits 2 Secondly, imperfections in the market will
and costs be expressed in, given a society's objec- raise prices above the marginal cost of produc-
tives and the fact that it has trading opportunities tion. Prices set by private monopolists and
with the rest of the world so that it can sell and public utilities may be particularly distorted.
buy outputs and inputs abroad (so that domestic 3 Thirdly, the existence of externalities, both
and foreign goods need to be made comparable)? positive and negative, will mean that the
There are two broad approaches to this question. prices of goods do not reflect their true value
First, benefits and costs may be measured at to society.
domestic market prices using consumption as
numeraire, with adjustments made for diver- The market prices of factors of production may
gences between market prices and social values, not reflect their true cost to society - that is, the
and making domestic and foreign resources com- opportunity cost of using them measured by their
parable using a shadow price of foreign exchange. marginal product in alternative uses. Labour's
This is sometimes referred to as the UNIDO ap- market price in the industrial sector (i.e. the in-
proach (see Dasgupta, Marglin and Sen (1972)). dustrial wage) is likely to exceed the cost to society
Second, benefits and costs may be measured at of using labour if there is disguised unemployment
world prices to reflect the true opportunity cost of on the land or in the petty service sector. Capital's
outputs and inputs (obviating also the need to use market price will be below its social cost if it is
a shadow foreign exchange rate), using public subsidised. Foreign exchange may also be too
saving measured in foreign exchange as numeraire cheap from a social point of view if the exchange
(i.e. converting everything into its foreign ex- rate (measured as the domestic price of foreign
change equivalent). This is referred to as the currency) is kept artificially low by exchange con-
Little-Mirrlees approach (see Little and Mirrlees trols of one form or another.
(1969) and (1974)). The fact that foreign ex- The existence of external economies and dis-
change is taken as numeraire does not mean that economies may also cause divergences between the
project accounts are expressed in foreign currency. market price of inputs and their social cost. If, for
The unit of account remains the domestic cur- example, a project purchases inputs from decreas-
rency, but the values recorded are the foreign ing cost industries, the social cost is not equal to
exchange equivalent, i.e. how much net foreign the price based on average cost but to the lesser
exchange is earned. figure of marginal cost.
Before proceeding to contrast the approaches, It is also possible that aggregate saving and
and to look at the problems of measurement, let us investment in an economy is less than socially
consider the important divergences which require desirable, but the market does not allow indi-
correction between the market prices of goods and viduals to express a preference for a higher rate of
factors of production and their value to society. investment and capital accumulation for growth
and future welfare. This is another example of the
isolation paradox - one solution to which is for
accounting prices. Adjusted market prices for Little-Mirrlees approaches) what we find is that
goods we shall call social prices, and adjusted the two approaches amount to the same thing if
market prices for factors of production (including the conversion factor used to convert the value of
foreign exchange) we shall call shadow prices. non-traded goods into their foreign exchange
equivalent is the reciprocal of the shadow price of
foreign exchange, i.e. the reciprocal of the ratio of
• Social Prices for Goods the shadow exchange rate to the official exchange
rate. Let us give a simple illustration. Suppose we
The first divergence mentioned above requires have a project producing exports, which uses both.
finding social prices for goods. As already stated, foreign and domestic inputs. Using the UNIDO
either domestic market prices may be corrected for methodology, the net benefit would be estimated
the various distortions and imperfections, with as:
domestic and foreign goods made comparable
using a shadow price of foreign exchange (the Net Benefit = (SER) (X - M) - D, (8.2)
UNIDO approach), or goods may be valued at
world prices, as recommended by Little and Mirr- where X is the border price of exports, M is the
lees. Doing the latter, it is argued, will give a truer border price of imported inputs, D is domestic
measure of the social valuation of goods than the inputs, and SER is the shadow exchange rate
first alternative of measuring some goods at (assuming the official exchange rate does not ac-
domestic prices (with adjustments), traded goods curately reflect the true value of foreign exchange
at their international price, and then making to the economy). Goods are all valued at domestic
domestic and foreign goods comparable using a prices but revalued by the shadow exchange rate.
shadow foreign exchange rate which may itself be If net benefit was greater than zero at the appro-
subject to distortions. To give a simple example of priate discount rate, the project would be accept-
the point being made: the effect of a project to able.
produce more wheat is to save wheat imports. The By contrast, Little and Mirrlees take foreign
true economic value of wheat output is its import exchange as numeraire (because extra foreign ex-
price (including cost, insurance and freight- c.i.f.) change in government hands is an addition to
whatever the domestic price is. The same argu- saving and investment) so that:
ment applies if the wheat is exported; its true
economic value is its border price (free on board- Net Benefit = (OER) (X - M) - aD (8.3)
f.o.b.), i.e. what the foreign exchange will buy in
world markets. where OER is the official exchange rate and a
The Little-Mirrlees approach of using world is the conversion factor which converts the value
prices for measurement presents no major prob- of domestic inputs into its foreign exchange equiv-
lems when goods are tradeable. The problem alent, and is defined as the ratio of OERISER.
comes with non-traded goods which by definition It is clear that the two approaches are equiv-
do not have world prices. Some method has to be alent since multiplying equation (8.2) by OERI
found of converting non-traded goods prices into SER yields equation (8.3). The reciprocal of this
their foreign exchange equivalent. ratio, i.e. SERIOER, is the shadow price of foreign
exchange- say, PP Therefore a = 1/PF.
into its traded and non-traded components in per dollar), but that the $100 bicycle can be sold in
successive rounds - backwards, through the chain India for 250 rupees. This means, in effect, that the
of production. A detailed input-output table would domestic price of foreign exchange is too low and
be required for the job to be done properly. If it should be raised (i.e. the currency should be de-
could be done, this would give a different social valued) to reflect its opportunity cost. Dollars are
price for each non-traded good. scarcer than the actual exchange rate allows for. In
In practice, only special inputs are treated in this case, the rupee is overvalued by 25 per cent
this way. For practical reasons, approximations because each rupee's worth of foreign exchange
have to be made for the valuation of most non- provides goods worth 25 per cent more when
traded goods at world prices, and for this purpose measured at domestic market prices. The shadow
it is convenient to have a standard conversion exchange rate should be 2.5 rupees to the dollar.
factor (SCF). The SCF translates domestic prices Extending this line of argument to many com-
into border prices (measured at the official ex- modities, the shadow price of foreign exchange
change rate) i.e. may be written as:
(8.4)
(8.8)
where Pd is domestic prices; Pw is world prices,
and OER is the official exchange rate measured as where i is the ith import and (; are the weights.
the domestic price of foreign currency. In this In the case of one commodity- bicycles:
sense, the standard conversion factor (SCF) is the
reciprocal of the shadow price of foreign exchange 250
(PF). To show this, from (8.4) we have: p = - = 1.25
F 200
p
SCF = ____:::_ (OER) (8.5) Therefore, the standard conversion factor (SCF)
pd IS:
or 1 1
SCF = - = - = 0.8 (8.9)
1 PF 1.25
SCF= - - - (8.6)
This equals the official exchange rate (2 rupees to
the $) divided by the shadow exchange rate (2.5
OER 2.0
where PdiPw is the shadow exchange rate (SER) rupees to the$) i.e. a = - - = - = 0.8
SER 2.5
i.e. the price of goods in domestic currency relative
to their world prices, i.e. • Traded Goods
1 1 Traded goods also need valuing. Little and Mire-
SCF=--=- (8.7) lees distinguish three categories of traded goods:
SER PF
OER 1 commodities that are being exported and im-
ported with infinite elasticities of demand and
Let us give a numerical example. Suppose that in supply, respectively;
India the official foreign exchange price of a bi- 2 commodities traded with less than infinitely
cycle costing $100 is 200 rupees (assuming, there- elastic demand and supply;
fore, an official exchange rate (OER) of 2 rupees 3 commodities that are not currently traded but
Project Appraisal, Social Cost-Benefit Analysis and Shadow Wages 201
which are potentially tradeable if the country price of labour bridges economic and social ap-
adopted optimal trade policies. praisal. The output forgone from the employment
of more labour on projects and the increased
For commodities in the first category, the valua-
consumption (or lost saving) must, of course, be
tion is in principle straightforward. Exports and
valued at world prices using Little-Mirrlees meth-
imports should be valued at border prices, net of
odology. This requires estimation of consumption
taxes, tariffs, transport and distribution costs etc.
conversion factors.
If import supply is infinite (the small country
We have already discussed estimation of the
assumption), the foreign price of imports will not
shadow exchange rate which will be redundant in
change as import demand rises. Likewise, if the
the Little-Mirrlees methodology, but will be necess-
demand for exports is infinite, export price will
ary using the UNIDO approach.
not be affected if more exports are supplied.
For commodities in the second category, the
supply of imports can be assumed to be infinite, • The Social Rate of Discount
but the demand for exports may be less than
infinite. In this case, the foreign exchange impact The choice of discount rate depends on the
will be less than the border price times the quan- numeraire taken. If consumption is taken as
tity sold. In other words, marginal revenue is less numeraire, the appropriate discount rate is the
than price. In this case, the social price of the good consumption rate of interest (CRI), measured as
is the border price multiplied by (1 - liT]), where the rate at which the marginal utility of income
T] is the price elasticity of demand. If T] = oo, the declines which may be approximated by the mar-
social price is the border price; if T] = 1, the social ket rate of interest.
price is zero, and if T] < 1, the social price is If public saving (measured by foreign exchange)
negative. is taken as numeraire, the appropriate discount
For commodities in the third category which rate is the rate at which the marginal utility of
are potentially tradeable, these can be treated as public saving falls. This rate is termed the account-
traded goods for all practical purposes. ing rate of interest (ARI) which should equal the
rate of return on public money. In practice, the
to lie somewhere between the limits of the oppor- societies are indifferent between the present and
tunity cost of labour on the one hand and the the future, the valuation coefficient of saving rela-
industrial wage on the other, depending on the tive to consumption will equal unity (S0 = 1) and
relative valuation of saving and consumption. We the shadow wage from equation (8.14) will b!:!:
may derive the optimal shadow wage by putting
the costs of using an additional unit of labour W* = PA
equal to the benefits, and solving the equation.
The social cost of the labour is: which is the opportunity cost of labour in alterna-
tive uses. This is the standard, static result. If the
PA + (C- m) (8.11) opportunity cost of labour is zero, the shadow
wage would be zero. If it is positive, as in Figure
where PA is the opportunity cost of labour and 8.1, the shadow wage would give employment
(C - m) is the total net increase in consumption, level, Ll"
(C is the increase in consumption in industry and At the other extreme, if societies place an in-
-m is the fall in consumption in agriculture as finite valuation on the future and none on the
labour migrates). present then the valuation coefficient of saving
The social benefit of the labour used on the relative to present consumption would be infinite
project is its marginal product (P1 ), plus that part (So = oo ), and the shadow wage from equation
of the increase in consumption that is valued (8.14) will be:
which we may write as (C- m)IS0 , where So is the
valuation of saving (or future consumption) rela- W* = PA + (C- m) (8.16)
tive to present consumption. The total social ben-
efit is thus: If workers' consumption in agriculture (m) is equal
to their marginal product (PA), and the increased
(C- m) consumption in industry (C) represents increased
PI+---- (8.12) workers' consumption out of the wage (W),l so
so that C = W, then the shadow wage is equal to the
industrial wage:
Labour should be employed up to the point where
the social benefit is equal to the social cost, i.e. up
W* = W (8.17)
to the point where:
(C- m)
In Figure 8.1, this would give employment level, L,
PI+ = PA + (C- m) (8.13) where savings are maximised.
so In practice, the shadow wage will lie some-
where between PA and W, depending on the value
or of S How do we measure the relative valuation of
0 •
---+
cl cz ct
+ ... + - - -
mal quantity of labour, L *, which in turn deter-
mines the level of industrial output from the
(1+i) _ _
So = ...:....___...:...._ (1+i)
_ _ _ _ _ _(1+i)t
2
_ __ production function. The shadow wage is then
co the marginal product (PI) at that point, given by
the slope of the tangent to the production func-
T ct tion. We illustrate this in Figure 8.3 below. Point L
t~1(1+i)t (8.18)
in Figure 8.3 corresponds to L in Figure 8.2 where
savings and investment are maximised. Point L 1
co corresponds to L 1 in Figure 8.2 where total output
is maximised, beyond which investment falls by
The value of So will depend on the marginal prod- more than consumption increases. The optimum
uct of capital, the length of the time horizon (T) quantity of labour, L *, implies a particular output
taken, and the discount rate (i) chosen. The longer and marginal product of labour which to be
the time horizon, and the lower the discount rate, achieved requires that the shadow wage be set at
the higher So and the higher the shadow wage rate. this level (W* = PI).
If So = 3, for example, then assuming PA and m to Note from Figure 8.2 that if an infinite valua-
be very small, the shadow wage would be ap- tion is placed on saving and investment (S 0 = oo),
proximately two-thirds of the industrial wage. In the indifference curve between investment and
the Little-Mirrlees approach to project appraisal, consumption would be a horizontal line and
the shadow wage is the principal means by which tangential to XW at A', giving employment level,
the scarcity of foreign exchange is allowed for. L, which maximises investment and saving with a
The lower the shadow wage, the greater the use of
domestic resources. Figure 8.3
We can illustrate how the trade-off between the
Marginal
present and the future affects the shadow wage product
and the level of employment with the aid of a in industry
simple diagram used by Joshi (Figure 8.2) Qoshi
(1972)). Shadow wage 1----"'r<----+-----lndustrial wage
The curve YZ shows society's indifference curve (W* = P1) -~----t--T------
between investment and consumption, and XW is 1---+--t-----"K:----Marginal product in
agriculture
the empirical trade-off curve between investment or----~~~--~--------L~a~b-ou-r
and consumption. Suppose that with no employ-
ment in industry, total consumption equals agri- Marginal product (P1)
Project Appraisal, Social Cost-Benefit Analysis and Shadow Wages 205
shadow wage equal to the industrial wage. Con- agriculture, and c' is the propensity to consume of
versely, if society is indifferent between the present those remaining in agriculture. Clearly if those
and the future (S = 1), the YZ curve would be a
0 remaining increase their consumption by as much
45° line (as shown) tangential to XW at T', giving consumption as the migrants 'release', so that
employment L 1 where total output is maximised c' = 1, agricultural consumption will not fall as
with the marginal product in industry equal to the labour migrates.
marginal product in agriculture and a shadow wage Substituting for C and m in the standard
equal to the marginal product in agriculture. 1 formulation for the shadow wage in equation
I
(8.14), we obtain:
I
that all 'profits' are saved. It has also been as-
sumed that consumption falls in agriculture to the
extent of the migrant's consumption. In practice,
The Valuation of Production
the marginal propensity to consume out of wages Forgone and the Increase in
may be less than unity; the marginal propensity to Consumption
save out of 'profits' may be less than unity; and
consumption in agriculture may not fall by the Using the Little-Mirrlees approach, the valuation
extent of the migrant's consumption. A more gen- of agricultural production forgone (P A), and the
eral formulation of the shadow wage is called for value of increased consumption (C- m), must be
which allows for these possibilities. measured at world prices. To value agricultural
The change in consumption in industry as more production forgone, a bundle of goods must be
labour is employed may be written as: taken to represent the marginal physical product
which then must be priced according to whether
C = We + c* (PI - W) (8.19) they are traded or non-traded, as described earlier.
To value the increased consumption also requires
where W is the industrial wage; (PI- W) is 'profit' taking a bundle of goods, distinguishing between
per worker; c is the marginal propensity to con- traded and non-traded goods. To recap, standard
sume out of wages, and c* is the marginal propen- conversion factors are recommended to reprice
sity to consume out of profits. non-traded goods, which are calculated as the
The change in consumption in agriculture as ratio of the weighted average of the world prices
labour is drawn away may be written as: of all exports and imports to the value of their
domestic prices.
m = d (1 - c') (8.20) As we saw earlier, it is generally accepted in the
comparison of the Little-Mirrlees and UNIDO
where d is the consumption of the migrants from approaches to project evaluation that the standard
conversion factor (SCF) should be the inverse of
1 It should be borne in mind that the indifference curve is not the shadow exchange rate (SER). The reason is
strictly exogenously given. The value of S0 is not independent that both approaches advocate the use of border
of the future level of savings and investment, and thus the
indifference curve may be expected to change its shape through prices to value traded goods, so while in the
time. Little-Mirrlees method they are automatically ex-
206 Planning, Resource Allocation, Development and Techniques
pressed in the numeraire, in the UNIDO approach Therefore, the distribution weighted relative valu-
they need to be converted into domestic prices ation of present versus future consumption is:
using a shadow exchange rate. With regard to
non-traded goods, the opposite is the case and the d
(8.24)
Little-Mirrlees approach must convert the domestic
prices of these goods into border prices using the
standard conversion factor. As the one process is Up to now it has been implicitly assumed that
the reverse of the other, it is accepted by both d = 1 - as if it is the average man who always
methodologies that SCF = 1/SER. (see p. 200). gains from projects or that the gains to all indi-
viduals are valued equally. If greater weight is
given to the consumption gains of the poor (d > 1)
• Social Appraisal than to the rich (d < 1), however, it can be seen
from equation (8.21) or (8.14) that the substitu-
DinDistributional
tion of d!So for 1/So will alter the shadow wage. A
Considerations high d will lower the shadow price of labour and
Project Appraisa/ 1
favour projects which provide consumption gains
to the poor, and a low d will raise the shadow
So far we have ignored the effect of project choice price of labour and favour projects which benefit
on the distribution of income. The distributional the wealthy.
consequences of projects can be included in the The question is: how is d determined? To derive
estimation of the shadow wage by altering the distribution weights, a utility function must be
valuation of present to future consumption (1/S0 ) specified. One possible utility function, with the
- increasing the value if the consumption gain is to underlying assumption of diminishing marginal
the poor, and decreasing the value if the consump- utility of consumption, is:
tion gain is to the rich. The distribution weighted
relative valuation of present to future consump- 1
tion can be thought of as being composed of two uc =e-n=-
en' (8.25)
parts: (i) the value of a marginal increase in con-
sumption to someone at a level of consumption, C, where C is consumption and n is a parameter of
divided by the value of a marginal increase in the utility function. The higher n, the higher the
consumption accruing to someone at the average rate of diminishing marginal utility. For example,
level of consumption, C. Let us denote this as: if n = 1, the utility of consumption for a person
with double the consumption of another (C = 2) is
We one-half; and if n = 2, the utility of consumption
We; (= d); (8.22) for a person with double the consumption of
another is one-quarter, and so on. To compare the
value of consumption to different people (or
(ii) the second part is the value of a marginal groups), some standard needs to be taken such as
increase in consumption to someone at the average the average. Thus:
level of consumption divided by the value of a
marginal increase in public income (saving). Let us
denote this as: d = Uc = (C) n (8.26)
. uc c
d
(8.23) where E is the average level of consumption (and
utility and consumption at the margin are in-
1 This section relies heavily on the exposition given in Squire versely related).
and van der Tak (1975). Equation (8.26) says, for example, that the
Project Appraisal, Social Cost-Benefit Analysis and Shadow Wages 207
Table 8.2 Values of the Consumption Distribution Weight (d) for Marginal Changes in Consumption
At At
existing relative And when n equals
consumption consumption
level (C) level (CIC) 0 0.5 1.0 1.5 2
marginal utility of consumption to someone with a value for d implies an existing level of consump-
level of consumption of half the average (0.5C) is tion equal to one-third of the average (see Table
(2)n. If n = 2, d = 4. The lower the level of 8.2). In this case the value of So used by the plan-
consumption relative to the average, and the ners would imply that the government is indiffer-
higher n, the higher the distributional weight will ent as between additions to its own income and
be, and the greater the egalitarian bias in project additions to the consumption of those currently
selection. Table 8.2 shows how the value of the consuming one third of the average level. This may
distribution weight changes with n and C/C, for not seem plausible in the light of other policies.
representative values of n and C/C with (C = For example, the government may be distributing
100). The values of C and n are not project various forms of subsidies at this level of con-
specific, but country specific, and must be pro- sumption, which suggests it values consumption
vided by the planning office. more highly than public income or saving. In this
Having discussed the determination of d in case it should lower So and put a higher value on
equation (8.24), we must return to the valuation present consumption to give a lower shadow
of S0 • We already discussed one method of valuing wage. An So that implied some starvation level of
I
So (see equation (8.18)). We now have some inde- consumption could be immediately ruled out.
pendent check of whether the value of So is plausi-
ble. One test is to estimate, at the chosen value of
S0 , the value of C/C at which the government is
The Equivalence of the
indifferent between its own income (saving) and Little-Mirrlees Formulation
consumption so that costs and benefits of in- of the Shadow Wage and the
creased consumption are assumed to be equal and
the shadow price of labour is measured simply as
UNIDO Approach
the efficiency price or opportunity cost. In other
In the UNIDO approach, the optimal shadow
words, what is the value of C/C at which d!S 0 = 1, wage is given by
so that 1 - d!So = 0? If So is assumed to be 3, then
d must equal 3. With n = 1 (say), this required W* = PA + s* (P 1N v - 1) W (8.27)
208 Planning, Resource Allocation, Development and Techniques
W* = PA + (1 -+) 0
(C- m)
essential ... the world pricing of non-traded in-
puts that has caused so much argument is a tem-
pest in a teapot. I doubt it will catch on and it will
not matter much if it doesn't'! Baldwin's first pre-
which, on the assumption that PA m, may be diction has not proved accurate. There are now
written as: many case studies which have used the Little-
Mirrlees methodology and students are encour-
aged to read some for themselves. 1 In his second
(8.30)
prediction, Baldwin may be right. Below we give
a simple hypothetical example of the application
Comparing equation (8.30) with the UNIDO of the UNIDO and Little-Mirrlees approaches
equation (8.29), it can be seen that the UNIDO assuming that the standard conversion factor and
formula is So times the Little-Mirrlees formula the shadow price of foreign exchange are the re-
because the UNIDO numeraire is 1/So times as ciprocal of each other.
valuable as the Little-Mirrlees numeraire.
The calculation of the shadow wage will be
different according to the two approaches (assum-
ing piNV = S0 ) only to the extent that they classify
goods into traded and non-traded in a different
way and that the standard conversion factor (SCF)
to convert non-trade goods into world prices is not
the reciprocal of the shadow price of foreign ex- 1 See, for example, Lal (1980), Scott, MacArthur and Newbery
change (PF) to convert traded goods prices into (1976), Stewart (1978) and the Symposium in the Oxford
domestic prices. Bulletin of Economics and Statistics, February 1972.
Project Appraisal, Social Cost-Benefit Analysis and Shadow Wages 209
Little-Mirrlees UNJDO
Net benefit $-1800 $1200 $1200 Net benefit R-2250 R1500 R1500
4
component of 1000 rupees.
There are traded inputs of $1000 and non-
traded inputs of 1000 rupees.
The accounting rate of interest is equal to the
consumption rate of interest.
We can now apply our net present value formula
Assume that world prices are measured in dollars
in equation (8.1) using the two approaches. Re-
($) and domestic prices in rupees (R); that the
member that using the Little-Mirrlees approach
shadow exchange rate is 1.25 rupees per $; that
we must convert all the prices of non-traded goods
the shadow price of foreign exchange (P F) = 1.25
into world prices using the standard conversion
and that the standard conversion factor for con-
factor of 0.8, and using the UNIDO approach we
verting non-traded goods prices into world prices
must convert all values at world prices ($) into
is 0.8, i.e. 1/1.25. Assume further that:
domestic prices using the shadow exchange rate of
1 All output is exported with an annual value of 1.25. We will do the analysis for three periods
$3000. only (see Table 8.3). We see that the results of
2 The cost of the investment has a foreign com- using the Little-Mirrlees approach and the UNIDO
ponent of $1000 and a local (non-traded) approach will differ only to the extent that the
210 Planning, Resource Allocation, Development and Techniques
shadow exchange rate is different from the actual than of the rich, which reduces the present value of
exchange rate. To obtain net present value, the net lost consumption. In the Little-Mirrlees approach
benefit streams in years 1 and 2 must be dis- distributional considerations are taken account
counted by the appropriate discount factors of by working out the value of So taking account
which we assume here to be the same using both of the standard of living of the particular extra
approaches. Assuming a discount rate of 10 per workers employed, as described above.
cent we have:
211
212 Planning, Resource Allocation, Development and Techniques
Micrograms per cubic meter of air Micrograms per cubic meter of air
1,800
50
40
1,200
30
600 20
10
0 0
100 1,000 100,000 100 10,000 100,000
Per capita income (dollars, log scale) Per capita income (dollars, log scale)
Carbon dioxide
Municipal wastes per capita emissions per capita•
Kilograms Tons
600 16
12
400
8
200 4
0 0
100 1,000 10,000 100,000 100 1,000 10,000 100,000
Per capita income (dollars, log scale) Per capita income (dollars, log scale)
Note: Estimates are based on cross-country regression analysis of data from the 1980s.
a. Emissions are from fossil fuels.
Sources: Shafik and Bandyopadhyay, background paper; World Bank data.
environment. The neoclassical analysis of equity generation whilst maintammg the potential to
within and between generations is considered and meet the needs of future generations. Fourth, a
its importance in the context of the environment is brief review is given of how environmental-
examined. Third, the concept of sustainable de- ists, economists and international agencies have
velopment is explained. This idea defines forms of approached the analysis of the environment and
development that meet the needs of the present the economy.
Development and the Environment 213
one function: e.g. the oceans are important in assumed that the value which a consumer places
determining the global and micro climates; they on additional consumption of a good declines with
are sources of many minerals and other resources; increasing consumption. Economic rationality dic-
they assimilate many different wastes; and they tates that consumption of a good continues up to
provide the space and opportunity for marine pas- the point at which the value placed on an ad-
times. Thus, in Figure 9.2, the four blocks repre- ditional unit is just equal to the price. Further
senting the different functions of the environment expenditure on the good would be inefficient, as
overlap. The functions of the environment may be greater value could be obtained from using the
competitive. For example, excessive discharges of additional expenditure to purchase more preferred
waste materials into the oceans will reduce their goods and services. Similarly, less expenditure is
capacity to provide a habitat for fish stocks. Alter- inefficient, as greater value could be obtained by
natively, environmental functions can be com- purchasing more of the good and fewer less pre-
plementary. For example, appropriate forestry ferred goods and services. Thus, the neoclassical
policies can provide a sustainable source of tim- model assumes that economic rationality gives
ber (a natural resource function) and reduce efficiency in consumption.
soil erosion (an improvement in the life-support The neoclassical view assumes that firms are
function). profit maximisers. This implies that firms mini-
mise costs. This gives efficiency in production.
I
Finally, it is assumed that competition among
The Market-Based Approach to firms forces them to charge prices that are equal to
Environmental Analysis their marginal costs of production. As consump-
tion decisions are based on prices, the equality
The market-based approach to environmental between prices and marginal costs means that
analysis has probably been the dominant view of these decisions are based upon the marginal costs
the relationship between the environment and the of production. This ensures efficiency between
economy. 1 In particular, many environmental consumption and production.
policies and much analysis are based on the view The neoclassical view has various important
that markets may not function efficiently with re- implications for the analysis of the relationship
gard to the environment and that the state has between the environment and the economy. First,
a duty to intervene and correct market failures. it is implicitly assumed that the value of consump-
The underlying assumptions of the market-based tion is determined by the individual consuming the
approach are examined and various applications good. The value of consumption is not determined
to the environment are considered. by the state or some higher authority. Addition-
The market or neoclassical approach to econ- ally, it is assumed that individual consumers and
omics is concerned with how scarce resources are producers do not consider the effects of their de-
allocated in a market economy. 2 Allocation is cisions on other economic agents. Second, econ-
assumed to take place on the basis of consumers' omic rationality implies that the value of marginal
preferences, the distribution of economic assets consumption of a good or service can be measured
and the costs of production. It is assumed that by price. Third, the neoclassical analysis of the
each consumer is rational and decides to purchase market is based upon considering small changes in
goods and services on the basis of prices and econ- consumption and production. This view extends
.omic assets, which include labour income. It is to the neoclassical view of the environment .
Fourth, the outcome of a market economy, in
terms of prices, quantities and the distribution of
1 For a good introduction to this subject, see Common (1988). economic welfare, depends on the initial distribu-
2Explanations of the neoclassical approach to economics can
be found in most intermediate microeconomics textbooks: see tion of economic assets. Different distributions or
Laidler and Estrin (1989) and Varian (1990). reallocations of assets give different outcomes. It is
Development and the Environment 215
frequently pointed out that under certain condi- actions of many individual inhabitants of the
tions the operation of the market may be efficient, Nepalese highlands. These actions may have unin-
but it may not be equitable. It may be possible to tended but disastrous consequences for people liv-
assess the efficiency of a market economy in an ing in lower-lying areas. The costs imposed on
objective manner, but evaluation of the equity of a these latter people are not considered by the in-
market outcome is a value judgement. habitants of the highlands. These effects are de-
finitely not controlled by the operation of the
market. In general, most economic activity in the
• Externalities highlands is not conducted through cash markets.
The over-grazing of land is a negative externality.
The idea of externalities can be used to analyse This externality is caused by jointness of pro-
many, but not all, types of environmental degrada- duction and lack of individual property rights. The
tion. Externalities occur when the actions of one over-grazing of land results in the production of
economic agent affect other economic agents and animals and gives rise to soil erosion, reduced soil
the actions are not controlled through the opera- fertility, silting-up of rivers, depositions of sedi-
tion of the market. Externalities have two related ment in reservoirs and lakes, greater run-off of
causes: lack of individual property rights, and water and increased risk of flooding - i.e. there is
jointness in either production or consumption (see jointness in production.
Boadway and Bruce (1984)). Individual property The economic cause of this externality is less
rights are exercised over goods, services and fac- clear and, in general, the economic analysis of the
tors of production and allow markets to function over-grazing of land is a complex issue. The analy-
efficiently. With a complete set of individual prop- sis of the interests of farmers and the inhabitants
erty rights, all the effects of an action are con- of low-lying areas is considered first (hereafter
trolled by the market, since consumption of a referred to as the farmers and the inhabitants). In
good or service and use of a factor require pay- the next section, over-grazing in the context of just
ment to the owner. Beneficial or positive exter- the interests of farmers is examined. A simple
nalities are likely to be under-supplied by a market, model is developed that compares the interests of
and negative externalities are likely to be over- the farmers and the inhabitants (see Figure 9.3).
supplied. For an externality to continue to exist, The grazing of the land in the highlands- is of
it is usually presumed that jointness in either benefit to the farmers as a group, since it allows
production or consumption is involved. The idea the production of animals. Thus, the environmen-
of an externality is explained in the following tal degradation inherent in anything but low-level
example. grazing is of benefit to the farmers. This is rep-
It has been suggested that man-made environ- resented by a marginal benefit curve (MB) that is
mental degradation in the Nepalese highlands, assumed to be downward sloping. The marginal
especially over-grazing of land, has led to soil benefit is measured in dollars. The downward
erosion, reduced soil fertility, the transport of sedi- slope of this curve can be justified by grazing
ment that silts up rivers and the greater run-off of taking place on increasingly less productive land,
water. In particular, it has been argued that these the value of a marginal increase in output declin-
man-made effects have contributed to flooding in ing with increasing output and any environmental
the plains of Bangladesh and Northern India. 1 effects that bear on the farmers, e.g. soil erosion
This environmental degradation is caused by the and reduced soil fertility.
The environmental effects of grazing on the in-
1 There is a consensus on a human contribution to this environ- habitants are generally negative and are listed
mental degradation and flooding, but its extent is disputed: above. These effects give rise to a net cost for the
e.g. see Blaikie (1989); Environmental Resources Limited/
MacDonald Agricultural Services Limited (1989); and Pearce inhabitants and this is represented by an upward-
et al. (1990). sloping marginal cost curve (MC). These costs are
216 Planning, Resource Allocation, Development and Techniques
Figure 9.3 the case of the farmers owning the rights, the
inhabitants would have to pay the farmers to re-
$
strict environmental degradation. In reality, such
property rights are likely to be ill-defined, particu-
larly across national boundaries. It might be
expected that no market controls this environ-
mental degradation. Farmers are likely to continue
MC degrading the environment until the marginal
benefit to farmers of degradation is zero, point Z
in Figure 9.3.
This analysis is one of market failure. A conven-
tional reaction to market failure is to suggest the
intervention of the state to secure a more efficient
outcome. There are three feasible policies that
have been suggested as solutions to this type of
externality problem: Pigovian taxes and subsidies
(named after the famous Cambridge economist A.
C. Pigou); Coasian bargains (named after the
X Z Environmental Nobel-Prize-Winning economist Ronald Coase);
degradation and administrative action and legislation (see
Boadway and Wildasin (1984)). The Pigovian tax
measured in dollars. The upward slope can be solution imposes an environmental-use tax on the
justified by the difficulty the environment has farmers of the value of the marginal cost of de-
in withstanding high levels of environmental gradation at the point of the optimal outcome X.
degradation, but its resilience to low levels of This forces the farmers to take account of the costs
degradation. they impose on the inhabitants. This is· shown in
The neoclassical view is that there is an optimal Figure 9.4, where the farmers face a new marginal
level of environmental degradation at which the
marginal benefit is equal to the marginal cost,
point X in Figure 9.3. Whether this level of de- Figure 9.4
gradation is small or large depends on the shape of
the marginal benefit and cost functions. This con-
clusion considers environmental effects purely
$
from the point of view of efficiency. However, it
should be remembered that the outcome X may be
efficient, but if the costs imposed on the inhabi-
tants are relatively large, the implied distribution
MC
of welfare may not be desirable.
The operation of a market economy is unlikely MB' ~ MB- t
tragedy of the commons. However, Dasgupta has In a neoclassical model of the behaviour of
forcefully argued that there has been considerable individual economic agents with finite lives, the
confusion over the economic analysis of this discount rate is simply the market rate of interest.
problem. 1 The analysis is considered in terms of The level of the market rate of interest is the
the previous example of Nepalese farmers over- outcome of the preferences of individuals for pre-
grazing their cattle, buffalo, sheep and goats on sent consumption over future consumption and
land whose access is open to all - i.e. there is a the physical possibilities for transforming present
common property right. consumption into future consumption. Even with
The rational individual farmer will use common a set of perfect capital markets, the resulting inter-
land without regard to the cost this use imposes on temporal allocation of resources is unlikely to be
other farmers. This behaviour is a negative exter- socially efficient for a number of reasons.
nality and is inefficient. The costs imposed on First, the outcome of perfect capital markets
other farmers are soil erosion and exhaustion of reflects the preferences and actions of those pre-
the soil. Both these effects will decrease the future sently alive. All individuals will eventually die and
value of the resource to farmers. In this sense, the presumably value their own consumption more
problem of the commons is an intertemporal ex- highly than their descendants. This implies the
ternality. However, it is not the case that free open market outcome may underweight the· consump-
access to grazing land necessarily destroys the use- tion of future generations. It might be argued that
fulness of the land. The extent of over-grazing the state should decide upon a distribution of econ-
depends on the private costs of rearing animals, omic welfare over time that favours future gen-
their market value and the ability of the land to erations more. Alternatively, it has been argued
support large numbers of animals. However, that technical progress will increase future income
appropriate co-operative action by farmers to re- and fairness requires redistribution from future
duce over-grazing would increase the economic generations to the present. However, it is unclear
welfare of farmers as a group. In Nepal, a lot of how the state can easily decide which distribution
pasture land is owned by the government, but is should be preferred (see Boadway and Bruce
used as open access land. There is some evidence (1984)).
that protection of common land and co-operation Second, even with regard to the preferences of
amongst farmers has dramatically increased the the present generation, the market outcome may
productivity of land. be inefficient. The present generation may wish to
save for the benefit of future generations. This can
lead to two types of market failure called the
• The Discount Rate assurance problem and the isolation paradox (see
Sen (1967)). Both phenomena are examples of
Degradation of the environment reduces the externalities. The assurance problem concerns
supply of environmental services in the future. The saving by one individual for future generations
economic analysis of the environment requires a that benefits all other individuals in the present
means of comparing the benefits and costs of en- who place value on the consumption of future
vironmental effects in the present and the future. generations. Thus, the market aggregate level of
This comparison is usually made through a weight- saving is inefficient and the market rate of interest
ing device called the discount factor (see Chapter undervalues future consumption. Aggregate sav-
8). The practice of discounting environmental ing would be increased if individuals were assured
costs and benefits has caused much confusion and that their additional savings would be matched by
dispute. other altruistic individuals.
The isolation paradox concerns the value indi-
1 See the discussion of 'the problem of the commons' in Das- viduals place on the their descendants' consump-
gupta (1982). tion compared with that of the rest of future
Development and the Environment 219
tween the price and the marginal cost curve. If the restrict the use of the resource below the efficient
price represents the marginal social value of the level.
mineral and the marginal cost curve is the same as It has been pointed out by Kay and Mirrlees
that for the marginal social cost, then the two (1975) that, for reasonable discount rates, one
objectives are the same. would expect the optimal price to be close to mar-
The optimal depletion of a non-renewable re- ginal costs for most of the lifetime of a resource.
source over time can be analysed in a very similar
manner to the harvesting of a renewable resource.
Again the objective is taken as the maximisation of • Other Values
the social value of the stock over time. The de-
cision to extract a non-renewable resource is sim- It is a central tenet of neoclassical economics that
pler in that there is no marginal product of the prices should reflect the marginal costs of produc-
stock to consider. It is assumed that the extraction tion. In a competitive economy, prices may reflect
of the resource is costless. The resource should be private marginal costs, but there are a number of
further conserved if other types of social costs that should be taken
into consideration. First, the external costs im-
!:!..v posed on other individuals should be taken into
> r (9.3) account. 1
v
Second, the economic rent in the use of non-
Equation (9.3) has a simple interpretation. If the renewable resources should be included in social
relative appreciation of the social value of the re- marginal costs. As noted before, the economic rent
source is greater than the discount rate, then mole can be regarded as a premium that has to be paid
of the resource should be saved for the future. for the use of the resource in the present rather
than in the future.
For an efficient outcome, the social value of
marginal consumption should be increasing at the There are three other types of values that have
not yet been considered: option, quasi-option and
rate r. This implies (through integration) that v is
given by the function v o e't, where v o is the social existence values. An option value is the value
value at time zero. If a constant marginal cost of placed on an option that allows use to be made of
extraction (me) is introduced into the analysis, the the environment in the future. The option is not
necessarily taken up, but it gives value. An
efficient outcome gives a final equation (the V 0 has
to be redefined) example of an option value is biodiversity. Protec-
tion of species of animals and plants may be de-
v(t) = me +V e't (9.4) sired in order to allow possible future uses of these
0
species as inputs to production and because many
individuals may wish to have the opportunity of
Equation (9 .4) reflects the optimal depletion
path. It is possible for a perfect market to give this seeing these species in the future. Quasi-option
value is the value placed on an option given an
outcome. In this case, the optimal price path is
expectation that there will be increases in knowl-
given by
edge. For example, the value of certain plant
p(t) = me +r e't (9.5) species may depend on the development of knowl-
0
edge of new uses of the plants.
Existence value is the value placed on a good or
The r 0 ert term is referred to as the discounted
service independent of any actual or possible
rental premium. It can be interpreted as the social
cost of consuming the resource in the present 1 The remaining values could strictly be classified as private or
rather than in the future. external costs, but for tlte purpose of exposition tltey are separ-
As before, private monopoly ownership will ated out into separate categories.
222 Planning, Resource Allocation, Development and Techniques
future consumption. This value is different from about the importance of man-made and natural
the other types of values in that it is unrelated to determinants of flooding in Northern India and
use. An example of existence value is the concern Bangladesh. EIAs can rarely firmly establish the
expressed by many individuals for the preserva- type and extent of environmental effects of
tion of the tropical forests, even though they are projects. Thus, the introduction of previously un-
unlikely to ever see, at first hand, or use this re- considered environmental effects into economic
source. decision-making should take account of this un-
Thus, the total economic cost should be com- certainty.
posed of six components Once the environmental effects of a project
have been estimated, there are three approaches to
Social Cost = Private Cost placing economic values on the effects. 1 First, the
+ 1 External Cost basic valuation technique in social cost-benefit
+ Rental Premium (9.6) analysis is to use market prices. This is justified by
+ Option Value the neoclassical assumption that prices reflect the
+ Quasi-option Value value of goods and services. In the case of environ-
+ Existence Value mental effects in developing countries, markets
and prices may not exist for many of the effects
Efficient allocation requires the consideration of that require valuation. For large environmental
all six components of social costs. effects, the project may actually alter prices. In this
case, the changes in the values placed on environ-
I Measuring Environmental
Values
mental effects should be modelled. In practice, this
is often impossible.
The second approach calculates the value of
environmental effects indirectly through observed
The analysis of this chapter suggests that a market economic behaviour. Within this approach, there
economy will not value all aspects of the environ- are a number of different techniques. One is the
ment appropriately. This view is widely held and preventive expenditure technique which takes the
has led to much intellectual and practical effort expenditure that people are prepared to undertake
being applied to the problem of how to introduce to prevent degradation as a measure of the value
appropriate environmental values into economic of the environment effects. Another is the replace-
decision-making. The following discussion con- ment cost technique which estimates the expendi-
siders the introduction of environmental consider- ture people are prepared to undertake to restore
ations into social cost-benefit analysis and national the environment to its previous state after de-
income accounting. gradation has occurred. 2 These techniques can be
Appraisals of many investment projects in de- very similar. The full long-term consequences of
veloping countries now include Environmental environmental effects may not be understood. Not
Impact Assessments (EIAs) that estimate the en- all environmental effects can be fully offset by
vironmental effects of the projects. This should be preventive expenditure and the environment can-
the first stage of the introduction of the environ- not always be restored after degradation. Such
mental effects of a project into social cost-benefit problems may be particularly important for large
analysis. Often it is very difficult to assess a pro- changes in the environment, e.g. changes in the
ject's physical effects on the environment. For ecology of a large watershed and global warming.
example, models of the effects of emissions of
carbon dioxide on warming of the earth have
1 More precise details and discussion of economic valuation
given quite different predictions (see, for example,
can be found in Winpenny (1991) and Dixon eta/. (1988).
Dornbusch and Poterba (1991)). Another example 2 These expenditures and costs may be difficult to observe and
is the previously referred differences in views both techniques often use experts to estimate them.
Development and the Environment 223
The ability of the population to fund these ex- their valuation of the environment. There are two
penditures may be limited by imperfect capital ways in which this question can be asked. Indi-
markets. For these reasons, it is usually thought viduals can be asked either their willingness to pay
that the two techniques may underestimate en- for an environmental benefit or their willingness to
vironmental costs. accept compensation for a loss of environmental
In the absence of a market for an environmental quality. Standard economic theory implies that the
effect, it is sometimes possible to derive the value two questions should receive the same answer. In
placed on the effect by the prices paid for other practice, there are typically large differences in the
goods and services which implicitly value the valuations produced from willingness to pay and
effect. For example, property values vary with willingness to accept compensation surveys. The
location and this may in part reflect differences in questions in this approach are hypothetical - no
the environment. The method of hedonic prices payments are actually made. If respondents believe
can produce estimates of the contribution of dif- that they can affect the outcome of decisions by
ferences in the environment to the prices of prop- their answers, they may attempt to reply in a
erty. This can be used to give an estimate of the strategic manner. It is not always clear how to
implied value of certain environmental qualities. gross up the response from a survey to represent
In developing countries, there are often significant the general population's valuation of an environ-
imperfections in markets, e.g. rent controls, which mental effect. The responses of individuals may
affect the validity of the technique. The hedonic reflect the context of the survey question. Thus,
price method requires large amounts of data. It is for example, individuals could, with appropriate
often difficult to measure the environmental quality questions, be induced to respond as citizens con-
that is being considered. The importance of the cerned with the public interest rather than con-
environmental variable may not be properly sumers pursuing their own self-interest. 1
understood by individuals. These problems limit In Chapter 8, the importance in social cost-
the usefulness of this technique, particularly in benefit analysis of the distribution of costs and
developing countries. benefits was considered. There are many environ-
The human capital technique values environ- mental effects that imply major changes in the
mental effects by their effect on human health. distribution of economic welfare, e.g. the resettle-
This is measured in terms of lost economic pro- ment of an indigenous population following the
duction and increased health-care costs. The construction of a dam. The distribution of en-
effects of the environment on health are not vironmental benefits and costs can affect the de-
known with certainty. The technique does not sirability of a project. Simple social cost-benefit
value the ill health of the unproductive and the analysis is concerned with improving the efficiency
psychic costs of ill health. of economic decision-making. The prices used in
The travel cost method values the time and social cost-benefit analysis reflect the distribution
costs that people are willing to incur in travelling of welfare. If this distribution is unfair, the use of
to areas with more pleasant environments. Thus, the resulting prices may be inappropriate. The in-
the method gives an implied value of environ- troduction of distributional issues means that
mental quality. The formal assumptions of the value judgements have to be made explicitly.
model and its applicability to developing countries The valuation of environmental costs is essen-
have been criticised (see Winpenny (1991)). The tial to improving economic decision-making on
method implicitly considers the environment in the environment and social cost-benefit analysis
terms of provision of recreational services rather has developed various techniques to this end.
than basic life-support services. However, there remain theoretical and practical
The final approach to valuing environmental problems with the use of these techniques.
effects is that of contingent valuation. A subset of
the population is surveyed and is asked directly 1 See Sagoff (1988) for a discussion of this view.
224 Planning, Resource Allocation, Development and Techniques
• National Income Accounting direct one, they are not recorded in national in-
come accounts. Degradation also reduces the
The neoclassical approach to economic analysis productive potential of the environment, e.g. non-
assumes that consumption in its widest sense is, natural causes of soil erosion and reductions in the
and should be, the objective of economic activity. ability of the epvironment to absorb waste prod-
The ethical issues concerning whose consumption ucts. Reductions in the productive potential of
should be considered were examined in Chapter 6 the environment are examples of the depreciation
on population. The conventional approach is to of the stock of natural capital. These types of
measure economic welfare in terms of per capita changes are not recorded in national income
income. This approach has been widely criticised accounts.
and alternative measures have been proposed, The use of non-renewable resources, e.g. fossil
many of which emphasise the importance of fuels, is not allowed for in a correct manner in
accounting for the environment. national income accounts. These resources are
Measures of economic welfare have to be part of the natural capital of the environment.
judged in terms of their theoretical definition and Their use in the present reduces the supply avail-
their practical application. The most obvious able for future generations. National income
measure of current economic welfare is per capita accounts consider the use of non-renewable re-
current consumption (see Lecomber (1978)). Cur- sources as a simple productive activity. It should
rent consumption can be increased by reducing also be considered as a depreciation of natural
investment and, thus, future consumption. This capital. 1
suggests that economic welfare in one period There have been two responses to the failure of
should be defined relative to a fixed capital stock. national income measures to account for the en-
Thus, additions to capital stock, though not in- vironment. The first method follows Nordhaus
creasing current consumption, should be reflected and Tobin's calculations (1972) of measures of
in a measure of economic welfare as they allow economic welfare, that attempt to recalculate
increases in future consumption. This idea under- national income accounts allowing for environ-
lies the conventional definition of income (see mental effects. These calculations are speculative
Hicks (1946)). and omit various environmental effects. Nordhaus
There are many conceptual and practical prob- and Tobin estimated defensive expenditures and
lems in the definition of income (see Lecomber loss of certain environmental services to represent
(1978) and Anderson (1991)). Only those directly 23 per cent of American GNP in 1958. More
concerned with accounting for the environment important, these aspects of economic welfare were
are examined here. Environmental degradation estimated to have deteriorated substantially over
can be mitigated by the actions of economic the period 1929-65. A more recent study (Repetto
agents, e.g. soil erosion can be reduced by planting et al. (1989)) for Indonesia estimated an environ-
forests. In national income accounts, such defens- mentally adjusted annual economic growth rate of
ive expenditures are taken as giving rise to in- 4 per cent for the period 1971-84 compared with
creases in economic welfare rather than as the GOP growth rate of 7.1 per cent. The environ-
attempts to maintain the environment. It is com- mental adjustment allowed for various changes in
monly argued that these expenditures should be petroleum, forest and soil natural capital. Thus,
excluded from measures of economic welfare and allowing for the environment can give quite differ-
account be taken of the environmental effects that ent estimates of economic welfare and economic
give rise to these expenditures. growth.
Environmental degradation affects economic
1 In the case of renewable resources, a similar analysis applies,
welfare as individuals directly consume environ-
as regeneration can require time and investment and, thus,
mental services, e.g. unpolluted air. As there is not present consumption of renewable resources can impose costs
always a market in such services or only an in- on future generations.
Development and the Environment 225
Another method of accounting for the environ- sis. As previous examples have shown, there is
ment in economic growth is to construct physical, scientific dispute about many important environ-
rather than monetary, accounts of the environ- mental effects. In the analysis of environmental
ment. These accounts divide up the environment policies, it is possible to distinguish two approaches
into different sectors and estimate the changes that to managing this uncertainty.
have taken place over time. For example, the use First, the different possible outcomes of a policy
and discovery of mineral and energy resources are predicted. Then probabilities are estimated for
would be recorded. The quality of air would be these different outcomes, though these probabilities
represented by the levels of different types of air are necessarily subjective. It can be argued that the
pollution. Norway, France and, more recently and notion of estimating probabilities for events like
to a lesser extent, America and Canada have pro- global warmiqg is not appropriate, as they cannot
duced physical environmental accounts. be considered as repeated probabilistic events like
The two methods of accounting for the environ- the throwing of a die. Notwithstanding this, policy
ment are not substitutes. The monetary approach analysis could proceed by selecting the most pre-
first requires the calculation of physical accounts. ferred policy on the basis of the probabilities of the
Physical environmental accounts are useful for different outcomes of the policies. If society is
considering ecological and environmental issues. averse to taking risks, it can be shown that uncer-
Monetary environmental accounts are useful as tain costs should be given more weight than the
they reduce all effects to a common measure and expected value of costs and uncertain benefits
estimate a net figure for the use of the environ- should be given less weight than their expected
ment. However, because of the difficulty of doing value.
this, they have been criticised on theoretical and The alternative procedure is to select the mean
practical grounds. estimates of the effects of different environmental
policies. These estimates are then used to decide
the most preferred policy. This procedure is the
• Risk and Uncertainty more commonly used. The choice of the best esti-
mates is highly subjective. More important, this
Risk exists where there is doubt about the out- approach estimates only the expected effect and, in
come of the future and it is possible to estimate this sense, does not take account of either risk or
objective probabilities of the occurrence of the uncertainty.
different possible future outcomes. The outcome
of a throw of a dice is an example of risk. Uncer-
tainty exists where there is doubt about the out-
come of the future and it is not possible to estimate
objective probabilities of the occurrence of the
I Economic Growth and
the Environment
different possible future outcomes. The outcome
of a throw of a die is an example of risk. Uncer- Figure 9.2 indicates that the environment is essen-
tainty exists where there is doubt about the out- tial for economic activity and growth. It shows the
certain future events. It is difficult to analyse un- importance of the effects of economic growth on
certain events and most environmental analysis the environment. Environmentalists have argued
that considers risk and uncertainty assumes, either that unconstrained economic growth will lead to
explicitly or implicitly, that it is possible to esti- the exhaustion of non-renewable resources and to
mate probabilities with some degree of objectivity levels of environmental degradation that seriously
- i.e. the circumstances are assumed to be those of affect economic production and the quality and
risk rather than uncertainty. existence of life (see Meadows et al. (1972) and
Uncertainty about the relationship between the Forrester (1971)). Economists believing in the
environment and the economy complicates analy- effectiveness of the market have responded to these
226 Planning, Resource Allocation, Development and Techniques
arguments (see Beckerman (1974) and Nordhaus debates on the relationships between the environ-
and Samuelson (1977)). ment and the economy can be resolved through
If markets operate effectively, increased scarcity exhaustive scientific and economic investigation.
of non-renewable resources will increase their Economic and environmental policies have to be
prices. These higher prices give incentives for formulated and carried out on the basis of existing
changes in economic behaviour. Firstly, the direct uncertain and disputed evidence.
consumption of these resources may fall - e.g.
lower consumption of scarce fossil fuels. Secondly, • Sustainable Development
the use of higher priced non-renewable resources
in production will decline through substitution Much of the vast literature on the environment
towards techniques of production that are less and the economy could be interpreted as a re-
intensive in these inputs - e.g. production will sponse to the concern that present patterns of
become less fossil fuel intensive. Thirdly, there will economic growth may seriously degrade the en-
be incentives to search for new supplies of these vironment and may be unsustainable, as the en-
resources- e.g. the level of exploration for new oil vironment cannot support economic growth
fields will increase. Fourthly, higher prices will forever. This proposition may or may not be sub-
encourage the development of new technologies stantially true. At its heart lies the view that past
that provide substitutes for the scarce resources - and present economic policies have been usually
e.g. non-fossil fuels such as 'bio-mass' or wind concerned with providing the conditions for
power - or utilise it more efficiently - e.g. fuel equilibrium economic growth as measured by
efficient cars. Thus, efficient markets may provide standard national accounting methods. Many en-
a solution to the running down of non-renewable vironmentalists are concerned that these policies
resources. have not attempted to ensure 'the existence of
Supporters of economic growth argue that its ecological conditions necessary to support human
contribution to environmental pollution has been life at a specified level of well-being through future
overestimated. They suggest that economic growth, generations' (see Lele (1991)). This concern is of
particularly in developing countries, will release major importance in the concept of sustainable
more resources that can then be used to reduce development.
environmental degradation, e.g. improve water There is a wide range of definitions and inter-
supplies and reduce urban congestion. This view pretations of the meaning of sustainable develop-
of the existence of opportunities for simultaneous ment. The term first came to prominence in the
economic development and improvement in the World Conservation Strategy presented in 1980
environment is supported by the World Bank. by the International Union for the Conservation of
However, the pursuit of these twin goals is usually Nature and Natural Resources. It was popularised
assumed to require the state to intervene and im- by the World Commission on the Environment
prove the operation of markets with regard to the and Development's study Our Common Future
environment. (1987), which is also known as the Brundtland
A different, perhaps intermediate, view of the Report, named in honour of its chairperson, the
relationship between the economy and the en- Norwegian Prime Minister. These and other
vironment is of a trade-off between economic studies have defined sustainable development in
growth and environmental degradation. Thus, a different ways. The most frequently quoted defini-
society has to accept that higher levels of material tion comes from the latter study:
standard of living will result in lower levels of
environmental quality (see Figure 9.1). Sustainable development is development that
All the different views of economic growth and meets the needs of the present without com-
environmental degradation considered here are promising the ability of future generations to
likely to be true in part. It is unlikely that the meet their own needs.
Development and the Environment 22 7
This definition would appear uncontroversial and ing the stock of natural capital at least constant.
is remarkably similar to the neoclassical definition This condition attaches greater importance to the
of income. Hicks (1946) has given a frequently stock of natural capital than to man-made and
quoted definition of income: human capital. The neoclassical approach to
analysis of the environment cannot be used to
A person's income is what he can consume dur- justify such a distinction between types of capital.
ing the week and still be as well off at the end of It is important to consider possible justifications
the week as he was at the beginning. for this distinction and, in particular, with respect
to the use of non-renewable resources.
However, the interpretation differs in that Our The study of environmental values suggests
Common Future examined how sustainable de- three possible ways in which these values could be
velopment can be achieved. This inevitably re- generated. First, the preferences of individuals give
quires the making of value judgements that link rise to values that with a complete set of perfect
the positive definition and the operational objec- markets are reflected in the prices of goods and
tives that it was suggested will result in the attain- services. This is the neoclassical approach to
ment of sustainable development. For this reason, valuation and examples of market failure have
there has been criticism of the connection between already been examined. Market failures suggest
the definition and the operational objectives. The that the environment will not be adequately
objectives are increasing economic growth, meet- accounted for in the operation of market economies.
ing basic needs, involving more of the population The second source of environmental values is
in development, controlling population growth, con- that of social preferences. Sago££ (1988) has sug-
serving and improving the environment, accounting gested that individuals are capable of considering
for the environment in economic decision-making, issues, in particular those concerning the environ-
changing technology, managing risk and changing ment, from the point of society. It is not clear how
international economic relationships. such values could be established in the psyche of
The concept of sustainable development has individuals. A possible explanation is a sociobiolo-
gained very wide acceptance and has become a gical one in that individuals behave as social organ-
standard model for thinking about the environ- isms for the benefit of the species (see Dawkins
ment, development and the economy. However, as (1976)). Environmental choices are so complex that
suggested above, what the concept of sustainable even if social preferences exist it is difficult to assume
development should imply for economic and en- that, apart from in a tautological sense, they will
vironmental policies is disputed (see, for example, result in decisions that improve social welfare.
Redclift (1987)). In particular, the concern for However, it has been suggested that the poor in
equity between and within generations is central developing countries are the most dependent on the
to most interpretations of the concept, but it is environment. Thus, if social preferences are to give
unclear how the welfare of individuals can be weight to the circumstances of the poor, the environ-
compared. This is a central problem in neoclassi- ment should be given greater weight than would
cal economics and the concept of sustainable de- occur from simple aggregation of the individual
velopment does not appear to provide a solution values placed on the environment.
to the problem. The third source of environmental values fol-
lows from the belief that ecological systems have
intrinsic value independent of any value placed on
• Natural Capital and Equity them by humans (see Norton (1987)). The indi-
vidual preferences basis for values considers only
In many definitions, sustainable development can humans to have rights. The ecological view rep-
only be achieved if the environment is conserved resents the extension of rights to other species.
and improved. This could be interpreted as keep- How these rights can be measured does not appear
228 Planning, Resource Allocation, Development and Techniques
to have been addressed. The ecological values view As discussed previously, uncertainty is crucial
suggests that greater weight should be attached to to the analysis of the relation between the environ-
the environment than would be given by taking ment and the economy. A possible policy response
social values or simple aggregation of individual to such uncertainty is to adopt policies that pro-
values. vide insurance against possibly disastrous future
Preserving or increasing the stock of natural outcomes. This risk-averse strategy of emphasising
capital has important effects on intergenerational the worst possible outcome might be justified by,
equity. If it is believed that present levels of en- say, the worst forecasts of the disastrous outcomes
vironmental degradation and resource use will of global warming. This argument supports the
substantially alter future human economic wel- setting of a constraint that keeps the stock of
fare, then intergenerational equity may be im- natural capital fixed. Alternatively, it has been
proved by the constraint that the stock of natural argued that the vast expenditure necessary to re-
capital be preserved. However, the substitution of duce global warming, the long period before such
this constraint by a more flexible approach that effects become important and the lack of absol-
allows some use of natural capital could conceiv- utely clear scientific proof of the size of these
ably increase economic welfare measured across effects suggest that a conservative approach ought
all present and future generations. to be adopted. It is unclear how uncertainty
The use of a positive discount rate weights fu- should be included in environmental decision-
ture environmental effects less heavily than those making, but it is clear that the treatment of uncer-
occurring in the present. This has been criticised as tainty has a very important effect on the actual
underestimating the importance of environmental decisions that have been or will be taken.
degradation and resource use. This criticism is The concept of sustainable development attaches
misplaced. If the arguments are accepted for the a special importance to natural capital. This dis-
social preference of the present compared to the tinction between natural and man-made and hu-
future, then discounting is appropriate. If it is felt man capital has been criticised. It is possible to
that too little weight is being attached to future substitute between the forms of capital and many
environmental effects, their estimated values should environmental policies rely on this substitutability.
be adjusted, but not the discount rate. For example, the use of fossil fuels can be reduced
Many environmental effects are irreversible, through energy conservation measures such as
e.g. the extinction of a species. Irreversibility has greater thermal insulation of buildings and ther-
been used as an argument for maintaining the mostatically controlled heating systems. A poss-
natural capital stock. However, the dislike of ible justification of a special role for natural capital
irreversible losses in natural capital can be cap- in development is the argument that past econ-
tured by the concept of option, quasi-option and omic growth has resulted in the accumulation of
existence values. man-made capital at the expense of natural capi-
The resilience of an ecosystem is its ability to tal. This use of natural capital occurred because it
return to its normal state after an external disturb- was undervalued by markets and the complex
ance. It has been suggested that the larger the functions of the environment were not, or poorly,
stock of natural capital, the more resilient an understood (see Pearce et al. (1990) and Panting
ecosystem is likely to be. This argument is justified (1991)).
on the basis of the idea that diversity of the ecosys- All these arguments suggest placing a higher
tem increases its resilience. However, the notion value on the environment than the operation of a
of resilience and the related concept of stab- market economy would give. Strictly, this is not
ility have been criticised, as no ecosystem is likely the same as suggesting that the stock of natural
to be globally stable and constant through time. capital should be maintained. However, the com-
This implies that the size of the external disturb- plexity of decision-making on the environment
ance is important (see Norton (1987)). might require a very approximate constraint on
Development and the Environment 229
the use of environment such as preservmg the types of natural capital, e.g. the ozone layer.
stock of natural capital. If the view is taken that the environment must
This critical discussion of the concept of be preserved, then social cost-benefit analysis of a
sustainable development suggests that the environ- project should be carried out subject to the ad-
ment has an important role in economic develop- ditional constraint that the net effects on the en-
ment and this may not have been fully understood vironment are zero or positive. The strength of this
in the past. The concept of sustainable develop- additional constraint can be weakened by adding
ment has won many academic and political adher- environmentally friendly investments to the pro-
ents. However, there are differences in opinion ject that allow the constraint to be met. If it is
whether natural capital deserves special protection considered necessary to preserve the different types
in economic development or whether it can be of natural stock, then there must be an additional
traded off against man-made and human capital. 1 constraint for each type of natural capital.
These differences are important in determin- The constraint of preservation of all aspects of
ing how the environment enters into economic the environment implies that national income
decision-making. accounting methods cannot be altered to allow the
There are also practical difficulties with the im- calculation of one measure of economic welfare
plementation of a constraint that keeps the stock that includes environmental effects. Thus, it has
of natural capital fixed. The environment is made been suggested that measures of economic welfare
up of many different resources and services. Con- be presented alongside a set of indicators of the
stancy of the stock of natural capital could be state of the environment.
interpreted as constancy of all types of natural The less restrictive interpretation of the concept
capital. This interpretation implies that any posi- of sustainable development allows the simple in-
tive use of non-renewable resources would not be clusion of the environment in social cost-benefit
compatible with sustainable development and is analysis and national income accounting. The in-
difficult to justify. clusion of the environment simply requires the
The alternative interpretation is to consider a correct valuation of environmental effects.
single measure of natural capital that appropri-
ately weights the different types of natural capital.
The obvious weights are the social values of the
types of natural capital. These values may not only
I Economic Thought
and the Environment2
reflect the ideas considered in equation (9 .6) but
the distributional views that are often associated Classical economists such as Malthus, Ricardo
with the idea of sustainable development. How- and Mill were generally pessimistic about the
ever, placing values on the different types of natu- possibility of continued economic progress. 3 These
ral capital would appear to deny the special role of economists assumed that there was diminishing
such capital. If natural capital can be valued so as returns to factors of production and the supply of
to give a single measure, this implies that it can be land was fixed. The growth in population and,
traded off against man-made and human capital thus, the labour force would lead to reductions in
and requires no special protection in the process of the marginal product of labour and declining aver-
development. age product of labour. Malthus and Ricardo
It may be the case that a single measure of most assumed a constant technology, with the inevit-
types of natural capital would be desirable with able result that average agricultural production
individual measures for the remaining and crucial per unit of labour would decline. Mill considered
1 For an example of the former view, see Pearce et al. (1990) 2 See Barbier (1989) for a good survey of economic thought on
and, for examples of the latter view, see World Bank (1992) the environment and development.
and Winpenny (1991). 3 See Malthus (1798), Ricardo (1817) and Mill (1856).
230 Planning, Resource Allocation, Development and Techniques
ary 1992.
Development and the Environment 231
The United Nations have been responsible for resources from rich to poor countries. One of the
the two reports, World Conservation Strategy and underlying assumptions of the concept of sustain-
Our Common Future, which have greatly in- able development is that poverty is an important
fluenced world opinion in favour of sustainable cause of environmental degradation. Lack of econ-
development. The United Nations' Development omic development in poor countries is likely to
Programme and the World Bank set up the Global lead to more environmental degradation.
Environment Facility in 1990. The purpose of this
fund is to subsidise projects in developing coun-
tries that protect the global environment. The fund
focuses on four areas: global warming; destruc-
I Questions for Discussion
and Review
tion of the ozone layer; pollution of international
waters; and reductions in biodiversity. The fund is 1. What are the functions of the environment in
financed by contributions from developed and de- supporting economic activity?
veloping countries to the extent of $3-4 billion. 2. What is an externality and why are externali-
The UN Conference on Environment and De- ties considered to be a problem?
velopment in June 1992 - the Earth Summit - 3. What are the different possible solutions to
reached agreements on various issues. A treaty to externalities?
avoid global warming was signed by 110 countries 4. Explain the causes of 'the tragedy of the
(but not the United States), most of which agreed commons'.
to limit atmospheric emissions in the year 2000 to 5. Why might perfect capital markets not give a
their 1990 levels. An agreement to protect plants socially efficient allocation of resources be-
and animals was signed, but not by the United tween generations?
States. A convention to reduce desertification was 6. What conditions determine the efficient use of
agreed. Many other issues were discussed and renewable and non-renewable resources?
Agenda 21 was written that lays down guidelines 7. What are the different types of values that
for environmentally sound development. The suc- should be included in social costs?
cess of many of the agreements and guidelines 8. How might one adjust for environmental
depends on the availability of funding to finance effects in social cost-benefit analysis and
appropriate development and monitoring. of the national income accounting practices?
development policies of individual governments. 9. Define and explain the idea of sustainable de-
The major omission from the treaties and guide- velopment.
lines at the Earth Summit was any commitment to 10. What are the arguments for and against keep-
increase aid, reduce debt and fundamentally shift ing the stock of natural capital fixed?
II Chapter 10 II
The Choice of Techniques
232
The Choice of Techniques 233
better or worse than local firms. On the first ques- and to raise the level of employment. In the choice
tion, the technologies used by multinationals are of new techniques, a conflict between objectives
unlikely to be very flexible because the companies may arise. First, a technique which maximises em-
tend to predominate in modern industries where ployment may involve a sacrifice of output.
processes are complex and continuous and, by Secondly, a technique which maximises employ-
their very nature, capital intensive. Outside pro- ment may involve a sacrifice of saving. As we have
cessing, however, ancillary activities such as the mentioned already, certainly one of the justifica-
handling of materials and packaging, may be tions for the use of modern capital-intensive tech-
amenable to substitution. On the second issue, it is nology used to be that labour-intensive techniques
unlikely that multinationals will undertake major, would reduce output and the investible surplus.
expensive alterations to technology simply to suit We need to look at this matter theoretically and
local conditions, and there is not much evidence empirically. We shall argue that while in theory
that they do so. On the third matter, however, in there may be a conflict, the assumptions on which
comparison with local firms, the experience of the a potential conflict is based are either invalid or
multinationals seems to be very mixed. The prob- too extreme, and that in practice developing coun-
lem here is that in making comparisons, like must tries could move towards the use of more labour-
be compared with like; that is, local and foreign intensive techniques without sacrificing the level of
firms must be compared in the same market, pro- present or future consumption. Some of the empiri-
ducing similar products with equal access to tech- cal evidence would seem to bear this out.
nology. Studies must therefore be treated with
caution. It is easy to reach the conclusion that
multinationals are more capital intensive than lo- • Employment vs Output
cal firms if they operate in different industries pro-
ducing different products. This, in fact, is often the A potential conflict between employment and out-
case; being concentrated in activities which are in- put exists in the choice of new techniques because
trinsically more capital intensive such as heavy in- methods which employ high labour-capital ratios
dustries and extractive industries. We shall have may involve high capital-output ratios because
more to say about the empirical evidence below and labour productivity is lower. 1 We may use again
more to say about multinational corporations when the illustration given in Chapter 7 (p. 181).
we consider the role of private foreign investment in Assume a fixed amount of capital, £1000, to be
the development process in Chapter 14. invested. Technique I employs 100 men with an
We turn now, however, to consider the poten- incremental capital-output ratio of 5 giving an
tial conflict between moving towards the use of annual flow of output of £200. Technique II em-
more labour-intensive techniques of production ploys 50 men with an incremental capital-output
and output on the one hand and saving on the ratio of 4 giving an annual flow of output of £250.
other. Therefore, the technique which maximises em-
I
ployment has a lower flow of current output.
It can be said straight away that there is very
The Conflict Between little evidence, if any, to support the view that
Employment and Output labour-intensive techniques have higher capital-
output ratios than capital-intensive techniques.
and Employment and Saving On the contrary, there is growing evidence that
in the Choice of Techniques
1 The capital-output ratio (K/0) may be expressed as the prod-
Developing countries have three broad objectives: uct of the capital-labour ratio and labour requirements per
unit of output i.e. K/0 = KIL • L/0. Techniques with a low
to raise the level of present consumption; to raise KIL may nonetheless have a high K/0 because L/0 is high, i.e.
the level of future consumption (by saving now), the productivity of labour is low.
236 Planning, Resource Allocation, Development and Techniques
(K/L); = [ (W/r); ] o
(KIL)i (Wlr)i
} India 400
Bicycles 0.24
Japan 520
} Japan 280
Grain milling 3.7
Israel 6 410
} India 214
Paints 1.6
Middle Europe 2 790
} Iran 6 240
Tyres 1.5
Mexico 10 600
} India 1100
Cotton textiles 2.0
Mexico 8 240
} India 260
Woolen textiles 1.2
Japan 4 600
The Choice of Techniques 237
Table 10.2 Fixed Investment and Employment Associated with Capital-Intensive and Appropriate Technologies
Shoes 300 000 pairs 334 155 2.2 165 218 0.8
Cotton weaving 40 000 000 square yards 9 779 260 37.6 4 715 544 8.7
Cotton spinning 2 000 tons 1440 98 14.7 480 240 2.0
Brickmaking 16 000 000 bricks 3 437 75 45.8 796 238 3.3
Maize milling 36 000 tons 613 63 9.7 219 96 2.9
Sugar processing 50 000 tons 6 386 1 030 6.2 3 882 4 986 0.8
Beer brewing 200 000 hectolitres 4 512 246 18.3 2 809 233 12.1
Leather processing 600 000 hides 6 692 185 36.2 4 832 311 15.5
Fertilizer 528 000 tons of urea 34132 248 137.6 29 597 242 122.3
rece1vmg, material handling among processes, of techniques and has worked out the aggregative
packaging and storage of the finished products. In effects on employment, wage income, non-wage
fact, many auxiliary activities are already very income and value-added of $100 million invest-
labour-intensive, and contrary to the conventional ment in each sector, using the most capital-
wisdom it was found that foreign-owned firms intensive technique, and the most appropriate
generally used more labour-intensive techniques technology defined as that which yields the highest
than indigenous firms. Pack ascribes this to the present discounted value per unit of capital (Pack
better managerial expertise and technical training (1982)). The results are very revealing, although
of personnel in foreign firms. Forsyth and Solo- Pack pinpoints many obstacles to the adoption of
mon (1977) in their study of Ghana also find scope more labour intensive technology. The industrial
for capital-labour substitution and find no over- sectors taken are shown Table 10.2, which gives
whelming evidence that foreign firms are more data on investment and employment in relation to
capital intensive than resident expatriate or pri- output for the two technologies compared. For
vate indigenous firms. The situation varies from most sectors there are wide differences in the
industry to industry. Helleiner (1975) concludes capital-output ratio and the capital-labour ratio.
his survey of multinational corporations and tech- To derive the aggregative implications of factor
nological choice by saying: 'In particular indus- substitution each sector is assumed to have in-
trial sectors, the multinational firm has often proven vested $100 million, either on the most capital
more responsive and adaptable in its factor and intensive process, or on the most appropriate tech-
input use, especially in the ancillary activities nology, from which employment, wage income
associated with the basic production processes, (assuming an annual average wage of $500 per
than local firms, and so it perhaps should be with worker), non-labour income and value-added can
its wide range of experience on which to draw.' be calculated for the two technologies. The results
are shown in Table 10.3.
I Aggregative Implications of
Factor Substitution
Focusing on the aggregate totals, it can be seen
that value-added on the appropriate technology is
nearly twice as high as on the most capital inten-
sive technology, and that the aggregate level of
Pack has taken nine industrial sectors from the employment is four times higher. Note also that
studies of others which have examined the choice while labour's share of value-added is higher on
238 Planning, Resource Allocation, Development and Techniques
Table 10.3 Annual Employment, Wage and Non-Labour Income, and Value-Added Under Alternative
Technologies
the more labour intensive technology, and the Even if more labour-intensive techniques can be
share of profits is lower, the absolute level of non- used without a sacrifice of output, there is still the
labour income is higher. There is no clash between question of whether the investible surplus, and
employment and output, or employment and the therefore future output, will be impaired. The
reinvestible surplus. However, value-added per work of Pack suggests otherwise, but let us turn to
worker on the more labour-intensive techniques is consider in more detail the potential conflict be-
less than half the level on the most capital- tween employment and saving, as the traditional
intensive techniques. What is also clear from the argument has it.
table is that there are large differences between
sectors in the capital-labour ratio using more
appropriate technology, so that the actual sectoral • Employment vs Saving
composition of investment will affect the aggregate
calculations of employment effects. To increase em- The potential conflict between employment and
ployment, therefore, it is possible to exploit the saving can be illustrated in its starkest form using
scope for factor substitution between sectors as a simple production function diagram first used in
well as within sectors. The obstacles identified by this context by Dobb (1955) and Sen (1968).
Pack to the adoption of more labour-intensive Consider the use of a given amount of investible
technology include: the costs of information; the resources OK and the possibility of employing
problems associated with the use of second-hand those resources with varying amounts of labour to
machinery; the fact that technical change may be produce output. 00 is the production function in
slowed down, and the shortages of skilled man- the consumption sector exhibiting diminishing re-
power. Pack shows high benefit-cost ratios to turns to labour. Now take the standard traditional
training in skills, and to overcome the problems (though not necessarily correct!) assumption that
arising from the adoption of more labour- in the industrial sector labour is paid a fixed wage
intensive technologies he suggests an industrial ex- which is all consumed so that a ray from the origin
tension service equivalent to the extension services (OC) with a constant slope (w) shows the level of
commonly available for the agricultural sector in the wage bill and consumption at each level of
developing countries. employment. The difference between 00 and OC
The Choice of Techniques 239
and the savings function as: The potential clash between increasing employ-
ment and maximising saving, represented by the
S = aL- bL2 - wL (10.2) difference between L, and Lin Figure 10.4, can be
seen, however, to be based on several assump-
the level of employment which maximises saving is tions, the validity of which may be questioned.
obtained by differentiating equation (10.2) with These assumptions are: (i) That the wage rate is
respect to L and setting equal to zero which gives: given and invariant with respect to the technique
of production. This assumption would seem to be
-
as = a - 2bL - w = 0 (10.3)
a hangover from Lewis's influential model of the
CJL development process (discussed in Chapter 3)
which assumes an elastic supply of labour to the
Therefore the level of employment which maxi- industrial sector at a constant wage. If this wage is
. . .
mtses savmg Is: above the minimum necessary, however, several
a- w implications follow. (ii) That all profits are saved
L =-- and all wages are consumed. (iii) That employ-
2b (10.4)
ment which results from the use of capital-
and the level of employment which maximises out- intensive techniques does not reduce community
put is: saving to the level of saving that would prevail
with more employment and a higher wage bill. (iv)
a That consumption is not productive (i.e. has no
L,
2b (10.5) investment component), or that present consump-
240 Planning, Resource Allocation, Development and Techniques
tion is no more productive than future consump- surplus increases the greater the volume of
tion. (v) That governments lack the ability to tax employment.
and to subsidise labour to reconcile the potential This is obvious since under these conditions the
conflict. surplus on intramarginal units of labour increases.
Let us relax these assumptions and see what The formal proof is as follows. From the produc-
difference is made. tion function in equation (10.1) the marginal prod-
uct of labour is (a - 2bL). Setting the wage equal
S = aL - bU - (a - 2bL)L (10.6)
Let us first relax the assumption that the wage rate
is given and the same for all techniques, regardless Partially differentiating equation (10.6) with re-
of the capital intensity. There are two fundamental spect to L gives:
points to be made here in the context of a develop-
ing country. The first is that a great deal of the -
as = 2bL > 0 (10.7)
technology, at least in the modern industrial sec- aL
tor, is not indigenous but imported from abroad.
In this case the wage structure is set by the skill Thus there is no conflict between saving and em-
mix demanded by the technology and the need to ployment at positive levels of employment if the
keep the labour force well nourished and con- wage rate equals the marginal product of labour,
tented if the capital equipment is to be worked both of which fall with the labour intensity of
productively and profitably. By and large it may be production.
expected that the greater the degree of capital We need not assume that the wage is equal to
intensity the higher the average wage paid. The the marginal product of labour. We can simply
second point is that with large amounts of dis- assume that the wage falls with the labour intensi-
guised and open unemployment in the urban ty of techniques, i.e. w = f(L), where f' < 0. Now
sector of developing countries there is likely to be rewrite the savings function as:
a big difference between the wage that is being
paid with the use of existing technology (imported S = aL - bU - f(L)L (10.8)
or indigenous) and the wage at which labour
would be willing to work given the opportunity differentiate with respect to L, and set equal to
with the use of more labour-intensive technology. zero:
If more labour-intensive technology could be de-
veloped and applied there is no reason why the
_E_§_ =a - 2bL - [f'(L)L + f(L)] = 0 (10.9)
wage rate should not be lower with the use of aL
these techniques unless there is strong trade union
resistance in certain sectors. The employment level which maximises saving is
If the wage is not assumed to be given but may now:
vary with the technique of production for the
reasons outlined above, the conclusion of a con- a- f(L)
L* (10.10)
flict between employment and saving in the choice 2b + f'(L)
of new techniques is affected considerably. Indeed
on the assumption that the marginal product of Since f' (L) < 0, L * > L, and the conflict between
labour declines with the labour intensity of pro- employment generation and savings maximisation
duction, and that the wage is equal to the mar- is narrowed. (Compare equation (10.4) with
ginal product, the conflict disappears entirely. The (10.10).)
The Choice of Techniques 241
Some care must be taken, however, over the inequality, may worsen the foreign exchange posi-
form of taxation. For example, if the wage is fixed tion, and in general produces a distorted economy,
in real terms, indirect taxes which raise prices will increasing the dependence of developing countries
reduce the real wage, and the money wage will on developed countries at the same time.
have to rise to compensate. Since the money wage There is now a strong movement throughout
is the cost to the employer, subsidies would then the developing countries which supports the cre-
have to be increased. The imposition of indirect ation of an intermediate technology using more
taxes to finance subsidies may lead to a spiral of labour per unit of capital and less foreign inputs.
increased taxation, inflation and subsidisation. What is required is a whole spectrum of tech-
Direct taxes on workers' incomes may also be niques to suit different circumstances, from which
counterproductive if workers bid for money-wage developing countries can choose. For this to trans-
increases to maintain disposable income. The only pire, developing countries need to encourage the
feasible taxes to finance subsidies may be on ex- establishment of their own capital goods indus-
ports or luxury consumption goods which do not tries; and more research and development is required
affect the real income of the broad mass of the both within, and on behalf of, poor countries. An
working class. While theoretically, therefore, a international technology bank would be a useful
policy of labour subsidisation financed by taxation starting point giving countries access to techno-
may reconcile the conflict between employment logical blue-prints from different sources.
and saving, it may run into a number of practical The capital intensity of production is also a
difficulties. function of the composition of output. There are
All of the factors discussed that may lead to an often many ways of meeting a given need, some of
increase in the labour intensity of production with- which may be more labour intensive than others.
out impairing the investible surplus may either be Where this is so, such as in the fields of transport,
thought of as additive, or any one of them by itself nutrition, housing, etc., serious consideration should
may be powerful enough to push employment be given to the most labour-intensive way of meet-
close to L 1 in Figure 10.4 without loss of saving or ing such needs, consistent with other objectives.
its benefits. Finally, the location of activity needs consider-
ing. Whatever technology is applied in the modern
sector, it will have implications for the rural sector
• Conclusion which will rebound on the modern sector. We saw
in Chapter 3 that the creation of more modern
It has become part of the conventional wisdom, sector jobs may encourage more migrants than the
and there may be a good deal of truth in the number of jobs created, thus increasing urban
assertion, that a major cause of the growth of unemployment. This would seem to call for the
urban unemployment in developing countries lies location of new labour intensive industries in the
in the application of 'inappropriate' techniques of rural sector, to curb the flow of migrants and to
production because of the limited choice of tech- ease urban unemployment.
niques available both from within the countries To conclude our analysis we have seen that
and from outside. The choice is limited from with- there are many reasons for believing that the poten-
in owing to the absence of a domestic capital goods tial conflicts inherent in the choice of new tech-
sector, and it is limited from without because the niques between employment and saving on the one
techniques imported reflect the labour-saving bias hand, and between employment and output on the
of technical progress in the developed countries other, have been exaggerated, and that techniques
from which they come. The application of 'inap- can be more labour intensive without impairing
propriate' technology not only exacerbates un- the level of the investible surplus or the level of
employment, but perpetuates the dualistic struc- output. It is in the direction of more rural-based
ture of developing countries; increases income labour-intensive projects that development strat-
The Choice of Techniques 245
egy ought to move for maximisation of the general of capital intensity of production in the manu-
welfare. facturing sector of developing countries?
6. Outline how a change in the product mix
246
Input-Output Analysis 247
ible, as opposed to forecasting, which is con- construction of the input-output table itself re-
cerned with what one expects to happen on cording the relevant transactions. The second stage
the basis of a certain set of assumptions. In the involves the derivation of what are called input-
case of simulation there is no presumption output coefficients (or input coefficients, for short).
that the simulated changes in the economy are The third task is the inversion of the so-called
actually going to occur. If they are economi- Leontief matrix to obtain a general solution. The
cally feasible the changes could occur, but content of these stages, and the underlying as-
whether they do or do not may depend on a sumptions of input-output analysis, will become
variety of prior changes of an economic or clear as we examine the three stages in turn. We
institutional nature which may be outside the shall wait until the end, however, to spell out the
planner's control. Using an input-output table assumptions explicitly, and to discuss the short-
for simulation purposes requires first that the comings of input-output analysis for planning
feasible changes (e.g. new activities such as purposes.
import substitutes) be identified, and then that
the table be used to estimate the impact of the
changes on the rest of the economy. Again, • The Input-Output Table
with some manipulation, the inter-industry
transactions matrix can then be used for pro- The layout of a typical input-output table, and the
viding answers to such questions as: how will sectors and transactions distinguished, is shown in
the production requirements of the economy Table 11.1. The table is divided horizontally into a
be altered if a new steel mill is introduced; or processing and payments sector, and vertically to
what will be the repercussions on the economy distinguish between intermediate users of goods
if a series of import-saving schemes are in- and factors of production, and final users. Thus
troduced? the upper left-hand quadrant of the table records
3 To forecast import requirements and the inter-industry transactions; the lower left-hand
balance-of-payments effects of given changes quadrant gives the payments by industries to the
in final demand. factors of production and to foreigners for the
4 To forecast labour requirements consistent purchase of imports; the upper right-hand quad-
with a given growth target. rant gives the final demand for goods and services
5 To forecast investment requirements consist- produced (including exports), and the lower
ent with a given growth target if information right-hand quadrant gives the direct sales of fac-
is available on incremental capital-output ra- tors of production and imports to final users, e.g.
tios sector by sector. the private consumption sector buys domestic
6 To calculate the matrix multiplier attached to help, and the government sector 'consumes' civil
different activities; that is, the direct and in- servants!
direct effects on the total output of all activi- The notation used in the table to denote the
ties in the system from a unit change in the various transactions should be easy to follow.
demand for the output of any one activity. Take first the processing sector. The Xs stand for
7 To show the strength of linkages between the value of output, and the two subscripts denote
activities in an economy. the origin of the output and its destination,
8 To portray the technology of an economy. respectively. Generalising, X;; denotes sales by indus-
try i to industry j or inputs into industry j from
Three major stages must be gone through be- industry i, where i = 1, ... , n, and j = 1, ... , n.
fore knowledge of input-output relations can be The disposal of outputs to final users can be repre-
put to practical uses in the planning field in the sented in exactly the same way.
manner described above. The first step must be the In the payments sector, the subscript simply refers
248 Planning, Resource Allocation, Development and Techniques
Private Government
Sales Industries (C) (G)
by
1 2 3 j n
p Wages wl w2 w3 W; wn We WG w
A
y
Rent Rt Rz R3 R; Rn Re RG R
M
E
N Interest Dt D2 D, D; Dn De DG D
T
s Profits pl p2 P, P; pn Pe PG p
Imports Mt Mz M3 M; Mn Me MG MI ME M
Total supply xl x2 x3 X; xn c G I E
to the industry or final demand sector making the inputs bought by the different industries.
factor payment, and the same for imports. In the intermediate sector, the sum of the
We see, then, that in the processing half of the columns gives the value of the total output of each
table each row shows how the output of each industry, i.e. the sum of the value of inputs in
industry is disposed of, and each column shows the processing half plus the sum of value-added in
the origins of inputs into each sector. The sum of the payments half plus imported inputs. Thus the
each row gives the total demand for each indus- columns in the intermediate sector and the rows in
try's output. the processing sector both add up to the total
In the payments half of the table, the sum of value of domestic production. Let us demonstrate
each row gives the value of the various factor this proposition using the notation of our table.
payments, and the sum of each column in the Call industry (1) the coal industry. The (domestic)
bottom left-hand quadrant gives the total value- output of coal must equal all its intermediate uses
added (in the form of factor payments) to the X w ... , Xw plus all its final uses. We thus have a
Input-Output Analysis 249
row for the coal industry of the form: Equation (11.3) for all industries, i = 1, ... , n,
n becomes a system of n simultaneous equations in n
x1 = L x1j + Xtc + xlG unknown variables which can be solved if certain
j- 1
conditions are satisfied. The technique is to specify
(11.1)
the final demands for each industry, i, and then to
determine the X;s from the new values of the input
But the (domestic) output of coal must also equal
requirements, which give both the direct and in-
the value of inputs into the coal industry plus the
direct requirements from each industry.
value added to those inputs by employing factors
In specifying the final demands for each indus-
of production to work on them plus imports. We
try, one obtains from equation (11.3) the follow-
thus have a column for the coal industry of the
ing set of relations for each industry:
form:
n
n
X;- L a;iXi = Y; i = 1, ... , n (11.4)
i = 1
i- 1
I
With two industries the equations of type (11.4)
become: A Digression on Matrix
Xl - allXl - a12X2 = yl Inversion
(11.6)
X2 - a21X1 - a22X2 = Y2 The inverse of a matrix, Z, is another matrix B
which when multiplied by Z gives the identity
Or in matrix form: matrix I. This corresponds to the inversion of real
numbers in ordinary algebra where b is the inverse
of a if ab = 1. Similarly in matrix algebra, B is the
inverse of Z if ZB = I. Thus the identity matrix in
matrix algebra plays a similar role to the number 1
The system in equation (11.7) may also be written in ordinary algebra. Hence B is the inverse of Z
as: if:
[I 1 0]-[all. a121
0 1 a21 a22
[Xl]=[Yl
x2 y2
I( 1 1.8) b121 =
b22
11
01 (11.11)
0 1
principal diagonal and zeros everywhere else. The importance product of the elements of the principal diagonal
of the identity matrix in matrix algebra is discussed below. in the Z matrix minus the product of the other
Input-Output Analysis 251
diagonal. This is called the determinant of the and similarly for matrices of higher dimensions.
matrix. The adjoint of Z is defined as the transpose of
In the language of matrix algebra the inverse of all the co-factors of the matrix. The co-factor of an
a matrix is the adjoint of the matrix divided by the element is that element's minor with the appropri-
determinant, i.e. ate sign attached. If the sum of the subscripts (ij) of
the minor is an even number (e.g. M 11 ) the co-
z-t = 121" adjoint z
1 factor will have a positive sign. If the sum of the
(11.12)
subscripts is an odd number (e.g. M 12), the co-
factor will have a negative sign. In the 2 X 2 case
where II denotes determinant. In general (for a the minors of the matrix Z will be:
square matrix of any dimension) we can write the
determinant as:
deleting the first row and first column of the Z Now the transpose of a matrix Cis another matrix
matrix. Thus M 11 of Z is z22 • Similarly, M 12 of
I 1 I 1
C', with the rows and columns interchanged.
Z is Z21 • Hence:
It follows from equation (11.13) in the 2 X 2
case that: C' (11.15)
X -z121 (11.16)
Zu
= Zu (z22Z33 - Z32ZzJ
- Z 12 (ZztZ33 - Zz3Z31)
252 Planning, Resource Allocation, Development and Techniques
0.1
Steel
0.4
possible to obtain a general solution to the simul- Steel 0.3 0.2
taneous equation system of n unknown outputs
(the Xs). From what we have said above about
matrix inversion, (I - At 1 is some matrix which tries listed at the top of the columns. For example,
we can call B, which when multiplied by I - A the matrix multiplier attached to industry 1 is
gives the identity matrix I. We now have: b 11 + b21 • The matrix multiplier is a useful concept
in planning because it gives a measure of the
X= BY (11.17) impact of the expansion of one activity on the level
of output of all other activities in the system. It is
In other words, each industry's output is equal to possible to identify, therefore, which activities
the sum of the elements of the final demand matrix may give the greatest stimulus to others through
Y (which is a column vector n X 1) times the the linkages in the system.
coefficients of the inverse of the matrix (I - A). In Now let us consider a simple arithmetical ex-
the 2 X 2 case: ample. Suppose that the direct input-output coef-
ficients (the a;;s) for the steel and coal industries of
(11.18) a country are as given in Table 11.2. We wish to
show what the output of coal and steel must be to
satisfy certain final demands for steel and coal.
This is exactly what is stated in equation form in
(11.5). By matrix multiplication:
X 1 = h11 Y1 + h12 Y2
A = I
0.1
0.3
0.41
0.2
x2 = hz!Y! + hz2Y2 I- A
In summary notation:
n
0.9
X; = L b;;Y; (i = 1, ... n) (11.19) -0.41
i- I -0.3 0.8
and for changes in Ys: By matrix inversion to derive the elements of the
n inverse matrix:
dX; =L h;;dY; (i = 1, ... n) (11.20)
i- I
These compare with out final results by matrix where M is the matrix of direct import coefficients,
methods of 7-i- and 3-j- for steel and coal, respec-
ln~
and M* is the matrix of direct plus indirect import
tively. coefficients. In the 2 X 2 case we have:
Calculation by this iterative procedure is clearly
tedious and becomes impossibly complicated with
more than five or six sectors to cope with. Similar-
ly, matrix inversion by hand is laborious and com-
[m" m.,
m21 m22 x2 (11.22)
plicated, but fortunately there is recourse to the
l [:: l
computer. When it comes to input-output work mu mn bll b12
for practical policy-making purposes, a computer
is indispensable. To be of much practical use, the m21 mzz b21 b22
degree of disaggregation required in input-output
analysis is such that work would be impossible Therefore:
without mechanical aids. A regular computer will
invert a 30 x 30 matrix in less than a second. M 1 = m 11 X 1 + m 12X2
(mubu + m12b21l Yl
+ (m 11 b12 + m 12 b22 ) Y2
and
Input-Output Analysis 255
n n
M2 = m21X1 + m22X2 ~M
i=t
L L m;b;;~Y;
j=l
(11.25)
(m2tb11 + m22h21) Yl
+ (m2tbu+ m22b22l ¥2 + mc~C + mc~G
+ m 1 ~1 + mE~E
If imports also go directly into final demand we
have:
In the 2 x 2 case:
~M = m 1 (b 11 ~Yl + bu~¥2)
and
I Forecasting Labour
Requirements
Total imports = M*Y + Mvyv
Changes in import requirements may then be If we have estimates of employment coefficients
calculated by specifying the changes in final de- industry by industry, defined as 1; = L;IX;, we can
mand, ~ Y and ~ yv, and assuming that the aver- estimate labour requirements from the input-
age and marginal import coefficients are the same. output model, given specified changes in final
Some imports will be competitive with domestic demand. Total labour requirements can be ex-
production; others not. In either case, the input- pressed as:
output model may be simulated to calculate the
effects throughout the system of import substitu- (11.27)
tion. In the case of replacing competitive imports, i=1
each of the column entries would have to be ad- where 1y is the employment coefficient of the final
justed and the input-ouput coefficients recalcu- demand sector, e.g. of government employment of
lated. In the case of non-competitive imports, a civil servants.
new row and column would have to be added to Assuming the marginal employment coefficient
the inter-industry matrix, and the Leontief inverse is equal to the average, the change in labour re-
recalculated to ascertain the likely impact. quirements is:
If imports into each industry remain aggre-
gated, as in Table 11.1, we may simply write the n
n
n
and, since ~X; = L b;;~ Yi
M = L m;X; + mcC + meG (11.24)
n
,~1
n
L L 1;b;;~Y; + 1y~Y
i=l
~L = (11.29)
i=l j=1
n
Since ~X; = L b;;~ Y; (from equation (11.20), Thus, given the specified changes in final demand
i~l
for each industry's output (~ Y;s), and given the
changes in import requirements may be calculated elements of the Leontief inverse (b;;s), the change
as: in total labour requirements can be forecast.
256 Planning, Resource Allocation, Development and Techniques
I Forecasting Investment
Requirements
itself. Likewise for industry 2, 0. 75 units of capital
are needed from industry 1 and 2.25 units from
itself to produce a unit flow of output.
Total investment requirements may then be
Changes in output to meet specified changes in
written as:
final demand over a plan period will require addi-
n
tions to the capital stock. In a normal input-
output table, as Table 11.1, all that is usually
I = !).K = L C;/). X; (11.30)
i=l
specified is the total amount of each sector's out-
where c; = !).KJ!).X; is the aggregate ICOR for
put that is allocated for the purpose of investment,
industry i.
without specifying the activities it goes into. In
n
principle, however, a table of investment flows or
capital transactions could be prepared, just as for
Since /).X; = L
;~t
b;;!). Y;, we have
current inputs, as in Table 11.3. n n
I = !).K = L L C;b;;/). Y; (11.31)
Table 11.3 Inter-Industry Capital Transactions i~l ;~t
1 1.0 0.75
2 4.0 2.25
Aggregate The forward linkages of any ith sector (LF;) can be
ICOR (c;) 5.0 3.00 measured as the ratio of inter-industry demand to
total demand, that is:
Table 11.4 says that industry 1 needs four units LX;;
of extra capital from industry 2 to produce a unit L F• = - ; -
flow of output, and one unit of extra capital from X;
Input-Output Analysis 257
where X; is the sum of inter-industry (LX ii) and tries is that other countries can see at a glance
I
final (Y;) demand for industry i. Industries can what industries they might encourage if the pre-
be ranked according to their backward or forward vailing economic conditions are similar.
linkages, or their sum. Both give a measure of the
stimulus that one industry may give to others.
I The Input-Output Table of
I Triangularised Input-Output
Tables
Papua New Guinea
Many developing countries have constructed input-
output tables to assist them in the planning pro-
A visual impression of the structural interdepend- cess, and they are put to a variety of uses, some
ence of different industries can be obtained by of which we have already described. To give just
triangularising the inter-industry transactions one example we reproduce, as Table 11.6, the
matrix to show interdependence on both the input 1970 input-output table for Papua New Guinea
and output sides. Two criteria may be applied in which was compiled by Parker of the Australian
triangularising matrices, or a combination of both. National University. 1 • The inter-industry transac-
One is to list the sector with the largest number of tions matrix has been consolidated from the ori-
zero-output entries at the top of the table and the ginal forty-six productive sectors to eleven. The
others in descending order. The second is to order table is fairly self-explanatory and follows the
rows so that final demand as a proportion of total standard form as outlined in Table 11.1. Parker
output declines as one reads down the table. Either uses the table mainly for the purpose of making
way a line drawn from the top left-hand corner of projections for the economy in 1978 based on
the table to the bottom right should reveal a big estimates of increases in final demand for each of
difference in the magnitude of the cell entries, and the industries identified and on the basis of known
the number of zeros, between the 'bottom' and changes in the structure of production over the
'top' triangles, as illustrated in Table 11.5. In real period, including the introduction of new indus-
life the triangularised matrix would not look quite tries and import-substitute activities. The Leontief
so symmetrical, but we illustrate the principle. In matrix is then inverted and estimates made of the
this example it can be seen at a glance that indus- output of each sector in 1978 consistent with the
try (5) has high backward linkages but no forward projected final demands (including exports) and
linkages, while industry (4) has strong forward the forecast structural changes. A comparison of
linkages but no backward linkages. One useful- the 1978 projections with the situation in 1970
ness of triangularising matrices for different coun- shows up the growth sectors of the economy, and
the structural changes necessary if the projec-
Table 11.5 A Hypothetical Triangularised Inter- tions are to be fulfilled. The implications of the
Industry Transactions Matrix projections for the balance-of-payments are also
considered.
Industries 5 2 3 1 4 To sum up, we can say that input-output analy-
sis serves three broad purposes in development
5 ~ 0 0 0 0 planning. First, it offers the possibility of provid-
2 8
~ 0 0 0 ing a set of consistent projections for an economy
indicating broadly the structQre of the economy
3 6 2
~ 0 0 that might emerge given a country's development
strategy. The implications of alternative develop-
1 12 4 4
~ 0
~
1 Parker (1974). Parker's article is a succinct illustration of
4 9 8 6 2
input-output analysis and the uses to which it may be put.
258 Planning, Resource Allocation, Development and Techniques
Table 11.6 Inter-Industry Transactions, Papua New Guinea, 1970 ($m.; purchasers' values)
Net Gross
Personal current domestic capital
consump- expen- Total
Item 4 5 7 8 9 10 11 tion diture"" Public Privatet Exports demand
(1) Agriculture 1.53 6.86 0.27 0.18 0.02 8.06 7.12 53.40 77.44
(2) Fishing, forestry,
mining 0.01 3.24 0.04 0.04 0.03 0.01 1.67 -0.07 5.78 10.75
(3) Manufacturing 5.73 0.28 4.48 26.61 7.53 1.57 1.25 4.96 0.79 1.60 32.42 0.69 1.51 13.45 102.87
(4) Building,
construction 0.26 0.15 0.47 0.13 0.45 0.77 11.33 0.69 0.05 36.24 63.91 114.45
(5) Transport
communication 2.97 0.20 3.06 2.83 2.22 1.04 3.22 10.83 0.18 7.07 11.11 -0.34 0.26 0.28 4.85 49.78
(6) Commerce 3.52 0.96 11.19 6.14 2.57 0.51 0.31 0.18 0.18 0.96 20.53 0.76 7.99 2.46 58.26
(7) Education, health 0.04 3.35 40.76 0.03 44.18
(8) Government services,
n.e.i. 0.63 0.72 0.13 0.73 0.25 1.08 0.01 0.13 3.96 0.21 81.10 6.90 0.23 96.08
(9) Other services 0.02 0.10 4.00 0.13 0.53 5.59 15.17 5.73 2.77 34.04
(10) Business expenses 1.16 0.32 3.23 5.49 1.71 9.36 0.37 1.43 2.71 2.43 28.21
(11) Non-market
production 185.50 31.70 6.70 223.90
Wages & salaries
Indigenous 13.53 1.53 6.83 8.50 5.66 4.90 9.92 15.38 7.99 74.24
Non-indigenous 2.90 0.80 11.60 12.31 10.11 8.47 20.08 36.67 7.29 110.23
Operating surplus :t: 37.56 2.71 17.40 5.90 4.58 21.13 1.28 0.23 7.43 223.90 322.12
Depreciation 2.01 0.70 3.99 4.22 5.77 3.19 0.06 0.19 1.70 21.83
Net indirect tax 0.13 0.13 7.74 1.20 0.79 0.78 0.03 0.03 0.23 0.55 10.49 0.09 2.58 0.85 25.62
Imports c.i.f. 5.50 2.40 22.95 40.01 8.36 1.78 6.44 13.98 0.85 12.15 78.80 14.71 58.08 4.10 270.11
Sales by final buyers -1.15 0.57 0.58
T oral supply 77.44 10.75 102.87114.45 49.78 58.26 44.18 96.08 34.04 28.21 223.90 367.10 127.25 90.20 148.67 90.93 1644.11
ment strategies can also be explored. Second, validity. The basic properties of traditional
it shows the structural changes that must occur (Leontief-type) input-output models are fourfold:
in the process of growth, which no aggregative first, that there are no joint products, which means
macroeconomic model can do. Third, the very that each commodity is produced by only one
construction of the input-output table provides industry and each industry produces only one pro-
structural information on a disaggregated basis duct; second, that technical coefficients are fixed,
which may become invaluable in other aspects of i.e. no substitutability between inputs, so that in-
development planning. put functions are linear and the marginal input
coefficient is equal to the average; third, that the
I
total effect of carrying on several activities is the
The Assumptions of sum of the separate effects, ruling out external
Input-Output Analysis 1 economies and diseconomies; and last, that tech-
nical progress is static and production is subject to
Now let us briefly turn to the assumptions under- constant returns. All these assumptions are neces-
lying input-output analysis and consider their sary if the input-output coefficients are to be con-
stant and the estimated inputs and outputs are to
1 For an excellent account of the practical problems of con-
balance at the aggregate level.
structing input-output tables in developing countries, see The validity of these assumptions is of course
Bulmer-Thomas (1982). open to question, especially over the long run.
Input-Output Analysis 259
Indeed, we know that changes do occur of a type this itself is more feasible. The problem can also be
which input-output analysis denies. The question overcome to a certain extent if some satisfactory
is essentially an empirical one: how large are the adjustment can be made to 'out-of-date' coef-
errors associated with sacrificing accuracy for con- ficients to allow for such factors as changes in
venience? In the short run they may not be sub- technology and the pattern of trade. It is fairly
stantial, and the use of input-output relations for common practice, for instance, to adjust out-of-
forecasting and simulation within periods of five date national coefficients for a sector by the coef-
years may not yield results that are too far wide of ficients prevailing in the best-practice techniques in
the mark. There may not be much substitutability the sector. And for developing countries, or back-
between inputs in the short run owing to the na- ward regions within a nation, it can be assumed
ture of technology or the comparative stability of that within a certain time period they will have the
relative factor prices. Over the long run, however, coefficients prevailing at the present in other, more
changes in the ratio of factor prices, and technical advanced, countries or regions.
progress, may alter input-output coefficients sub- In growth and planning exercises, knowledge of
stantially in physical terms. 1 Similarly, the com- input-output relationships is of greatest use when
position of demand may be assumed to be fairly growth is based on the expansion of domestic
static in the short run, but is liable to considerable demand and where there is considerable inter-
change in the longer run. If commodities with dependence between activities. We noted earlier,
different input coefficients are grouped together in however, that typically in developing countries the
the same sectors, a changing pattern of demand backward and forward linkages between sectors
will alter a sector's input-output coefficient auto- are not very great. Unless there is a great deal of
matically. To overcome this problem it is advis- consolidation of sectors, many of the cells in the
able to use the similarity of input structures as a inter-industry transactions matrix are likely to be
criterion for the aggregation of activities in the empty. The reason is that a great deal of output
original input-output table. goes directly to meet final demand, particularly
The most serious criticism of input-output into exports. If growth is primarily based on ex-
analysis for projection, forecasting and simulation ports, the traditional input-output table is of li-
purposes is the fact that the marginal or in- mited use, although there are a number of ways in
cremental input coefficient may differ substantially which it may be modified for the general purpose
from the average relationship embodied in the of assisting the achievement of balance within the
matrix. With technical change, increasing returns economy. 2
to scale, and the changing structure of interna-
tional trade, marginal input coefficients may di-
verge substantially from average coefficients over
time. Needless to say, this possibility could lead
to inaccurate forecasts of the need for certain
I Input-Output, Linkage Analysis
and Development Strategy
commodities on the basis of projections of final
demand. But there are ways of overcoming this We discussed in Chapter 7 the thesis of the disting-
inherent weakness of traditional input-output uished development economist, Professor Hirsch-
economics. The problem is lessened if the transac- man, that the scarcest resource in developing
tions table from which the input coefficients are countries is a shortage of decision-takers, which
derived can be produced at regular and frequent leads him to the conclusion that development
intervals. With better methods of data collection, strategy ought to proceed in such a way as to set
1 If the coefficients from one time period to the next are calcu- 2 For Zambia, for example, Seers has used the inter-industry
lated at current prices, then changes in relative prices will not matrix in a social accounting framework for the wider purpose
change the value coefficients if the elasticity of substitution of balance in sectors of the economy other than the production
between inputs is unity. sector. See Seers (1966).
260 Planning, Resource Allocation, Development and Techniques
Low LF High LF
up pressures and obvious incentives for things to overall growth rate and the Hirschman com-
get done. Since, in any case, not everything can be pliance index?
done at once, the sequence of activities should be
that which maximises what Hirschman calls 'in-
duced decision-making'. This general view leads to • Empirical Studies of Linkages
two broad conclusions: first, there is a case to be
made for unbalanced growth in order to promote One early empirical study of linkages was that of
overall growth, as we discussed in Chapter 7; Chenery and Watanabe (1958), who took input-
second, activities should be encouraged which output tables for the US, Japan, Italy and Norway
have the strongest linkage effects in input-output and computed backward and forward linkages for
terms, in order to maximise induced decision- 29 sectors in each country, and found them to be
making. very similar in each country. They therefore aver-
In connection with the second point, three ques- aged the linkage measure for each sector across the
tions naturally arise: (i) what are the industries four countries, and categorised industries into four
with high linkages? (ii) do countries tend to en- groups, as shown in Table 11.7:
courage the growth of sectors with high linkages?
Is there a correlation within countries between a High forward, low backward- Intermedi-
sector's growth rate and its total linkage index (the ate primary production
so-called Hirschman compliance test)? (iii) is there II High forward, high backward - In-
a correlation across countries between a country's termediate manufactures
Input-Output Analysis 261
Table 11.8 Sectoral Linkage Indexes and Comparison of Rankings: 18 X 18 1-0 Tables, Developed Countries
Chenery-
Watanabe-
Hirschman
Total Forward Backward
Lr Rank Rank Class LF LB
III High backward, low forward Final In terms of Hirschman's model, the best activi-
manufactures ties to encourage would be those in category II -
IV Low backward, low forward Final namely intermediate manufactures - with high
primary production backward and forward linkages.
Yotopoulos and Nugent (1973) have also taken
Intermediate primary products have high for- eleven input-output tables - six for developed
ward and low backward linkages because they countries (Canada, Israel, Japan, Sweden, UK and
tend to be processed domestically, but require few US) and five for developing countries (Chile,
domestic inputs. Intermediate manufactures, how- Greece, Korea, Mexico and Spain) and consolidate
ever, also have high backward linkages because each table into an 18 X 18 matrix. They calculate
manufactures tends to demand more processed for each sector, backward linkages, forward link-
inputs than land based activities. Final manufac- ages and total linkage effects (measured as the
tures have high backward linkages, but low matrix multiplier for each activity which therefore
forward linkages because they are consumed, includes direct and indirect effects of each activity
invested or exported directly. Final primary pro- on others). As far as the strength of linkages is
duction has both low backward and low for- concerned, they find a close correspondence with
ward linkages, because primary products require the results of Chenery and Watanabe. They look
few domestic inputs and a large fraction of out- separately at the results for developed and de-
put is exported. veloping countries (see Table 11.8 and 11.9) and
262 Planning, Resource Allocation, Development and Techniques
Table 11.9 Sectoral Linkage Indexes and Comparison of Rankings: 18 X 18 1-0 Tables, Less Developed
Countries
Chenery-
Watanabe-
Hirschman
Total Forward Backward
L, Rank Rank Class LF LB
Leather 2.39 1 2 II 0.645 0.683
Basic metals 2.36 2 3 II 0.980 0.632
Clothing 2.32 3 8 III 0.025 0.621
Textiles 2.24 4 5 II 0.590 0.621
Food, beverage manufactures 2.22 5 7 III 0.272 0.718
Paper 2.17 6 1 II 0.788 0.648
Chemicals and petroleum
refining 2.13 7 4 II 0.599 0.637
Metal products and machinery 2.12 8 9 III 0.430 0.558
Wood, furniture 2.07 9 6 II 0.582 0.620
Construction 2.04 10 10 III 0.093 0.543
Printing 1.98 11 14 IV 0.508 0.509
Other manufactures 1.94 12 16 IV 0.362 0.505
Rubber 1.93 13 15 IV 0.453 0.481
Minerals (nonmetallic) 1.83 14 11 I 0.870 0.517
Agriculture 1.59 15 17 IV 0.502 0.368
Utilities 1.49 16 12 I 0.614 0.296
Mining 1.47 17 13 I 0.638 0.288
Services 1.41 18 18 IV 0.378 0.255
find a considerable similarity in the structure of and 20 developing countries. The correlation
linkages between the two sets of countries, across the two sets of countries (and all 36 coun-
although, not surprisingly, the indices are gener- tries) are positive but not statistically significant.
ally higher for developed countries. Yotopoulos and Nugent argue, however, that
I
following a policy of encouraging the growth of
sectors with high total linkages may produce an
The Hirschman Compliance unacceptable degree of imbalance within an econ-
omy which may impair growth. Thus, the above
Index and the Growth of test of the Hirschman compliance rule is an ex-
Countries treme test of the hypothesis of unbalanced growth
since there is no limit to the desirable degree of
A simple test of the Hirschman compliance imbalance. Yotopoulos and Nugent therefore
hypothesis is first to calculate each country's com- propose what they call a balanced growth version
pliance index (i.e. the correlation between sector of the linkage hypothesis. This hypothesis argues
growth rates and their total linkage index) and that a sector (i) should grow at the overall growth
then correlate the compliance index with each rate of a country (G;) weighted by the total linkage
country's growth rate. Yotopoulos and Nugent do index (LT;). The coefficient of variation (Vu) in the
this taking 36 countries- 16 developed countries actual sectoral growth rates, g;;, around the
Input-Output Analysis 263
linkage-weighted overall growth rate therefore namely that countries have grown fastest where
measures the degree of imbalance relative to the growth of sectors has been proportional to the
linkage-balanced growth, i.e. value of their total linkage index. This is a topic on
which more work needs doing.
I
(11.32)
Questions for Discussion and
where w;/s are the weights of each industry in Review
total output.
According to equation (11.32), country j's 1. What does an input-output table show?
growth is linkage-balanced when each sector's 2. What are the major purposes of input-output
growth rate is proportional to each sector's total analysis?
linkage index. A high VL; would indicate that a 3. What are 'input-output coefficients', and
country has deviated from this 'optimum' balance. what conditions must be fulfilled if they are to
The lower VL; the greater the degree of linkage- be stable through time?
balance achieved. Therefore the balanced growth 4. What is the 'Leontief inverse matrix' and what
version of the linkage hypothesis would be sup- does it show?
ported by finding a negative correlation across 5. How would you derive the matrix multiplier
countries between the VL; for each country and its for each industry from the Leontief inverse
overall growth rate, i.e. the lower the index, the matrix?
higher the growth rate should be, and vice versa. 6. Define the backward and forward linkages of
Yotopoulos and Nugent find the hypothesis sup- each industry and how might linkage analysis
ported across a total of 34 countries, and also be used in planning economic development.
separately for 15 developed countries and 19 de- 7. Give examples of how you would use an
veloping countries. input-output table for 'simulation' purposes?
We may conclude this section by saying that on 8. What information would be required to use
the basis of the strength of linkages, policy-makers input-output analysis for forecasting invest-
should favour manufacturing activities over agri- ment requirements?
culture or services. There is no support for the 9. Show how the balance of payments implica-
extreme Hirschman ·hypothesis that countries tions of a given growth in final demand can be
grow fast where the growth of high linkage indus- forecast by using input-output analysis.
tries has been fastest. But there is support for the 10. How indispensable is input-output analysis as
balanced growth version of the linkage hypothesis, a planning technique?
II Chapter 12 II
The Progratntning Approach to
Developtnent
The main task of development strategy is to ensure social considerations are taken into account in the
that resources will be forthcoming to meet the application of investment criteria, as social cost-
goals of a development programme, and that the benefit analysis tries to do. The programming
resources are allocated efficiently subject to certain approach also tends to be more dynamic, looking
constraints. In our earlier discussion of resource at the development of the economy and the inter-
allocation we were more concerned with the in- relationship between projects over a long period of
vestment criteria that should be applied in the light time.
of particular goals than with the efficiency with Programming in general is best described as the
which resources were to be used, or whether the mathematical method for the analysis and deriva-
application of the criteria violated certain of the tion of optimum decisions which do not violate
broader constraints mentioned. This was, in fact, a non-specific constraints. Theoretically, it offers the
matter of necessity because ordinary marginal best solution to rational decision-making in econ-
analysis is not appropriate to situations in which omic planning. Indeed, it is virtually true to say
the aim is to obtain an 'optimum' solution subject that the optimal solution to· a given problem with-
to constraints which are not precisely specified (or in constraints can only be given by the program-
what are called inequalities, e.g. that no more than ming approach. The methods of computation
R resources should be used). Programming, normally involve trial-and-error procedures, but
however, can provide a simultaneous solution to the methods are so constructed that each trial
the three basic purposes of development planning, yields values which are closer to the correct answer
which are: the 'optimum' allocation of resources; than the preceding values. We shall not here go
efficiency in the use of resources (through the into the computational methods. We are more
proper valuation of resources, and the avoidance concerned with the underlying principles.
of 'social' waste); and the balance between diffe- The programming approach to development
rent branches of the national economy. planning was initially used for the purpose of
The essential feature of the programming achieving balance between the supply of and de-
approach is that it deals with a whole complex of mand for commodities and factors of production.
interrelated projects rather than with a marginal As Chenery (1961) says, it can be considered, his-
project, and is concerned with much wider consid- torically speaking, the operational counterpart of
erations than marginal analysis. The partial the theory of balanced growth. With the advent of
equilibrium approach in development planning is mathematical programming techniques, however,
only justified if the number of projects is small or it has also become possible to test the efficiency
264
The Programming Approach to Development 265
with which resources are used, and to reconcile the problem, let us illustrate the principle of linear
consistency of plans (i.e. balance) with efficiency programming, and its important use for the valua-
(which means comparative advantage in an open tion of resources, by taking the case of the choice
economy). One particular programming technique of outputs XI and x2 that can be produced with
which can assist in providing a simultaneous solu- given techniques subject to constraints over the
tion to the three main tasks of development plan- availability of resources Y1 and Y2 •
ning is the technique of linear programming. The Consider, then, the case of two commodities
prefix 'linear' will become clear below. The pur- XI and x2 whose price per unit is PI and P2.
pose here is to describe the features of a simple The objective function to be maximised is
linear programming problem, and to show how P1 X 1 + P2 X 2 , which will maximise national in-
the solution to the problem of the optimum alloca- come. The problem is what combination of X 1 and
tion of resources also implies a solution to the x2 to produce, subject to the non-negativity condi-
proper valuation of resources and efficiency in tions, X 1 ~ 0, X 1 ~ 0, and the resource con-
their use. In other words we shall show, given straints. Suppose that there are two resources,
certain constraints, how a solution to the problem capital and labour, and that no more than Y1
of resource valuation emerges as a simultaneous labour is available and no more than Y2 capital.
by-product of the solution to the problem of re- Suppose further that commodity X 1 requires a 11
source allocation and which commodities to pro- labour and a11 capital, and commodity X 2 requires
duce. This property of linear programming is a 11 labour and a 22 capital, per unit of output. The
called the duality of price determination and objective function must therefore be maximised
allocation. subject to the two constraints or inequalities:
• Linear Programming
Linear programming is a very versatile technique.
Four important uses to which it can be put in the The problem is linear since in both the expressions
context of developing countries (or any country to be maximised, and in the constraints, all the
concerned with allocative efficiency) are as fol- variables are multiplied by constants and added
lows: first, it can be used for choosing between together. Commodity prices remain the same re-
different techniques for making the same com- gardless of the level of output; similarly, the input
modity; second, it can be used for deciding the coefficients remain constant, implying constant re-
best combination of outputs with given techniques turns to scale.
and factor endowments; third, it can be used for Our programming problem can now be con-
deciding whether it is more efficient to produce sidered diagrammatically. In Figure 12.1 the quan-
commodities at home or buy them from abroad; tities of the two goods, X 1 and X 2 , are measured
and fourth, it can be used to determine the most
efficient spatial location of activities. All the Figure 12.1
above-mentioned issues are optimising decisions
of one form or another and can be incorporated X2
into the standard form of a programming problem
Y,
consisting of three parts: (1) the objective function
''
to be maximised; (2) the constraints which must
not be violated; and (3) the non-negativity condi-
tions, e.g. that outputs or exports should not be
negative.
Given this standard form of a programming
266 Planning, Resource Allocation, Development and Techniques
Maximise P, X, + P2 X2
subject to a 11 X, + a 12X 2 + S, = Y,
a 2 ,X, + a 22 X2 + S2 = Y2
straint equations. Let us label the slack variables in To produce one unit of commodity X 1 the total
the dual as Z 1 and Z 2 • The constraints now be- value of inputs is 4r1 + 3r2. This may exceed or
come equalities and the primal and dual may be equal, but not be less than, 2, which is the price
written as: per unit of output X 1 • The inequality sign tells us
that we must assign values to each of the inputs
Maximise P1 X 1 + P2 X 2 sufficient to account for the price of the commodi-
subject to all xl + au x2 + sl = yl ty in question. An analogy with a business enter-
a21 xl + a22 x2 + s2 = y2 prise will be useful here. A firm must choose values
for its scarce inputs (Y1 and Y2 ) that will account
Minimise r1 ¥ 1 + r2 ¥2 for all its profits. Values of r 1 and r 2 must be
subject to all rl + a21 r2 - zl = pl chosen so that the net profit from production is
a21 rl + a22 r2 - z2 = p2 accounted for. If the accounting values are such
that profits are not completely imputed to the
If we now put the primal and the dual in matrix factors, then the accounting values must be raised
form, the symmetry between the two problems until the unimputed profit has been eliminated.
becomes apparent immediately: Thus the variables r 1 and r 2 in the dual problem
can be interpreted as the required accounting
Primal matrix Dual matrix
values of the scarce inputs. If, of course, factors
xl x2 rt r2 are not scarce, their accounting values must be
zero because if their supply increased profits could
pl p2 yl y2 not be increased because of other constraints, and
sl yl all au zl pl all a2t if their supply was reduced profits would not fall
s2 y2 a2t a22 z2 p2 au a22 because output would not be affected. Thus the
aim of the dual is to minimise the total cost of
If we look at the primal and dual in equation providing the inputs in question. At the minimum
and matrix form we observe the following: if the the total cost of providing the inputs will be exact-
primal involves ~ signs, the dual involves ::::; signs; ly equal to the total profit derived from their use. If
the price constants, P1 and P2 , in the primal, be- an input is in excess supply, an additional unit will
come constraints in the dual- replacing the capa- add nothing to profit and therefore its opportunity
city constraints Y1 and Y2 ; the coefficients in the cost is zero.
constraint inequalities, aw aw which go from left The valuation of the factor inputs affects the
to right in the primal, go from top to bottom in the optimum combination of outputs through the
dual. And, as far as the two matrices are con- slack variables, zl and z2, in the dual.
cerned, the dual matrix is merely the primal mat- We previously wrote the dual equation for pro-
rix with the positions of the bottom left-hand cor- duct xl as:
ner and the top right-hand corner reversed.
Let us now give a numerical example of the
primal and dual and use this example to give an
economic interpretation of the dual: This can be written:
tion of factors, therefore, affects the opportunity (as under perfect competition) and to the com-
cost of producing products. Products with non- bination of outputs. In the language of pro-
zero slack variables should not be produced. If, gramming, these derived or shadow prices are the
however, resources were valued such that there Lagrange multipliers of a constrained optimisation
was no difference between the total value of re- problem. They correspond with the marginal pro-
sources and the price of the commodity, then Z 1 ducts of factors of production in an optimal situa-
would be zero and it would be 'profitable' to pro- tion when all alternative uses have been taken into
duce X 1 • (In a nutshell, this is why valuing surplus account. That combination of products which
labour at zero would lead to the production of maximises income and minimises costs by obtain-
commodities using labour-intensive techniques.) ing the shadow prices of factors is called 'efficient'.
We are now in a position to state an important The properties of the set of prices associated with
duality theorem. An optimal solution to the the point of efficiency are:
allocation and valuation problems requires that:
1 that no activity has a positive profitability;
2 that every activity carried out has zero pro-
XiZi = 0 for each commodity j
fitability; and
3 that the prices of all factors which are not
and
exhausted are zero.
r;S; = 0 for each input i Linear programming highlights the importance of
using shadow prices for factors in achieving
xlzl = 0 requires either that xl = 0 or that zl = 'efficient' resource allocation. The results are iden-
0 (or both). If the output of xl is positive, then we tical with those that would prevail under perfect
must have Z 1 = 0 (i.e. its accounting loss must be competition, given the same technological assump-
zero with all profits imputed to the scarce factors). tions. The shadow prices themselves may therefore
If zl > 0, then we must have xl = 0 (i.e. xl must be considered 'efficiency' prices since they lead to
not be produced). The logic of not producing com- the most efficient allocation of resources.
modities with a non-zero accounting loss is simply Two main drawbacks of linear programmmg
that the inputs used in producing the good would may be cited. First, the programming problem
be more valuable elsewhere. The accounting losses may not be linear, in which case other techniques
may be thought of as opportunity costs. Thus if must be resorted to. Second, it is a weakness of
two commodities required the same amount of linear programming that product prices are
scarce inputs, it would pay to produce the com- assumed to reflect society's marginal valuation of
modity with the least opportunity cost. them. On the one hand there is the problem of
The interpretation of the other equation is simi- imperfect product markets with prices in excess of
lar. r;S; = 0 requires that either r; = 0 or S; = 0 (or marginal cost. The other related, but more serious,
both). If S; > 0 (i.e. there are surplus inputs), then problem is that the relative prices of capital and
we must have r; = 0 (i.e. the input must be given a consumption goods may undervalue the import-
zero accounting price). The logic of valuing sur- ance that a society attaches to growth. If so, either
plus inputs at zero is simply that if an extra unit of shadow prices must be derived for products, or
the input was forthcoming, it would add nothing some allowance must be made in valuing the fac-
to profit because it is already in surplus; similarly, tors of production in recognition of the growth
if a unit were taken away it would not subtract objective. The latter solution in the case of labour
from profit. was considered in Chapter 8, where a more gener-
When all profits have been eliminated, there al formulation is presented of the valuation of
will be a unique set of factor prices corresponding labour in surplus-labour economies in which
to each factor's marginal contribution to output emphasis is on growth as well as efficiency.
Part V
Financing Econotnic Developtn ent
II Chapter 13 II
Financing Development
from Domestic Resources'
273
274 Financing Economic Development
exists, and consider the supply of domestic savings It can also be a source of savings by stimulating
to developing countries. In this respect we must income and employing previously underutilised re-
not only consider the sectors from which saving sources. Second, borrowing from abroad provides
originates but also how savings may be stimulated, resources for investment by enabling imports to
especially through the deliberate policy actions of exceed exports, which in the national accounts
government. This will involve a brief considera- shows up as investment in excess of domestic sav-
tion of fiscal and monetary policy in developing ing. Foreign assistance may be from multilateral or
countries, including the role of inflationary finance bilateral sources, and may take a variety of forms
in providing real resources for capital formation. ranging from loans at commercial rates of interest
As far as domestic saving is concerned, three to outright gifts of goods and services and technic-
broad 'types' may be distinguished: voluntary; in- al assistance. Last, a country's commercial policy
voluntary; and savings generated through policies can stimulate savings and release resources for
to increase output in situations of unemployed or investment purposes. Trade itself, and an improve-
underemployed resources. The origin of these ment in a country's terms of trade, can provide
'types' of saving should be fairly self-explanatory. additional resources for investment if the increase
Voluntary savings are savings that arise through in real income made possible is not fully con-
voluntary reductions in consumption out of dis- sumed. Likewise, policies to restrict imports of
posable income. Both the household and the busi- consumption goods can release additional re-
ness sectors may be a source of voluntary savings. sources for investment, provided that domestic saving
By contrast, involuntary savings (or what is euphe- is not reduced by the purchasing power released
mistically called 'collective thrift') are savings being switched to home consumption goods. These
brought about through involuntary reductions in topics are taken up in subsequent chapters.
consumption. All forms of taxation, and schemes There are three main analytic approaches to the
for compulsory lending to governments, are tradi- study of the finance of development from domestic
tional measures involving involuntary reductions resources. First, there is the prior-savings approach
in consumption. In addition, consumption may be which stresses the importance of prior savings for
reduced by the process of inflation (i.e. rising investment and the need for policies to raise the
prices), and this is often referred to as 'forced' level of savings either voluntarily, or involuntarily,
savings. 1 For a variety of reasons, which will be or both. The approach is very classical in concep-
considered later, inflation is likely to be a natural tion, emphasising saving as a prerequisite of in-
concomitant of development, but it can also be vestment. The approach is also characterised by a
deliberately induced or exacerbated by policy me- strong aversion to inflation and a belief that saving
asures such as monetary expansion and deficit will readily find investment outlets.
finance at full employment. Third, deficit finance Second, there is the Keynesian approach to the
at less than full employment can generate saving finance of development which rejects the idea that
by activating unemployed or underemployed re- saving determines investment and argues instead
sources. An increase in the volume of real saving that the encouragement of investment will gener-
can always be brought about by increases in real ate its own saving, either through increases in
output, provided the propensity to consume out of output if resources are unemployed, or through
extra income generated is less than unity. income redistribution from groups with a low
Domestic savings for investment can also be propensity to save to groups with a high propensi-
supplemented from abroad. Private foreign invest- ty to save as a result of inflation if resources are
ment is a direct source of capital formation and fully employed.
provides a direct addition to domestic investment. Third, there is the so-called Quantity Theory
approach to the finance of development which
1 Some inflation-induced saving may be voluntary, some in- points to the role of government monetary expan-
voluntary. sion in appropriating resources for development.
Financing Development from Domestic Resources 275
If developing countries are characterised acceptable and reliable monetary institutions, the
as fully employed in the Keynesian sense (with interest rate offered in relation to risk and time
no spare capacity in the consumption-goods preference, and general societal attitudes to con-
industries), both the Keynesian and Quantity sumption and the accumulation of wealth. Differ-
Theory approaches to the finance of development ences in the willingness to save between countries
will involve inflation. Plans to invest in excess of may distort the estimation of saving functions
plans to save at full employment will drive the across countries based on economic variables
price level up, and so will monetary expansion by alone. 1
government. In this sense there is an important Having said this, however, the time-series and
practical, as well as a theoretical, difference be- cross-section evidence is that the level of savings
tween the prior-savings approach and the other per head and the savings ratio is primarily a func-
two approaches. In the prior-savings approach the tion of the level of per capita income, and to a
resources released for investment come from lesser extent a function of the rate of growth of
voluntary and involuntary saving and no inflation income and the distribution of income between
is involved. In the Keynesian and Quantity Theory wages and profits. Economic theory predicts this.
approaches the resources are released through the The hypothesis that savings per head, and the
process of inflation, by income redistribution from savings ratio, is a function of income per head is
classes with low propensities to save to those with part of the Keynesian absolute-income hypothesis
higher propensities to save, and by inflation as a that saving is a function of income. If we write the
'tax' on money. Keynesian savings function as S = - a0 + b0 (Y)
and divide through by the population level (N) we
have:
• The Prior-Savings Approach
SIN= -a 1 + h1 (YIN) (13.1)
In classical theory saving and investment are one
and the same thing. All saving finds investment Now to obtain an expression for the savings ratio,
outlets through variations in the rate of interest. multiply equation (13.1) by Nand divide through
Investment and the development process are led by by Y:
savings. It is this classical view of the development
process which underlies such phrases in the de- (13.1)
velopment literature as the 'mobilisation of sav-
ings for development' and which also underlies the The Keynesian absolute-income hypothesis there-
policy recommendation of high interest rates to fore predicts that savings per head (SIN) is a linear
encourage voluntary saving. Lewis's influential (but non-proportional) function of income per
model of the development process, which we con- head (YIN), and that the savings ratio (SlY) is a
sidered in Chapter 3, is a classical model stressing hyperbolic function of the level of income per
the importance for development of the reinvest- head; that is, that the savings ratio will rise with
ment of the capitalist surplus. the level of per capita income but at a decreasing
The level of saving, and the ratio of saving to rate. As YIN~ oo, SlY~ to the asymptote b~"
national income, in developing countries is likely A number of studies have fitted equation (13.1)
to be a function of many variables affecting the to cross-section data for different samples of coun-
ability and willingness to save. The main determi- tries and found a significant non-proportional re-
nants of the ability to save will be the average level lation. Leff (1969) has fitted the function to data
of per capita income, the rate of growth of income in logarithmic form for samples of developed and
and the distribution of income between rich and
poor. The willingness to save, in turn, will depend 1 For a survey of savings behaviour in developing countries, see
developing economies and finds that the elasticity between investment and foreign capital inflows. As
of savings per capita with respect to income per investment expenditure becomes more faithfully
capita exceeds unity in both cases. Williamson and accurately recorded as development proceeds
(1968), using pooled time-series data for a sample (as per capita income rises) the savings ratio is also
of Asian countries, finds the intercept term in shown to increase. But there are also a number of
equation (13.1) significantly negative, indicating economic factors that no doubt play a contribu-
that the average propensity to save rises with the tory role in explaining the relation. One is the
level of per capita income. Houthakker (1965) has growth of the money economy. As money replaces
taken consumption per head instead of savings per barter for transactions, the public will wish to
head and regressed the logarithm of domestic con- hold a higher proportion of their income in the
sumption per capita on the logarithm of income form of money which they can only do by giving
per capita for thirty-four countries and finds an up command over real resources. This hypothesis
elasticity of less than unity, indicating that the is supported by what we know about the income
consumption ratio falls and the savings ratio rises elasticity of demand for money in developing
with increases in the level of per capita income. countries, which exceeds unity. (For evidence, see
Other studies, such as that by Chenery and Eck- Thirlwall (1974) ch. 5.) A second possible ex-
stein (1970) for 16 Latin American countries, sup- planation is that population growth decreases
port the Keynesian savings function, but find very with increases in the level of per capita income so
little difference between the average and marginal that population growth absorbs household saving
propensity to save, indicating very little increase in to a lesser and lesser extent. Another plausible
the savings ratio as income rises. hypothesis is that in the early stages of develop-
When equation (13.2) is fitted directly to cross- ment the distribution of income, both personal
section data the positive dependence of the savings and functional, grows more unequal but at a de-
ratio on per capita income is also very apparent. creasing rate. If higher-income groups have higher
The savings ratio rises with the level of per capita propensities to save than lower-income groups,
income and then levels off. Singh (1972) in a major and profit-earners have a higher propensity to save
cross-section study taking 70 countries over the than wage-earners, the savings ratio will be posi-
period 1960-65, found that the gross savings ratio tively related to the degree of inequality in the
rose 8 percentage points as per capita income rose income distribution (the personal income distribu-
from $100 to $1000 per annum (at prices then tion) and to the share of profits in total income
prevailing). But he concluded that with per capita (the functional income distribution). Some evi-
income growing at 2 per cent per annum it would dence of the widening distribution of income in
take 50 years for the savings ratio to rise by 3 the early stages of development was given in
percentage points. The average gross domestic Chapter 1. The hypothesis that the savings ratio
savings ratio by continent is now approximately as in developing countries is functionally related to
follows: sub-Saharan Africa (12 per cent); East the distribution of income has been tested by
Asia (31 per cent); South Asia (19 per cent); Houthakker (1965) with respect to the functional
Europe, Middle East and North Africa (28 per distribution of income, and he concludes that the
cent); and Latin America and Caribbean (21 per distribution of income between wages and profits
cent) (World Development Report, 1989). is a significant determinant of the overall savings
The reasons why the savings ratio should rise as ratio.
per capita income increases and then level off are It will be remembered from Chapter 3 that in
not clear cut. It is as if saving is a luxury good in Lewis's model of development with unlimited sup-
the early stages of development which then loses plies of labour it is not the absolute level of per
its appeal. Part of the reason may be purely 'statis- capita income that is the prime determinant of the
tical' arising from the way saving is normally savings ratio but the size of the capitalist surplus
defined in developing countries as the difference and the distribution of income between entrep-
Financing Development from Domestic Resources 2 77
reneurial profits and other income. Lewis says, 'if indirectly, by allocating capital in the most pro-
we ask why the less developed countries save so ductive way possible.
little the answer is not because they are so poor
but because their capitalist sector is so small'.
Lewis also expressed the view that no nation is so • Monetary Policy 1
poor that it could not save and invest at least 12
per cent of its national income if it so wished. Monetary policy to encourage saving largely takes
Investment as a proportion of national income is the form of the development of financial interme-
not small because of an incapacity to save but diaries, which can encourage those with a produc-
because the surplus generated in developing coun- tive surplus to save by taking the risk out of savers
tries is used to maintain 'unproductive hoards of lending directly to investors, and the development
retainers' and for conspicuous consumption in of branch banking which can tap small savings.
general. Lewis's view is very much in line with our Because of the law of large numbers, financial
earlier remark that in the early stage of develop- intermediaries are also able to borrow short and
ment there may be no savings-investment gap in lend long, which is advantageous to lenders
the sense of an incapacity to save, but an unwil- (by giving them liquidity) and borrowers alike.
lingness to save or to use saving for productive Monetary policy to encourage saving may also
capital formation. attempt to encroach on the unorganised money
Studies by Modigliani (1970) and others also market, which lends mainly for consumption pur-
show that the savings ratio is positively related to poses. Paradoxically (on a classical view of the
the rate of growth of income. All this evidence world) the development of the organised money
suggests that development and rising living stan- market can both lower average interest rates in the
dards is a cumulative phenomenon. Growth de- economy at large and raise the level of saving
pends on saving and capital formation, but saving because the unorganised money market charges
in turn depends on growth and the level of per very high interest rates and lends mainly for con-
capita income. A virtuous circle can be started sumption purposes, whereas in the organised
once the growth of income rises above the growth money market interest rates are lower and lending
of population, allowing per capita income to rise. is more for investment purposes.
The virtuous circle of growth must be initiated by A well-developed financial system, and especial-
raising directly the desperately low levels of per ly financial intermediation, is also important for
capita income of the vast majority of people by the efficient allocation of capital between compet-
making their labour more productive. This is the ing uses and to ensure that saving is used for
first task of financing capital formation by domes- investment purposes. In the early stages of de-
tic voluntary means within the prior-savings velopment most saving is done by the household
approach. The second task is to encourage and sector of the economy, which invests less than it
exhort those with the ability to save to curtail saves. In the absence of financial assets, saving
extravagant consumption and to invest produc- typically takes the form of the acquisition of
tively the surplus of income over whatever level of physical assets, including animals, land, jewellery,
consumption is decided upon. The encouragement and the like. The purchase of such assets, provided
to save and invest productively must come from they are 'second hand', frees resources for invest-
the government or some organ of government ment, but there is no guarantee that the seller of
such as the planning agency. This is where monet- the assets will use the sale proceeds for investment
ary and fiscal policies become important. At the purposes. The proceeds may be consumed; alter-
practical level this is exactly what the prior-
savings approach to development is concerned 1 For more detailed expositions of the role of monetary policy
with - designing monetary and fiscal policies and institutions, see Drake (1980); Ghatak (1981), and Eshag
which raise the level of savings directly, and also (1983).
278 Financing Economic Development
natively, investment may take place in relatively releases resources, but it also saves and generates
unprofitable activities because there is no mechan- resources. It saves resources by replacing barter
ism for the distribution of new capital beyond the objects, or commodity money which may be costly
sectors in which it is generated. The existence of to produce, with money which is virtually costless
monetary assets and financial intermediaries pro- to produce. It also saves time, which is a resource
vides a surer guarantee that the act of saving will if the marginal product of labour time is positive,
lead to investment and that the return on the in- by avoiding the double coincidence of wants ne-
vestment will be maximised. cessitated by barter. Money generates resources by
It is also particularly important that the capital facilitating exchange and thereby permitting the
market should be integrated, in the sense that the greater division of labour and specialisation.
interest-rate structure is unified. The consequence Historically, the growth of the money economy
of a fragmented capital market in which interest has also been a powerful stimulus to the develop-
rates vary from one sector to another because of a ment of banking and credit mechanisms which
lack of information and factor immobility is that themselves can act as a stimulus to saving and
some sectors of the economy may be able to bor- investment. When the range of financial assets is
row funds far below the rate of interest prevailing narrow, saving tends to take the form of the ac-
in other sectors where the productivity of capital is quisition of physical assets. While in principle this
higher. The allocation of capital is distorted and should not mean that the level of saving is reduced
inefficient and the capital-output ratio is higher below what it might otherwise be, in practice it
than it would otherwise be. The solution is to depends on how sellers of physical assets dispose
encourage funds into the organised money market, of the sale proceeds. If a portion of the proceeds is
and to extend the provision of financial institu- consumed, the saving of one person is offset by the
tions into sectors of the economy which lack them. dissaving of another, and less resources are re-
A well-developed financial system has four leased for investment than if financial assets had
main requisites, each of which can contribute to been acquired, issued by financial institutions with
the process of financial deepening and to raising an investment function. This is a major reason
the level of saving. These four requisites comprise: why the statistics on saving and investment in
the monetisation of the economy and the replace- developing countries understate the saving and in-
ment of barter as a means of exchange; the estab- vestment capacity of these countries.
lishment of a central bank; the development of a
commercial banking system; and the development
of a well-co-ordinated capital market.
The monetisation of an economy possesses the
I The Theory of Financial
Liberalisation
potential for generating a real investible surplus in
several ways. As fiat money replaces barter in Many developing countries are characterised by
transactions, the demand for money relative to financial repression, which may be defined as a
income rises, which releases real resources of situation in which government and Central Bank
equivalent value. The increase in real saving is regulations distort the operation of financial mar-
equal to the increase in the real stock of money kets. These regulations include: ceilings on the
held. The issuer of money can appropriate the nominal rate of interest (making the real rate of
released resources and increase the level of invest- interest very low or negative in times of inflation);
ment accordingly. In a growing economy monet- the imposition of reserve requirements on the
ary expansion is also required to allow an in- commercial banks, limiting their ability to lend;
creased volume of transactions to take place. the requirement that banks lend to the government
Monetary expansion for this purpose, too, can be to finance budget deficits, and compulsory credit
appropriated by governments for development ceilings. The consequence of these restrictions, so
purposes. The increased use of money not only the argument goes, is to reduce the flow of funds
Financing Development from Domestic Resources 2 79
to the formal financial sector and to distort the ing'. In fact, many of the recent empirical studies
most productive allocation of resources, leading to and surveys of the results of financialliberalisation
lower levels of saving, investment and growth than in various countries are extremely cautious in their
otherwise would be the case. conclusions. Research by Gupta (1987) on 22
The importance of the growth of the money Asian and Latin American countries over the
economy and financial deepening for economic period 1967-76 suggests that there is little support
development on the lines indicated above has been for the 'repressionist' hypothesis that the positive
stressed in the development literature for a long substitution effect of real interest rates on savings
time/ but it was McKinnon (1973) and Shaw dominates the negative income effect. The most
(1973) independently in that year, who first high- important determinant of saving is real income.
lighted the dangers of financial repression in a Giovannini (1983) concludes from his research on
rigorous way, and argued the case for financial eight Asian countries that his results 'cast serious
liberalisation. Their arguments differ, however. doubts on the view that the interest elasticity of
McKinnon's argument is that money holdings and savings is significantly positive and easy to detect
capital accumulation are complementary in the in developing countries'. Similarly, a study by two
development process. Because of the lumpiness of World Bank economists (Cho and Khatkhate
investment expenditure and the reliance on self- (1990)) of the financialliberalisation experience of
finance, agents need to accumulate money bal- five Asian countries concludes that
ances before investment takes place. Positive (and
high) real interest rates are necessary to encourage financial reform, whether comprehensive and
agents to accumulate money balances, and invest- sweeping or measured and gradual, does not
ment will take place as long as the real interest rate seem to have made any significant difference to
does not exceed the real rate of return on invest- the saving and investment activities in the lib-
ment. Shaw's argument, on the other hand, stresses eralised countries. It was believed until recently
the importance of financialliberalisation for finan- that removal of the repressive policies would
cial deepening, and the effect of high interest rates boost saving. The survey in this paper of the
on the encouragement to save and the discourage- consequences of reform does not reveal any
ment to investment in low-yielding projects. The systematic trend or pattern in regard to sav-
increased liabilities of the banking system, result- ing ... it lends support to the conclusion that
ing from higher real interest rates, enable the decisions to save are determined by several fac-
banking system to lend more resources for pro- tors and the relationship between savings and
ductive investment in a more efficient way. real interest rates is at best ambiguous.
The financial liberalisation school, however, is
not without its critics. Firstly, financial saving is If financial liberalisation does not increase aggre-
only one type of saving. As interest rates are raised gate saving, its positive impact on development
there may simply be a substitution between finan- must come through a more efficient allocation of
cial assets and other assets leaving total saving society's real resources which raises the pro-
unchanged. Also, it is well known that any price ductivity of investment, but there is no firm evi-
change has income effects as well as substitution dence of this.
effects, and if the one offsets the other, the effect A second weakness of the financial liberalisa-
on total saving will be negligible. This being so, it tion school is that it is implicitly assumed that the
is perhaps surprising, as Dornbusch and Reynoso supply of loans is dependent on the volume of
(1989) have remarked, 'to find so strong a belief in deposits held by the banks. In other words, it
the ability of higher interest rates to mobilise sav- treats the supply of credit as exogenous. Banks,
however, have the power to create credit; they can
1 See, for example, Gurley and Shaw (1960) and Tun Wai expand their loans despite their reserves and their
(1972). deposits by borrowing from the Central Bank. In a
280 Financing Economic Development
credit money system, the supply of credit is en- subject to reserve requirements, which the curb
dogenous. Within this framework, what is import- market is not. For financial liberalisation to suc-
ant is not incentives for saving, but incentives for ceed, demand deposits must be much better substi-
investment. This being so, high interest rates may tutes with currency and foreign bonds than with
actually discourage total saving by discouraging curb loans. This again is an empirical matter, but
investment. This is the Keynesian or Post- very difficult to test directly without information
Keynesian riposte to the financial liberalisation on the supply of credit from the curb market. To
school. The work of Davidson (1986) and Asima- the extent, however, that curb loans are for con-
kopulos (1986) is representative of this line of sumption purposes, and the government uses the
thinking. Davidson argues that all that is needed reserve requirements of the banks for productive
to initiate additional real investment is finance investment, the reallocation of funds between
provided by an increase in total bank loans with no markets may not unduly affect the total level of
need for increased saving 'as long as the banks can saving and investment from the supply side.
create new finance via acceptable bank accounting
practices'. In the same vein, Asimakopoulos re-
marks 'the investment market can become con-
gested through a shortage of cash. It can never
I The Development of the
Banking System
become congested through a shortage of saving.' If
banks can create credit without having to increase The development of a national banking system,
their deposits, an increase in financial saving may comprising a central bank, a commercial banking
make no difference to the amount of total credit system and special development banks, is one of
given to the private sector. The total amount of the first priorities of development planning. The
credit is determined not by the supply of loans but functions of a central bank include the following:
by demand, i.e. by the decision to invest. How the the issue of currency and lending to government
supply of credit responds to the interest rate, and which can transfer real resources to government in
how investment is affected by the supply of credit the manner described earlier (with a strong central
and the rate of interest becomes very much an bank it is very much easier to give priority to the
empirical matter which can.only be settled by an needs of the government and the public sector);
appeal to the facts. In work on Mexico by War- the development of a fractional reserve banking
man and the present author (Warman and Thirl- system through which it can provide liquidity and
wall (1994)), we find that financial saving does control credit (a central bank can require member
respond positively to the rate of interest, and this banks to hold reserves in government bonds, and
also leads to an increase in the supply of credit the growth of the bond market itself can aid
from the banking system to the private sector. development without excessive monetary expan-
However, while the increased supply of credit sion); the development of other financial institu-
affects investment positively, there is a strong tions, especially institutions to provide long-term
negative effect of interest rates on the level of loan finance for development and to provide a
investment, holding the supply of credit constant, market for government securities; the mainten-
and the net effect of higher real interest rates on ance of a high level of demand to achieve ca-
investment is adverse. pacity growth; and the application of selective
A third worry about the financialliberalisation credit controls if necessary in the interests of de-
argument concerns the relationship between the veloping particular sectors of the economy. The
formal money market and the informal money stabilisation role of the central bank is essentially
market, or curb market, which is unregulated. If secondary to its development role. Stabilisation is
more funds become allocated to financial institu- particularly difficult in a developing country where
tions as interest rates rise, the total supply of loans credit control, the main instrument of stabilisation
may be reduced because financial institutions are policy, is ill-developed, and where the major
Financing Development from Domestic Resources 281
causes of fluctuations in income tend to be the foster the role of banks in promoting development
variability of export receipts and the volatility of in previously neglected regions and sectors of the
overseas investment. economy, in particular in small businesses in rural
The commercial banking system has two im- areas. Between 1969 and 1972 over 3000 new
portant functions: one to create credit; the other branch bank offices were set up throughout India
to encourage thrift and to allocate saving in the by the fourteen newly nationalised banks. The
most socially productive manner. The ability of an story is told that the opening of four branch banks
economic system to create credit is important for in villages near New Delhi attracted two million
two main reasons. First, it can compensate for the rupees in one day, including a 200 000 rupee
failure of the economic system to equalise planned hoard from a local temple.
saving and investment. Second, it provides the Special development banks also have a role to
means by which growth is financed. This is the real play in financing development. They have several
significance of the invention of paper money and purposes: to provide finance for industry, es-
credit- permitting the economic system to expand pecially where there is difficulty in raising finance
in response to the continual opportunities for through existing financial channels, to assist the
growth provided by technical progress, which a development of the capital market, and to stimu-
barter system, or a purely metallic currency, does late leading sectors of the economy. The emphasis
not allow. of special development banks differs between
Banks can encourage thrift and allocate savings countries. Some invest directly, others guarantee
more productively than otherwise by offering a loans floated by private industry. In general, how-
return on savings and by enabling savings to be ever, the emphasis is on long-term finance, and
used outside the sector in which they originate. on assistance to specific sectors of the economy
Banks can help to break down sectoral bottlenecks where the risks of investment may be higher than
and to unify interest rates. But commercial bank- the ordinary commercial banking system is willing
ing is still rudimentary in most developing econ- to accept. Development banks also have a role to
omies. The ratio of bank deposits to national play in stimulating the capital market. This they can
income averages approximately 15 per cent and do by selling their own stocks and bonds, by help-
the proportion of demand deposits to the total ing enterprises float or place their securities, and by
money supply averages between 25 and 30 per selling from their own portfolio of investments.
cent. In developed countries, by contrast, the ratio The importance of developing and integrating
of bank deposits to national income usually ex- the capital market cannot be overstressed, both
ceeds 30 per cent and the money supply consists from the point of view of encouraging saving and
largely of the deposits of the commercial banks. from the point of view of the most productive use
The number of banks relative to population size is of saving. One of the objects of the extension of
also small. In the developing countries as a whole, the money economy must be to reduce fragmenta-
the average number of banks per million of the tion of the capital market, and in particular to
population is about ten compared with 180 in reduce the dominance of the unorganised money
developed countries. Banks need to be numerous market, where interest rates are very high. Since
and dispersed if they are to act as catalysts for the unorganised market largely embraces the rural
small savings. Lewis comments that experience areas and agriculture, a fragmented market means
shows that the volume of saving partly depends on high interest rates for agriculture and low interest
how widespread savings institutions are: 'if they rates for industry where the returns to investment
are pushed under the individual's nose people save may be lower. Furthermore, within the rural areas
more than if the nearest savings institution is some themselves, the limited outlets for saving can lead
distance away' (Lewis (1955) ). One of the pur- to the wasteful use of resources. In the absence of
poses of the extensive bank nationalisation in In- outlets for saving other than hoarding or invest-
dia in 1969 was to expand branch banking and to ment within the sector, peasants with cash sur-
282 Financing Economic Development
pluses may be forced into hasty decision-making, high savers, and money illusion.
leading to overinvestment and wasteful investment Fiscal policy to raise the marginal propensity to
in some sectors and underinvestment in others. save above the average is concerned with the de-
Monetary policies which are non-inflationary sign and implementation of taxes to reduce private
are essentially designed to raise the level of saving consumption. Tax revenue as a percentage of
and investment voluntarily. Monetary policies can national income and the relative importance of
also 'force' saving, as we shall see later when the different taxes are shown in Table 13.1. It can be
Quantity Theory approach to the finance of de- seen that tax revenue as a percentage of GNP is
velopment is discussed. Before, this, however, typically low in developing countries, averaging
there is another arm of the prior-savings approach about 20 per cent, compared to over 30 per cent in
that needs considering, namely the use of fiscal developed countries, and that taxes on income are
policy to raise the level of saving. Saving raised by a minor source of tax revenue compared with
fiscal policy is essentially involuntary saving ex- indirect taxes. The proportion of the population
cept to the extent that the fiscal policy pursued that pays income tax in developing countries is
encourages increased production which generates correspondingly low, averaging about 10 per cent,
its own saving if the marginal propensity to save is compared to the vast majority of the working
positive. population in developed countries which consti-
tutes between 30 and 40 per cent of the total
population. On the surface there would appear
• Fiscal Policy to be a great deal of scope for using tax policy to
raise the level of community saving relative to
Fiscal policy has two major roles in the finance of income. Two important points must be borne in
development. One is to maintain an economy at mind, however. The first is that the rudimentary
full employment so that the savings capacity of the nature of the tax system in developing countries is
economy is not impaired. The second is to raise partly a reflection of the stage of development
the marginal propensity to save of the community itself. Thus the scope for increasing tax revenue as
as far above the average propensity as possible a proportion of income may in practice be severely
without discouraging work effort or violating circumscribed. There are the difficulties of defining
canons of equity. Using fiscal policy to maintain and measuring the tax base and of assessing and
full employment will involve deficit finance if there collecting taxes in circumstances where the
exists unemployed or underused real resources in population is dispersed and primarily engaged in
the Keynesian sense. While deficit finance is likely producing for subsistence, and where illiteracy is
to be inflationary in the short run until supply has also rife. And there is also the fact that, as far as
had time to adjust, there is an important analytical income tax is concerned, the income of the vast
distinction between the means by which resources majority of economic agents is so low anyway that
are made available for investment through deficit they must fall outside the scope of the tax system.
finance at less than full employment and the means Whereas 70 per cent of national income is subject
by which savings are generated by inflation. In the to income tax in developed countries, only about
former case savings are generated by the increase 30 per cent is subject in developing countries.
in real output, in the latter case by a reduction in Even if there was scope for raising considerably
real consumption through a combination of fac- more revenue by means of taxation, whether the
tors including a real balance effect on outside total level of saving would be raised depends on
money, 1 income redistribution from low savers to how tax payments are financed - whether out of
consumption or saving- and how income (output}
1 The real balance effect on outside money refers to the attempt
is affected. It is often the case that taxes which
by holders of money assets to restore the real value of their
money balances, eroded by inflation, by reducing their con- would make tax revenue highly elastic with re-
sumption. For a fuller discussion, see below. spect to income are taxes which would be met
Financing Development from Domestic Resources 283
Table 13.1 Developing Countries: Tax Revenue by Type of Tax (per cent of GDP)
GDP
per
capita Years Total Income Indirect Trade
(1987 taxes tax taxes taxes
dollars)
Table 13.1 Developing Countries: Tax Revenue by Type of Tax (per cent of GDP) (continued)
GDP
per
capita Years Total Income Indirect Trade
(1987 taxes tax taxes taxes
dollars)
Table 13.1 Developing Countries: Tax Revenue by Type of Tax {per cent of GDP) (continued)
GDP
per
capita Years Total Income Indirect Trade
(1987 taxes tax taxes taxes
dollars)
Source: V. Tanzi, Public Finance in Developing Countries (Aldershot: Edward Elgar, 1991).
mainly out of saving or have the most discourag- munity saving increases depends on how much
ing effects on incentives. For example, very pro- work effort is discouraged and on the relative
gressive income tax will discourage work effort if propensities to consume and save of those who
the substitution effect of the tax outweighs the pay the tax compared to those of the government.
income effect; and to the extent that high marginal In general the most effective tax policy to raise the
rates of tax fall primarily on the upper-income level of saving relative to income would be to
groups with low propensities to consume, saving impose taxes on those with high marginal propen-
may fall by nearly as much as tax revenue rises. To sities to consume, namely the poor, but there are
avoid such large reductions in private saving, an obvious considerations of equity to bear in mind
expenditure tax on upper-income groups, which in pursuing such a policy as well as the practical
exempts saving from taxation, is an alternative to consideration of political feasibility.
a progressive income tax, but the disincentive The predominant importance of agriculture in
effects on work effort are not necessarily avoided. developing countries makes agricultural taxation a
This is so because if the expenditure tax encour- potentially significant source of tax revenue and a
ages saving, the tax rate must be higher to yield the means of transferring resources into investment.
same revenue as the income tax. If people work to There are a great variety of tax instruments for
consume and the price of consumption is raised, taxing agriculture, including taxes on land area,
work effort will be curtailed if the substitution on land value, on net income, marketing taxes,
effect of the change outweighs the income effect. export taxes, land transfer taxes, and so on. If
The more successful the expenditure tax is in sti- revenue is the aim, then marketing and export
mulating saving out of a given income, the higher taxes are probably the most efficient and the
must be the rate of tax to keep the yields from the easiest to collect. As far as exports are concerned
two taxes equal, and the greater the disincentive to two main systems may be adopted. Either the
work effort is likely to be. If the expenditure tax is state-controlled marketing board may pay the pro-
in addition to the income tax, however, there is no ducer a price less than the international price
reason to expect any substitution effect in favour received, or alternatively the government may re-
of private saving, so that whether aggregate com- quire that all foreign exchange receipts be surren-
286 Financing Economic Development
dered, with compensation given in local currency ment is more socially productive than its private
at an exchange rate which overvalues the local counterpart.
currency. Export taxes may, however, have disin-
centive effects. The substitution effect of export
taxes will be to discourage production, or to
switch production to the home market if the home
I Tax Reform in Developing
. 1
Countnes
market is not saturated. Either way, the yield from
tax will fall if the tax base (the level of exports) The efficient utilisation of the tax potential of
falls more than in proportion to the rise in the developing countries raises problems which vary
export tax. In theory, land taxes are probably the with the circumstances of each country, but there
most desirable way to transfer resources from are certain fundamental changes in most of these
agriculture, but in practice land taxes are not im- countries which if adopted would make it possible
portant as a source of tax revenue. It is also worth to increase public revenue and reduce some of the
remarking that no developing country has yet suc- inequities which now exist. Particularly, if a tax
cessfully applied a conventional income tax to system is to be accepted by a poor community, it
agricultural income. The nearest countries get is to must be seen to be administered honestly and
tax the value of land, the imputed income from efficiently, which means that every attempt must
land or the potential physical yield from land. be made to minimise the scope for avoidance
The i;>alance between direct taxes on income (legal) and evasion (illegal).
and indirect taxation on expenditures and trade in According to the classical canons of taxation, a
the economy at large is heavily weighted in the tax system is to be judged by the standards of
direction of the latter, particularly in the form of equity, efficiency and administrative convenience.
import duties and sales taxes (see Table 13.1). The In most developing countries, the tax system is
emphasis on indirect taxes originates from the dif- neither equitable nor efficient and is administra-
ficulties already mentioned of levying direct taxes, tively cumbersome. Avoidance and evasion are
and the disincentive effects that direct taxes can rife.
have. This is not to say that indirect taxes are Equity requires a comprehensive definition of
totally devoid of disincentive effects, but they are income and non-discrimination between income
probably less, especially if taxes such as sales taxes sources. A major deficiency of tax systems all over
and import duties can be levied on necessities the world, and particularly in developing coun-
without too much social hardship. Indirect taxes tries, is that there is no single comprehensive tax
on luxuries will raise revenue, the more so the on all income. Typically there is a 'cedular' system
more price inelastic the demand, but the taxes may with separate taxes on different sources of income:
largely be paid out of saving to the extent that Wage and salary earners ('earned' incomes) tend
luxuries are consumed by the upper-income to be discriminated against vis-a-vis the owners of
groups with low propensities to consume. The property and capital and the self-employed (pro-
equity grounds for such taxation, however, are fessional people and small traders). An equitable
still strong. system should also be such that it discourages
Taxes on business are easy to collect and admin- luxury consumption and makes it difficult to avoid
ister, but again business taxation may merely re- and evade taxation.
place one form of saving with another. The mar- Taxable capacity is not measured by income
ginal propensity to save out of profits is typically alone, but also by wealth. Equity therefore also
high. The main justification for company taxation requires the taxation of wealth. The ownership of
must be to retain control of resources which might wealth endows the owner with an inherent taxable
otherwise leave the country if the business is
foreign-owned, or to substitute public for pri- 1 For an excellent discussion of general issues, and with specific
vate investment on the grounds that public invest- references to Pakistan, see Ahmad and Stern (1991).
Financing Development from Domestic Resources 287
capacity, irrespective of the money income which 3 The institution of a wealth tax.
the asset yields. Consider the case of a beggar with 4 The institution of a gifts tax.
nothing and a rich man who holds all his wealth in
the form of jewellery and gold which yields no Kaldor was a tax adviser to India, Sri Lanka,
money income. Judged by income their taxable Turkey, Mexico, Ghana, British Guiana, Iran and
capacity is the same: nil! Surely no one could Venezuela and recommended tax reform along
claim, however, that their ability to pay was the these lines. Needless to say, the proposals were
same, and that for tax purposes they should be frequently met with opposition and rejection, not
treated equally. only by the ruling vested interests, but sometimes
Income tax is not only inequitable between by workers as well. Kaldor's classic and pioneer-
those with property and those without, but also ing report was prepared for India in 1956. There,
between property holders. For example, two prop- many of the recommendations were first im-
erty holders may derive the same income from plemented, but then whittled down in force.
property but the value of their property may differ In Sri Lanka, the then Prime Minister, Mr Ban-
greatly. One has a greater taxable capacity than daranaike, was strong enough at the time for the
the other. Only a combination of income and proposals to be implemented, but successive
property taxes can achieve equity according to governments were not powerful enough to enforce
ability to pay. This is the case for a wealth tax. them. In Mexico, Kaldor's visit was so politically
Equity also requires that gifts between indi- sensitive that his location in writing the Report
viduals be taxed, on death and inter-vivos. was kept secret. Kaldor himself did not believe at
Efficiency requires that the entire tax system the time that Mexico was politically ready for a
be self-reinforcing and self-checking so that the progressive reform of the tax system, but the
attempt to escape one tax increases the liability to Finar.....e Minister insisted and promised freedom
other taxes. The system should also, as far as possi- to publish the Report. As it turned out the Report
ble, be based on a comprehensive annual return. was never officially published, but was given in-
The above considerations, stressed by Kaldor 1 stead to a series of committees for consideration.
on his many tax missions to developing countries, The proposals were then blocked by President
suggest at least four major reforms of the tax Mateos and his Cabinet.
system in developing countries, which at the same In Ghana, Kaldor was asked by Dr Nkrumah to
time would release resources for investment and advise on the budgetary position and tax system
act as an incentive to effort: during the economic crisis there in 1961. Kaldor
described the ambience of Nkrumah's government
1 That all income (including capital gains) be as that of a medieval court 'flamboyant, extravag-
aggregated and taxed in the same way, at a ant and corrupt'. Kaldor wanted to reform com-
progressive rate, but not exceeding a max- pany taxation to prevent foreign firms escaping
imum marginal rate of, say, 50 per cent. Mar- tax through transfer pricing, and to introduce a
ginal rates above this level may not only scheme of compulsory saving to aid the develop-
discourage incentive but may also be counter- ment effort. The latter proposals, however, led to
productive by encouraging evasion and avoi- political agitation and a workers' strike. In British
dance. Guiana, Kaldor's recommendations led to political
2 The institution of a progressive personal ex- disturbances so severe that the British military had
penditure tax levied on rich individuals who to be called in. The trouble there brewed quickly
reach the maximum marginal rate of income because vested interests had anticipated his visit
tax. and made plans accordingly. There was particular
dislike again of the proposed compulsory saving
1See Kaldor (1980). See also my book, Nicholas Kaldor scheme, and an attempt was made by the trade
(Brighton: Wheatsheaf Books, 1987). unions to depose the goverment by strike action.
288 Financing Economic Development
In Turkey, where a land tax was proposed to and decline, respectively. Keynes was certainly
encourage the more intensive use of land there was more predisposed to inflation than to deflation. He
a collective resignation of the top officials of the described inflation as unjust and deflation as inex-
State Planning Organisation and none of the pro- pedient but of the two inflation is to be preferred
posals ever reached the legislative stage. Such is because 'it is worse in an impoverished world to
the fate of tax advisers in developing countries! provoke unemployment than to disappoint the
In his own retrospective reflections on his role as rentier' (Keynes (1931) ). While recognising that
adviser, Kaldor says that through the unpopularity inflation to increase capital accumulation may
engendered, it became clear that the power behind have regressive distributional consequences, he
the scenes of the wealthy property owning classes further argued that the long-run gains to the wage-
was very much greater than the political leaders earners can outweigh the short-term losses: 'the
suspected. But he did not repent: 'progressive taxa- working class may benefit far more in the long run
tion is, in the end, the only alternative to complete from the forced abstinence which a profit inflation
expropriation through violent revolution'. imposes on them than they lose in the first instance
in the shape of diminished consumption so long as
wealth and its fruits are not consumed by the
• Inflation, Saving and Growth nominal owner but are accumulated' (Keynes
(1930) ).
If voluntary and involuntary saving are inad-
equate, inflationary policies which 'force' saving
by 'taxing' money and by redistributing income
between classes within the private sector are an
I The Keynesian Approach to the
Finance of Development
alternative possibility. The price of financial con-
servatism may well be economic stagnation. The The Keynesian approach to the finance of develop-
potential benefits of inflationary finance, which ment by inflationary means stresses first that in-
embrace both the Keynesian and Quantity Theory vestment can generate its own saving by raising
approaches to development finance, have been dis- the level of income when the economy is operating
cussed by economists 1 at least since David Hume, below capacity, and by redistributing income from
and several economic historians (including wage-earners with a low propensity to save to
Keynes) claim to have discerned a relationship in profit-earners with a high propensity to save when
history between periods of inflation and rapid econ- the economy is working at full capacity, and
omic development. Hamilton (1952) has claimed second that inflation itself can encourage invest-
that inflation has been a powerful stimulant to ment by raising the nominal rate of return on
growth in a wide number of historical contexts investment and by reducing the real rate of in-
through the favourable effect of excess demand on terest. Only the first of these two aspects of the
profits, saving and investment; for example, in Keynesian approach will be considered here.
England and France in the sixteenth and seven- Unemployed resources provide the classic
teenth centuries and in England in the latter half of argument for Keynesian policies of inflationary
the eighteenth century. Rostow (1960) also claims finance. If resources are unemployed or under-
that inflation has been important for several in- used, real output and real savings can be increased
dustrial take-offs. Keynes in the Treatise on by governments running budget deficits financed
Money similarly remarked on the apparent ex- either by printing money or by issuing government
traordinary correspondence in history between bonds to the banking system and the public.
periods of inflation and deflation and national rise In a situation of genuine 'Keynesian' unemploy-
ment any tendency towards inflation, whatever
1 Including Malthus, Bentham, Thornton, Robertson and, method of deficit finance is used, should burn itself
more recently, Kaldor. out as the supply of goods rises to meet the ad-
Financing Development from Domestic Resources 289
ditional purchasing power created. Some econom- opportunities for investment which can yield out-
ists have questioned, however, whether the puts several times the money value of capital in-
observed unemployment of labour in developing vested in a very short space of time. In agricuiture,
countries is strictly of the Keynesian vatiety, and the use of fertilisers and the provision of transport
whether the supply of output would respond very facilities are good examples. Credit expansion for
much to increased demand. An early exponent of these activities can soon generate output sufficient
this view was Professor Rao, who disputes the to absorb the demand-creating effects of the new
secondary repercussions on output as visualised by money in circulation. In Ecuador, it has been esti-
the multiplier process: mated that with investment of between $10 and
$15 of money capital per hectare (at 1960s prices),
the secondary, tertiary and other increases in settlers can clear and cultivate land which yields
income, output and employment visualised by output of between $88 and $145 for internal con-
the multiplier principle do not follow, even sumption and export, respectively (Bottomley
though the marginal propensity to consume is (1965) ). This is a very high output-capital ratio
very high. This is because the consumption and the gestation period is short. In Morocco some
goods industries to which the increased demand of the investments as part of the employment-
is directed are not in a position to expand out- generating programme, particularly irrigation
put and offer effective additional employment schemes, have yielded quick and high returns, espe-
(Rao (1952) ). cially evaluating costs and benefits at shadow prices
(see Jackson and Turner (1973) ).
Professor Reddaway reiterates this view by question- Thus while it may be conceded that much of the
ing whether putting unlimited supplies of labour to unemployment in developing countries is not of
work will have the significant real income multiplier the Keynesian variety, it does not follow that
repercussions that Keynesian theory suggests. Refer- monetary expansion in conditions of unemploy-
ring to road building he says: ment cannot generate secondary employment
and output effects. The capacity-generating effects
The secondary consequences of this, in the shape need to be considered in conjunction with the
of additional deJ:Dand for consumer goods, emphasis on demand in Keynesian static multiplier
mainly serve to increase the demand for food; theory.
and the output of foods is not limited by the Let us tum now to the Keynesian full-employ-
lack of demand, even though there is plenty of ment case. At full employment, inflation is the
underemployed labour attached to agriculture. inevitable result of the Keynesian approach to de-
The extra demand consequently falls on the velopment. In contrast to classical and neoclassical
balance of payments [and/or) it serves to drive theory, Keynesian theory specifies independent
up prices. There is growth in the national in- saving and investment functions and allows price
come corresponding with the work done on the changes in reponse to excess demand in the goods
road building, but there is little or no multiplier market to raise saving by redistributing income.
effect (Reddaway (1963), pp. 8-9). Inflation is the means by which resources are redis-
tributed between consumption and investment. In
While there is some element of truth in these Keynesian models, investment is not constrained
statements, there are arguments to be put on the by saving but by the inflation rate willing to be
other side. Some deficit-financed projects may tolerated by wage-earners who have had their real
have considerable secondary repercussions on out- wages cut.
put if they eliminate production bottlenecks at the If plans to invest exceed plans to save it is reason-
same time. In the agricultural sector of developing able to suppose that both investors and consumers
countries, and in the production of consumer have their plans thwarted. Capital formation is less
goods in the industrial sector, there are many than firms desire, but greater than consumers plan to
290 Financing Economic Development
save. Let us assume, therefore, that the actual growth where W is the wage bill, w is the wage rate, P is
of capital is a linear combination of planned saving price per unit of output, Y is income, and r = YIL
and planned investment: is the productivity of labour. Hence, the rate of
change of labour's share may be written:
dK I S
- = a- + (1 - a)- a< 1 (13.3)
K K K - _ (dw
dZ - ---dP) - dr
- (13.7)
z w P r
where K is the quantity of capital, I is planned
investment, and S is planned saving. Now assume From this equation a number of interesting prop-
that the rate of inflation is proportional to the ositions can be established. First, given a positive
degree of excess demand as measured by the differ- rate of growth of productivity, a sufficient condi-
ence between plans to invest and save: tion for a redistribution of income from wages to
profits is that prices rise faster than wages. Note,
~) however, that in a growing economy (with posi-
dP = A ( _!___ _ A>O (13.4)
P K K tive productivity growth) it is not a necessary con-
dition. Labour's share will fall and the share of
where P is the price level. Substituting the express- profits rise as long as (dw/w - dPIP) < drlr; that
ion for IlK into (13.3) gives: is, as long as the real wage rises less than the
growth of labour productivity. In a growing econ-
dK a(dP/P) S omy, therefore, there is no necessary clash be-
---+- (13.5) tween the real wage and profits. The real wage can
K A K rise and the share of profits in income can also rise
as long as some of the gains in labour productivity
SIK is planned saving and a(dP/P)IA is forced sav-
are appropriated by the capitalists. Second, it can
ing, per unit of capital. Forced saving results from
be shown that, on the classical savings assump-
the inability of consumers to fulfil their planned
tions that the propensity to save out of profits is
consumption in conditions of excess demand. The unity and the propensity to save out of wages is
underlying mechanism which thwarts the plans of
zero, the rise in the aggregate savings ratio will be
consumers is the inflation which redistributes in-
equal to the fall in labour's share of income. If all
come from wage-earners to profits. Other things
wages are consumed and all profits are saved
remaining the same, if prices rise faster than
equation (13.7) may be written as:
wages, real consumption will fall and real saving
increase as long as the propensity to save out of
dZ de dr
profits is higher than the propensity to save out of (13.8)
wages. In Keynesian models, therefore, the effect z c r
of inflation on saving depends on two factors: where cis real consumption per worker. Hence:
first, the extent to which income is redistributed
between wages and profits; and second, the extent dZ dC dY d(C/Y)
of the difference in the propensity to save out of -=---=
wages and profits. The relation between wages,
z c y CIY
prices and profits, and the consequent effect of where C is aggregate consumption, Y is income,
income redistribution on saving, is best illustrated and C/Y is the consumption-income ratio. Since
using simple algebra. Let Z be labour's share of d(C/Y)/(C/Y) = - d(S/Y)/(C/Y), and dZ =
national income so that: d(C/Y), we have the result that - d(SIY) = dZ, i.e.
labour's share and the aggregate savings ratio
W wL w change by exactly the same amount (in opposite
Z=-=-=- (13.6)
py PY Pr directions).
Financing Development from Domestic Resources 291
The basic Keynesian notion that investment the rate of capital accumulation and the rate
determines saving forms the backbone of neo- of growth. This follows since S = I = rtK, and
Keynesian growth theory as expounded by Robin- t!.K = rtK; therefore t!.KIK = rt. And if the capital-
son (1962) and Kaldor (1955-6). Variations in the output ratio is fixed, t!.KIK = t!. YIY; hence rt =
savings ratio resulting from inflation and income t!.KIK = t!. YIY. Variations in the rate of profit and
redistribution is one af the many possible adjust- corresponding variations in the real wage provide
ment mechanisms for raising the warranted the mechanism which equilibrates plans to save
growth rate towards the natural rate. As Robinson and invest and the actual and warranted growth
used to argue, in response to the neoclassical rates. If the actual growth rate equals the natural
adjustment mechanisms of variations in interest rate, the warranted and natural growth rates will
rates and the capital-output ratio, there is nothing also be equalised. If the real wage remains un-
in the laws of nature to guarantee growth at the changed as investment takes place, however, sav-
natural rate, but if entrepreneurs wish to invest ing cannot adapt and a greater volume of real
sufficient to grow at the natural rate then saving investment cannot be financed. This is the inflation
will adapt, subject to an inflation barrier. 1 When a barrier in a static model. It appears, in fact, that in
steady rate of growth is going on, the share of a static context the growth rate can only be raised
savings adapts to it. In effect, the actual growth at the expense of the real wage, which comes close
rate pulls up the warranted growth rate by forcing to the pessimistic development theories of Ricardo
saving. Saving adapts to investment through the and Marx. In a growing economy such pessimism
dependence of saving on the share of profits in would be unfounded because it can be seen from
income which rises with the level of investment equation (13.1 0) that the rate of profit and capital
relative to income in the way that has already been accumulation can rise even if the real wage is
described. Profits in turn depend on what happens rising as long as the growth in labour productivity
to real wages when the system is out of equilib- exceeds the increase in the real wage.
rium. The basic equation of Robinson's model is Kaldor in his model also makes saving adjust to
the distribution equation: the desired level of investment through a rise in the
share of profits in national income. The model
PY = wL + rtPK (13.9) consists of three basic equations:
The ratio of profits to income and the investment Now let w = a + a(p), where a is the rate of
ratio are positively related as long as the propensi- autonomous wage change and a is the wage-price
ty to save out of profits exceeds the propensity to coefficient. Equation (13.17) may then be written:
save out of wages. The investment ratio must
clearly be the independent variable in the system.
Capitalists can decide how much they are going to (13.18)
consume and invest but they cannot decide how
much profit they are going to make. If sr = 1 and
sw = 0, then IIY = RIY, and, multiplying both The effect of inflation on the savings ratio through
sides of equation (13.15) by YIK we have Robin- time can be ascertained by differentiating equation
son's result that the rate of profit, the rate of (13.18) with respect to time:
capital accumulation and the rate of growth are all
equal. A higher level of investment can raise the
rate of capital accumulation by raising the profit [a + p(a - 1)] ( Wo) eP(a-l)t+at(sw - Sr)
rate and the share of saving in total income, sub- Yo (13.19)
ject, of course, to the inflation barrier. The
mechanism which gives this result is rising prices
relative to wages. Given the target rise in the savings ratio required
It is interesting to consider, using a model like during a particular time period, an approximate
Kaldor's, how much inflation is necessary to raise solution to p can be obtained given the parameter
the savings ratio by a given amount. There are two values of the model.
methods of approach to this question which can To consider the increase in the inflation rate
both be considered using the same model. One is necessary to raise the savings ratio by a given
to consider the redistributive effects of inflation amount differentiate equation (13.18) with respect
through time and ask how much inflation there to p:
would have to be within a certain time period for
the savings target to be achieved holding the par-
ameters of the model constant. The second
approach is to consider what increase in the rate of a(S/Y)t = (a - 1)t ( Wo) eP(a-l)+at(sw - Sr)
inflation is required for a once-for-all increase in ap Yo (13.20)
the savings ratio of a given amount. Both methods
of approach can be considered if Kaldor's model is
formulated in continuous time. Taking a savings The reciprocal of equation (13.20) then gives the
function of the Kaldor type, s = Sw w + srR, let: extra inflation required to raise the savings ratio
by one percentage point. The change in the savings
ratio with respect to a change in the inflation rate
can be seen to depend on four factors: (i) the
where W0 is the initial wage bill, Y 0 is the initial difference in the propensity to save out of wages
income level, w is the rate of growth of wages, and and profits (sw - sr); (ii) the wage-price coefficient
p is the rate of growth of money income (= the (a); (iii) labour's initial share of income (W0 /Y0 );
rate of inflation). Dividing through by Y 0 ePt to and (iv) the rates of inflation and autonomous
obtain an expression for the savings ratio at time t, wage increases already prevailing (p and a). It is
and rearranging, gives: clear from equation (13.20) that if a = 1 and/or
sw = s" there can be no redistribution effects on
saving from generating extra inflation.
The extra inflation required to raise the savings
Financing Development from Domestic Resources 293
ratio is very sensltlve to the parameter values The essential point of Keynes' teaching remains. It
taken. On classical assumptions that sw = 0 and is decisions about how much investment is to be
sr = 1, the extra inflation required to raise the made that governs the rate at which wealth will
savings ratio by one percentage point is relatively accumulate, not decisions about savings.' A start
mild regardless of the value of the wage-price coef- at reconciliation would be for the prior-savings
ficient and the initial share of wages in income. 1 school to admit the possibility of forced saving
The classical assumptions are somewhat unrealis- and to reduce their aversion to demand inflation.
tic, however. Taking Houthakker's (1965) long- Equally, the Keynesians could admit that saving
run estimates of sw = 0.02 and sr = 0.24, depends on factors other than the functional dis-
combined with W0 /Y0 = 0.7 and a= 0.5, gives an tribution of income, and that for any desired
inflation rate of 13 per cent (starting from zero) to savings-investment ratio inflation will be less, the
raise the savings ratio by one percentage point. A more voluntary saving can be encouraged.
wage-price coefficient of 0.9, however, raises the
required rate to 66 per cent. Even Keynesians
might agree that 66 per cent extra inflation to raise
the savings ratio by one percentage point is a high
I The Quantity Theory Approach
to the Finance of Development
price to pay for extra growth!
I
The quantity theory approach to the finance of
development stresses the effect of inflation as a tax
Reconciling the Prior-Saving vs on real money balances. Suppose a government
Forced-Saving Approaches to wishes to divert more of a country's resources to
investment, one of the ways it can do so is to invest
Development itself on society's behalf, financing the investment
by expanding the money supply. In conditions
There can be little doubt that the traditional de- where capital is already fully employed, monetary
velopment literature and the governments of most expansion will be inflationary. Inflation is the
developing countries have veered towards the clas- means by which resources are effectively trans-
sical view of development in policy prescriptions ferred to government. Inflation imposes a tax on
and in the formulation of plans. But there is surely money holdings which consists of the reduction in
scope for a more eclectic approach. It is not necess- the real purchasing power of money and of the
ary to be a classicist to recognise the importance of real resources that the holders of money must
voluntary saving in capital-scarce economies, and forgo to restore the value of their money holdings.
it should not be necessary to be a Keynesian to The base of the tax is the level of real cash balances
admit that investors may lay claim on real re- (M/P), and the tax rate is the rate at which the real
sources in excess of the community's plans to save. value of money is deteriorating, which is equal to
The Keynesian can welcome prior saving. What the rate of inflation (dPIP). The real yield from the
he disputes is that saving is necessary for invest- tax is the product of the tax base and the tax rate,
ment; that investment is constrained by saving. As i.e. (MIP)(dPIP), which will be maximised (as in
Robinson (1960, vol. II) has said in discussing the standard tax theory) where the elasticity of the
relation between savings and investment at full base with respect to the rate of tax is equal to -1.
employment: 'We cannot return to the pre- If the rate of inflation is equal to the rate of monet-
Keynesian view that savings governs investment. ary expansion, the real tax yield (R) will equal the
real value of the new money issued, i.e. (MIP)(dM!
1 The initial values of p and a can be ignored because for
M) = dMIP. If dPIP > dM!M, some of the poten-
reasonable values the expression ,J'{a-t)+at .is approximately tial tax yield will be lost owing to a reduction in
uniry. the tax base. The inflation tax can be illustrated
294 Financing Economic Development
I Non-Inflationary Finance of
Investment
plicity that the banks operate a 100 per cent re-
serve system. 1 Setting p = 0, the approximate
increase in the demand for money is equal to the
product of the money stock and the rate of growth
Up to now it has been assumed that the rate of of the money stock:
inflation is equal to the rate of monetary expan-
sion. If output is growing, however, and/or the dM = Mm = M(kd + y) (13.24)
demand to hold money relative to income is rising,
a proportion of the expansion of the money supply Dividing through by Y gives:
will be non-inflationary, enabling some govern-
ment investment to be financed without any in-
crease in the general price level. This is easily seen
taking the fundamental equation of exchange:
If y is the target growth rate, and c, is the required
MV = PY, capital-output ratio, the investment ratio to achieve
the growth rate is:
or
I
(13.22) (13.26)
financed without inflation, we assume for sim- finance government investment without inflation.
296 Financing Economic Development
dY 1 dM
-- = ro- (13.34)
An attempt has been made by Mundell (1965) to dt p dt
calculate the inflation rate required to raise the
growth rate by any given amount on the assump- Dividing (13.34) by Y gives:
tions of full employment and that monetary ex-
pansion is the only means of diverting resources to dY 1 1 dM
investment. We start with the fundamental equa- - = ro - -
dt y py dt
tion of exchange in its rate of growth form (see
equation (13.23)):
or
y=m+v-p (13.28)
M
y=rom-- (13.35)
Now let the equation for output be written as: py
inflation proceeds. To incorporate the effect of volved in pursuing a deliberate inflationary policy
inflation on velocity into the model, assume that to stimulate development which need to be borne
velocity is a linear function of the inflation rate: in mind. The most serious threats to growth from
inflation come from the effect on the balance of
V =Yo+ ~ 0 (p) (13.37) payments if foreign exchange is a scarce resource,
and from the possibility that voluntary saving,
Substituting (13.37) into (13.36) gives: productive investment and the use of money as a
medium of exchange may be discouraged if infla-
tion becomes excessive. If one country inflates at a
p- [ (V0 1ro) - 1 ]
y (13.38) faster rate than others, its balance of payments
1 - (~ 0 /ro)y
may suffer severely, necessitating import-substitution
From equation (13.38) it can be seen that the policies and exchange controls, thus leading to
inflation-growth coefficient now increases with the inefficiency in resource allocation. As far as invest-
growth rate because higher growth through infla- ment is concerned, if inflation becomes excessive,
tion involves an increased velocity of circulation of investment in physical plant and equipment may
money. There is now a limit to which growth can become unattractive relative to speculative invest-
be financed by borrowing from the central bank ments in inventories, overseas assets, property and
given by y = ro/~ 0 • This is the value of y when the artefacts which absorb a society's real resources. If
denominator of equation (13.38) is zero. If, for the real rate of interest becomes negative (i.e. the
example, ~ 0 = 10, to raise the growth rate by 1 per rate of inflation exceeds the nominal rate of
cent requires a 57 per cent rate of inflation interest) it may even become attractive to claim
(p = 0.57), and the maximum growth rate possi- real resources and not to use them.
ble (the growth rate at which inflation in infinite) Inflation clearly reduces the purchasing power
is 1.5 per cent. of money. If inflation becomes excessive not only
may voluntary saving be discouraged but the use
of money as a medium of exchange may be dis-
• The Dangers of Inflation couraged, involving society in real resource costs
and welfare losses. Since inflation reduces the pur-
Some of the advantages of inflation have been chasing power of money, holders may be expected
considered, especially the ability of inflation to to avoid the loss by cutting down their holdings of
release resources for development by the redis- money for transactions purposes. The cost of infla-
tribution of income between classes within the tion arises from the fact that cash balances yield
private sector and from the private sector to the utility and contribute to production, and inflation
government. Inflation is not without its dangers, causes energy, time and resources to be devoted to
however, and these must be briefly mentioned. minimising the use of cash balances which are
First, a distinction needs to be made between the costless to produce, e.g. the frequency of trips to
different types of inflation that may be experienced the bank may increase, which absorbs labour time,
by a developing country: demand inflation, cost and credit mechanisms may be resorted to, which
inflation and structural inflation. The argument absorb society's resources.
for inflationary finance is an argument for demand There are also the distributional consequences
inflation. Cost inflation by reducing profits will of inflation to consider. These are difficult to
not be conducive to development. Structural infla- assess. All that can be said with some confidence is
tion may be the inevitable price of development the following: debtors benefit at the expense of
but there is nothing in the process of structural creditors; profit-earners gain at the expense of
inflation itself that will necessarily accelerate the wage-earners in times of demand inflation and lose
development process. at the expense of wage-earners in times of wage
There are also certain dangers and costs in- inflation; real-asset holders probably gain relative
298 Financing Economic Development
to money-asset holders; the strong (in a bargaining example, for seventeen developed countries with
sense) probably gain relative to the weak and the per capita incomes in excess of $800 per annum,
young gain relative to the old, who tend to live on all of which experienced mild inflation between 3
fixed contractual incomes. In developing countries and 8 per cent per annum, the following result was
the possible inegalitarian distributional conse- obtained: g = 2. 79 + 0.61 p; r 2 = 0.48, where g is
quences of demand inflation should not be allowed, the growth rate and p is the rate of inflation. For
however, to constitute an argument against the use the developing countries the evidence was incon-
of mildly inflationary policies if one of the objects clusive, except that there appeared to be a definite
of the policies is to create additional employment. negative relation between inflation and growth
The major beneficiaries of inflationary finance among countries which experienced annual rates
should be the unemployed and the underem- of inflation in excess of 10 per cent. Over all
ployed, which represents a move towards a more countries, it was found that mild inflation tends to
egalitarian structure of household incomes. be associated with the highest ratio of investment
Having considered some of the potential dan- to income, compared with countries with relative
gers of inflation it can be seen that there is plenty price stability or inflation in excess of 10 per cent.
of room for disagreement over whether inflation is In a study of thirty-one developing countries,
a help or a hindrance to development. Some argue Tun Wai (1959) found a positive relation between
that it can help to raise the level of real saving and inflation and growth up to a critical inflation rate,
encourage investment, while others maintain that after which growth apparently declined. This is
it is liable to stimulate the 'wrong' type of invest- the type of relation that one might expect in the
ment and that inflation may get out of control and light of our discussion of the advantages and dan-
retard development through its adverse effects on gers of inflation. In Tun Wai's model, the inflation
productive investment and the balance of pay- rate which maximises the growth rate is 12.8 per
ments. A lot clearly depends on the type of infla- cent. Other economists have suggested between 5
tion under discussion and its rate. What is badly and 10 per cent inflation as the optimum rate of
needed is a substantial body of empirical evidence inflation (e.g. Harberger (1964)). Dorrance (1966),
(both cross-section and time-series) of the relation in a similar statistical study, finds that the evidence
between inflation and some of the key variables in supports the argument for mild inflation.
the development process, especially savings and On the other hand, Wallich (1969), in a cross-
investment, as well as between inflation and de- section of forty-three countries over the period
velopment itself. There is some evidence which is 1956-65, finds inflation and growth negatively
considered below, but it is very inconclusive. 1 related. A rate of inflation of 1 per cent above the
average appears to be associated with a growth
I
rate of 0.04 percentage points below the average.
Inflation and Growth: The Wallich blames the effect of inflation on the
Empirical Evidence quality, distribution and cost of investment. 2
least until the recent past, was extremely mild. It tion of some of the countries in Latin America,
was a myth that developing countries were typi- where inflation has been endemic for many years,
cally prone to high rates of inflation. Out of a almost from the start of the industrialisation pro-
sample of forty-eight developing countries over cess. This chapter concludes with a brief dis-
the period 1958-68, thirty-eight recorded average cussion of the Latin American experience and of
rates of inflation of less than 6 per cent per annum the 'structuralist-monetarist' controversy over the
(see Thirlwall (1974), p. 35 and appendix 1). Over causes of rapid inflation.
the period of 1949-65 Adekunle (1968) found an
average rate of inflation of 3.6 per cent for twenty-
four developing countries compared with over 4.0
per cent for a sample of twenty-three more de-
I The Structuralist-Monetarist
Debate in Latin America
veloped countries. In a further study, Jackson,
Turner and Wilkinson (1972) also show the mild, Since 1965, the inflation rate in Bolivia, Peru,
and broadly uniform, inflationary experience of Argentina and Brazil has averaged over 100 per
most developing countries outside Latin America. cent per annum. In Chile, Mexico and Uruguay it
Two distinct groupings were observed: one around a has averaged from 40 to 70 per cent. Only in
mean rate of inflation of 3 per cent per annum, the Venezuela, Colombia and Paraguay has the rate
other around a mean rate of 30 per cent per been relatively mild at 20 per cent. A heated de-
annum, with only a very small group in between. bate developed in the early post-war years, which
Historically, most developing countries have been still smoulders today, over the primary impetus
very conservative financially. behind rapid price incre~ses. Participants in the
In the 1970s there was a marked acceleration in debate polarised into two schools, frequently
the rate of inflation, and Table 13.2 compares and referred to as the 'structuralists' and the 'monetar-
contrasts the rate of inflation between groups of ists'. Although the debate is set in the Latin Amer-
countries pre- and post-1980. ican context, it is none the less of general interest
and in many ways has been analogous to the
Table 13.2 Average Rates of Inflation by Income Keynesian-monetarist debate over the causes of
Group(%) inflation in developed countries. It might also be
said that the two debates have been equally sterile
1965-80 1980-90 and inconclusive.
The essence of the structuralist argument is that
Low income countries 4.5 9.6 price stability can only be attained through selec-
China and India 2.7 6.8
tive and managed policies for economic growth. It
Middle-income countries 21.1 85.6
Industrialised countries 7.6 4.5 is claimed that the basic forces of inflation are
structural in nature, that inflation is a supply
Source: World Development Report, 1992 (World Bank). phenomenon and, as such, can only be remedied
by monetary and fiscal means at the expense of
Over the period 1965-90 the rate of inflation intolerable underutilisation of resources. Structur-
has averaged 7 per cent in low income countries, alists do not deny that inflation could not persist
over 50 per cent in the middle income countries, for long without monetary expansion, but they
and 6 per cent in the industrialised countries. The regard this as irrelevant because price stability
average rates of inflation for individual countries could only be achieved by monetary means at the
are shown in Table 1.2 (p. 15). There is a wide cost of stagnation and underemployed resources.
variety of experience exhibited between countries Thus the role of financial factors in propagating
but on balance the developing countries seem to inflations is not denied; what is disputed is that
have been only slightly more inflation prone than inflation has its origins in monetary factors. In the
the developed countries, with the notable excep- structuralists' view, monetary policy would only
300 Financing Economic Development
attack the symptoms of inflation, not its root America), instead of tackling the root causes of
causes. They argue further that, owing to the in- inflation, creates bottlenecks which subsequently
stability of export proceeds, and the slower feed the inflation. But in the first instance inflation
growth of exports relative to the demand for im- is caused by excess demand due to monetary ex-
ports, the control of inflation in the short run, for pansion. And balance-of-payments difficulties are
balance-of-payments reasons, is virtually imposs- also ascribed to monetary irresponsibility. In sum-
ible without external assistance, unless growth is mary, the monetarists hold that the only way to
to dry up completely. curb inflation is through monetary and fiscal pol-
In support of their case that inflation emanates icy to dampen demand, and that most of the
from the supply side, the structuralists point to the alleged supply inelasticities and bottlenecks are
characteristic features of developing countries: the not autonomous, or structural, but result from
rapid structural changes taking place in the econ- price and exchange-rate distortions generated in
omy, the supply inelasticities leading to bottlenecks, the inflationary process. And on the broader ques-
etc., and refer back to the pre-industrialisation era tion of whether or not the inflation is desirable in
in Latin America when inflation was much less the interests of development, the answer of the
severe than it has been in the recent past. The main monetarists is an unequivocal 'no'.
plank of the argument, and on which blame for It is true that it is hard to find a systematic
inflation is placed, seems to be the lack of pre- relation between the rate of inflation and the rate
paredness for industrialisation. Prior to 1930 there of development. If anything, the relation may be
was relative price stability due to fairly elastic negative. Argentina, Chile and Bolivia have stag-
supplies of agricultural output and low population nated with rapid increases in the price level, while
growth. It is claimed, however, that Latin America Mexico, Venezuela and Ecuador, which stand
entered the industrialisation era burdened with a lower in the inflation league, have developed com-
capitalist class unwilling to invest and a growing paratively quickly. It also seems to be the case that
pressure of population on food supplies, which in countries where prices have risen fastest the
together contributed to bottlenecks and the begin- money supply has also grown most rapidly, at
nings of inflation - subsequently exacerbated by a rates of between 20 and 30 per cent per annum.
wage-price spiral. Neither of these observations, however, answers
There is some dispute, though, whether this is the question of whether monetary expansion in-
an accurate picture for the whole of Latin Amer- itiates inflation or whether it simply stokes in-
ica. According to some observers the sequence of flationary tendencies already present on the supply
events described by the structuralist school is more side. Moreover, if monetary expansion was cur-
a description of a particular -country, Chile. In- tailed, would it be output or prices that would fall
deed, Campos (1961) has gone as far as to say that the most? There is no consensus, but a majority of
any visitor to the Economic Commission for Latin observers, as far as Peru, Argentina and Chile are
America in Santiago cannot help feeling that the concerned, seem to pinpoint supply factors as the
thinking of the structuralist school has been main contributors to rising prices. In the case of
affected by the peculiarities of the Chilean infla- Chile and Argentina, especially, there seems to be
tion. But Campos is a confessed monetarist! For a fair degree of unanimity that inflation has re-
even in the Chilean case he claims that the bottle- sulted from a combination of policies to foster
necks observed were induced by inflation itself high-priced import-substitute activities and ex-
and were not causal elements in the process. This change depreciation due to balance-of-payments
is a more general claim of the monetarist school. difficulties. It is of course possible to argue that all
They argue that supply bottlenecks are created by balance-of-payments deficits are a monetary phenom-
policies which discourage investment, e.g. price enon, but the more relevant question is: what is
controls. Thus they maintain that the process of the cost of balance-of-payments stability in terms
repressing inflation (which is fairly typical in Latin of growth? If the cost is high, inflation may
Financing Development from Domestic Resources 301
be regarded as the price paid for the worthy goal doubtedly to play safe and steer a middle course.
of attempting to maintain growth in the face of Indeed, it would not be difficult to defend the
balance-of-payments deficits. There is a case, at view, even without much knowledge of individual
least for policy-making purposes, for regarding situations, that inflation has probably been a com-
inflation as primarily a supply phenomenon if a bination of both demand and supply factors; all
reasonable rate of growth is incompatible with a inflations, other than hyperinflations, usually are!
balance on international account, or if price stab-
ility is only compatible with massive underutilisa-
tion of resources. A case in point is Chile. Some
past evidence for the modern sector of Chile sug-
I Questions for Discussion and
Review
gested, for example, that while wage-rate increases
and prices are responsive to variations in the press- 1. What is the difference between voluntary sav-
ure of demand, complete wage and price stability ing, compulsory saving, and 'forced' saving?
would require unemployment rates of between 15 2. What are the main determinants of voluntary
and 20 per cent (Coot (1969)). This is prima facie saving?
evidence of extreme structural disequilibrium in 3. How can 'monetisation' of the economy help
the economy, and although demand management to raise the level and productivity of capital
could be used to control inflation, the extent of accumulation in developing economies?
unemployment implied would be very high indeed. 4. What factors determine the rate of monetary
In situations like this, what is clearly required are expansion consistent with stable prices?
policies on the supply side to bring about a greater 5. What are the advantages of credit money over
degree of balance between sub-markets so as to commodity money for a developing country?
shift inwards the 'trade-off' curve (as conven- 6. Suggest r-eforms to the tax system in develop-
tionally drawn) between inflation and the pressure ing countries that would promote both equity
of demand in the total economy. 1 and capital accumulation.
What, then, are we to make of these two 7. What is meant by 'inflation as a tax on
schools of thought on inflation in Latin America, money'?
and the relatively scanty evidence on which to 8. In what ways is demand inflation conducive to
make a judgement? The best solution is un- growth and development?
9. Should interest rates be as high, or as low, as
possible for rapid development?
1 For a 'structural' interpretation of Bolivian hyperinflation, see 10. What is the role of special development banks
Pastor (1991). in the development process?
II Chapter 14 II
Foreign Assistance, Debt and
Developn1ent
Introduction 302 The Types and Magnitude of International
Dual-Gap Analysis and Foreign Capital Flows 330
Borrowing 304 The Total Net Flow of Financial Resources
The Investment-Savings Gap 305 to Developing Countries 331
The Import-Export, or Foreign Exchange, Official Development Assistance 331
Gap 307 Total Net Flow of Financial Resources by
A Practical Case Study of Dual-Gap DAC Countries 332
Analysis 307 United Kingdom Assistance to Developing
The Assumptions of Dual-Gap Analysis 308 Countries 332
Models of Capital Imports and Growth 309 OPEC Assistance 336
Capital Imports, Domestic Saving and the Multilateral Assistance 336
Capital-Output Ratio 310 World Bank Activities 337
The Balance of Payments, Foreign Structural Adjustment Lending 338
Borrowing and the Debt Burden 311 The Recipients of External Assistance 339
The Debt Service Problem 312 Estimating the Aid Component of
The Debt Crisis of the 1980s 319 International Assistance 340
Solutions to Debt Difficulties 322 Aid-tying 345
The Debate Over International Assistance The Distribution of International
to Developing Countries 326 Assistance 347
The Motives for Official Assistance 326 Schemes for Increasing the Flow of
Private Investment and the Multinational Resources 349
Corporation 328
302
Foreign Assistance, Debt and Development 303
would be confined to sectors of economic activity deficit on current account, while domestic re-
which have a surplus of income over current re- sources lie idle. These deficits require financing not
quirements, which would be inefficient and sub- only in the interests of the countries themselves,
optimal from a growth point of view. Very often but for the sake of the growth momentum of the
the factors which cause the supply of capital to whole world economy. There is a mutual inter-
increase create its own demand. The most obvious dependence in the world economic system because
example of this, at the international level, in recent countries are linked through trade. The alternative
years was the increase in the price of oil in 1973 to the financing of deficits is adjustment by defla-
and 1979 which created both large surpluses for tion, which means slower growth in the system as
oil-exporting countries and the need to borrow by a whole.
oil-importing countries to maintain economic If the historical experience of countries now
growth without curtailing imports. Going back developed is considered, in cases where borrowing
into history, sovereign lending (and the problems took place (mainly from the United Kingdom as
associated with it) has been a feature of inter- the major creditor) the borrowing was ultimately
national economic life at least since the Medicis of converted into an export surplus which enabled
Florence started making loans to the English and the country to redeem its debt and to become a net
Spanish monarchs in the fourteenth century. His- creditor. The condition for this to happen is that
torically, the international lending and borrowing the marginal savings ratio should exceed the aver-
process has played an integral part in the develop- age to eliminate a savings-investment gap if that is
ment of most major industrialised countries, and the dominant constraint, or that the marginal
continues to play a significant role in the economic propensity to export should exceed the marginal
transformation of today's developing countries. propensity to import if foreign exchange is the
Traditionally, the role of foreign borrowing dominant constraint. For most developing coun-
was seen by countries as a supplement to domestic tries today there is little evidence that they have
saving to bridge a savings-investment gap for the either the desire or the ability to reduce the level of
achievement of faster growth. The concept of net resource inflows and indebtedness - without
dual-gap analysis, however, pioneered by Hollis major disruption of their economies. The need for
Chenery and his collaborators (see later), shows resources is as acute as ever, and indebtedness
that foreign borrowing may also be viewed as a mounts because of a dominant foreign exchange
supplement to foreign exchange if to achieve a gap to meet development requirements and to pay
faster rate of growth and development the gap interest and amortisation on past borrowing. The
between foreign exchange earnings from exports countries find it difficult to convert domestic re-
and necessary imports is larger than the domestic sources into foreign exchange in adequate quanti-
savings-investment gap, and domestic and foreign ties, not only cyclically when the world economy is
resources are not easily substitutable for one depressed, but also secularly owing to their econo-
another. Foreign borrowing must fill the larger of mic structure which produces goods, the demand
the two gaps if the target growth rate is to be for which tends to be both price and income in-
achieved. The historical sequence of experience elastic in world trade. In the first edition of this
originally suggested by Chenery was that countries book in 1972, I predicted: 'unless something is
in the pre take-off stage of development would done the debt servicing problem arising from
have a dominant savings-investment gap, then fol- mounting resource flows may well become un-
lowed by a dominant foreign exchange gap, with manageable in the not too distant future. It will
the possibility of a skill constraint at any stage. certainly be a long time before these countries
Most of today's developing countries, apart from become net exporters of capital even in the ab-
the oil-producing and oil-exporting countries, sence of a savings-investment gap.' This predic-
have a dominant foreign exchange gap, which tion was made even before the Organization of
manifests itself in a chronic balance of payments Petroleum Exporting Countries (OPEC) cartel first
304 Financing Economic Development
exerted its influence on the world economy in that why the two gaps should be equal ex ante (in a
fateful month of December 1973. Third world planned sense), i.e. that plans to invest in excess of
debt now stands at $1400 billion, and $130 billion planned saving should exactly equal plans to im-
flows out of the developing countries each year to port in excess of plans to export. This is the
service the debts. starting-point of dual-gap analysis.
Before going into dual-gap analysis in more
be foreign exchange constrained and a proportion sis to development theory is that if foreign ex-
of domestic saving would go unused. The policy change is the dominant constraint it points to the
implications are clear: there will be resource waste dual role of foreign borrowing in supplementing
as long as one resource constraint is dominant. If not only deficient domestic saving but also foreign
foreign exchange is the dominant constraint ways exchange. Dual-gap theory thus performs the
must be found of using unused domestic resources valuable service of emphasising the role of imports
to earn more foreign exchange, and/or to raise the and foreign exchange in the development process.
productivity of imports. If domestic saving is the It synthesises traditional and more modern views
dominant constraint ways must be found of using concerning aid, trade and development. On the
foreign exchange to augment domestic saving, one hand it embraces the traditional view of
and/or raise the productivity of domestic resources foreign assistance as merely a boost to domestic
(by relaxing a skill constraint, for example). saving; on the other hand, it takes the more mod-
Suppose now a country sets a target rate of ern view that many goods necessary for growth
growth, r. From our simple growth equations cannot be produced by the developing countries
(identities), the required savings ratio (s*) to themselves and must therefore be imported with
achieve the target is s* = rip, and the required the aid of foreign assistance. Indeed, if foreign
import ratio (i*) is i* = rim'. If domestic saving is exchange is truly the dominant constraint, it can
calculated to be less than the level required to be argued that dual-gap analysis also presents a
achieve the target rate of growth, there is said to more relevant theory of trade for developing coun-
exist an investment-savings gap equal at timet, to: tries which justifies protection and import sub-
stitution (Linder (1967)). If growth is constrained
(14.1) by a lack of foreign exchange, free trade cannot
guarantee simultaneous internal and external
equilibrium, and the gains from trade may be
Similarly, if mmtmum import requirements to offset by the underutilisation of domestic re-
achieve the growth target are calculated to be sources. We shall take up this matter in Chapter
greater than the maximum level of export earnings 15. Before evaluating the assumptions of dual-gap
available for investment purposes, there is said to analysis, and its practical policy implications,
exist an import-export gap, or foreign exchange however, let us first analyse the two gaps in more
gap, equal at time t, to: detail and consider the role of foreign borrowing
in relation to them.
(14.2)
• The Investment-Savings Gap
Suppose to start with that we assume that the I-S
where i is the ratio of imports to output which is gap is the larger of the two gaps, so that foreign
permitted by export earnings. If the target growth borrowing must be sufficient to meet the shortfall
rate is to be achieved, foreign capital flows must of domestic saving below the level necessary to
fill the largest of the two gaps. The two gaps are achieve the target rate of growth. What we wish to
not additive. If the import-export gap is the consider is the size of the initial gap that must be
larger, then foreign borrowing to fill it will also filled by foreign borrowing and the determinants
fill the investment-saving gap. If the investment- of the size of the gap to be filled in future years by
saving gap is the larger, foreign borrowing to fill foreign assistance. If the gap is to narrow, and
it will obviously cover the smaller foreign ex- foreign borrowing is to be terminated, the pre-
change gap. sumption must be that additional increments to
The distinctive contribution of dual-gap analy- saving out of the increases in national income
306 Financing Economic Development
generated are greater than the increments of in- generated by rising income. If foreign assistance is
vestment. For any target rate of growth, r, the to decline (i.e. Ft < F0 ), liS must be greater than
required foreign assistance in the base year (F0 ) is: !11. The investment-savings gap will disappear,
and the phase of investment-limited growth come
F0 = 10 - S0 = Y 0 cr - Y 0 Sa to an end, when domestic saving reaches a level
adequate to sustain the target rate of growth.
= Y 0 (cr - Sa) (14.3)
From (14.7) the rate of growth that can be
achieved with an exogenously given inflow of
where 10 is investment in the base period, S0 is
foreign capital is: 1
savings in the base period, Y0 is income in the base
period, c is the incremental capital-output ratio, sa
is the average savings ratio, and r is the target rate (14.9)
of growth.
If the rate of saving is expected to rise over time,
the savings function may now be written as: The derivative of r with respect to F is positive, so
that a larger inflow of foreign capital can achieve a
+ s'(Yt- Y0 )
St = saYo higher growth rate, provided there is no rise in c-
the capital-output ratio - or fall in s'. 2
=(sa- s')Y0 + s'Yt (14.4) From (14.7) we can also calculate the number
of years after which a country can generate
where s' is the marginal savings ratio. Rewriting enough domestic saving to finance its target rate
investment requirements at time t as: of growth and dispense with foreign borrowing.
Equation (14.7) becomes in the nth year, when
(14.5) Fn = 0:
and combining (14.4) and (14.5), we get the net (cr - s') yn + (s' - Sa) Yo = 0 (14.10)
inflow of capital required in time t:
rate of investment, i.e. s' > cr in (14.13) above. n from (14.5), we have:
is obviously highly sensitive to s' and c.
(14.18)
(14.20)
(14.14)
where M0 is imports in the base period, X 0 is The export-import gap will become less and less
exports in the base period, Y0 is income in the base restrictive as time goes on, provided exports in-
period, rna is the average import coefficient, and Xa crease at a faster rate than national income (i.e. if
is the average export coefficient. x' > xa), and/or if m; falls, which is likely as more
If imports in year t equal: and more capital goods are produced domesti-
cally.
(14.15) With respect to policy, the analysis highlights
the importance of a greater proportion of re-
and exports in year t equal: sources devoted to exports. The M-X gap will
only disappear, and trade-limited growth come to
(14.16) an end, when exports rise to a level sufficient to
meet the import requirements of the target rate of
where m' is the marginal import coefficient, x' is growth set. One of the preconditions of an end to
the marginal export coefficient, and Yt = It/cr, reliance on foreign borrowing to finance develop-
then the foreign borrowing requirement in time t ment, and to pay off past debts, is that a balance-
to achieve the target rate of growth is: of-payments deficit be turned into a continuing
surplus through structural change or price and
Ft =maYo+ m'(Yt- Yo) - XaYo income adjustment mechanisms internally.
- x'(Yt- Yo) (14.17)
Table 14.1 Estimates of the Investment-Saving and Import-Export Gaps Assuming a 7.5 Per Cent Growth of
GDP, 1977-8 to 1982-3 (£s million)
Yo yl y2 ¥3 y4 Ys ¥6
Base year 1977-78 1978-79 1979-80 1980-81 1981-82 1982-83
1976-77
annum. The assumed capital-output ratio is 3, so The calculated import-export gap is also shown in
that investment requirements in time t may be Table 14.1. The results indicate that while, ex
written as: post, the two gaps were equal in the 1976-7 base
year from the national accounts, the forecast gaps,
ex ante, diverge through time, with the import-
export gap dominant. For the target rate of
A savings function was estimated of the form: growth to be achieved there would have to be
foreign borrowing each year to fill the biggest of
the two gaps. The analysis here is brief and mecha-
nistic, but it illustrates the principle and what can
Thus, given the target level of income, Y 1(t = 1 to be done in a simple way as a first approach.
6), from applying the target rate of growth to the
I
base year level of income (Y0 ), the I-S gap can be
estimated for each year in the future. The results The Assumptions. of Dual-Gap
are shown in Table 14.1. All values are in Analysis
Sudanese pounds at constant (1976) prices.
For import requirements, the historical incre- The basic underlying assumption of dual-gap ana-
mental output-import ratio (m') was taken of lysis is a lack of substitutability between foreign
0.29. Therefore: and domestic resources. This may seem a strin-
gent assumption, but nonetheless may be valid
particularly in the short period. 1 If foreign ex-
Equation (14.25) shows that the growth of output rate of interest. In some circumstances however
will be higher than the rate obtainable from this condition may be a fairly stringen; one also.'
I
domestic saving alone as long as ~D > srD, that is
as long as new inflows of capital exceed the
amount of outflow on past loans that would other- Capital Imports, Domestic
wise have been saved. This is a fairly stringent Saving and the Capital-Output
condition unless it is assumed that the interest
payments due are met by creating new debt. It can Ratio
be seen from equation (14.25) that if rD = ~D,
the rate of growth of output with capital imports From the discussion above it would appear that
will always be higher than without capital imports import surpluses have great potential in the de-
as long as s < 1 (which is the normal case to velopment process. It is sometimes argued, how-
consider). It may be concluded, then, that if in- ever, that import surpluses financed by foreign
terest payments on past loans can be borrowed in capital inflows increase the capital-output ratio
perpetuity, there is a permanent gain to be had (i.e. reduce the productivity of capital) and dis-
from running an import surplus. In practice, courage domestic saving; in addition, that a large
however, a country that continually rescheduled fraction of capital inflows is consumed rather
its debts might ultimately be classified by the inter- than invested. The net result may be no extra
national community as uncreditworthy and there- growth at all or that the growth rate is even
fore not be able to borrow continually. reduced. 1 In terms of equation (14.25) and
Now let us consider the rate of growth of in- (14.29), the inflow of capital ~D may reduces and
come as the dependent variable. From (14.21) a and only a fraction of ~D may be invested.
As far as the relation between capital imports
~y = ~0- r~D (14.26) and domestic saving is concerned, many studies
find a negative relation. Care must be taken in
Substituting (14.24) into (14.23) and the result interpreting the relationship, however, because,
into (14.26) gives: owing to the way saving is defined, a negative
relationship is bound to be found as long as a pro-
~y = a(sO + ~D- srD) - r~D (14.27) portion of capital imports is consumed. As we said
before, domestic saving is normally defined in de-
Now since Y = 0- rD, we can also write (14.27) veloping countries as investment minus foreign
as: capital inflows: S = I - F. IfF rises, and I rises by
~Y=asY+~D(a-r) (14.28) less than F, S must fall for the equality to hold.
Thus a negative statistical relationship between
and dividing through by Y we have an expression foreign capital inflows and domestic saving cannot
for the rate of growth of income of: necessarily be interpreted as a weakening of the
development effort; it may simply reflect the fact
~y ~D
that a proportion of capital inflows is consumed.
- = as + (a - r ) -
y
(14.29) The important point is that no studies find a nega-
y
tive relation between capital inflows and the in-
Equation (14.29) shows that the growth rate of vestment ratio. This means that capital inflows
income with capital imports will be higher than must finance some additional growth unless the
that obtained from domestic saving alone as long productivity of capital falls drastically.
as the productivity of capital imports (a) exceeds Griffin argues that foreign capital inflows do
the rate of interest on foreign borrowing (r). This 1 This argument has been put forward notably by Griffin
is a standard result showing that investment is (1970), and has since been the subject of continual scrutiny.
profitable as long as the rate of return exceeds the For the latest evidence, see the survey by White (1992).
Foreign Assistance, Debt and Development 311
lower the productivity of capital and raise the and the methods of financing them. Naturally, all
capital-output ratio because of the tendency for accounting figures are ex post and therefore give
international assistance to be used for prestige no measure of the magnitude of the foreign ex-
projects and because of a bias towards the use of change gap on current account had the countries
international resource flows for infrastructure pro- been willing and able to finance larger deficits at
jects and social-overhead capital. It should be re- higher levels of economic activity. Undoubtedly,
membered, however, that there is an important the deficits would have been larger post-1973 and
distinction to be made between the capital-output post-1979 had not some adjustment, as well as
ratio of a particular project on the one hand and financing, taken place to accomodate the massive
the capital-output ratio for the economy as a increase in the price of oil in those years. Even so,
whole, which is the ratio relevant to the model. It the deficits have been huge by any standards,
would be quite possible for the overall capital- reaching a peak of over $100 billion in 1981. Had
output ratio to fall even though projects financed borrowing not been undertaken the adjustment
by capital inflows were relatively capital-intensive. required could have precipitated a world recession
This could happen in at least two ways. First, the more severe than the great depression of the
greater availability of foreign exchange could en- 1930s.
able a more productive use to be made of capital Table 14.2 shows the deficit on current
resources as a whole, e.g. if output is depressed account, and the methods of financing it, for the
because foreign exchange is the dominant con- developing countries in more recent years (exclud-
straint. Capital inflows also allow a change in the ing Eastern Europe and the former USSR). The
product-mix towards more labour-intensive com- deficit fell from its peak of over $100 billion in
modities which can reduce the overall capital- 1981 to $17.6 billion in 1987, and then rose
output ratio of the economy. The second point is again. In the 1980s, there was a colossal outflow
that the particular projects undertaken could have of debt service payments averaging over $80 bil-
external effects on the output of other sectors. This lion per annum, itself a function and reflection of
is the 'externalities' argument for the public provi- past capital inflows. The net deficit on service pay-
sion of infrastructure projects which themselves ments and private transfers accounted for more
may have very high capital-output ratios. There is than one-third of the total current account deficit.
no convincing evidence that countries with a high Table 14.2 gives the four major categories of
ratio of capital inflows to national income have a balance-of-payments financing: non-debt-creating
higher capital-output ratio than other countries, flows (including direct private investment); asset
and there is no convincing evidence that the pro- transactions (including export credits); the use of
ductivity of foreign resource inflows is lower than foreign exchange reserves; and net external bor-
the productivity of domestic savings. On the con- rowing (mainly from the private banking system).
trary, the evidence we have from the studies of Since the mid-1980s, non-debt-creating flows have
Papanek (1973) and Pesmazoglu (1972) is that shown a trend increase. Direct private investment
foreign capital inflows are more productive than does not create debt, but it gives rise to future
domestic resources. foreign exchange outflows if profits are repatri-
I
ated. The total of non-debt-creating flows was
$26.7 billion in 1991. There was also a trend
The Balance of Payments, increase in net external borrowing from the mid-
1980s, rising to $85.7 billion in 1991. This mainly
Foreign Borrowing and the Debt reflects the recovery of bank lending, following the
Burden cut-back in the early 1980s in the wake of the debt
crisis. International reserves have also been heavily
It is instructive to examine the balance of pay- used as a means of balance-of-payments support.
ments deficits of the non-oil-developing countries, In 1991, the current value of outstanding debt
312 Financing Economic Development
Table 14.2 The Balance of Payments of Developing Countries and Methods of Financing 1984-91 ($US billion)
Note: Except where footnoted, estimates are based on national balance of payments statistics. These flows are not
always reconcilable with year-to-year changes in either debtor- or creditor-reported debt statistics, in part because the
latter are affected by changes in valuation.
1 Equivalent to current account deficit less official transfers. Official transfers are treated in this table as external
financing.
2 Pertains to export credit, recorded changes in private foreign assets, and collateral for debt-reduction operations.
3 Positioned here on the presumption that estimates reflect primarily unrecorded capital outflows.
4 Includes use of Fund credit under the General Resources Account, Trust Fund, structural adjustment facility, and
enhanced structural adjustment facility.
5 Comprises short-term borrowing by monetary authorities from other monetary authorities.
6 Residually calculated. Except for discrepancies in coverage, amounts shown reflect net external borrowing from
official and private creditors as well as short-term flows.
Source: World Economic Outlook, May 1992 (IMF).
was of the order of $1300 billion, and debt service from 1970 to 1990 is given in Table 14.3, and the
payments amounted to $150 billion, comprising outstanding external debt of individual countries
$80 billion repayment of principal (amortisation) is given in Table 14.4.
and $70 billion payment of interest. In many
countries in the 1980s, debt-service payments ex-
ceeded the value of new gross capital inflows mak- • The Debt Service Problem
ing them net exporters of capital. Payments on
past debts also absorb a high proportion of foreign The fact that the rate of return on investment in
exchange earnings from exports, typically in the the borrowing country exceeds the rate of interest
region of 20 to 50 per cent, depending on the is no indication of whether the debt can be ser-
country. A summary of outstanding debt and viced since the loan must be repaid with interest in
debt-service payments of the developing countries foreign currency. Thus the questions of the pro-
Foreign Assistance, Debt and Development 313
Table 14.3 Summary of Outstanding Debt and Debt fitability of borrowing and of the capacity to ser-
Service Payments of Capital Importing Developing vice debt are conceptually distinct. The ability to
Countries 1970 to 1990 service debt depends on whether additional foreign
exchange can be earned or saved by the borrow-
1980 1986 1990 ing. This depends on the domestic economic policy
pursued by the country concerned, and on the
Total debt($ US billion) 572.7 1062.2 1280.5
ability to export which depends to a large extent
Debt-export ratio (%) 131 236 177
Debt-GDP ratio (%) 28 50 42 on world economic conditions. A major part of
the debt-servicing difficulties that have arisen in
Interest payments 47.0 64.7 63.4 recent years has more to do with changes in world
Principal repayments 45.0 70.2 79.9 economic conditions which depressed the foreign
exchange earnings of developing countries in the
Debt service ratio 21.1 30.0 19.8 first half of the 1980s than with the miscalculation
of rates of return on investment, the misuse of
Source: World Debt Tables 1991-92, Vol. I. Analysis and investment funds, or the use of capital inflows to
Summary Tables (World Bank, 1992).
Table 14.4 Total External Public and Private Debt and Debt Service Ratios
Table 14.4 Total External Public and Private Debt and Debt Service Ratios (continued)
Table 14.4 Total External Public and Private Debt and Debt Service Ratios (continued)
Table 14.4 Total External Public and Private Debt and Debt Service Ratios (continued)
vate and social interest, this would seem to call for optimal strategy from the borrower's point of
an international subsidy for lenders and borrowers view: borrow as much as possible and delay repay-
to accept more rescheduling. The solution so far ment indefinitely! Debt as a proportion of national
has been to require the debtor countries to accept income is sometimes taken as a criterion. This
adjustment and rescheduling with very little sub- proportion depends not only on the interest rate
sidy at all. If the international economy derives a on loans but also on the relation between the
benefit from rescheduling, however, why should average and marginal savings ratio. Consider two
the poor debtor countries bear the full cost? There extremes. At one extreme savings equals required
is a great source of international inequality here, investment so that the debt increases at a rate
particularly when it was largely the deflationary equal to the rate of interest, and if the interest rate
policies pursued by the lender countries whidr exceeds the rate of growth of income debt as a pro-
caused the servicing of debt to become so prob- portion of income will rise. At the other extreme
lematic in the first place. -. savings exceed investment by just enough to meet
The benefits of borrowing to individual coun- interest payments on past debt so that there is no
tries, and to the world economy at large, are clear. increase in net indebtedness. Between these two
But how far should borrowing go? Is it possible extremes, given the size of the debt relative to
that after a certain point, even though a develop- national income, and a marginal savings rate grea-
ing country still requires resources for develop- ter than the investment ratio, there will be some
ment, the disadvantages of further borrowing rate of interest such that debt will increase at the
outweigh the advantages? Unfortunately there are same rate as the national income. Assuming no
no precise objective criteria that can be laid down debt at the beginning of the period this critical
to answer this question. If a country has an inter- interest rate can be shown (see Hayes (1964)) to be
temporal budget constraint, so that no creditor is a function of the initial and marginal savings ratio,
to be left unpaid over time, clearly trade surpluses the capital-output ratio and the desired growth
and deficits must balance over the long run, and rate, in the formula:
the question is not whether to borrow but when.
The optimal timing of deficits will depend on cur- . r(s 0 - s') (14.30)
rent and future conditions in the economy. As far t =
s0 - cr
as borrowing for consumption is concerned, to
smooth out consumption over time, the relation where r is the desired growth rate, s0 is the initial
between the market rate of interest and the rate of savings ratio, cis the capital-output ratio, and s' is
time preference is important. As far as borrowing the marginal savings ratio. If the critical rate of
for investment is concerned, the relation between interest is exceeded the debt could well become
the rate of interest and the productivity of invest- unmanageable, in the sense of being unserviceable
ment is important. But suppose there is not an inter- by further borrowing. Foreign capital may dry up
temporal constraint, and countries can borrow in and creditors may be forced to expropriate assets.
perpetuity, how then should the problem be formu- There has been a progressive rise in the ratio of
lated? And what about the fact that countries must debt to the GDP of developing countries from
service and repay debt in foreign currency? 1 approximately 20 per cent in the early 1970s to
Most of the criteria for the evaluation of optim- over 40 per cent in 1990, but it is not clear what
al borrowing relate to the proneness to default economic significance should be attached to this
which may impair future borrowing capacity. This ratio as a measure of the ability to service debt and
makes sense, since if it wasn't for the possibility of therefore as a measure of the possibility of default.
mortgaging the future, default would be the It is true that to service the debt export earnings as
a proportion of national income should rise, but
1 For a useful survey of the literature on optimal borrowing this suggests a more direct measure of the prone-
and debt capacity, see McDonald (1982). ness to default relating debt-service payments to
318 Financing Economic Development
dicators that they thought might be of importance, newly-industrialising countries, mainly in Latin
but found only three to be statistically significant: America, who borrowed from the commercial
the debt-service ratio; the rate of amortisation of banking system at floating rates of interest whose
outstanding debt (the inverse of the average export markets then became depressed. The sums
maturity of debt), and the ratio of imports to of money involved here are huge. Non-repayment
international reserves. 1 of debt becomes a crisis for the private banking
system (which in retrospect clearly over-extended
itself), and a crisis for individual countries if the
• The Debt Crisis of the 1980s2 threat of default dries up the flow of new capital.
There would also be a crisis for the world econ-
The debt 'crisis' erupted in the summer of 1982 omy if there was a major default which led to a
when Mexico suspended for the first time the massive contraction of lending throughout the sys-
repayment of loans due to the private banking tem; but this has not happened. Lending did con-
system and sovereign lenders. The crisis has tract sharply in the early 1980s but then rose again
smouldered ever since with more and more coun- as difficulties were resolved by various forms of
tries finding it difficult to service accumulated international co-operation.
debts out of foreign exchange earnings. In 1987, The origin of the current debt difficulties of
Brazil became the first country to suspend interest certain countries is no mystery. Massive balance-
payments to foreign creditors. of-payments surpluses arose in the early 1970s
The 'crisis' aspects of debt can be looked at in the oil-exporting countries with counterpart
from different standpoints: from the point of view deficits elsewhere. The factors which caused the
of the individual borrowing countries, or the supply of capital to increase created its own de-
lenders (private and sovereign governments), or mand. Private banks were anxious to on-lend and
the whole world economy. As far as borrowers are there was no shortage of demand. Demand was
concerned, there are basically two types of 'prob- particularly strong because commodity prices
lem' countries. First, there are a small number of were generally high, exports were buoyant, and
poor commodity dependent countries, mainly in inflation had reduced the real rate of interest on
Africa but also elsewhere, where private banks are loans to virtually zero. Credit looked cheap and
not involved. It becomes a crisis for these countries borrowers looked good risks from the lender's
if they have to cut back essential imports in order point of view. But these circumstances suddenly
to service debt, but not a crisis for the banking changed. Depression in the developed countries,
system or for the world economy if they default. mainly self-inflicted to reduce the rate of inflation,
The absolute sums of money involved are rela- caused world commodity prices to tumble, exports
tively small and their future entitlement to official to languish, and real interest rates to rise. On top
borrowing would probably not be jeopardised. of this nominal interest rates floated upwards and
The rescheduling of debt has already been under- the dollar appreciated.
taken in many cases. There have been over 80 The characteristics of the current debt 'crisis'
reschedulings in Africa alone during the last ten are shown in Table 14.3. Of the total outstanding
years. The second set of countries comprises a few debt of $1280 billion in 1990, long-term debt (of
more than one year maturity) comprised $1047
billion. This compares with long-term debt of $61
1 Frank and Cline (1969). The eight indicators were: the debt-
billion in 1970 (before the oil crisis), and as little
service ratio; export growth; the variability of export earnings;
the ratio of unnecessary to necessary imports; the amortisation as $10 billion in 1956. The ratio of current exter-
rate; the import ratio; the ratio of imports to reserves, and per nal debt to export earnings is 177 per cent, and the
capita income. ratio of debt to GDP is 42 per cent. Of the total
2 Useful books on the 1980s debt crisis include: Cline (1984);
Claudon (ed.) (1986); Lomax (1986); Lever and Huhne long-term debt, over $600 billion is owed to pri-
(1985); Griffith-Jones and Sunkel (1986). vate financial institutions. By region, over 30 per
320 Financing Economic Development
Debt indicators,
Debt outstanding, 1990 Debt service, 1990 1990 (per cent)
(US$ billions)
Total Total private Debt/GNP Interest/exports,
Country (US$ b) sources(%) Total Interest 1990 1990
cent of the debt is held by Latin America with earn enough foreign exchange through exports to
roughly equal proportions shared between Southern service foreign debts and to sustain the growth of
Africa, North Africa and the Middle East, East Asia output (which requires foreign exchange to pay
and the Pacific, South Asia, and the Mediterranean for imports) at the same time. Either service pay-
countries. The sixteen most heavily indebted coun- ments have to be suspended or growth curtailed,
tries, listed in Table 14.5, account for over half of or a combination of both. Unfortunately for the
total debt and for nearly 90 per cent of debt owed debtor countries, and indeed the whole world econ-
to the private banking system. omy, it is the growth of living standards that has
The increase in the volume of debt and higher suffered. The indebted less-developed countries
rates of interest in the early 1980s led to an in- are stagnating under a total burden of debt which
crease in debt-service payments from $18 billion has now reached $1400 billion, with expected re-
in 1973 to over $140 billion in 1990. Debt and source transfers to service the debt of over $100
interest rates grew rapidly till 1986 and then be- billion per annum.
gan to level off. The debt service ratio reached a All this is part of the transfer problem analysed
peak of 30 per cent in 1986, and then fell to 19.8 by Keynes in the 1920s in the wake of the contro-
per cent in 1990. This has partly been due to debt versy over the reparation payments imposed on
rescheduling, but mainly due to the increase in Germany by the Treaty of Versailles in 1919
export earnings as the world economy recovered (Keynes (1919)). Keynes mocked the folly and
in the second half of the 1980s. futility of the whole exercise on the grounds that it
The world debt problem is a foreign exchange would be likely to be self-defeating, and so it
problem. It represents the inability of debtors to turned out to be. Similarly today, the attempt to
Foreign Assistance, Debt and Development 321
extract such large transfers from Latin America adjust - a euphemism for deflation - increases.
and Africa is leading nowhere. The economies of Notwithstanding the huge debt burden of some
Latin America and Africa slide further into chaos, countries, most observers agree that the debt prob-
and the poor in these continents become progress- lem is a liquidity problem, not one of insolvency.
ively poorer. When debt-servicing difficulties began to emerge,
There are two aspects of the transfer problem. the private banks increased the proportion of
First there is the budgetary problem for govern- short- to long-term loans which exacerbated cash-
ments of acquiring the domestic resources for the flow problems with large amounts of short-term
repayment of debt, and secondly the problem of borrowing falling due for repayment within a
turning the resources into foreign exchange - or year. If credit is further shortened or withheld
the 'pure' transfer problem as Keynes called it. The entirely, a crisis then ensues. Such situations al-
transfer burden is the export surplus that has to be ways pose a dilemma for banks. If they do withhold
generated to acquire the foreign exchange, plus the further credit, they contribute to default; if they
possibility of a deterioration in the terms of trade continue to lend they expose themselves even
if, in order to sell more exports, prices must be more. Understandably there was greater paranoia
reduced. Even if prices do fall there is still no in the United States than in Europe over the possi-
guarantee that export earnings will increase if the bility of default since the US banks were much
quantity sold does not rise in proportion. In these more exposed. Roughly 30 per cent of internation-
circumstances, the transfer becomes impossible al lending by US banks was to developing coun-
without a contraction of domestic output to com- tries, compared with only 20 per cent in Europe.
press imports. There is substantial evidence that In the early 1980s the nine largest US banks had
the indebted countries collectively are caught in an exposure to Brazil equal to 40 per cent of
this trap, since for a large part of their trade they shareholders' capital; to Mexico 38 per cent and
compete with each other; and competitive price to Korea 19 per cent. If these debts had been
reductions leaves total earnings unchanged. To written off a major part of the capital and reserves
date, it is the contraction of living standards that of the banking system would have been wiped out.
has generated the export surplus by reducing the With the intricate network of interbank lending
import bill. That is no good for the developing that exists, there would have been the possibility
countries, or for the health of the world economy. of a chain of bank collapses. There is no lender of
The other side of the coin is that, if total trade is last resort in the United States. Moreover, private
static, increased exports from debtors take mar- lending by US banks does not have the same de-
kets away from domestic producers in other coun- gree of official guarantees as in Europe, where at
tries, and the extraction of the surplus from the least 30 per cent of lending is for export credits. It
debtors reduces welfare all round. This was one of was not conceivable, however, that a major US
Keynes's major objections to the excessive repara- bank would be allowed to collapse simply for
tions imposed on Germany; that the transfer from want of a debt rescheduling agreement. Indeed, to
Germany would be generated at the expense of the date there have been no cases of default, and only
victors' industries. a few cases of interest payment arrears. In most
History has lessons to teach. The magnitude of countries rescheduling arrangements have been
the transfer now expected from Latin America is, satisfactorily concluded with the help of interna-
in fact, greater as a proportion of total output and tional consortia and the IMF. Up to now the so-
trade than that imposed on Germany, and there is called 'Paris Club' of creditor nations has adopted
little sign of it easing. What we are witnessing in a case-by-case approach. At the international level
the world economy is a vast charade of money emergency financing was made available under the
being recycled from creditors to debtors and back auspices of the Bank for International Settlements,
again to the creditors, while the total volume of and in January 1983 the IMF established a Special
debt grows and the pressure on debtor countries to Drawing Rights (SDR) 17 billion emergency fund
322 Financing Economic Development
under the General Agreement to Borrow (GAB). As far as the private banks are concerned, they
The debt crisis of the early 1980s has subsided, should take some losses for their imprudence, but
but the debt-problem has not gone away. Donors there is clearly a limit to which they are able to
have been as much responsible as borrowers. The provide debt forgiveness without jeopardising the
developed countries must bear a major responsi- net worth of the banking system. Apart from in-
bility for the world recession of the 1980s, and centives that the banks themselves might have for
private banks voluntarily over-extended them- writing down debt (for example, the hope of high-
selves. Shared blame requires shared solutions. er payments in the future), what is required is a
form of creative accounting that writes down the
debt and keeps banks solvent at the same time,
• Solutions to Debt Difficulties with no real costs.
One such scheme would be for US banks to
Debt in many ways is like a cancer - once it gets a exchange debt for shares in the Federal Reserve,
grip on a country it is very hard to eradicate, and and for the Federal Reserve to sell debt to the
may envelop every other organ of life, unless the rest government in exchange for government bonds.
of the economy can be reinforced to overcome it. The government would then negotiate a forgive-
There are no easy solutions to the debt- ness ratio with each debtor country. The interest
servicing problem short of a massive programme payable to the Federal Reserve on the bonds
of debt forgiveness, which leaves a manageable would be returned to the US government as 'ex-
debt that the debtors can service. There has to be cess' income so that there would be no additional
debt relief if there is to be any easing of the trans- burden on the taxpayer (see Davidson (1992)).
fer burden. Further borrowing, without relief at Another scheme would be for the Federal Reserve
the same time, increases debt service payments arid to supply dollars to the Central Banks of creditor
simply makes matters worse, creating what might countries to compensate the banks for write-offs.
be called a debt trap. Since the lenders, the bor- All these schemes would be merely book-keeping
rowers and the whole world community benefited transfers without real costs, but with very real
from the debt-creation process, there is a strong benefits to the debtors. Debt relief of at least $500
case for saying that the same three parties should billion is required to leave a manageable debt for
share the burden of relief. It is not fair that the the debtors to service.
debtor countries (the borrowers) should bear the Apart from bold, imaginative, global schemes
whole of the adjustment burden. Up to now, the of debt relief, there are a number of piecemeal
world community (including the creditor coun- ways in which the present and future burden on
tries) has contributed virtually nothing to ease the the debtor developing countries could be amelio-
plight of the debtors. There are three reasons why rated. This is how the debt problem has so far
it should: first, the world community received an been handled- on a piecemeal, case-by-case basis.
external benefit when the debt was created by the
on-lending process in the 1970s, preventing out-
put contraction in countries with balance-of- 0 1. Debt Rescheduling
payments deficits, and thereby avoiding world
slump; second, much of the debt problem arose in The initial US response to the debt crisis was to
the first place through no fault of the contracting attempt to increase liquidity, to give developing
parties, but as a result of events in the world countries more breathing space to 'grow out' of
economy - rising oil prices, rising interest rates, their debt problems. This was the thinking behind
world recession, falling commodity prices and so the so-called Baker Plan of October 1988 which
on; and thirdly because relief could actually confer made provision for $20 billion of additional lend-
a global benefit by easing the deflationary forces ing from the commercial banks and $9 billion of
associated with the huge debt overhang. multilateral lending to the 15 or so most severely
Foreign Assistance, Debt and Development 323
indebted countries, contingent on market-friendly, in debt with a per capita income of less than
growth-oriented structural adjustment program- $1195 were eligible. For ODA, countries were
mes being adopted. There was no acceptance of given 20 years to pay with a grace period of 10
debt reduction by banks, and the sums of money years. For non-ODA, countries were given 15
were a drop in the ocean. In the event, most of the years to pay with a grace period of 8 years and a
money was not lent because of the continued vul- market rate of interest.
nerability of the banks and the deteriorating exter- Apart from these official initiatives, there has
nal situation. been a great deal of other debt rescheduling ar-
The abortive Baker Plan was followed by the ranged privately between individual countries
so-called Brady Plan of 1989 which did accept and the creditor banks. These ease the short-term
debt reduction, and has been more successful. The pressure, but do not reduce future repayment
two main elements of the plan were the provision obligations, unless the rescheduled debt is on sof-
of funds via the IMF and W odd Bank for various ter terms.
forms of debt relief to middle-income debtor coun-
tries willing to adopt policy reforms, and secondly
the encouragement to countries to buy back debt D 2. Debt Service Capping
from banks at a discount thereby reducing future
obligations. One possibility was for countries to To avoid debt-service payments becoming exces-
swap old loans for new long-term (30-year) bonds sive, several schemes have been suggested. One is
at a discount of some 35 per cent with an interest for variable maturity loans to be issued so that
rate only marginally above the market rate, and debt-service payments remain unaltered as interest
the bonds guaranteed by the IMF. To date, five rates float upwards on private debt (rather like
major agreements of this type have been reached mortgage loans are variable in the housing mar-
with Mexico, the Philippines, Costa Rica, Vene- ket). Or maturities could be varied automatically
zuela and Uruguay. The deal with Mexico has to keep the debt-service ratio unchanged. This
relieved it of $20 billion of debt service payments. would accommodate fluctuations in foreign ex-
Other multilateral initiatives have focused on change receipts from exports as well. These
the poorest countries in debt. The governments of schemes are equivalent to capitalising interest pay-
the OECD countries representing the so-called ments above a certain level. In 1985 Peru imposed
Paris Club adopted two major initiatives in 1988 unilaterally a 10 per cent ceiling on debt-service
and 1990- the Toronto Terms (September 1988) payments as a proportion of export earnings.
and the Trinidad Terms (September 1990). These Another possibility is that zero coupon bonds
initiatives related to official debt (i.e. debt owed to might be offered which delay interest payments
governments) and first of all made provision for until the loan has matured. This would reduce the
substantial cancellation of debt. For the remainder present value of interest payments, but more im-
of the debt, substantial restructuring was offered. portant, it would allow investment to be fully
Under the Toronto terms, countries eligible were productive before there was any commitment of
those receiving concessional assistance from the foreign exchange. It does not ensure, however,
soft-loan affiliate of the World Bank, the Interna- against the bunching of repayment commitments
tional Development Association, and a distinction when foreign exchange earnings might be low.
was made between official development assistance
D3.Swaps
(ODA) and non-ODA. For ODA, countries were
given 25 years to pay with a grace period of 14 Debt Buy-Backs and Debt
years, with no change in the interest rate. For
non-ODA, three options were offered of different
combinations of rescheduling, relief and interest Another solution to the. debt service problem,
rates. Under the Trinidad terms, countries heavily which has gained favour in recent years, is for
324 Financing Economic Development
countries to buy back their debt at a discount or to Wide Fund for Nature has bought third world
exchange the debt in various ways which fully or debt at a considerable dis~ount and exchanged it
partially relieve the burden of interest and princip- for local currency for use on environmental pro-
al repayments. Third world debt trades in a secon- jects within the developing countries. In 1988 UN-
dary market, where some countries' debt can be ICEF bought Sudanese debt from the Midland
bought at a discount of more than 50 per cent. At Bank and this was redeemed by the Sudanese gov-
one time Sudanese debt could be bought in the ernment to finance water sanitation programmes
secondary market for $2 per $100. If Sudan was in Central Sudan.
able and willing to use its foreign exchange re- Debt for Bonds. Yet another swap scheme is
serves to buy its own debt, it could have wiped for debtor countries to offer fixed-interest long-
out, say, $1 million of debt for as little as $20 000. term bonds in exchange for debt held by the
The secondary market, however, is generally thin, banks. They can be advantageous if the debt can
and heavy buying is likely to raise the price con- be exchanged at a discount at a more favourable
siderably. Even so, the use of foreign exchange re- rate of interest. In 1988 Mexico launched a
serves to buy back debt at a discount of 20-30 per scheme offering $10 billion of bonds to its creditor
cent could make a useful contribution to debt relief. banks, hoping to sell at a discount of 50 per cent.
Debt-Equity Swaps are a way of eliminating The sale turned out to be disappointing, however.
debt service payments altogether. A debt-equity Only 100 out of the 500 banks bid for the bonds,
swap involves the debt held by the creditor being and the debt was discounted by only 30 per cent.
converted into an equity stake in enterprises with- Even so, some saving was made by the Mexican
in the debtor country. The creditors have a claim government. Exit bonds are a particular type of
on future profits, but the debtor countries are re- bond which give a bank a lower rate of interest
lieved of interest payments. Such swaps can be than on the original debt, but end the banks' liabil-
mutually profitable to all parties. A classic exam- ity to provide new money. One way of encourag-
ple was the Nissan motor company's purchase of ing this type of arrangement would be for the IMF
Mexican debt for investment in its Mexican sub- to guarantee interest payments on the exit bonds
sidiary in 1982. Nissan bought $60 million of which would encourage the banks to swap debt
Mexican debt held by the Citicorp bank at a price for this type of bond.
of $40 million - a discount of one-third. Nissan
redeemed the debt certificates at the Mexican cen-
tral bank for $54 million in Mexican pesos, which
were then invested in its subsidiary. The Citibank
D4.LocalRepayment
Currency
of Loans m
unloaded its debt at the 'market' price; Nissan
made a profit in dollars, and Mexico was relieved There are also various schemes that would permit
of interest payments in foreign currency. There debtor countries to repay loans in local currency
have been several other debt-equity swaps since rather than foreign currency, which could become
1986, and increasingly they are being linked with an instrument for trade promotion at the same
privatisation programmes in the debtor countries, time. An early proposal of this type was put for-
but the absolute magnitude of the sums involved ward by Khatkhate (1966). The essence of the
are still relatively small in relation to the size of the scheme is that instead of developing countries re-
debt burden. paying loans with interest to donor countries in
Debt for Nature and Debt for Development scarce convertible currencies, they would service
Swaps. These work in the same way as debt- the debt by making payments in local currencies to
equity swaps, except the debt is bought by a gov- regional development banks, which would then
ernmental or charitable organisation and the pro- relend the local currencies to other developing
ceeds are used for environmental or development countries for the purchase of exports from the
purposes within the debtor country. The World debtor countries.
Foreign Assistance, Debt and Development 325
The developing countries which receive these crease in the transfer of resources, without arous-
exports would increase their liabilities to the credi- ing public hostility, simply by maintaining its flow
tor developed countries to the same extent as the of gross aid.
debt liabilities of the developing countries which Multilateral institutions would also suffer under
export these goods are reduced. As far as the credi- the scheme through the non-repayment of loans.
tor developed countries are concerned, it would The proposal does not imply default, however, or
mean that the repayments due to them from one writing-off interest payments. It involves a transfer
debtor developing country would be re-lent im- of the debt liabilities that developing countries
mediately to another developing country, and so have to the World Bank to regional development
on. This process could continue until all the de- banks. The World Bank could roll over its debt by
veloping countries had built up their economies to new bond flotations, in the same way that a
such an extent that they are able to raise their national government might fund its national debt.
exports to the developed countries and eventually A similar, but more restrictive, scheme would
to discharge their debt obligations to them. The be arrangements whereby debtor countries could
proposal amounts to postponement of the retire- repay loans, particularly tied loans, in local cur-
ment of debt to some indefinite date. Such a rencies with the donors agreeing to buy the
scheme is attractive on the surface, but has certain debtor's exports. This is sometimes called re-
limitations. First, it must be recognised that the ciprocal tying, formerly practised by the centrally
proposal amounts to a form of 'aid-tying' between planned economies of Eastern Europe. It is parti-
the developing countries themselves, and the ques- cularly pernicious that loans should not only be
tion must be asked; how many developing coun- tied to the donor's exports (see later) but should
tries are there that can provide the sort of goods also have to be repaid in scarce foreign currency. A
that other developing countries require for de- scheme of this type would be of considerable be-
velopment purposes? On the other hand, trade nefit to the foreign exchange reserves of the de-
between the developing countries is something to veloping countries at little cost to the balance of
be encouraged, and this kind of scheme would payments of donor countries in the short run. In
provide a useful stimulus, and need not preclude this respect the scheme has considerable advantage
the expansion of trade with the developed nations over the unilateral untying of assistance. The dif-
as well. ficulty is the limited range of products produced by
The feasibility of such a scheme would depend the developing countries which the developed
on the attitude of the creditor developed nations countries would wish to buy.
and of the multilateral aid-giving institutions such
as the World Bank. The balance of payments of
creditor countries would be affected adversely in D 5. Long-Term Solutions
at least two ways. First, the inflow of interest and
amortisation payments from developing countries On a longer-term basis, developed countries might
would cease (although interest would continue set up machinery to guarantee loans from private
to accumulate to be paid at some future date). sources (in addition to export credit guarantees)
Secondly, exports to developing countries, and establish a fund from which commercial in-
financed by foreign assistance, would probably terest rates might be subsidised. Such a scheme
fall. The scheme would involve a balance-of- would mean that private lenders would not be
payments loss to developed countries unless gross deterred from lending through fear of default; de-
aid is reduced. If so desired, however, the scheme veloping countries would receive cheaper credit,
would be a disguised way for governments to in- and the donor's contribution in the form of pay-
crease net aid. Since people in general appear to ments to private lenders would not burden the
attach more importance to gross figures than to balance of payments (if this was regarded as an
net figures, a government could achieve a net in- obstacle to a higher level of official assistance).
326 Financing Economic Development
Secondly, official development assistance might tries become very much a matter of subjective
be given as grants rather than loans. The grant assessment, depending on the meaning and vision
element of official assistance is already high, and of the development process held by the protagon-
this further step would not only give extra margin- ists. There is a substantial body of opinion on both
al help but would also avoid haggling over debt the right and left of the political spectrum which
renegotiations if the need for rescheduling arose. argues that not only are financial resource trans-
Finally, there is urgent need to devise schemes fers unnecessary for development, but may even be
to stabilise the price or terms of trade of primary inimical to development by fostering dependence;
commodities. A large part of the 1980s debt crisis weakening the domestic development effort, and
resulted from the collapse of primary product leading to a distorted structure of consumption
prices. and production (as well as to the debt servicing
To stabilise the terms of trade, indexation may problems - and profit outflows - already men-
be appropriate for some commodities, for exam- tioned). These criticisms are levelled both at
ple, oil. For other primary commodities, credit official assistance, 2 and at private investment, par-
creation to finance merchants' stocks would assist. ticularly at the activities of multinational com-
Special Drawing Rights (see Chapter 16) might panies (see, for example, Frank (1981)). We shall
play a useful role here for buying up surplus stocks consider some of these concerns later, but first let
of primary commodities that are storable, or for us examine the motives for assistance and why
income compensation for commodities that are developing countries accept the transfers.
not. It seems incredible that years on from Key-
I
nes's war-time plan for an international agency for
stabilising commodity prices, 1 the world still lacks The Motives for Official
the requisite international agreement and institu- Assistance
tional structures for greater stability and a fairer
deal for developing countries that live by export- There are several motives which inspire financial
I
ing primary commodities. assistance from public bodies on concessionary
terms, but they can be grouped under three headings.
The Debate Over International 1 There is the moral, humanitarian motive to
Assistance to Developing assist poor countries, and particularly poor
Countries people in poor countries. The same arguments
which provide the basis for income redistribu-
As indicated above, capital flows to developing tion within nations can also be applied at the
countries come in many different forms from global level, namely that absolute poverty is
grants or pure aid, to loans, to portfolio invest- intolerable and that if the marginal utility of
ment and direct investment by multinational com- income diminishes, total welfare will be in-
panies. The magnitude of these various flows will creased by a redistribution of income from
be given later in the chapter. Donor countries and rich to poor. From a moral and welfare point
institutions provide aid, loans and investment, and of view, national boundaries are quite arti-
the developing countries accept the flows, for a ficial constructions. Developing countries
mixture of reasons. But the motives and the wider accept assistance with this concern in mind
interests of the developing countries as a whole not only from national governments as part of
may not always coincide. The rationale and rele- their regular aid programme, but also from
vance of financial assistance to developing coun- many voluntary and charitable organisations,
1 See Thirlwall (ed.) (1987). See Chapter 15 for partial schemes 2See, for example, the work of Bauer (1971) and (1981); also
already in existence. Bauer and Yamey (1981).
Foreign Assistance, Debt and Development 327
and from emergency and disaster relief funds. the system itself with its use as a potential instru-
2 There are the political, military and historical ment for the improvement of material well-being
motives for granting assistance. A large part of in less developed countries, and by arguing from
the American aid programme is designed as a the particular to the general case. For example, aid
bulwark against the spread of communism, antagonists argue that assistance is maldistributed
and the regional and country distribution of and does not reach the poorest people in the
assistance can only be satisfactorily explained poorest countries. If true this would partly under-
in these terms. United Kingdom and French mine the humanitarian objective of aid, but it is
assistance tends to be concentrated on ex- not a criticism of aid as such, but of its administra-
colonial territories reflecting strong historical tion. Secondly, critics argue that assistance has
ties, and perhaps some recompense for former not helped economic development. The evidence
colonial neglect. Most developing countries brought to bear on this contention is that many
are willing to accept assistance on this basis, countries are still desperately poor after forty
as an aid to their development effort, particu- _ years of assistance, and that many parts of the
lady by governments threatened by hostile Third World - in South East Asia, West Africa,
forces from within or without. and Latin America - made rapid progress long
3 There are economic motives for developed before the advent of official assistance. But clearly
countries investing in developing countries, this is not conclusive evidence. In the first place,
not only to raise the growth rate of the de- the per capita levels of annual assistance are tri-
veloping countries, but also in their own self- vial; in the second place, the countries might have
interest to raise their own welfare, in which been worse off without assistance, and thirdly, it
case international assistance can be mutually cannot logically follow that because some coun-
profitable. If the rate of interest on loans is tries progressed without official assistance that it is
higher than the productivity of capital in de- necessarily unproductive. The capital that went
veloped countries and lower than the produc- into South East Asia, West Africa and Latin Amer-
tivity of capital in developing countries, both ica before the Second World War was commercial
parties will gain. If there are under-utilised capital, but there is no reason for believing
resources in developed countries, which could that official capital from bilateral or multilateral
not otherwise be activated because of balance- sources would have been any less productive.
of-payments constraints, international assist- The critics are on much stronger ground when
ance will be mutually profitable through an they argue that international assistance may help
addition to resources in developing countries to support governments which are pursuing pol-
and a fuller utilisation of resources in de- icies that are obstructing development, and that by
veloped countries. This is the strong Keyne- increasing the power of government, assistance
sian argument for international assistance, breeds corruption, inefficiency and tensions in
also argued by the Brandt Report discussed in society which retard development. Assistance may
Chapter 1. Developing countries accept these also encourage irresponsible financial policies, and
financial flows because most are desperately if the assistance is free (pure aid) there may be no
short of foreign exchange (see Chapter 16), incentive to use resources productively. There are
and judge the benefits of the programmes and elements of truth in these arguments, but it is
the projects that they finance to be greater not clear that the same policies would not be pur-
than the costs and any unfavourable side- sued without aid. Indeed, the alternatives might be
effects. worse, because with assistance comes a certain
amount of 'leverage', which can be an influence
The critics of official assistance dispute the for good as well as bad. Would the Tanzanian
alleged advantages of international assistance but experiment of 'villagisation', which many would
weaken their case by confusing the operation of argue has undermined the performance of the
328 Financing Economic Development
economy, not have taken place without the gov- panies with headquarters in developed countries
ernment of Tanzania being in receipt of official involves not only a transfer of funds (including the
assistance? It is doubtful; and paradoxically for reinvestment of profits) but a whole package of
the critics, it will probably be Western aid that physical capital, techniques of production, mana-
comes to the rescue. It is also a paradox that the gerial and marketing expertise, products, advertis-
critics of official assistance, at least those on the ing and business practices for the maximisation of
political right, are generally supporters of govern- global profits. There can be little doubt that such
ments that maintain inegalitarian structures which investment augments real resources directly;
they claim assistance reinforces. A distinction also the question is whether such investment contrib-
needs to be made in this argument between pro- utes to the broader aspects of development relat-
gramme and project aid. Programme aid is much ing to the pattern of development and the distribu-
more open to abuse than supervised project aid tion of income. The activities of the multinationals
whether free or not. Why should a government come under attack on a variety of grounds. First,
that wants to construct a road build it inferior because they locate in urban areas they widen the
simply because it is financed on concessional terms income gap between the urban and rural sector,
rather than on commercial terms? No one who has perpetuating dualism and widening the income
seen infrastructure projects the world over, distribution. This criticism, however, cannot be
financed on concessional terms by donor countries levelled exclusively against multinationals because
and multilateral agencies, could possibly claim any new industrial activity establishing in existing
that developing countries cannot benefit from aid. urban centres would have the same effect. A
The most recent evidence on the effectiveness of second and more serious criticism is the way in
aid, based on a detailed study of seven countries which they encourage and manipulate consump-
(Bangladesh, Colombia, India, Kenya, Korea, tion. Not only do they tend to cater for the tastes
Malawi and Mali), shows that most aid achieves of the already well-to-do, which itself acts as a
its development objectives, although in several in- divisive force, but also they tend to encourage
stances the performance could be improved (Cas- forms of consumption among the broad mass of
sen (1986)). The provision of aid has played a people, particularly in the urban areas, which are
major part in the green revolution in South-East inappropriate to the stage of development and
Asia, in the building of infrastructure in southern often nutritionally damaging. Prime examples are
Africa, and in the direct provision of basic needs powdered baby milk and coca-cola. These tend-
and the relief of poverty in many countries. The encies are not only wasteful, but they encourage
study also found, however, that aid performance acquisitiveness, reduce domestic saving and can
appeared to be least satisfactory where it is most worsen balance-of-payments difficulties by en-
needed, and that improved performance requires couraging expensive tastes. A third criticism,
above all more collaboration between aid agencies. which we have already dealt with in Chapter 10, is
that they may introduce inappropriate technology
Foreign
Foreign investment investment
Gross at beginning at end of Outflow of Net
Year inflow of period period profits inflow
easily avoid the effects of domestic monetary pol- Suppose that there is a steady gross inflow of 100
icy because of easy access to foreign capital mar- units of foreign capital per annum; that the pro-
kets and their own internal resources. They can ductivity of capital is 20 per cent; and that one
avoid tax by shifting profits abroad. Countries half of the profits are reinvested and the other half
may wish a company to do one thing, but it may are repatriated. Table 14.6 shows that on these
not readily comply because the action may conflict assumptions the balance-of-payments effect turns
with the global profit objectives of the multi- negative after the eighth year. To keep the net
national company as a whole. Firms may exploit inflow of resources positive requires a steadily ris-
resources more quickly than is desirable, and ex- ing gross flow of private foreign investment, with
ploit consumers and owners of factors of produc- all the implications that this may have for the
tion through the exercise of monopoly and pattern of development in the future.
monopsony power. What is the solution to the dilemmas posed
There is also the question of the repatriation of above? As Colman and Nixson (1978) succinctly
profits. Direct private foreign investment has the state:
potential disadvantage, even compared with loan
finance, that there may be a continual outflow of Transnational corporations cannot be directly
profits lasting much longer than outflows of debt- blamed for the lack of development (or the
service payments on a loan of equivalent amount. direction development is taking) within less de-
While a loan only creates obligations for a definite veloped countries. Their prime objective is
number of years, private investment may involve global profit maximisation and their actions are
an unending commitment. This has serious im- aimed at achieving that objective, not develop-
plications for the balance of payments and for ing the host less developed country. If the tech-
domestic resource utilisation if foreign exchange is nology and the products that they introduce are
a scarce resource. We can show with a numerical 'inappropriate', if their actions exacerbate re-
example that in the long run if profits are repatri- gional and social inequalities, if they weaken
ated the impact of continuous private foreign in- the balance-of-payments position, in the last
vestment on the balance-of-payments must be resort it is up to the less developed country
negative unless the gross inflow of foreign invest- government to pursue policies which will elim-
ment grows substantially from year to year. This, inate the causes of these problems.
of course, then increases the power and influence
of foreign interests within the country concerned. It is extremely difficult to measure the full
330 Financing Economic Development
impact and real costs of multinational investment 1 Official flows from bilateral sources (including
using economic calculus alone, but this is what the developed and OPEC countries) and multi-
developing countries must do. What would be the lateral sources (such as the World Bank and its
real income gains and losses of controlling the free two affiliates, the International Development
mobility of private foreign investment? Alterna- Association (IDA), and the International
tively, other ways of taking advantage of foreign Finance Corporation (IF C)), on concessional
private capital might be actively explored, includ- and non-concessional terms.
ing joint ventures and turn-key projects whereby 2 Direct private investment.
the foreign investor pays for and builds the project 3 Commercial Bank Loans (including export
in collaboration with the host country, which is credits).
then run by the host country's staff. There is
already evidence that this is the direction in which Because of the different types of capital flows, and
developing countries are moving. Developing the different terms of borrowing, there is an im-
countries must lay down very clearly the condi- portant distinction to be made between the nom-
tions under which they will accept multinational inal value of capital flows and their worth in terms
investments and monitor the companies' opera- of the increased command over goods and services
tions so that distorted development and the ques- that they represent to the recipient. There is also
tion of exploitation does not arise. the distinction to be made between the return to in-
Political considerations, disillusion with assist- ternational assistance, the benefit of international
ance, and a sense of frustration that it has pro- assistance (in a cost-benefit sense) and the value of
duced little in the way of tangible results, now international assistance.
unite large sections of the political right and left in The return to international assistance is the dif-
an uncanny alliance against international resource ference between the nominal value of assistance
flows, public and private, from rich to poor coun- and the repayments discounted by the productivity
tries. In the last resort the arguments largely boil of the assistance in the recipient country. The re-
down to an expression of value judgements con- turn to assistance is measured in the same way as
cerning the nature and character of development. the return to any other investment.
Ignoring political extremists, however, who rarely The benefit of assistance is the difference be-
argue on pragmatic grounds anyway, none of the tween the nominal value of assistance and repay-
indictments against international resource flows ments discounted by the rate of interest at which
are sufficient in themselves to establish a case the country would have had to borrow in the
against international assistance as such; only capital market. The benefit of assistance is
against the form it takes, the terms on which it is measured as a differential as in cost-benefit analy-
given and the use to which it is put within the sis. It is this calculation which we shall refer to
recipient countries. subsequently as the 'grant element' or 'aid compo-
Let us now distinguish more clearly the types nent' of the capital flow, representing 'something
and magnitudes of international capital flows for nothing' to the recipient country. Clearly, if the
from various sources, including the OECD, the terms on which the country borrows from the
United Kingdom, OPEC and the World Bank. donor are no different from those prevailing in the
free market, there is no grant element attached to
assistance below what it would otherwise be. 1 in recent years, the countries of OPEC have lent
Looked at from the point of view of the donor, substantial sums on concessional terms. Non-
a positive benefit to the recipient does not necess- concessional flows are primarily bilateral consist-
arily mean a cost or sacrifice to the donor. There ing mainly of direct private investment; export
is a sacrifice to the donor only to the extent that credits and syndicated bank loans. The magnitude
the opportunity cost of capital, or the rate at of these various types of flow over the period 1980
which the donor would have had to borrow from to 1990 is shown in Table 14.7. The total net flow
another source to give the loan, exceeds the rate of of financial resources in 1990 was $140 billion, of
interest charged. Nor is any real resource transfer which $62 billion was official development assist-
from the donor country necessarily implied. This ance and $78 billion consisted of non-concessional
depends on whether the donor country provides flows. In the latter category there was an enor-
the real counterpart of the financial flow in terms mous increase in private bank lending to develop-
of an export surplus. It is quite possible that the ing countries up to 1981, following the rise in oil
real transfer may be provided by another donor prices, which then fell dramatically during the rest
country. Before going into the measurement of of the 1980s. Official development assistance has
these concepts in greater detail, however, let us grown steadily over the years from both bilateral
first outline the major forms of international capi- and multilateral sources in money and real terms.
tal flows and give some idea of their nominal The aid targets set for the developed countries of 1
magnitude. per cent of their national incomes refer to the total
I
net flow of financial resources, while the target for
official development assistance alone is 0. 7 per
The Total Net Flow of cent of donor countries' national incomes. It must
Financial Resources to also be remembered that the net flow of financial
resources is not the same thing as the flow of real
Developing Countries resources, since the former excludes interest pay-
ments and profit repatriation. If the terms of lend-
The total net flow of financial resources to de- ing are steady over time the net transfer of
veloping countries is the total of all official and resources in any one year (i.e., the gross capital
private flows to developing countries net of repay- inflow net of amortisation and interest and profit
ments of past loans (amortisation). It includes payments) will be approximately equal to the esti-
flows given bilaterally by individual donor coun- mated grant equivalent or aid component of assist-
tries and multilaterally through international ance, the measurement of which is discussed later
organisations, and includes flows both with and (seep. 344).
without concessionary terms. Most official flows
are given on concessionary terms and are referred
to as Official Development Assistance. To qualify • Official Development Assistance
as such, the concessional (or grant) element of the
flow must be at least 25 per cent. Only the con- The total flow of official development assistance in
cessional element of international financial flows 1990 was $62 billion. The contribution of the
really qualify for the term 'Aid'. The major donors DAC countries of the OECD was $54 billion, of
of Official Development Assistance are the eight- which approximately $33 billion consisted of
een developed countries of the OECD which form grants, including $12 billion for technical assist-
the Development Assistance Committee (DAC), ance and $15 billion represented contributions to
and the various multilateral agencies. In addition, multilateral institutions. The recent record of indi-
vidual DAC countries as providers of official de-
1 For the calculation of the grant element, see p. 344. velopment assistance is shown in Table 14.8,
332 Financing Economic Development
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1982 1985 1990
I. OFFICIAL DEVELOPMENT
FINANCE (ODF) ...................... 45.6 45.5 44.1 42.4 47.5 48.6 55.8 61.5 65.5 65.5 78.8 38.0 58.5 54.6
I. Official development
assistance (ODA) .................. 37.8 36.8 33.8 33.9 34.8 37.0 43.9 48.2 51.4 52.9 62.6 29.1 44.5 43.4
Of which: Bilateral
disbursements 30.0 28.9 26.3 26.3 27.2 28.8 35.0 38.3 40.2 40.7 49.4 22.7 34.7 34.3
Multilateral
disbursements 7.8 7.9 7.5 7.6 7.6 8.2 8.9 9.9 11.2 12.2 13.2 6.5 9.9 9.2
2. Other ODF ............................ 7.8 8.7 10.3 8.5 12.7 11.6 11.9 13.3 14.1 12.6 16.2 8.9 14.0 11.2
Of which: Bilateral ........... 3.0 3.0 3.7 1.3 4.5 3.7 4.1 6.6 7.6 5.6 6.0 3.2 4.5 4.2
Multilateral... ... 4.8 5.7 6.6 7.2 8.2 7.9 7.8 6.7 6.5 7.0 10.2 5.7 9.5 7.1
II. TOTAL EXPORT CREDITS .... 16.5 17.6 13.7 4.6 6.2 4.0 -0.7 -2.6 -2.1 9.5 4.6 11.8 4.8 3.2
1. DAC countries ...................... 15.4 16.2 12.7 3.9 5.2 3.4 -0.9 -2.9 -2.1 9.6 4.5 10.9 4.1 3.1
Of which: Short-term ........ 1.8 2.9 3.0 -3.5 0.3 3.2 3.0 4.1 2.0 4.8 3.0
2. Other countries ..................... 1.1 1.4 1.0 0.7 1.0 0.6 0.2 0.3 X -0.1 0.1 0.9 0.7 0.1
lll. PRIVATE FLOWS .................... 66.2 74.3 58.2 47.8 31.7 30.5 26.7 33.7 43.8 48.3 60.8 50.2 36.7 42.2
I. Direct investment (OECD) .... 11.2 17.2 12.8 9.3 11.3 6.6 11.3 21.1 25.3 30.4 32.0 11.0 7.9 22.2
Of which: Offshore
centres .............. 3.0 4.1 4.1 3.7 3.8 3.7 6.2 12.6 11.4 8.0 ..
2. International bank lending .... 49.0 52.3 37.9 35.0 17.2 15.2 7.0 7.0 7.8 10.5 18.5 32.7 18.3 12.8
Of which: Short-term ........ 26.0 22.0 15.0 -25.0 -6.0 12.0 -4.0 5.0 4.0 8.0 9.0
3. Total bond lending ............... 1.6 1.3 4.8 1.0 0.3 4.5 1.2 -0.4 1.3 -0.3 0.8 4.1 5.4 0.6
4. Other private ........................ 2.0 1.5 0.4 0.2 0.3 1.3 3.9 2.5 5.2 3.7 5.0 0.3 1.6 3.5
5. Grants by non-governmental
organisations ........................ 2.4 2.0 2.3 2.3 2.6 2.9 3.3 3.5 4.2 4.0 4.5 2.0 3.5 3.1
together with the flow measured as a proportion developing countries and multilateral agencies, is
of the donor's GNP. It will be seen that only shown in Table 14.9 for 1989, together with the
the Netherlands, Denmark, Norway, France and total flow as a proportion of the donor's GNP. It
Sweden met the aid target in 1990 of 0.7 per cent can be seen that some of the countries that failed
of GNP. The United States is the major provider of to meet the official development assistance target
development assistance, but contributes the lowest in 1989 managed to meet the total net financial
proportion of GNP (apart from Ireland). The ratio flow target of 1 per cent of GNP by virtue of large
for all DAC countries has not changed over the volumes of private lending. The $28.9 billion flow
decade 1980 to 1990. of private capital in 1989 compares with $57
billion at its peak in 1981.
Table 14.8 Net Official Development Assistance from DAC Countries to Developing Countries and Multilateral
Organisations (1979-81 average, 1985-90)
Net disbursements $million and per cent of GNP
Australia........................ 649 0.4 7 749 0.48 752 0.47 627 0.34 1 101 0.46 1 020 0.38 955 0.34
Austria........................... 176 0.25 248 0.38 198 0.21 201 0.17 301 0.24 282 0.23 394 0.25
Belgium.......................... 604 0.55 440 0.55 547 0.48 687 0.48 601 0.39 703 0.46 889 0.46
Canada......................... 1 106 0.44 1 631 0.49 1 695 0.48 1 885 0.47 2 347 0.50 2 320 0.44 2 470 0.44
Denmark........................ 448 0.73 440 0.80 695 0.89 859 0.88 922 0.89 937 0.93 1 171 0.93
Finland........................... 112 0.24 211 0.40 313 0.45 433 0.49 608 0.59 706 0.63 846 0.64
France........................... 3 929 0.65 3 995 0.78 5 105 0.70 6 525 0.74 6 865 0.72 7 450 0.78 9 380 0.79
Germany....................... 3 380 0.45 2 942 0.47 3 832 0.43 4 391 0.39 4 731 0.39 4 948 0.41 6 320 0.42
Ireland ........................... 29 0.17 39 0.24 62 0.28 51 0.19 57 0.20 49 0.17 57 0.16
Italy............................... 541 0.14 1 098 0.26 2 403 0.40 2 615 0.35 3 193 0.39 3 613 0.42 3 395 0.12
Japan ............................. 3 070 0.29 3 797 0.29 5 634 0.29 7 342 0.31 9 134 0.32 8 965 0.31 9 069 0.31
Netherlands................... 1 538 0.99 1 136 0.91 1 740 . 1.01 2 094 0.98 2 231 0.98 2 094 0.94 2 592 0.94
New Zealand................. 69 0.32 54 0.25 75 0.30 87 0.26 104 0.27 87 0.22 93 0.22
Norway......................... 461 0.88 574 1.01 798 1.17 890 1.09 985 1.13 917 1.05 1205 1.17
Sweden........................... 956 0.84 840 0.86 1 090 0.85 1 375 0.88 1 534 0.86 1 799 0.96 2 012 0.90
Switzerland.................... 234 0.23 303 0.31 422 0.30 547 0.31 617 0.32 558 0.30 750 0.31
United Kingdom ............ 2 067 0.42 1 530 0.33 1 737 0.31 1 871 0.28 2 645 0.32 2 587 0.31 2 647 0.27
United States .................. 5 868 0.22 9 403 0.24 9 564 0.23 9 115 0.20 10 141 0.21 7 676 0.15 11 366 0.21
Total DAC ................ 25 238 0.35 29 429 0.35 36 663 0.35 41 595 0.35 48 114 0.36 46 712 0.34 54 OTt' 0.35
from 0.42 per cent in 1980 to 0.27 in 1990. This is 1990 prices. The recent levels of total official and
way below the UN target of 0.7 per cent. Most of private flows are shown in Table 14.10.
the development assistance is now given in the As far as the geographical distribution of total
form of grants. This represents a dramatic soften- official bilateral assistance is concerned, approxi-
ing of the terms of assistance over the years, when mately 50 per cent was disbursed to sub-Saharan
in the 1960s assistance was largely in the form of Africa in 1990; 37 per cent to Asia, and the re-
loans at near market rates of interest. Just over mainder to South America, Oceania and Europe.
one-half of assistance is bilateral, and the remain- Over 130 countries received assistance varying in
der multilateral; 75 per cent is financial aid and 25 amounts from as little as $5000 to $140 million in
per cent represents technical assistance. Technical the case of India, the largest recipient. To put the
assistance is an integral part of the UK aid pro- Indian sum in perspective, however, this total rep-
gramme and expenditure on it has risen from resents only 15 cents per head of India's popula-
$100 million in 1970 to $709 million in 1990. Of tion. This compares with the ~verage per capita
total bilateral aid, approximately 45 per cent is for assistance from the UK to all developing countries
technical assistance; 30 per cent for projects, and of 90 cents.
the remainder for non-project purposes including The fact that assistance is tied to the purchase
programme and debt relief. Over 60 per cent of of UK goods means, of course, that the foreign
gross bilateral aid goes to the 50 poorest countries exchange cost of the UK aid programme is much
with a per capita income of less than $1000 at less than the budgetary cost or financial flow.
334 Financing Economic Development
Table 14.9 Total Net Flow of Financial Resources direct effect of assistance on exports, however, is
by DAC Countries to Developing Countries and not an adequate measure of the true return to the
Multilateral Agencies, 1989 balance of payments because certain indirect effects
are ignored. Some of the assistance may be tied
Flow of private Total net flow
to exports which would have been bought by the
capital 1 of financial
resources 2 recipient country anyway. In this case, assistance
merely releases foreign exchange, some of which
$ As% $ As% may be spent on UK exports but some of which
million of GNP million of GNP
may be spent elsewhere. It is difficult to obtain a
Australia 306 0.11 1547 0.57 direct measure of the extent of what may be called
Austria -111 -0.09 152 0.12 'switching', but Hopkin puts the loss at £18.9
Belgium 377 0.25 1467 0.96 . million, thus lowering the true return below the
Canada -208 -0.04 2 718 0.51 prima facie return by the same amount. Offsetting
Denmark 46 0.05 904 0.90 this, however, there are bound to be induced im-
Finland 221 0.20 941 0.83 ports from the spending of assistance in the recipi-
France -1630 -0.17 7 232 0.75 ent country, some of which are likely to be bought
Germany 5 495 0.46 12147 1.01 from the donor country. In the case of Britain this
Ireland 30 0.11 105 0.36 is estimated by Hopkin to be £4.1 per £100 of
Italy 974 0.47 5 752 0.67 assistance. Last, there will be reflection effects as a
Japan 13 502 0.08 24133 0.84 result of assistance being spent in third countries
Netherlands 169 2 460 1.10 to which the donor is a supplier. Britain is esti-
New Zealand 100 0.25 mated to benefit from this effect to the extent of
Norway -43 -0.05 902 1.03 £4.9 per £100 of assistance. The effect of these
Sweden 412 0.22 2 343 1.25 three sorts of indirect effects on the estimated re-
Switzerland 2 018 1.08 2 660 1.43 turn to the United Kingdom of £100 of bilateral
United Kingdom 69 0.01 3 377 0.41 assistance may be summarised as follows, and a
United States 7 325 0.14 16 382 0.32 calculation of the 'true' return made:
Total DAC 28 951 0.21 85 322 0.61
countries Prima facie return +£72.5
Effect of switching -£18.9
1
Excluding grants by voluntary agencies. Induced imports +£ 4.1
2
Including official development assistance, but exclud- Reflection effects +£ 4.9
ing grants by voluntary agencies.
Source: OECD, Development Cooperation 1991 Review. +£62.6
An interesting study of the effect of UK assist- Ignoring repayments of loans and interest, the im-
ance on British exports has been undertaken by mediate foreign exchange cost of bilateral assistance
Mr Hopkin et al. (1970) for the period of the is only 37.4 per cent of the total disbursements.
mid-1960s. Although the study is now somewhat The United Kingdom's balance of payments
dated, the methodology is interesting and it still probably gains from international assistance in
has relevance because the present level of aid-tying general. Its exports benefit from assistance pro-
is little different from what it was in the 1960s. vided by other countries. The United Kingdom
The calculations are shown in Table 14.11. provides approximately 5 per cent of total official
Considering simply the direct effect of assist- assistance from developed to developing countries
ance on the balance-of-payments, the calculations but supplies 12 per cent of the exports from de-
suggest that for every £100 of assistance, £72.5 veloped to developing countries. The World Bank
'returns' in the form of increased exports. The has estimated that for every £1 the United King-
Foreign Assistance, Debt and Development 335
Table 14.10 Total Net Flow of Financial Resources from the United Kingdom to Developing Countries and
Multilateral Agencies ($ million)
1979-1981
average
1987 1988 1989 1990
NET DISBURSEMENTS
I. Official Development Assistance (ODA), (A + B) 2 067 1 871 2 645 2 587 2 647
ODA as o/o of GNP ................................................ 0.42 0.28 0.32 0.31 0.27
A. Bilateral Official Development Assistance
(1 + 2) ............................................................... 1290 1 008 1 430 1 463 1 483
1. Grants and grant like contributions ............... 1 303 1 093 1 528 1548 1 567
of which: Technical assistance ....................... 444 462 642 608 709
Administrative costs ....................... 62 65 82 79 99
2. Development lending and capital.. .................. -13 -85 -98 -86 -83
of which: New development lending .............. -17 -114 -128 22 11
B. Contributions to multilateral institutions
(1+2+3) ........................................................ 778 863 1 215 1124 1 164
1. Grants .............................................................. 425 544 725 744 814
of which: UN Agencies ................................... 118 158 192 190 196
EEC ................................................ 284 363 488 499 587
2. Capital subscription payments and similar to 352 320 489 381 352
of which: IDA ................................................ 286 219 311 286 310
Regional Development Banks ......... 66 84 50 88 41
3. Concessionallending ...................................... 1 - - -1 -2
II. Other Official Flows (OOF), net (A + B) ............... 109 264 323 459 616
A. Bilateral Other Official Flows (1 + 2) ................ 109 264 323 459 616
1. Official export credits• ................................... -530 191 196 342 464
2. Equities and other bilateral assets .................. 639 73 127 117 151
B. Multilateral Institutions ...................................... - - - - -
III. Grants by Private Voluntary Agencies ..................... 108 221 239 262 327
dom gives the IDA it receives £1.5 of export orders year. During the 1970s there was a colossal in-
from projects financed by IDA credits. This, of crease in the amount of bank lending and portfolio
course, IS a statistical association, not a causal investment in developing countries, largely con-
connection. sisting of the recycling of OPEC oil revenues depo-
The level of net private flows to developing sited in London. The average annual level of
countries from the UK is very volatile from year to private flows from 1970 to 1972 was only $500
336 Financing Economic Development
million. This had risen to $10 billion in 1980, but Table 14.12 OHicial Development Assistance from
has since fallen back. Because of these private OPEC Members, 1990 ($ million)
flows, the UN target for total flows of 1 per cent of
national income is often met, while the target for Official development % of
assistance GNP
official development assistance has never been
met. Nigeria 13 0.06
Algeria 7 0.03
Venezuela 15 0.03
• OPEC Assistance Saudi Arabia 3692 3.90
Libya 4 0.01
The oil-producing countries which form OPEC Kuwait 1666
also provide substantial amounts of official de- United Arab Emirates 888 2.65
velopment assistance to developing countries,
both bilaterally and in support of various multi- Total OPEC 6341
lateral development agencies although much less
Source: World Development Report, 1992.
now than in 1980. The grant element of OPEC
assistance is substantial, averaging 90 per cent in
1990. The record of the OPEC countries is shown Corporation (IFC); the United Nations; and var-
in Table 14.12. ious Development Banks. Total disbursements in
1989-90 totalled over $18 billion, of which nearly
10 billion was on concessional terms. A detailed
• Multilateral Assistance breakdown of the lending by the various multi-
lateral agencies in 1989-90 is shown in Table
The major sources of multilateral assistance to 14.13.
developing countries are the World Bank and its The disbursements by multilateral agencies to
two affiliates, the International Development developing countries consist not only of the con-
Association (IDA) and the International Finance tributions of developed countries but also of funds
Foreign Assistance, Debt and Development 337
Concessional Non-concessional
raised on the capital market and repayments of The Bank began to realise, however, that infra-
previous loans. As can be seen from Table 14.13, structure investment was not enough; that it had a
the World Bank is essentially a commercial institu- role to play in lending to support directly produc-
tion lending on non-concessional terms, and it tive activities. It also recognised inadequacies in
raises large sums of money on the world's capital education and managerial skills, and became in-
markets. The IDA is the 'soft' loan affiliate of the creasingly aware that the development taking
World Bank which dispenses loans at very low place was not trickling down to the vast masses of
rates of interest with long repayment periods. The the poor. In the late 1960s, and throughout the
IFC concentrates on encouraging private enter- 1970s, the Bank began to take a more activist role
prise in developing countries by making equity in the fields of agriculture and in helping both the
investments. rural and urban poor. Mr McNamara, the Presi-
dent of the Bank from 1968 to 1981, inaugurated
this radical change of emphasis in his annual
• World Bank Activities address to the Bank in Nairobi in 1973. He de-
fined absolute poverty as 'a condition of life so
The activities of the World Bank since its inception degraded by disease, illiteracy, malnutrition and
have broadly reflected changes in thinking about squalor as to deny its victims basic human necess-
development policy and development priorities - ities', and he pledged the Bank to make a concerted
changes that the World Bank itself has played a attack on rural poverty, to raise the productivity
large part in promoting. In the early years, and of the poor and to raise the incomes of small
throughout the 1960s, the major emphasis of the farmers. The objective was to provide most of the
Bank was on financing infrastructure projects in benefits of lending to those in the bottom 40 per
the field of power generation and distribution; cent of income groups. In 1975, the Bank
transportation; ports; telecommunications, and announced that it would also attempt to deal with
irrigation. There was very little support for agri- the problems of the urban poor by promoting
culture and rural development, or industry and productive employment opportunities on labour-
tourism; and programme loans (as opposed to intensive projects, and by developing basic services
project assistance) were largely confined to coun- to serve the poor at low cost, e.g. water supplies,
tries outside those classified as less developed. sanitation, family planning, etc. The Bank has
338 Financing Economic Development
already financed a number of so-called 'integrated policies acceptable to the Bank designed to secure
urban projects' in over twenty-five countries, lend- external equilibrium in the long run without re-
ing for various urbanisation programmes. straining demand and sacrificing growth. Structural
It was mentioned in Chapter 1 that the new adjustment with a human face is now the watch-
President of the World Bank, Mr Lewis Preston, word (see Cornia, Jolly and Stewart (1987 and
announced in May 1992 that poverty reduction 1988)). Balance-of-payments support has been the
will be the 'benchmark by which our performance traditional preserve of the International Monetary
as a development institution will be measured'. Fund (see Chapter 16), but there is a difference of
The current amount and distribution of World emphasis between the Fund and the Bank. Where-
Bank assistance for various purposes is shown in as the policies of the Fund focus primarily on
Table 14.14. balance-of-payments management, the Bank is
more concerned with promoting policies to in-
crease efficiency and incentives to raise export
earnings and reduce import payments. Clearly,
• Structural Adjustment Lending however, the roles of the two institutions now
overlap and will do so increasingly as the Fund
A further new initiative was announced by the itself insists on supply-side policies as a condition
Bank in October 1979 of structural adjustment for assistance, as well as on the traditional
lending to countries in order to support their demand-side policies of devaluation and monetary
balance of payments. To qualify for structural contraction. The distinct roles of the IMF and the
adjustment loans, however, a country must adopt World Bank are outlined in the box below.
Foreign Assistance, Debt and Development 339
The World Bank itself defines structural adjust- impact seems to have been disappointing. Accord-
ment loans as 'non-project lending to support ing to research on 40 countries by Harrigan and
programmes of policy and institutional change to Mosley (1991), the effect on GDP growth has been
modify the structure of the economy so that it can negligible; export growth and the balance of pay-
maintain both its growth rate and the viability of ments has improved, but investment has declined.
its balance of payments in the medium term'. The The main reason for the disappointing results
loans are medium term geared to supply-side re- appears to be the heavy requirements (or con-
forms, e.g. improving the efficiency with which ditionality) placed. on recipient governments
markets operate; price reform; changing the price which depress demand and depress confidence.
of tradeable goods relative to non-tradeables; get- There is a general consensus that the requirements
ting the 'correct' terms of trade between agricultu- should be less stringent and more selective, and
ral goods and industrial goods; reducing the size more sensitive to particular country circumstances
of the public sector; financial reforms; tax re- (see Mosley, Harrigan and Toye (1991)).
forms, etc. Governments must commit themselves This is confirmed by a study by the World Bank
to policy reform before loans are disbursed. Since itself which concludes that structural adjustment
1980, 187 loans have been disbursed to over 50 lending has achieved a modest degree of success in
countries with a total value of $32 billion. In helping developing countries improve their bal-
1990, $4 billion was disbursed, representing 20 ance of payments, but it has failed to lead to an
per cent of World Bank lending. upsurge of investment or to enable countries to
Since the purpose of structural adjustment lend- 'grow out of debt' (World Bank (1990)).
I
ing is to improve the economic performance of
countries, the evaluation of lending by the World The Recipients of External
Bank and independent investigators has focused Assistance
on four key macroeconomic indicators: the
growth of GDP; the growth of exports; invest- We end the statistical section by showing the dis-
ment; and the balance of payments. So far, the tribution of external capital by country for 1970
340 Financing Economic Development
and 1990 (the latest year available at the time of are discounted. If the rate of interest at which the
writing). It is well to remember that while official country would have had to borrow in the free
development assistance in 1990 amounted to market is greater than the actual rate of interest it
approximately $62 billion, it was spread over 3 has to pay, the 'worth' or benefit will be positive.
billion people in developing countries giving an If the rate of interest at which it would have had to
average annual per capita receipt of $20. In India, borrow is less than the actual rate, the 'worth' or
the largest developing country in receipt of official benefit will be negative because the recipient
development assistance from the DAC, assistance would be paying back more than it need have
per head is approximately $2 per annum. The net done. (This is unlikely to happen.) The grant
inflows of official and private capital for the low- equivalent or aid component of assistance is mea-
and middle-income countries of the world are sured in this differential benefit sense. The return
shown in Table 14.15. Aggregate net resource flows on the assistance may of course be much greater
are the sum of net flows of long-term debt, official than the benefit if the productivity of the assist-
grants and net foreign direct investment. Aggre- ance is higher than the free-market rate of interest.
gate net transfers are equal to aggregate net To measure the grant equivalent or aid compo-
resource flows minus interest payments on long- nent of international flows from the donor's point
term loans and remittances of all profits. It will be of view, the correct discount rate to employ would
seen that for many Latin American countries (and seem to be the interest rate at which the donor
also for other countries too) there was a negative would have to borrow to make the loan. The grant
net transfer of resources in 1990 reflecting heavy equivalent of the loan is then a measure of the cost
debt-service repayments from inflows in the past of the lender of making the loan on a concession-
and the reduction in new lending. Brazil, for ex- ary basis. Traditionally the discount rate suggested
ample, has a negative resource transfer of nearly was the opportunity cost of funds in the donor
$4 billion, while the figure for Argentina and country but this would be the appropriate dis-
Venezuela is over $1.5 billion. count rate only if it is assumed that loans are made
at the sacrifice of domestic investment.
Public and pub- Private Net foreign Aggregate net Aggregate net
licly guaranteed nonguaranteed Official grants direct investment resource flows transfers
1970 1990 1970 1990 1970 1990 1970 1990 1970 1990 1970 1990
Low-income economies
India 594 3 029 0 -104 157 684 6 0 757 3 610 565 200
Benin 1 90 0 0 9 110 7 0 17 200 13 196
China .. 6 249 0 0 0 333 0 3 489 0 10 071 0 7 492
Haiti 1 31 0 0 2 88 3 8 6 128 2 114
Kenya 17 394 30 -37 4 942 14 26 64 1 324 -2 1 010
Pakistan 375 923 2 -13 79 381 23 249 479 1 540 395 978
Ghana 28 257 0 0 9 440 68 15 104 712 79 646
Central African Rep. -1 116 0 0 6 87 1 0 7 203 5 194
Togo 3 54 0 0 7 97 1 0 11 152 5 98
Zambia 316 61 5 2 2 633 -297 0 26 696 -65 638
Table 14.15 Aggregate Net Resource Flows and Net Transfers (continued)
Public and pub- Private Net foreign Aggregate net Aggregate net
lic/y guaranteed nonguaranteed Official grants direct investment resource flows transfers
1910 1990 1910 1990 1910 1990 1910 1990 1910 1990 1910 1990
Middle-income economies
Lower-middle-income
Table 14.15 Aggregate Net Resource Flows and Net Transfers (continued)
Public and pub- Private Net foreign Aggregate net Aggregate net
lic/y guaranteed nonguaranteed Official grants direct investment resource flows transfers
1970 1990 1970 1990 1970 1990 1970 1990 1970 1990 1970 1990
Upper-middle-income
value of the future discounted repayments. be worked out for different combinations of in-
Through the technique of discounting, any com- terest rates, discount rates, grace periods and
bination of repayment terms can be brought to a length of maturity. At the two extremes, if the
common measure. All three factors referred to - financial flow is a pure grant then Pt = 0, and the
the interest-rate subsidy, the grace period and the grant element is 100 per cent. If the financial flow
maturity of the loan - can be incorporated into a is at a rate of interest equal to the market rate of
simple formula for calculating the grant equivalent interest, and the grace period and maturity of the
of a loan. The grant equivalent or aid component loan are the same as in the free market, the sum of
of a loan (as a percentage of its face value) is called the discounted future repayments will equal the
the grant element, equal to: face value of the flow, and the grant element will
be zero. For combinations of conditions between
F- ( t (1 : r)t)
100
the two extremes, Table 14.16 gives some illustra-
tive calculations. For example, the grant element
of a ten-year loan at 5 per cent interest with a
F
grace period of five years with the recipient dis-
counting repayments at 10 per cent would be 26.1
where F is the face value of the loan, Pt is the total per cent. It can be seen that the grant element is
repayment of principal and interest in year t, T is quite sensitive to small changes in the interest rate
the maturity of the loan and r is the rate of dis- and the discount rate but relatively insensitive to
count. Since Pt includes interest charges it can be variations in the grace period and the length of
seen that the lower the interest rate relative to the maturity. Long maturities and grace periods are
rate of discount (r), and the more repayments can mainly means of providing liquidity rather than
be delayed through time, the greater will be the aid. The terms of Official Development Assistance
grant element of the loan. The grant element can from the DAC members in 1989 and 1990 are
344 Financing Economic Development
shown in Table 14.17. The average rate of interest giving a grant element of the loans of approxi-
charged has been 2.5 per cent; the average grace mately 65 per cent. In 1990 the grant element of
period has been nine years and the average ma- total net financial resource flows was approxi-
turity of loans has been approximately 27 years. mately 45 per cent, while the grant element of
The discount rate normally applied is 10 per cent, 1 total official development assistance was over 90
1 What might appear to be a low rate of interest is a reflection
per cent. Since 1972 the DAC countries have been
of the fact that the aid donors' club tends to measure the grant instructed to reach and maintain an average grant
equivalent of assistance from the donors' point of view. element of at least 84 per cent in their disburse-
Foreign Assistance, Debt and Development 345
Total DAC ............ 78.5 77.2 59.1 57.6 28.0 27.0 9.0 9.0 2.5 2.7
Source: OECD, Development Cooperation Review 1991 (Paris) .
pients from shopping around to find exactly the repayments in the recipient's currency, saving the
goods they want in the cheapest markets. Use re- recipient's scarce foreign exchange and possibly
strictions normally mean tying assistance to cover promoting trade at the same time. The one miti-
the foreign exchange costs of an identifiable pro- gating factor in all this discussion is that the pro-
ject. Restricting the use of assistance to particular ject for which assistance is given in tied form may
projects as well as to a country's goods amounts to have been undertaken anyway using the same
double-tying. Tying can be extremely expensive. source of supplies, in which case the assistance
One study of twenty projects in Pakistan (Haq releases the resources for something else which can
(1967)) found that the lowest prices from tied be used freely. In other words, assistance to a
sources were over 50 per cent higher than the certain extent is fungible because of resource
lowest bids on international tendering, and Bhag- switching. The fungibility of assistance also means
wati (1970) found that on tenders from twenty that the balance-of-payments gain to the donor
World Bank loans and three International De- from tying may be quite small in practice because
velopment Association credits the ratio of the dif- one form of purchase is substituted for another.
ference between high bids and successful bids to This could be used as a bargaining weapon to
successful bids was on average 49.3 per cent, reduce the extent of tying, the major reason for
which is a measure of the potential excess cost. which at present seems to be balance-of-payments
Moreover, there are many other costs of tying protection.
apart from the inability of the recipient to buy in Several proposals have been put forward in re-
the cheapest market. If there is double-tying, the cent years for mitigating the disadvantages to the
project for which assistance is given might not fit developing countries of aid-tying without strain-
perfectly into the recipient's development prog- ing the balance of payments of the donor coun-
ramme, the technology might be inappropriate, tries. One possibility is to institute bilateral
the donor may raise the import content unneces- purchasing arrangements between donor countries
sarily, the suppliers may exploit knowing that they whereby assistance from one donor to developing
have a captive consumer, and servicing over the countries could be swopped for assistance from
life of the investment may be expensive. another donor country leaving tying levels intact
The excess cost of the imported goods from the but increasing the competitive opportunities open
tied source represents a form of export subsidy to to the recipient countries. Another possibility is
the donor country in the sense that if the aid-tying multilateral purchasing arrangements which allow
had not been imposed, and the donor was to re- recipients to buy in the cheapest markets within a
main competitive, the subsidy would have had to group of countries which are so chosen that the
be paid by the donor country itself. In other gains and losses from untying assistance would
words, aid-tying saves the donor the cost of the cancel out. Levitt (1970) has outlined a precise
export subsidy. Excess costs probably range be- methodology for establishing an individual donor's
tween 10 and 20 per cent. It is incredible that exchange gains and losses from assistance which
developing countries should have to pay interest could be used to explore ways of untying assist-
on export subsidies to developed countries' expor- ance and for increasing assistance without increas-
ters. It would be fairer to deduct these excess costs, ing the net exchange loss to any donor. To avoid
which would relieve the developing countries of any one donor being involved in an exchange
some of their interest burden and bring the mea- loss through untying, each donor must untie at
sure of aid closer to its real worth at the same time. different rates depending on their relative share of
Equally pernicious is the practice of donor coun- exports to developing (recipient) countries and on
tries of both tying assistance and also insisting that their relative share of aid disbursed. Levitt calcu-
loans be repaid in scarce foreign currency. If tying lated the percentage untying to match untying by
is necessary to protect the balance of payments of the United States of 1 per cent to be: France 1.2
donors, it would help for the donors to accept loan per cent; West Germany 2.1 per cent; the United
Foreign Assistance, Debt and Development 34 7
Kingdom 3.1 per cent; Japan 9.2 per cent; and the The aid coefficient is highly significant and is also
rest of the world 4.3 per cent. Of course, a scheme higher in absolute value than any of the other
of this nature can only achieve partial untying coefficients, suggesting that aid is more productive
because 100 per cent US untying would require than domestic resources and other capital inflows.
over 100 per cent untying by everybody else, Sub-samples of countries by continents yield simi-
which is impossible unless other donors increase lar results.
their assistance simultaneously. The scope for in- The criteria for the distribution of bilateral
creasing assistance without any donor suffering an assistance are largely a matter for the donors con-
exchange loss is calculated as follows: for every cerned. In practice the criteria employed often
extra $100 from the United States, the aid con- tend to be more non-economic than economic,
tributions required from other donors would be: reflecting historical relationships between coun-
France $22.6, West Germany $22.6; the United tries, as well as military and political objectives. In
Kingdom $32.7; Japan $28.7; and the rest of the the past many of the developing countries became
world $52.6. The percentage shares of additional a battleground in the Cold War, and the distribu-
aid would be: United States 38.6 per cent; France tion of bilateral assistance still reflects this. Most
8.7 per cent; West Germany 8.7 per cent; the donors refrain from making explicit the criteria on
United Kingdom 12.6 per cent; Japan 11.1 per which they distribute assistance, but Ohlin (1965)
cent; and the rest of the world 20.3 per cent. These suggests that four distinct systems of development
shares can also be taken to indicate the shares of assistance can be discerned. First, there is US in-
total aid which would ensure that no donor in- volvement in world-wide political development.
curred foreign exchange losses as a result of the Second, there is the assistance of colonial powers
aid-giving process. to former territories. Third, there is the emergence
of countries, like West Germany and Japan, mak-
ing extensive grants and loans aimed at promoting
I The Distribution of
International Assistance
economic relationships between donor and reci-
pient. Last, there is the existence of smaller donor
countries which give assistance multilaterally.
The criteria for the distribution of multilateral
The distribution of international assistance will assistance through international agencies, to
affect comparative rates of growth of the develop- which many countries contribute, are of wider
ing countries if aid is a positive growth-inducing concern. Although the international aid doctrine is
force. A major study by Papanek (1973) suggests essentially a moral one, the fact remains that if the
that aid and growth are positively correlated supply of resources is limited in relation to de-
across countries despite the paltry levels of assist- mand, the issue must be discussed of what princi-
ance received per head and the fact that the pro- ples, if any, should govern the distribution of
ductivity of foreign resources may differ markedly assistance between countries. Furthermore, the
between countries. Papanek relates domestic humanitarian motive is very inadequate as an ex-
growth to three types of foreign capital inflow: aid planation of why and how assistance has actually
(a), private foreign investment (f), and other fore- been given.
ign inflows (o). Taking eighty-five countries and There can be no doubt that the distribution of
including the domestic savings ratio (sd) as an assistance in relation to the population of develop-
additional explanatory variable, the following ing countries is extremely unequal. Whereas some
equation is estimated (t statistics in parentheses): countries receive less than $5 per head per annum,
others receive over $100. Assistance as a propor-
y = 1.5 + 0.20 (sd) + 0.39 (a) + 0.17 (f) + 0.19 (o) tion of national income also differs widely between
(6.0) (5.8) (2.5) (2.1) countries. Although no country, or multilateral
r2 = 0.37 institution, has stated explicitly the criteria it uses
348 Financing Economic Development
for allocating assistance between countries, it is servicing problems will arise. One possible crite-
clear from the facts that different bodies and coun- rion to adopt as a guide to distribution, therefore,
tries have different motives and purposes. A large might be a productivity criterion, as an indication
fraction of bilateral assistance, for example, clear- of a country's capacity to pay back the loan with
ly has political and military objectives, and histor- interest. Before the World Bank lends, it must be
ical relations also play a part in determining the satisfied that the borrowing country will be in a
flows. Given that the objectives of aid are obscure position to repay the loan. To this end, its foreign
and differ between donor countries, it is not sur- exchange position is scrutinised carefully, because
prising that the distribution of assistance cannot loans are made, and must usually be repaid, in
readily be explained by such developmental con- currencies other than that of the borrowing coun-
siderations as low per capita income, balance-of- try. How a productivity criterion would be applied
payments difficulties and absorptive capacity of in practice, however, is not so clear cut. It can be
the recipient countries. Studies by Davenport argued that assistance should not be given to a
(1970) and Henderson (1971) find no significant country where the productivity of capital is below
correlation between per capita assistance as a the rate of interest; but should assistance neces-
proportion of national income and such factors as sarily be distributed to those countries where its
past growth rates as a measure of absorptive productivity is highest? The return from assistance
capacity and the domestic savings ratio or returns would be maximised, but distribution would be
on investment as a measure of productive poten- unrelated to needs, and not necessarily related to
tial. And, if anything, the relation between per each country's long-term prospects of develop-
capita assistance and per capita income tends to be ment unless they could somehow be incorporated
positive. The most consistently significant ex- into the measure of productivity. The reciprocal of
planatory variable found by Davenport is the ratio a country's capital-output ratio may be used as
of foreign reserves to imports. It apparently pays a the measure of productivity, but we have already
country to remain as illiquid as possible. Other discussed the dangers of using the capital-output
than that, it would seem advantageous to be a ratio as a measure of the productivity of capital,
small island of ex-colonial status in a politically and as a criterion for the allocation of investment
sensitive area of the world. High levels of per resources when different projects have different
capita assistance are closely associated with these life-spans and dissimilar external and secondary
characteristics. It should also be noted that multi- repercussions. The use of a productivity criterion
lateral assistance appears to be as 'randomly' dis- also takes the terms of the assistance as datum,
tributed as bilateral assistance. whereas one might well argue for a change in the
The question arises of what criteria for distribu- terms on which assistance is given, in which case
tion should be applied. The answer must depend the capacity to repay assistance in foreign ex-
on the objective function to be maximised. If differ- change becomes less relevant.
ent countries have different objective functions, The productivity criterion for distribution is
the criteria will inevitably differ. The question is closely linked with the notion of absorptive capac-
more appropriately directed to the multilateral in- ity and the view that assistance ought to be
stitutions which are supported by the world com- distributed according to absorptive capacity. Un-
munity and which should not be influenced by the fortunately the absorptive capacity criterion suf-
political considerations and historical ties of indi- fers from the lack of an adequate and acceptable
vidual countries. definition of absorptive capacity. One possible me-
Most assistance provided by multilateral agen- asure is a country's past rate of increase in invest-
cies is in the form of loans. We saw in the section ment expenditure (Rosenstein-Rodan (1961)), but
on foreign borrowing that if the interest rate on this ignores the varying levels of productivity on
loans is in excess of the productivity of capital, or past investment and neglects future productivity.
the rate inflow of new investment, certain debt- Absorptive capacity clearly implies some accept-
Foreign Assistance, Debt and Development 349
able rate of return on investment, but what rate of which would operate rather like an international
return should be regarded as acceptable, and how negative income tax. Certain graduated rates of
should factors that contribute to the productivity per capita income assistance could be applied to
of capital be treated? If a workable definition of the gap between the actual level of per capita
absorptive capacity could be agreed on, it might be income and the target level. A country which fell
argued that assistance should not be distributed to way below the target would receive a greater
countries which lack the capacity to absorb it; on amount of assistance per head of the population
the other hand, it could equally be argued that one than a country which approached the target or
of the main purposes of assistance should be to exceeded it. The rates of per capita assistance
remove obstacles, such as domestic or import would need to be worked out actuarially so that
bottlenecks, which limit absorptive capacity. assistance was not solely distributed on the 'worst-
Rosenstein-Rodan's suggestion is that assistance first' principle. Given knowledge of the total
should be distributed according to the degree of amount of resources available, rates could be fixed
induced domestic effort in the recipient countries which ensured a wide spread of assistance across
which accompanies aid, which he suggests could countries, but which did not make demands on
be judged on the country's own investment record, resources in excess of supply.
trends in the marginal savings ratio, and its orga- Given the paucity of international assistance,
nisational and administrative capacity. This is very one wonders whether very precise criteria for dis-
much in line with America's self-help philosophy, tribution are worth formulating. Annual assist-
or what is called the criterion of potential per- ance provided by multilateral institutions amounts
formance, which insists that before countries re- to less than $5 per head of the population in
ceive assistance for non-military purposes they developing countries, and the total of non-private
must present self-help development strategies as resource flows amounts to little more than $20 per
evidence of their capacity to develop. Crude re- head. If bilateral assistance continues to be the
liance on savings rates and the rate of growth of major form of official assistance to developing
productivity, however, can be very misleading in- countries, the allocation of resources will continue
dicators of self-help if the initial conditions and to be determined largely by political, military and
natural endowments of countries vary. historical considerations. The only hope for a
Another possible criterion is the availability of more just and rational allocation of resources
foreign exchange. Until recently it was the rule of available is greater commitment towards multi-
the World Bank only to meet the foreign exchange lateral institutions on the part of individual na-
costs of particular projects. If foreign exchange is tions. The criteria to be applied will then take on
scarce, and the import-export gap is the dominant more importance.
constraint, this seems an attractive criterion on the
surface. On the other hand, it has no regard to the
capacity to repay, or absorptive capacity. It would
be distribution mainly on the basis of need.
I Schemes for Increasing the
Flow of Resources
In the absence of an economically objective and
value-free criterion for the allocation of assistance, The net flow of financial resources to developing
some would argue that the criterion of need is as countries can be increased in one of two ways, or
good as any. One possibility in this connection by a combination of both. Either nominal assistance
would be to gear the allocation of assistance to can be left unchanged and repayment obligations
raising per capita income in different countries by reduced, or nominal assistance can be increased
a specified amount. Assuming that assistance is leaving the terms of repayment unchanged.
productive, one type of scheme would be to distri- Schemes for increasing the flow of resources can
bute assistance on a per capita income basis be divided into three main categories: (i) those
according to some target per capita income level, designed to reduce repayment obligations in scarce
350 Financing Economic Development
foreign currency in the present, such as the Khat- of assistance; and second, to involve the indi-
khate proposal discussed earlier; (ii) those de- viduals of donor countries in the spirit of interna-
signed to increase the effectiveness of assistance by tional aid-giving and to foster their interest in the
increasing its real worth through untying, which challenge of development. The basic rudiments of
have already been discussed; and (iii) proposals the scheme are that the taxpayers could elect to
for increasing the volume of assistance as a means pay a certain percentage of their tax obligations in
of increasing the flow of resources. We shall con- the form of donations to a series of competitive
centrate here on measures that might increase the 'Development Funds' which would channel finan-
flow of resources by raising the volume of nominal cial assistance to various investors in developing
assistance. countries, private and public. Individuals would
One quick way to increase the flow would be receive tax credits for their contribution, and poss-
for all the developed countries to meet their assist- ibly interest-bearing shares in the Funds as well.
ance targets of 1 per cent of national income for The 'Development Funds' would be free to invest
total assistance and 0.7 per cent of national in- where they liked, subject to a reasonable degree of
come for official development assistance. The equity in the distribution of resources between
Brandt Report laid emphasis on this. A significant developing countries and provided the Funds do
increase in the, resource flow by a deliberate not acquire complete control of the projects they
budget decision in the developed countries is only finance.
likely to occur, however, if there is widespread The objective of divorcing assistance from its
public support for the programme. In recent years, administration, and encouraging public participa-
however, there have been signs of diminished pub- tion, could also be achieved in principle with ear-
lic support for aid, based on the belief that a good marked taxes for development which were then
deal of assistance is wasted and misused. If there is transferred to the World Bank. The World Bank
disillusion with assistance - or aid 'fatigue', as it itself, however, has not escaped criticism of exces-
has been called - an increased flow of assistance in sive interference and leverage which may have
the future is unlikely in the absence of some recog- reduced the effectiveness of past assistance; and
nisable improvement in the efficiency with which earmarked taxes are not quite the same thing as
current assistance is used. It will be difficult to tax credits for the encouragement of voluntary
convince people in developed countries, whose participation in the aid-giving process. Even under
standard of living is not that high, to acquiesce in the Hirschman-Bird scheme, however, it is dif-
programmes to transfer resources from themselves ficult to see how some national or supranational
which are then wasted, or which end up in the body can fail to become embroiled in decisions
hands of people in recipient countries who are about how international assistance is used, and the
richer than themselves. The major reasons for complementary domestic policies that should be
waste and misuse of resources in the past have pursued to make assistance effective.
been inefficiency and corruption on the part of
recipient governments and interference from donor
countries in the administration of programme
assistance (Hayter (1971)). The solution would
seem to be schemes for divorcing the granting of
I Questions for Discussion and
Review
assistance from its administration by either donor
or recipient, coupled with a much greater interest 1. What is the distinctive contribution of dual-
and involvement of the public in the aid-giving gap analysis to the theory of development?
process. This is the essence of a scheme once prop- 2. Under what circumstances will foreign bor-
osed by Hirschman and Bird (1968), who had two rowing (i) raise the rate of growth of income,
major objectives in mind: first, to reduce the in- and (ii) raise the rate of growth of output?
terference of donor countries in the administration 3. Can a country borrow too much?
Foreign Assistance, Debt and Development 351
4. What factors determine the grant element of a 8. How would you evaluate whether foreign
financial flow? capital inflows weaken the internal develop-
5. What do you understand by the term 'debt ment effort?
crisis'? 9. Evaluate the costs and benefits to a developing
6. Think of imaginative schemes to relieve the country of investment by multinational com-
debt-servicing burden of developing countries. panies?
7. Discuss the view that foreign lending is merely 10. How should international assistance be distri-
a pernicious device for transferring resources buted between developing countries?
from poor to rich countries.
Part VI
Internation al Trade, the Balance
of Payments and Developm ent
II Chapter 15 II
Trade and Developtnent
355
356 International Trade, The Balance of Payments and Development
and imports for individual countries, and the tries that were industrialising had access to food
terms of trade, which measures the real buying and raw materials in primary-producing countries
power of exports over imports, are shown in which allowed the more developed countries to
Table 15.1 for the years 1965 to 1990. reap the gains from international specialisation.
Although the export trade of developing coun- The developing countries, in turn, were assisted in
tries is dominated by primary products, the con- their development by the demand for raw mate-
ception mustbe dispelled that the world is neatly rials and the international investment that fol-
polarised into two camps: the underdeveloped world lowed in its train. The situation today is very
producing and exporting solely primary products in different. Most world trade takes place in indust-
exchange for manufactures from developed coun- rial commodities from which the developing coun-
tries, and the developed world producing and ex- tries are largely excluded, and the demand for
porting solely manufactures in exchange for pri- developing countries' traditional exports is slack
mary commodities from developing countries. In relative to the demand for industrial goods. Except
practice, a good deal of trade in both manufac- for spasmodic commodity booms, such as between
tures and primary products goes on among the 1972 and 1974, and 1979 to 1980, trade does not
developed and developing countries alike, with the seem to work to the equal advantage of both sets
developed countries exporting substantial quanti- of countries.
ties of primary commodities (especially temperate- Three distinct factors have been at work in the
zone foodstuffs) and the developing countries developed countries retarding the growth of the
exporting a few manufactured goods. Developed traditional exports of the developing countries.
countries, in fact, account for about 50 per cent of First, the pattern of demand has shifted to goods
the world's supply of primary products. In short, with a relatively low import content of primary
the distinction between developing and developed commodities. Second, technological change has
countries is not wholly synonymous with the dis- led to the development of synthetic substitutes for
tinction between primary producers and produc- raw materials. Third, developed countries have
ers of manufactured goods. This must be borne in pursued protectionist policies which have retarded
mind in discussing the terms of trade- the ratio of the growth of their imports of both primary com-
export to import prices. There is a distinction to be modities and manufactured goods from develop-
made between the terms of trade for developing ing countries.
and developed countries and the terms of trade for In view of these trading developments, and the
primary and manufactured goods. emergence of a foreign exchange gap as the con-
The fact remains, however, that primary pro- straint on growth in developing countries, there
ducts do dominate the balance of payments of has been a complete rethinking by some econom-
most developing countries, and that the develop- ists in recent years as to the lines on which trade
ing countries' share of world trade in manufac- should take place. The balance-of-payments dif-
tures is very small. Exports of primary products ficulties and foreign exchange shortage of develop-
account for approximately 85 per cent of the ex- ing countries has led to a switch from viewing
port earnings of the developing countries taken trade from the traditional classical standpoint of
together, and manufactured goods from develop- resource allocation to viewing the effects of trade
ing countries account for not more than 15 per on the balance of payments. It is balance-of-
cent of world trade in manufactures. Moreover, payments difficulties, necessitating foreign bor-
the range of these traded goods is narrow, about rowing if growth is to be sustained, that has led to
80 per cent consisting of textiles and light manu- the cry in recent years of 'Trade, not aid'. The
factures in which world competition is intense. relevance of this slogan is examined in a later
Historically, trade has been an important main- section. The problem facing developing countries
spring of growth for countries at different stages of is not so much whether to trade but in what com-
development. In the nineteenth century the coun- modities to trade, and to ensure that the terms on
Trade and Development 357
Table 15.1 Export and Import Growth and Terms of Trade, 1965-90
Merchandise trade
(millions of dollars) Average annual growth rate (per cent)
Terms of trade
Exports Imports (1987 = 100)
Exports Imports
1990 1990 1965-80 1980-90 1965-80 1980-90 1985 1990
Low-income economies 141176 144 431 5.1 w 5.4 w 4.8 w 2.8 w 107m lOOm
China and India 80 059 77 037 4.1 w 9.8 w 4.4 w 8.0 w 103m 103m
Other low-income 61117 67 394 5.8 w 1.5 w 5.0 w -1.9 w 107m 100m
Mozambique .. .. .. .. .. .. .. ..
Tanzania 300 935 -4.2 -7.4 1.6 -0.5 101 108
Ethiopia 297 1 081 -0.5 -0.3 -0.9 4.2 117 84
Somalia 130 360 4.4 -3.3 4.4 -4.3 107 111
Nepal 162 543 .. .. .. .. 98 ..
Malawi 412 576 5.1 4.3 3.3 0.7 104 93
Bangladesh 1674 3 646 .. 7.6 .. 8.0 109 95
Table 15.1 Export and Import Growth and Terms of Trade, 1965-90 (continued)
Merchandise trade
(millions of dollars) Average annual growth ratea (per cent)
Terms of trade
Exports Imports (1987 = 100)
Exports Imports
1990 1990 1965-80 1980-90 1965-80 1980-90 1985 1990
Middle-income economies 491128 485 897 3.9 w 3.8 w 6.1 w 0.9 w 110m 102m
Lower-middle-income 184 340 195 680 .. 7.2 w 4.7 w 2.1 w 110m 99m
Table 15.1 Export and Import Growth and Terms of Trade, 1965-90 (continued)
Merchandise trade
(millions of dollars) Average annual growth ratea (per cent)
Terms of trade
Exports Imports (1987 = 100)
Exports Imports
1990 1990 1965-80 1980--90 1965-80 1980--90 1985 1990
Upper-middle-income 306 789 290 217 3.9 w 1.9 w 7.2 w 0.1 w 111m 105m
High-income economies 2 555 661 t 2 725 419 t 7.3 w 4.3 w 4.4 w 5.3 w 97 m 100m
OECD members 2 379 089 t 2 501 753 t 7.2 w 4.1 w 4.1 w 5.2 w 94m lOOm
Other 176 573 t 223 666 t 8.8 w 8.3 w 9.8 w 6.7 w 100m 100m
Netherlands 131 479 125 909 8.0 4.4 4.4 3.5 101 102
Austria 41 876 49 960 8.2 6.2 6.1 5.2 87 92
France 209 491 232 525 8.5 3.4 4.3 3.2 96 102
United Arab Emirates .. .. 13.3 .. .. .. .. ..
Canada 125 056 115 882 5.4 5.9 2.5 8.4 110 109
360 International Trade, The Balance of Payments and Development
Table 15.1 Export and Import Growth and Terms of Trade, 1965-90 (continued)
Merchandise trade
(millions of dollars) Average annual growth rate• (per cent)
Terms of trade
Exports Imports (1987 = 100)
Exports Imports
1990 1990 1965-80 1980--90 1965-80 1980--90 1985 1990
United States 371 466 515 635 6.4 3.3 5.5 7.6 100 100
Denmark 34 801 31562 5.4 5.1 1.7 4.2 93 104
Germany 397 912 341 248 7.2 4.2 5.3 3.9 82 97
Norway 34 072 26 889 8.2 7.2 3.0 2.5 130 91
Sweden 57 326 54 536 4.9 4.4 1.8 3.5 94 101
which they trade with the developed countries are the latter implying import substitution. These
favourable. There is no dispute that there are both dynamic considerations relating to the demand for
static and dynamic gains from trade. What is in existing export products and the utilisation of in-
dispute is whether the overall gains could not be creases in factor supplies do not diminish the case
greater, and the distribution of gains between for international specialisation. What is involved
countries fairer, if the pattern of trade was differ- is a reconsideration of what lines of activity to
ent from its present structure and the developed pursue in the face of changed circumstances, and a
countries were to modify their trading policies recognition of the distinction between established
towards the developing world. comparative advantage and incremental compara-
If the price elasticity of demand for the exports tive advantage. Before going on to consider trade
of developing countries is low, and demand is slow strategy for developing countries in the light of
in expanding, it would seem counter-productive to these 'new' trade theories, let us first establish
allocate factors of production to existing export more firmly the static and dynamic gains from
activities. The effect of increased output would be trade stressed by traditional theory.
to reduce prices and worsen the terms of trade.
This is the notion of 'immiserising growth', with
adverse movements in the terms of trade out- • The Gains from Trade
weighing the gains from a larger volume of
production. 1 So what are the developing countries While it is quite legitimate to look at trade from
to do? The answer would appear to be indus- the point of view of the balance of payments, and
trialisation - the production of industrial goods to regard the balance of payments as a ·develop-
with a higher price and income elasticity of de- ment problem that can only be solved by new
mand, either for export or for the home market, trade policies, the benefit from trade in traditional
trade theory is not measured by the foreign ex-
1 This is the basis of J. Bhagwati's (1958) model of immiseris- change earned but by the increase in the value of
ing growth. output and real income from domestic resources
Trade and Development 361
that trade permits. Optimal trade policy, • The Static Gains from Trade
measured by the output gains from trade, must be
clearly distinguished from the maximisation of The static gains from trade are based on the law of
foreign exchange earnings. comparative advantage. Consider the case of two
The gains from trade can be divided into static countries A and B both with the capacity to pro-
and dynamic gains. The static gains are those duce commodities X and Y. The simple proposi-
which accrue from international specialisation tion of classical trade theory is that if country A
according to the doctrine of comparative advan- has the comparative advantage in the production
tage. The dynamic gains are those which result of commodity X, and country B has the compara-
from the impact of trade on production possi- tive advantage in the production of commodity Y,
bilities at large. Economies of scale, international it will be mutually profitable for country A to
investment and the transmission of technical specialise in the production of X and for country B
knowledge would be examples of dynamic gains. to specialise in the production of Y, and for sur-
In addition, trade can provide a vent for surplus pluses of X and Yin excess of domestic needs to be
commodities, which brings otherwise unemployed freely traded, provided that the international rate
resources into employment, and also enables of exchange between the two commodities lies
countries to purchase goods from abroad, which between the domestic rates of exchange. Com-
can be important for two reasons. The first is that parative advantage is an opportunity-cost concept
if there are no domestic substitutes, the ability to measured by the marginal rate of transformation
import can relieve domestic bottlenecks in produc- between one commodity and another as given by
tion. The second is that imports may simply be the slope of the production-possibility curve.
more productive than domestic resources. Given perfect competition, which the above analy-
In this chapter we must do two things. First, we sis assumes, the domestic price ratio between two
must establish the precise nature of the benefits of commodities will equal their marginal rate of
trade, and second we must examine critically the transformation. If this were not so, it would pay
underlying assumptions of the comparative advan- producers to switch from one commodity to
tage doctrine and the classical advocacy of inter- another to take advantage of the relatively favour-
national specialisation and free trade. We can then able price ratio.
go on to consider the argument that the balance- Now let us give a practical example of the static
of-payments implications of international special- gains from trade. In Figure 15.1, the production-
isation and free trade may seriously offset the possibility curves for countries A and B are drawn
allocative gains from trade, and whether this showing the different combinations of the two
establishes a case for protection. goods X and Y that can be produced with each
Figure 15.1
Country A Country B
X X
b,
0 a, y y
362 International Trade, The Balance of Payments and Development
country's given factor endowments. We assume produced from a given amount of factor resources.
for simplicity that factors of production in both The increase in welfare that trade permits results
countries are sufficiently versatile as to be able to from the opportunity to obtain foreign products
produce either commodity equally efficiently so more cheaply, in terms of real resources forgone,
that the production-possibility curves are linear; than the alternative of import substitution which
that is, there is a constant marginal rate of trans- means domestic production. In Hicks's beautifully
formation. Curves I and II are indifference curves concise phrase, 'the gain from trade is the differ-
showing levels of community welfare. ence between the value of things that are got and
Now suppose that the marginal rate of trans- the value of things that are given up' (Hicks
formation between X and Yin country A is 10/8, (1959), p. 181). Through the international divi-
and in country B, 10/2. Commodity X is relatively sion of labour one is supposed to get more than
cheaper in country B than A measured by the one gives up! If comparative advantage was exact-
amount of commodity Y that must be forgone, ly the same in the two countries there would, of
and Y is relatively cheaper in country A. We say course, be no static gains and the justification for
that country A has the comparative advantage in the trade would be to reap economies of scale and
production of Y, and country B in the production other dynamic gains.
of X, and that it will be mutually advantageous for Whether the consumption of both commodi-
A to concentrate on Y, and B on X, and for A to ties in both countries rises depends on the inter-
swop Y for X and for B to swop X for Y. national rate of exchange. At some rates of ex-
Before trade each country produces combina- change, even between the two domestic price
tions of goods X and Y which give a level of utility ratios, the consumption of one of the commodities
represented by indifference curve I. The two coun- in one of the countries after trade may be less than
tries produce at a and b respectively. With the before trade. Even so, it can still be maintained
opening of trade there can only be one price ratio that the post-trade position is superior to the pre-
between X and Y determined by the interaction of trade position, if those individuals whose welfare
demand and supply in both countries together, is increased can fully compensate those who suffer
and which will lie somewhere between each coun- and still be better off.
try's transformation (price) ratio. Assume that the The static gains from trade are the same gains
international rate of exchange settles at 10/5, as from trade creation that accrue with the estab-
shown by the broken lines in Figure 15.1. Country lishment of customs unions, when high-cost sup-
A, specialising in the production of Y, can ex- pliers are replaced by lower-cost suppliers. It is the
change Y for more X internationally than it could doctrine of comparative costs that provides the
domestically, and country B, specialising in the rationale for the increasing advocacy of the forma-
production of X, can exchange X for more Y tion of customs unions, or trading areas, between
internationally than it could domestically. For ex- developing countries. It should be emphasised,
ample, suppose after trade production in country though, that there is nothing in the comparative
A shifts to at and in country B to bt. Country A, cost doctrine that ensures equality in the distribu-
trading oat of Y, can now consume oc of X which tion of gains from trade creation (which explains,
it obtains from country B. Country B, trading obt in part, why attempts in East Africa and the West
of X, can now consume oct of Y which it obtains Indies to establish free-trade areas met with
from country A. Both countries move to higher difficulties).
indifference curves, to higher levels of welfare on There is also the important question of whether
indifference curve II. the full employment of resources can be main-
As a result of the international division of tained in each country. The classical doctrine of
labour world production increases, and so does free trade assumes that all commodities are pro-
world welfare. Specialisation on the basis of com- duced under conditions of constant returns to
parative advantage enables the maximum to be scale and that the full employment of resources is
Trade and Development 363
maintained as resources are switched from one tion for a commodity before it can be produced
activity to another in accordance with compara- economically and compete in world markets. At
tive advantage. If some activities, such as primary least sixty countries classified as 'developing',
commodities, are subject to diminishing returns, however, have populations of less than 15 million.
however, there is a limit to employment in these Other important dynamic effects of trade consist
activities, and it is possible that the real income of the stimulus to competition, the acquisition of
gains from specialisation will be offset by the real new knowledge, new ideas and the dissemination
income losses from unemployed resources. of technical knowledge, the possibility of ac-
If industrial activities are subject to increasing companying capital flows, increased specialisation
returns, trade will lead to the unequal accumula- leading to more roundabout methods of produc-
tion of resources between primary producing and tion, and changes in attitudes and institutions. In
industrial countries, and be a force perpetuating terms of Figure 15 .1, the effect of dynamic benefits
inequality, as we saw in Chapter 5. is to shift outwards the production-possibility
curves of both countries leading to a higher level
of community welfare.
• The Dynamic Gains from Trade
Now let us turn to the dynamic gains from trade. • Trade as a Vent for Surplus
The major dynamic benefit of trade is that export
markets widen the total market for a country's Another important potential gain from trade is the
producers. If production is subject to increasing provision of an outlet for a country's surplus com-
returns, the total gains from trade will exceed the modities which would otherwise go unsold and
static gains from a more efficient allocation of represent a waste of resources. This is the so-called
resources. With increasing returns to scale, any 'vent for surplus' gain from trade. In Figure 15.1
country may benefit from trade irrespective of the this is represented by a movement from a point
terms of trade. Hicks (1959) has argued that it is inside the production-possibility frontier to a
impossible to make sense of the phenomenon of point on the frontier - which represents a higher
international trade unless one lays great stress level of welfare. For there to be a gain implies that
upon increasing returns owing to the close connec- the 'surplus' export resources have no alternative
tion between increasing returns and the accumula- uses and could not be switched to domestic use.
tion of capital. For a small country with no trade This may not be as unreasonable an assumption as
there is very limited scope for large-scale invest- it sounds, bearing in mind the country's resource
ment in advanced capital equipment; specialisa- endowments in relation to its population size and
tion is limited by the extent of the market. But if the tastes of the community. Mines and fishing
the poor developing country can trade, there is grounds, for example, have no alternative uses,
some prospect of industrialisation and of dispens- and the marginal utility of consuming their prod-
ing with traditional methods of production. The ucts would soon become zero if demand was
larger the market, the easier capital accumulation confined to domestic consumption alone. As a
becomes if there are increasing returns to scale. In theory of trade, Myint (1958) has argued that the
this respect large countries, like India, are in a vent for surplus theory is a much more plausible
more favourable position than smaller countries, theory than the comparative cost doctrine in ex-
such as Sri Lanka or Jamaica. India's large popula- plaining the rapid expansion of export production
tion offers a promising basis for the establishment in most parts of the developing world in the
of capital-goods industries and the production of nineteenth century. First, had there not been un-
manufactured goods, since production can take utilised resources the expansion process could not
place on a viable basis before trade. The smaller have kept going. Second, the comparative cost
country, however, may need substantial protec- theory cannot explain why, when two countries
364 International Trade, The Balance of Payments and Development
are similar, one develops a major export sector there is no demand among them, and brings
while the other does not; vent for surplus (related back in return for it something else for which
to relative population pressures) is one possible there is a demand. It gives a value to their
explanation. Third, vent for surplus is a much superfluities, by exchanging them for something
more plausible explanation for the start of trade. It else, which may satisfy a part of their wants and
is difficult to believe that small-scale peasant far- increase their enjoyments. By means of it, the
mers with no surplus would start specialising narrowness of the home market does not hinder
according to the law of comparative advantage in the division of labour in any particular branch
the anticipation of reaching a higher consumption- of art or manufacture from being carried to the
possibility curve. In response to Myint's arguments highest perfection. By opening a more extensive
there is a distinction to be made here between the market for whatever part of the produce of
type of commodity traded and the basis for trade their labour may exceed the home consump-
in the sense of what gets trade started. Vent for tion, it encourages them to improve its produc-
surplus may explain better the original basis of tive powers and to augment its annual p.t;oduce
trade, while comparative cost theory explains the to the utmost, and thereby to increase the real
type of commodity traded. Vent for surplus has no revenue of wealth and society (Smith (1776)).
explanatory power in this latter connection.
Finally, a fourth potential gain from trade, In the nineteenth century Smith's productivity
which merits distinguishing as a separate effect, is doctrine developed beyond a free-trade argument
that exports permit imports which may be more into an export-drive argument, particularly in the
productive than domestic resources both directly colonies. This partly explains why some critics
and indirectly. We saw in the discussion of dual- have associated the classical theory of trade with
gap analysis in Chapter 14 that imports can be colonialism, and why Smith has been attacked and
regarded as substitutes for domestic capital goods not Ricardo, the official founder of classical free-
with the capacity to lower the overall capital- trade theory.
output ratio through their superior efficiency and J. S. Mill (1806-73) rejected Smith's vent for
impact on the economy at large, especially by re- surplus argument on the grounds that resources
lieving domestic bottlenecks. In this sense exports are mobile. But Mill did accept the importance of
have supply effects as well as demand effects which the dynamic-effects of trade (what he called in-
it is important to take into account in considering direct effects) and he also stressed the favourable
the relation between exports and growth. effect of imports on work effort (the international
demonstration effect in modern parlance).
The development literature abounds with mod-
• Export-Led Growth els of export-led growth, and it is claimed that
both historically and in the contemporary world
Historically, David Ricardo (1772-1823) was the economy, trade has been the engine of growth.
founder of the comparative cost, classical free- Chenery and Strout (1966) remark that there is
trade doctrine. Before him Adam Smith (1723-90) almost no example of a country which has for a
had stressed the importance of trade as a vent for long period sustained a growth rate substantially
surplus and as a means of widening the market, higher than its growth of exports, and the Pearson
thereby improving the division of labour and the Commission (1969) claimed that the growth rates
level of productivity. According to Smith: of individual developing countries since 1950
correlate better with their export performance
between whatever places foreign trade is carried than with any other single economic indicator. We
on, they all of them derive two distinct benefits have given reasons why this might be so. In mod-
from it. It carries out the surplus part of the ern times countries such as Singapore, Japan,
produce of their land and labour for which South Korea and Hong Kong have certainly
Trade and Development 365
achieved remarkable growth by the export of supply potential of the economy, by raising the
manufactures, and historically there seems to be a capacity to import. Some studies of the role of
consensus among economic historians that in the exports examine the export-growth relation di-
nineteenth century trade acted as an engine of rectly, others the import-growth relation.
growth, not only in that it contributed to a more The export-growth studies are of two types:
efficient allocation of resources within countries, time-series for individual countries; and cross-
but because it transmitted growth from one part of section taking a sample of countries at a point in
the world to another. The demand in Europe, and time. In a fifty-country cross-section study, Emery
in Britain in particular, for raw materials brought (1967) found a strong relation taking average
prosperity to such countries as Canada, Argentina, values of per capita income growth and export
South Africa, Australia and New Zealand. As the growth over the period 1953-63. Syron and
demand for their commodities increased, invest- Walsh (1968) divided Emery's sample into 'de-
ment in these countries also increased. Trade was veloped' and 'less developed' countries and found
mutually profitable. Alfred Marshall wrote in the the relation to be strong in both groups of coun-
nineteenth century: 'the causes which determine tries. In a twenty-country study for the period
the economic progress of nations belong to the 1961-6 Stein (1971) found a strong relation be-
study of international trade' (Marshall (1890)). tween both exports and imports and growth. The
One of the foremost contemporary exponents of correlation between imports and growth is slightly
trade as the engine of growth was Arthur Lewis, higher than between exports and growth but both
who bases his theory on what appears to be from correlations are significant at the 95 per cent con-
his researches a stable relationship between econ- fidence level. Maizels (1968) has related output
omic growth in developed countries and export growth to export growth for sixteen countries
growth in developing countries (see, for example, over the period 1953-62, and estimates the equa-
Lewis (1980)). tion y =a+ 0.55(x), r 2 = 0.47. He concludes that
There are two main categories of model of ex- the relation is not particularly strong; on the other
port-led growth. The first relates to the possibility hand, he finds a strong time-series relation be-
that export growth may set up a virtuous circle tween exports and growth within countries. So,
of growth, such that once a country is launched on too, does the most recent work of Salvatore and
the path, it maintains its competitive position in Hatcher (1991) who take 26 countries over the
world trade and performs continually better rela- years 1963 and 1985, and find the export growth
tive to other countries. This type of model can be variable significantly positive in 16 of the countries.
used to explain geographic dualism in the world The South East Asian countries of Japan, South
economy, and we articulated such a model in Korea, Taiwan, Singapore and Hong Kong pro-
Chapter 5. The second category of model stresses vide classic case studies of export-led growth, as
that export growth relieves a country of a balance- do Germany and Italy among developed countries
of-payments constraint on demand, so that the in the 1950s and 1960s.
faster exports grow, the faster output growth can Studies have also been done of the direct effect
be without running into balance-of-payments dif- of exports on savings. Exports are important for
ficulties. This type of model is developed in the saving not only through their effects on output but
next chapter on the balance of payments and also because the export sector tends to have a
growth. higher propensity to save than the rest of the
The statistical evidence for today's developing economy. Exports, especially of primary commodi-
countries is not unequivocal, but in general it sup- ties, tend to produce highly concentrated incomes
ports the hypothesis that the growth of exports which raises the level of saving for any given
plays a major part in the growth process by stimu- aggregate level of income. Also it should be re-
lating demand and encouraging saving and capital membered that government saving relies heavily
accumulation, and, because exports increase the on export taxes in many developing countries.
366 International Trade, The Balance of Payments and Development
Maizels (1968) has fitted the savings function, efficiency. As many economists have commented,
S = a0 + b(Y - X) + c0 (X), where Y is gross the doctrine of comparative advantage is more
national product and X is export earnings, to data useful in explaining the past pattern of trade than
for eleven countries. In eight out of the eleven for providing a guide as to what the future pattern
countries he finds that export earnings contributed of trade should be as a stimulus to development.
significantly to savings. Lee (1971) has extended The question is not whether there should be
Maizel's analysis taking twenty-eight countries for trade but whether there should be free trade, as the
a longer time period. Maizels's results are further doctrine of comparative costs implies. Might the
supported, and Lee finds the coefficient on X sub- long-run needs of the developing countries not be
stantially higher than on Y - X for many coun- better served by protection? Those who question
tries. Chenery and Eckstein (1970) and Papanek the assumptions of the comparative cost model,
(1973) obtain similar results for different samples and who stress the relation between development
and different time periods. and the balance of payments, express the view that
the efficiency gains from free trade are unlikely to
trade effect. If the terms of trade effect does offset demned to the production and export of the same
the gains from trade, this would appear to provide commodities for ever. If comparative advantage is
a valid argument for protection. This is one of the not given by nature, as the doctrine of free trade
lines that modern protectionists take. The case for seems to suggest, but can be altered, the case for
protection of manufactured goods produced by protection is strengthened.
developing countries is greater: the less the de- It should also be remembered that the concept
mand for existing primary products is expected to of comparative advantage is based on calculations
grow and the lower the price elasticity; the higher of private cost. But we have seen in Chapter 8 that
the internal elasticity of demand for manufactured in developing countries social costs may diverge
products from the outside world, and the less the markedly from private costs, and that social ben-
likelihood of retaliation by other countries. efit may exceed the private benefit because of
A second factor which the free-trade doctrine externalities. If private costs exceed social costs in
tends to overlook is that some activities are subject industry (because wage rates are artificially high,
to increasing returns while others are subject to for example), and social benefits from industrial
diminishing returns. The commodities most sus- projects exceed private benefits, there is a strong
ceptible to diminishing returns are primary pro- argument for protecting industry in order to en-
ducts, where the scope for technical progress is courage the transfer of labour from other activities
also probably less than in the case of manufac- into industry to equate private and social cost and
tured goods. This being so, one might expect a rise private and social benefit.
in the ratio of primary to manufactured good Last, it may be mentioned that the export
prices, and diminishing returns would not matter growth of some activities has relatively little
so much if the goods were price inelastic. In prac- secondary impact on other activities. Primary
tice, however, there has been a substitution of commodities fall into this category. The evidence
synthetic substitutes for primary products, and the is abundant that the export growth of primary
terms of trade have deteriorated (see later) partly commodities has not had the development impact
because of substitution and partly because of the that might be expected from the expansion of
fact that the demand for primary commodities in industrial exports. The reasons are not hard to
general, in relation to supply, has expanded much understand. Primary production has very few
less than in the case of manufactured commodi- backward or forward linkages; and, historically, it
ties. But whatever the movement in the terms of has tended to be undertaken by foreign enterprise
trade, it is somehow perverse to recommend a with a consequent outflow of profits. The second-
trade and development policy based on activities ary repercussions of the pattern of trade also tend
subject to diminishing returns, particularly in the to be overlooked by the free-trade doctrine.
light of the theory of cumulative causation that we
discussed in Chapter 5.
A third disadvantage of adherence to the com-
parative advantage doctrine is that it could lead to
I Tariffs vs Subsidies as a Means
of Protection
excessive specialisation on a narrow range of prod-
ucts, putting the economy at the mercy of outside We have seen that there are benefits from trade,
influences. The possibility of severe balance-of- but that it does not follow that the freer trade is
payments instability resulting from specialisation the better. There are many disadvantages that the
may be damaging to development. doctrine of free trade overlooks when trade is
Fourth, comparative cost analysis glosses over looked at in a long-run development context, as
the fact that comparative advantage may change opposed to the static short-run context of the doc-
over time, or that it could be changed by deliberate trine of comparative advantage. Furthermore, free
policies for the protection of certain activities. trade does not guarantee an equal distribution of
There is no reason why countries should be con- the gains from trade, and this is an important
368 International Trade, The Balance of Payments and Development
/
a category of purely economic arguments that s
comprise all those arguments for protection as a
means of increasing real output or income above Pr (1 + d) -- --
what it would otherwise be. These include: (i) the /
/
/
infant industry argument, to allow industries to
reap their optimum size in terms of minimum
average cost of production; (ii) the existence of
external economies in production, where the o a, 02
social cost of production is less than the private
cost; (iii) distortions in the labour market, which a domestic distortion, which is an economic argu-
make the social cost of using labour less than the ment for protection.
private cost; and (iv) international distortions Secondly, there is a category of non-economic
which cause the domestic rate of transformation arguments for protection which comprise argu-
between goods to diverge from the foreign rate of ments for protection for its own sake rather than
transformation due, for example, to monopoly to increase output or income above what it would
power in international trade. This argument for otherwise be. For example, industrialisation at
protection is often referred to as the optimum any price, or self sufficiency for strategic reasons,
tariff argument. would be arguments of this type.
Into this category of economic arguments might Having summarised the arguments for protec-
also be put two factors previously stressed: first tion, the question then is what is the best means
terms-of-trade deterioration, and secondly balance- of protection? It can be shown that tariffs are
of-payments difficulties arising from the pattern of appropriate only under special circumstances:
trade. Now Johnson has argued (1964), and these are where distortions are international (the
others of neoclassical persuasion, that these are optimum tariff argument) and when self-suf-
non-economic arguments. In the case of the terms ficiency is the objective. All other arguments for
of trade, the restriction of import supply will not protection are arguments for subsidies, the reason
reduce import prices for a small country. In the being that where distortions are domestic a tariff
case of the balance of payments, equilibrium can will introduce further distortions and according to
be achieved automatically by allowing the ex- the theory of the second best there is no knowing a
change rate to fluctuate freely. The terms of trade priori whether the situation will be made better or
argument may be correct, but the balance of pay- worse off. Let us illustrate the argument with a
ments argument suffers from the confusion between diagram. Consider Figure 15.2 where we have
a balance-of-payments equilibrium on current a good producible domestically but subject to a
account which affects the real economy, and balance domestic distortion such that the private cost of
in the foreign exchange market. The two are not the production (S'S') is d per cent above the social cost
same. A floating exchange rate will equilibriate the (SS). The demand curve is DD and the good is also
foreign exchange market by definition, but will not importable at the international price PT' Under
necessarily equilibrate the balance-of-payments on free trade, domestic producers will produce OQD
current account. If both terms-of-trade deteriora- and Q 1 Q 4 will be imported. Q 1 Q 2 imports could
tion and balance-of-payments difficulties constrain be replaced, however, by additional domestic pro-
growth and lead to unemployment, the social cost duction, with real savings equal to the shaded area
of labour will be less than the private cost which is A, if domestic producers were given a subsidy of
Trade and Development 369
imports of non-durable consumption goods, such tween Latin America and South-East Asia. In
as clothing, footwear, leather and wood products. Latin America there was a general move towards
Countries in the early stages of industrialisation more 'outward-looking' policies which favoured
are naturally suited to these products and rela- both export promotion and domestic production.
tively little protection is required. Once this stage Although subsidies were given to export, however,
is over, the maintenance of high growth rates then exporters were still required to use domestic in-
requires the import substitution of other goods if puts produced under protection, and the subsidies
the strategy is to be continued. The problem with were generally insufficient to provide incentives to
this second stage of import substitution is that exports comparable to the protection of domestic
relatively high rates of protection are required, markets, and thus there has been a continued bias
because intermediate goods such as steel and pro- in favour of import substitution. In South East
ducer durables are subject to substantial econo- Asia by contrast, the policy has been one of relent-
mies of scale, both internal and external, so that less export expansion - in Japan, South Korea,
unit costs are very high if output is low. The Singapore and Taiwan. In the last three countries,
problem with high rates of protection is that they the incentive system has consisted of exporters
breed inefficiency, and more importantly act as a being exempted from indirect taxes on output and
tax on exports by keeping costs and the exchange inputs and from duties on imported inputs. Tax
rate high. The catalogue of costs and distortions holidays, and other tax concessions on profits
introduced by protective import-substitution poli- from exports, have also been offered.
cies is formidable. In a major study of industry and Balassa (1980 for summary) has amassed con-
trade in seven developing countries, Little, Sci- siderable evidence to show that export perform-
tovsky and Scott (1970) argue that import sub- ance is positively related to the degree of incen-
stitution tends to shift the distribution of income tives, taking the growth of exports and changes in
in favour of the urban sector and the higher in- the ratio of exports to output. He also finds that
come groups with a higher propensity to import, the capital-labour ratio tends to be lower in ex-
thereby worsening the balance of payments. Pro- port industries than in import-substitute activities
tection taxes agriculture since it raises the price of and that export industries are generally more
industrial goods relative to agricultural goods. labour-intensive. Both the foreign exchange con-
Furthermore, since protection maintains an arti- straint and the savings constraint have been eased
ficially high exchange rate it reduces receipts in by export promotion, and foreign investment has
terms of domestic currency from a given quantity also been encouraged. It is these favourable effects,
of agricultural exports, which may discourage concludes Balassa, that have produced a positive
agricultural exports. Import substitution may also correlation between exports and economic growth.
worsen unemployment by encouraging capital- In 1987 the World Development Report of the
intensive activities. W odd Bank classified a group of 41 developing
Despite the dangers of this second stage of im- countries according to their trade orientation to
port substitution, this is the strategy that many compare the performance of countries with differ-
Latin American, South East Asian and Eastern ent degrees of outward/inward orientation. Four
European countries adopted in the immediate categories of countries were identified: (i) strongly
post-war years. The consequence was that the ex- outward oriented countries, where there are very
ports of manufacturers were discouraged and the few trade or foreign exchange controls in which
terms of trade turned against agriculture within trade and industrial policies do not discriminate
the countries, discouraging agricultural output between production for the home market and ex-
and reducing the growth of demand for industrial ports, and between purchases of domestic goods
products internally. In the 1960s reforms were and foreign goods - in other words, there is a
undertaken in several countries, but there was a policy of trade neutrality; (ii) moderately outward
distinct difference in emphasis and approach be- oriented countries, where the overall incentive
Trade and Development 371
structure is moderately biased towards the pro- work of the traditional two-country, two-
duction of goods for the home market rather than commodity case of international trade theory -
for exports, and favours the purchases of domestic equating the developing countries with primary
goods; (iii) moderately inward oriented countries, pr('ducers (the 'periphery') and the developed
in which there is a more definite bias against ex- countries with secondary producers (the 'centre').
ports and in favour of import substitution; (iv)
strongly inward oriented countries, in which trade
controls and the incentive structures strongly
favour production for the domestic market and
I Technical Progress and the
Terms of Tr.tde
discriminate strongly against imports. Some coun-
tries may lie on the borderline between categories, As we said earlier, in theory the barter terms of
or switch categories through time, but the distinc- trade might be expected to move in favour of the
tion between the strongly outward and inward developing countries. For one thing, primary-
oriented categories is clear-cut, and the World product production tends to be subject to dimin-
Bank find the economic performance of the coun- ishing returns, and for another technical progress
tries in the strongly outward oriented category tends to be more rapid in manufacturing industry
markedly superior. than in agriculture. If prices are related to costs
I
one would expect in theory the ratio of primary-
product prices to industrial-good prices to rise.
New Trade Theories for According to Prebisch, however, the ratio has
shown a long-run tendency to fall. He advances
Developing Countries: two explanations for this and hence why the ben-
The Prebisch Doctrine 1 efits of technical progress tend to flow from the
developing to developed countries and not the
Raul Prebisch was one of the first development other way round. His first explanation concerns
economists to question the mutual profitability of the relation between incomes and productivity. He
the international division of labour for developing suggests that whereas factor incomes tend to rise
countries on existing lines. Prebisch is one of those with productivity increases in developed countries,
who looks at the relation between trade and de- they rise more slowly than productivity in the
velopment from the standpoint of the balance of developing countries owing to population pressure
payments rather than real resources. His major and surplus manpower. Thus there is a greater
claim is that the unfavourable impact of unre- upward pressure on final goods' prices. in de-
stricted trade on the terms of trade and balance of veloped than in developing countries, causing the
payments of developing countries far outweighs ratio of prices to move in the opposite direction to
any advantages with respect to a more efficient that suggested by the pace of technical progress.
allocation of resources. His concern is with two The second explanation is that a ratchet effect
distinct, but not unrelated, phenomena. One is the operates with primary product prices relative to
transference of the benefits of technical progress manufactured goods' prices falling during cyclical
from the developing to the developed countries. downturns by more than they rise relative to the
The second is the balance-of-payments effects of prices of manufacturers on the upturns. Such
differences in the income elasticity of demand for asymmetrical cycles, illustrated in Figure 15.4,
different types of products. He divides the world would produce a secular trend deterioration. 2
into industrial 'centres' and 'peripheral' countries Furthermore, according to Prebisch, not only do
and then conducts his analysis within the frame-
2 For an empirical investigation of the asymmetry hypothesis,
see Thirlwall and Bergevin (1985). As it happens, the hypoth-
1 Prebisch (1950). See also his later work (1959). For an excel-
esis does not seem to be supported in the years since the Second
lent evaluation of the Prebisch thesis, see Flanders (1964). World War. Seep. 373 for further discussion.
372 International Trade, The Balance of Payments and Development
Figure 15.4 cent: exports will then grow at 2.4 per cent. Now
suppose that the income elasticity of demand for
Industrial prices
(I P) the exports of developed countries is 1.3 and the
Primary product
growth of world income is 3.0 per cent; exports of
prices (P P) developed countries will then grow at 3.9 per cent.
Since there are only two sets of countries, the
developing countries' exports are the imports of
developed countries and the exports of developed
countries are the imports of the developing coun-
tries. Thus developing countries' exports grow at
Time 2.4 per cent but imports grow at 3.9 per cent;
developed countries' exports grow at 3.9 per cent
the terms of trade deteriorate, but if prices must be and imports at 2.4 per cent. Starting from equilib-
reduced to clear the market, export earnings will rium, the balance of payments of the developing
fall if the demand for primary commodities is price countries automatically worsens while the de-
inelastic. This is a related sense in which technical veloped countries show a surplus. This has further
progress is 'transferred' from the developing coun- repercussions on the terms of trade. With imports
tries to the industrial 'centres'. growing faster than exports in developing coun-
I
tries, and the balance of payments deteriorating,
the terms of trade will also deteriorate through
The Income Elasticity of depreciation of the currency, which may cause the
balance of payments to deteriorate even more if
Demand for Products and the imports and exports are price inelastic.
Balance of Payments Moreover, this is not the end of the story if we
take the per capita income growth between de-
The second phenomenon mentioned by Prebisch is veloped and developing countries. If population
the balance-of-payments effects of differences in growth is faster in developing countries, the
the income elasticity of demand for different types growth of income must also be faster than in the
of products. It is generally recognised and agreed developed countries if per capita income growth
that the income elasticity of demand for most rates are to remain the same. This will mean an
primary commodities is lower than that for manu- even faster growth rate of imports into developing
factured products. On average, the elasticity is countries and a more serious deterioration in the
probably less than unity, resulting in a decreasing balance of payments. And if the goal is to narrow
proportion of income spent on those commodities relative or absolute differences in per capita in-
(commonly known as Engel's Law). In the two- come between developed and developing coun-
country, two-commodity case the lower-income tries, the balance-of-payments implications will be
elasticity of demand for primary commodities will even more severe. In the example previously given,
mean that for a given growth of world income the which ignores differences in population growth, it
balance of payments of primary-producing, de- is easily seen that the price of balance-of-payments
veloping countries will automatically deteriorate equilibrium is slower growth for the developing
vis-a-vis the balance of payments of developed countries. If their exports are growing at 2.4 per
countries producing and exporting industrial cent, import growth must be constrained to 2.4
goods. A simple example will illustrate the point per cent which means that with an income elas-
(see also Chapter 5). ticity of demand for imports of 1.3, income
Suppose that the income elasticity of demand growth in the developing countries must be res-
for the exports of the developing countries is 0.8 trained to 2.4/1.3 = 1.85 per cent for balance-of-
and that the growth of world income is 3.0 per payments equilibrium. In the absence of foreign
Trade and Development 3 73
borrowing to bridge the foreign exchange gap, or prove its terms of trade which offset any losses
a change in the structure of exports, the result of from resource 'misallocation' as a result of the
different income elasticities of demand for primary tariff- provided, of course, the other country does
and manufactured products is slower growth in not retaliate. This is the notion of the 'optimum'
the primary-producing countries - perpetuating the tariff.
development 'gap'. In the absence of protection, the There are several benefits that Prebisch expects
only other alternative is deliberate depreciation of from protection. Protection would enable scarce
the currency. This has several disadvantages. For foreign exchange to be rationed between different
one thing the price elasticities of exports and im- categories of imports, and could help to correct
ports may not be right for foreign exchange earn- balance-of-payments disequilibrium resulting from
ings to be increased, and second, depreciation will a high income elasticity of demand for certain
encourage production in existing activities, the types of imports. Second, it could help to arrest the
concentration on which has contributed to the deterioration in the terms of trade by damping
balance-of-payments difficulties in the first place. down the demand for imports; and third, it pro-
There are certain equilibrating mechanisms vides the opportunity to diversify exports and to
in existence which may reverse the tendencies start producing and exporting goods with a much
referred to, but they are likely to be weak and higher income elasticity of demand in world mar-
fairly slow in operating. First of all, it cannot be kets. Following our earlier argument, however,
assumed that the industrial structure of the de- protection by tariffs is only appropriate if the
veloping countries will remain unchanged. Over arguments for protection do not arise from domes-
time it is natural that the proportion of total re- tic distortions.
sources employed in the production of manufac-
tured goods should increase, decreasing the rate of
increase of imports of manufactured goods.
Second, assuming that money income and popula-
I Recent Trends tn the Terms of
Trade
tion grow at the same rate in both sets of coun-
tries, if the terms of trade are deteriorating for the Whether the terms of trade have moved unfavour-
developing countries, then real per capita income ably against primary commodities and the de-
cannot be growing so rapidly in developing coun- veloping countries is an empirical question. Pre-
tries. Thus even with a high income elasticity of bisch originally suggested an average deterioration
demand for imports in developing countries, the of the terms of trade of primary commodities be-
absolute increments in imports may eventually tween 1876 and 1938 of 0.9 per cent per annum.
equal exports through a terms of trade effect. Pre- Work by Hans Singer at the United Nations in
bisch recognises this latter equilibrating mechan- 1949 also suggested a trend deterioration of 0.64
ism, but rejects reliance upon it because of the per cent per annum over the same period. The
sacrifice of real growth that it clearly involves. Prebisch-Singer thesis of the declining terms of
For balance-of-payments and terms-of-trade trade for primary commodities was born (see Sin-
reasons (which are not unconnected), Prebisch ger (1950)). In a detailed reappraisal of Prebisch's
therefore argues for the protection of certain work, Spraos (1980) confirms the historical trend
domestically produced goods and the virtual deterioration, but at the lower rate of approxi-
establishment of monopolist export pricing by mately 0.5 per cent, having corrected the statistics
developing countries. Prebisch's balance-of-payments for the changing quality of goods, shipping costs
argument reinforces the classical infant-industry and so on. Extending the data to 1970, however,
argument for protection to safeguard the terms of Spraos concluded that there is no significant trend
trade. Scitovsky (1942) showed long ago that in deterioration. Sapsford ((1985) and (1988)),
the two-country, two-commodity case a country however, shows that it is the wartime structural
can always gain by levying certain tariffs to im- break which makes the whole series look trend-
374 International Trade, The Balance of Payments and Development
130
Index: 1980-100
120
110
90
80
70
60L-------~~----~~~
1870 1890 1910 1970 1990
less. If the series is divided into two sub-periods - the oil shock) and 1973 to 1982 using quarterly
pre- and post-Second World War - there is a trend data. For all primary commodities from develop-
deterioration in both subperiods and the estimated ing countries, the annual trend deterioration was
trend deterioration over the whole period 1900- 0.5 per cent from 1960 to 1972 and 0.36 per cent
82 is 1.2 per cent per annum, allowing for the from 1973 to 1982 (excluding oil). For primary
wartime structural break. The downward trend commodities from developed countries, the trend
has continued (see Figure 15.5). was not significant.
Grilli and Yang (1988) at the World Bank reach The terms of trade of primary commodities re-
the same conclusion as Sapsford. Over the period lative to manufactures is not necessarily the same
1900 to 1983, they put the percentage terms of as the terms of trade of developing countries rela-
trade deterioration of all primary commodities at tive to industrial countries, because both sets of
0.5 per cent per annum, and 0.6 per cent per countries export and import both types of goods
annum for non-fuel commodities (allowing for the (albeit in different ratios), but in practice there is
wartime structural break). For individual com- likely to be a close overlap and parallel movement
modities, the trend deterioration is estimated as: between the two. Sarkar (1986) has looked at the
food (-0.3 per cent p.a.); cereals (-0.6 per cent export prices of developing countries relative to
p.a.); non-food agricultural commodities (-0.8 developed countries, and also at the prices of ex-
per cent p.a.), and metals (-0.8 per cent p.a.). ports from developing to developed countries rela-
Only tropical beverages registered an improve- tive to prices of imports from developed countries
ment (0.6 per cent p.a.) to developing countries (both excluding fuel). In
My own work with Bergevin (Thirlwall and the first case, the trend deterioration was 0.51 per
Bergevin (1985)) concentrated on the post-war cent per annum; in the second case, the relative
years, distinguishing between primary commodi- deterioration was 0.93 per cent per annum. Over-
ties exported by developing countries on the one all, there can be little doubt that over the last 30
hand and by developed countries on the other, years or so both the terms of trade of primary
estimating separately from 1960 to 1972 (before commodities, and the terms of trade of the de-
Trade and Development 3 75
veloping countries as a whole, have deteriorated at relative to imports owing to increased efficiency in
roughly the average rate of the deterioration in the the exporting country, and this releases resources
terms of trade of primary commodities since the for further exports which subsequently expand
turn of the century. more than proportionately to the fall in price. The
Sarkar and Singer (1991) have also looked at barter terms of trade would have worsened, but
the terms of trade of manufactures exported by development would be stimulated. It is also worth
developing countries relative to developed coun- remembering that when a country devalues its cur-
tries over the period 1970-87, and find a de- rency it deliberately worsens its barter terms of
terioration of approximately 1 per cent per trade in the hope that the balance of payments will
annum. It appears, therefore, that the developing improve, providing scope for a faster growth of
countries suffer double jeopardy. Not only do the real income through a rapidly improved income
prices of their primary products decline relative to terms of trade. On the other hand, if the demand
manufactured goods, but also the prices of these for a country's exports is inelastic, then a decline
manufactured exports decline relative to those of in the barter terms of trade will also mean a de-
developed countries, reflecting, no doubt, the com- terioration in the income terms of trade.
modity composition of their exports - their lower In the long run, if world trade is buoyant, every
value-added and lower income elasticity of de- country can experience an improvement in its in-
mand in world markets. come terms of trade. The question is not who are
The terms of trade for each developing country the gainers and who are the losers, as in the case of
between 1985 and 1990 is shown in Table 15.1. It the barter terms of trade, but what are the relative
can be seen from the table that there is a wide rates of improvement in the income terms of
variety of experience between countries reflecting trade? It is fairly clear that since the barter terms
the diverse commodity composition of their ex- of trade has deteriorated for developing countries,
ports and imports; but taking the low-income and and the rate of export growth has been slower in
middle-income countries together, the evidence developing countries than in developed countries
shows a deterioration for the developing countries (see Table 15.1), the income terms of trade has
as a whole of 6 per cent. During the previous also grown slower for the developing countries.
twenty years there had already been a 15 per cent
deterioration in low-income countries. For the in-
dustrialised countries there was virtually no
change - the rise in the price of manufactures
I Trade Theory and Dual-Gap
Analysis
being offset by the rise in the price of oil. A large
part of the debt problem was the result of the Another dimension to the protectionist argument
collapse of commodity prices in the 1980s. has been added by Linder (1967), drawing expli-
There is a distinction to be made between citly on dual-gap analysis. The crucial question,
the barter (or commodity) terms of trade which argues Linder, is whether a developing country's
measures the ratio of export to import prices, and economic potential can be fully utilised at the
the income terms of trade, which is the ratio of same time as equilibrium is maintained externally.
export to import prices times the quantity of ex- Free trade may not lead to the full employment of
ports (i.e. (Px/Pm) X Qx). The income terms of resources for two reasons: first, because of factor
trade is thus a measure of the total purchasing immobility; and second, because certain imports
power of exports over imports. may be required to achieve full utilisation of re-
From the point of view of development, sources and these import requirements may exceed
measured by per capita income, the income terms exports. In our earlier discussion of dual-gap
of trade is perhaps the more relevant concept to analysis in Chapter 14, we saw that if the import-
consider than the barter terms of trade. It may well export gap is dominant and foreign exchange is
be, for instance, that the price of exports falls scarce, domestic resources may go unutilised in the
376 International Trade, The Balance of Payments and Development
absence of development policies to equate the only qualification Linder makes to his argument
import-export gap and the investment-savings for development based on import substitution and
gap ex ante. Potential domestic saving will fall the expansion of domestic demand is if value-
either through a fall in the potential level of output added is negative; that is, if imported inputs for
or through a fall in the propensity to save through domestic production involve a higher foreign
a redirection of expenditure. One solution, how- exchange cost than the importation of the end-
ever, is to devote more domestic resources to im- products themselves. Except in these circumst-
port substitution or export promotion. ances, there is no conflict between allocation and
But Linder argues that in developing countries capacity considerations or allocative efficiency and
it may not be possible to solve the problem of the import substitution as long as a foreign exchange
domestic underutilisation of resources through gap exists. Import substitution frees foreign ex-
trade because of an export maximum. Classical change for imported inputs which allow the full
trade theory, however, does not admit this. The utilisation of domestic resources.
notion of an export maximum is related to what
Linder calls the theory of 'representative demand',
which determines the relative price structure for • Trade Policies
goods. The theory of representative demand states
that the production function for a commodity will Prebisch and Linder both provide powerful
be the more advantageous in a country the more critiques of neoclassical trade theory, but attack
the demand for a commodity is typical of the from different angles. While Linder argues the case
economic structure of a country compared with for protection for the full utilisation of domestic
other countries. The chief determinant of demand resources, Prebisch argues the case for protection
structure is per capita income, so that goods in on the more 'orthodox' grounds of improving the
demand in advanced countries have unfavourable terms of trade, and as a substitute for exchange
production functions in developing countries and depreciation to preserve simultaneous internal and
vice versa. The developing countries are therefore external equilibrium. Moreover, while Linder
faced with severe marketing problems if they are argues explicitly for import substitution because
to develop by trade. The goods they are best at of the existence of an export maximum, Prebisch
producing are not demanded in developed coun- seems to be more optimistic about growth through
tries, and they are very inefficient at producing the trade and against 'inward-looking' development
goods that are demanded in developed countries. policies. New export activities may, of course, re-
Productivity may not be high enough to support quire tariff protection or subsidisation in the early
resources in the production of these goods, and stages of their establishment, but there is a distinct
imported inputs for export production might difference between identifying lines of activity in
absorb more foreign exchange than the exports which to promote exports and identifying lines of
eventually yield. activity in which to develop import substitutes,
In Linder's view these circumstances provide a and we must briefly examine these different
case for protection to save foreign exchange and to strategies. In the former case, one is seeking out
enable the full utilisation of domestic resources. lines of comparative advantage; in the latter case,
This contrasts with conventional theory which one is attempting to reverse the pattern of trade by
does not allow for protection for balance-of- altering comparative advantage.
payments reasons or to increase the effective If we accept the possibility of an import-export
demand for domestic products to eliminate under- gap, because of a lack of substitutability in the
employment. Moreover, protection in this model short run between imports and domestic re-
involves no allocation losses because if foreign sources, Linder's argument for import substitution
exchange is required to utilise domestic resources basically reduces to pessimism over the chances of
fully, the opportunity cost of resources is zero. The promoting exports as an alternative means of fully
Trade and Development 377
utilising domestic resources. He admits that import- tries. There are several ways in which the de-
substitution activities will themselves require veloped countries can contribute to a solution of
imports and presumably thinks, therefore, that, the balance-of-payments problems of developing
per unit of expansion of domestic output, import countries, especially by helping export earnings.
substitution would save more foreign exchange The means of help fall into two main categories
than could be earned by export promotion. The which we shall consider in turn: first, the granting
traditional case for export promotion is that it of trade preferences; and second, international
allows growth to proceed without foreign ex- commodity agreements to stabilise or increase
change difficulties and without suffering the earnings from exports.
allocative losses from violating comparative
advantage.
What trade policy should be adopted by any • Trade Preferences
particular country clearly depends on circum-
stances. Certainly not all developing countries fit The main pressure group for trade preferences for
the Linder model. Most developing countries do developing countries' exports is the UN Confer-
suffer from severe foreign exchange shortages, but ence on Trade and Development (UNCTAD),
one must be alittle suspicious of the concept of the which was first convened in Geneva in 1964. It
export maximum. It is true that the demand for was in this year that the Conference was converted
developing countries' exports tends to lag behind into a permanent organisation consisting of 132
that of the developed countries, but as our earlier member countries, with a fifty-five-member
figures in Table 15.1 show, the export record of Directing Board and a permanent Secretariat
developing countries as a whole over the last two under Prebisch (who previously headed the UN
decades is not unrespectable. This, in some mea- Commission for Latin America) as Secretary-
sure, is due to the greater diversification of exports General. There have been seven further meetings
than in the past, and there must be room for of UNCT AD, the latest being in Colombia in
considerable improvement. The great danger of 1992. Apart from these periodic meetings, the
import-substitution policies is that by violating organisation exists as a continuous pressure group
comparative advantage, increasing costs, and re- with the aim of assisting developing countries
ducing competitiveness, they may impair the long- through trade and aid - primarily trade. Included
run efficiency and export-growth prospects of a among its objectives are: greater access to the mar-
country in the future. kets of the developed countries through the reduc-
The more lasting solution to balance-of- tion of trade restrictions; more stable commodity
payments difficulties would seem to be the promo- prices; assistance from the developed countries
tion of manufactured-goods exports, preferably equivalent to 1 per cent of their national income;
with high price and income elasticities of demand, and compensation for developing countries whose
coupled with policies to substitute domestic re- foreign exchange earnings fall below 'expecta-
sources for imports. If the prices of domestic and tions' owing to deterioration in their terms of
foreign resources reflected more accurately their trade. Its main platform, however, is for a system
opportunity costs, the import content of many of tariff preferences for the developing countries'
activities might be reduced substantially. At the exports of manufactured and semi-manufactured
same time new areas of comparative advantage goods on the lines of the Commonwealth prefer-
must be sought. If trade is not the engine of ence agreement, or in the form of quotas of duty-
growth, it is probably a more desirable hand- free imports. In this respect, there is an important
maiden than development by import substitution. difference between UNCTAD and other bodies
The policy recommendation of export-led merely concerned with non-discriminatory reduc-
growth leads on to the question of the trading tions in barriers to world trade, e.g. the General
relation between developed and developing coun- Agreement on Tariffs and Trade (GATT).
378 International Trade, The Balance of Payments and Development
ported inputs, and the higher the proportion of The calculations of the effective rate of protec-
value added to total output, the higher the effec- tion also depend on what exchange rate is em-
tive rate of protection. If the tariff on finished ployed. If the exchange rate of a country in the
goods is very high and the tariff on inputs is low, protected situation is overvalued, the price of im-
domestic value added can be very high; world ported inputs measured in domestic currency will
value added in turn can be very low, giving enor- be undervalued and this will affect the calculation
mous rates of effective protection, sometimes in of the domestic value added and the value added
excess of 1000 per cent. at world market prices. Without adjustment for
Let us now give a practical example. Suppose this factor, effective rates of protection are de-
Indian textiles have a world price of $5, of which scribed as 'gross'; with adjustment they are
$3 represents raw-material costs and $2 represents referred to as 'net'.
value added. Now let us suppose that imports of Our example of the effective rate of protection
Indian textiles into a developed country are sub- also assumed that all inputs are traded. Some in-
ject to a tariff of 20 per cent while domestic pro- puts will be non-traded, however, and their price
ducers must pay a tariff of 10 per cent on textile enters into both the value of total output and total
raw materials. To remain competitive, the domes- inputs. If the effect of protection on the price of
tic producer must produce the commodity for not non-traded goods is ignored, the rates of effective
more than $6. The value added can be $6 minus protection will be overestimated. It is not in prac-
the cost of raw materials plus the tariff on raw tice easy to estimate the effect of protection on the
materials, i.e. $6 - ($3 + $0.30) = $2.70. The price of non-traded goods.
effective rate of protection is the difference be- The theory of effective protection suggests that
tween the domestic value added and Indian value the same nominal tariff cuts mean different degrees
added (i.e. value added at world prices) expressed of change in effective rates of protection, and it
as a percentage of Indian value added, i.e. (2.70 - may thus be unwise for the developing countries to
2)/2 = 35 per cent. This is the effective rate of press for across-the-board tariff cuts on all com-
protection equal to the difference between the modities. Reductions in tariffs against their prim-
gross subsidy on value added provided by the tariff ary products will increase the effective rate of
on the final product ($(112) = 50 per cent) and the protection against their manufactures, which, we
implicit tax on value added as a result of the tariff have argued, are more important exports as far as
on raw materials ($(0.30/2) = 15 per cent). This is long-run development prospects are concerned.
the extent (35 per cent) to which production can The average nominal level of protection in de-
be more costly in the developed country without veloped countries is about 12 per cent, but effec-
losing competitive advantage, or, to put it another tive protection against the goods of developing
way, it is the degree to which Indian textile pro- countries may well be in the region of 30 per cent
ducers would have to be more productive to com- or more. Developing countries themselves may
pete in the developed country market. give their own producers very high rates of effec-
Effective rates of protection almost always ex- tive protection. Little, Scitovsky and Scott (1970)
ceed nominal rates. At one extreme if a country quote average rates on manufactured goods of 162
gets raw material inputs duty free (at world prices) per cent in Argentina, 116 per cent in Brazil, 271
but puts a tariff on the final good, the effective rate per cent in Pakistan and 313 per cent in India. 2
must be higher than the nominal rate. At the other The argument for reductions in tariffs against
extreme, if a country puts a tariff on inputs but no the final manufactured goods of developing coun-
tariff on the finished good, the effective rate of tries is unexceptional, but is it doubtful whether
protection is negative. 1 there is much scope for preferences to contribute
1 Students might like to prove these propositions for themselves 2 See also the pioneer work of Lewis and Guisinger (1968) and
using the formula for the effective rate of protection. the work of Balassa et al. (1971).
380 International Trade, The Balance of Payments and Development
substantially to an increase in export earmngs. countries as a group should issue their own inter-
Export prices would have to be less than the national money, rocnabs (bancor backwards,
domestic price in the preference-giving country which was the name for the new international
and must not exceed the competitor's price by money suggested by Keynes at Bretton Woods in
more than the amount of the preference. On the 1944), which they would agree to accept in part
assumption that the tariff rate on manufactured payment for goods sold to each other. This would
goods in the advanced industrial countries is be- have the effect of increasing the purchasing power
tween 10 and 15 per cent, and that the advanced of every developing country over the goods and
countries were willing to give 50 per cent prefer- services of every other country in the group. Ex-
ence, this would mean a preference margin of only ports would expand, but the reserve position of
5-8 per cent. Industries in which a preference the importing country would be unimpaired. In
margin of 5-8 per cent would enable developing effect rocnabs would work like Special Drawing
countries to take markets away from domestic Rights work on a world scale (see Chapter 16).
producers and developed country competitors are Because countries would accept rocnabs in part
likely to be few and far between. payment for exports there would be an incentive
But it is not only tariffs that restrict trade. There for countries with foreign exchange difficulties to
are many non-tariff barriers to trade in manufac- switch imports from developed countries to other
tures between developed and developing coun- developing countries because imports would cost
tries, the removal of which might contribute more less in convertible currencies. Exports to other
to increasing export earnings than a simple reduc- developing countries would be encouraged where
tion in tariff barriers, e.g. licensing requirements, countries could not sell all they could produce in
quotas, foreign exchange restrictions, procure- hard-currency markets. One problem that might
ment policies favouring domestic products, anti- arise is some countries accumulating rocnabs
dumping regulations, subsidies to exports in de- which they had no use for, while other countries in
veloped countries, and so on. persistent deficit run short. To make the scheme
workable it might be necessary to get each country
I
achievement of a higher utilisation of manufactur-
ing capacity and the avoidance of payments prob- International Commodity
lems with developed countries is for the develop-
Agreements 1
ing countries to issue their own international
money, on lines originally suggested by the Ste-
The developing countries in particular, and the
warts (1972), which would increase the purchas-
world economy in general, suffer several problems
ing power of each developing country and encour-
age trade between the developing countries them- 1 For an up-to-date discussion of the issues involved in this
selves. The Stewarts suggest that the developing section, see Maizels (ed.) (1987).
Trade and Development 381
from the uncontrolled movements of primary before and during the Second World War. In a
commodity prices. First there is the fact already memorandum in 1942 on the 'International Regu-
mentioned of the gradual trend deterioration in lation of Primary Commodities' he remarked: 'one
the prices of primary commodities relative to in- of the greatest evils in international trade before
dustrial goods, which reduces the real income and the war was the wide and rapid fluctuations in the
welfare of the developing countries directly. world price of primary commodities ... It must be
Secondly, primary product prices are much more the primary purpose of control to prevent these
cyclically volatile than industrial goods' prices. wide fluctuations' (Moggridge 1980).) Keynes fol-
Since 1960, for every 1 per cent change (up and lowed up his observations and proposals with a
down) in the prices of industrial goods, primary more detailed plan for what he called 'commod
product prices have fluctuated by 2.4 per cent (see control' - an international body representing lead-
Thirlwall and Bergevin (1985)). Disaggregation by ing producers and consumers that would stand
commodity group shows a cyclical elasticity of ready to buy 'commods' (Keynes's name for typi-
1.25 for food; 1.3 for agricultural non-food pro- cal commodities), and store them, at a price (say)
ducts, and 2.9 for minerals (including petroleum). 10 per cent below the fixed basic price and sell
This volatility has a number of detrimental con- them at 10 per cent above (Moggridge (1980)).
sequences. First it leads to a great deal of instabil- The basic price would have to be adjusted accord-
ity in the foreign exchange earnings and balance of ing to whether there was a gradual run-down or
payments position of developing countries which build-up of stocks, indicating that the price is
makes investment planning and economic man- either 'too low' or 'too high'. If production did not
agement much more difficult than otherwise adjust (at least downwards), Keynes recognised
would be the case. Secondly, because of asymmet- that production quotas might have to be im-
ries in the economic system, volatility imparts plemented. Commodities should be stored as
inflationary bias combined with tendencies to de- widely as possible across producing and consum-
pression in the world economy at large. When ing centres. This proposal is of some contempor-
primary product prices fall, the demand for in- ary relevance as a means of responding quickly to
dustrial goods falls but their prices are sticky conditions of famine. There could be a system of
downwards. When primary product prices rise, granaries strategically placed across the world
industrial goods' prices are quick to follow suit under international supervision which could store
and governments depress demand to control infla- surpluses and release them at time of need. The
tion. The result is stagflation. Thirdly, the volatil- finance for the storage and holding of 'commods'
ity of primary product prices leads to volatility in in Keynes's scheme would have been provided
the terms of trade which may not reflect move- through his proposal for an International Clearing
ments in the equilibrium terms of trade between Union, acting like a world Central Bank, with
primary products and industrial goods in the sense which 'commod controls' would keep accounts.
that supply and demand are equated in both mar- At the present time, finance for storage and
kets. In these circumstances world economic holding could be provided through the issue of
growth becomes either supply constrained if pri- Special Drawing Rights (SDRs) by the IMF (see
mary product prices are 'too high' or demand Chapter 16, p. 407). A scheme, such as 'commod
constrained if primary product prices are 'too low' control' could make a major contribution to
(see Chapter 3, p. 101) (Thirlwall (1986)). On all curing the international trade cycle with all its
these macroeconomic grounds there is a prima attendant implications. Over fifty years on from
facie case for attempting to introduce a greater Keynes's wartime proposal, primary product price
degree of stability into markets for primary com- fluctuations still plague the world economy. The
modities (including, I believe, oil). world still lacks the requisite international
The issue of primary product price instability is mechanisms to rectify what is a major source of
not something new. It preoccupied Keynes both instability for the world economy. From 1980 to
382 International Trade, The Balance of Payments and Development
1991, primary product prices fell on average by 40 variations in supply as the major determinant of
per cent, and this has been a major cause of the the instability of export earnings. If the source of
international debt crisis which still lingers. instability does come from the side of supply, sta-
In the recent past there have been five main bilising prices will not, of course, stabilise earn-
international commodity agreements in operation ings. It will positively impair them in times of
accounting for some 35 per cent of non-oil exports scarcity and boost them in periods of glut. If there
of the developing countries, but all have had their is a tendency towards perpetual over-supply, and
difficulties in achieving price objectives. The agree- demand is price inelastic, price stabilisation will
ments which have operated with spasmodic suc- maintain earnings, but price stabilisation will
cess are the International Sugar Agreement (1977), further encourage supply, which may then necessi-
the Sixth International Tin Agreement (1981), the tate production quotas and lead to inefficiency in
International Natural Rubber Agreement (1979), production if producing countries are allocated
the International Cocoa Agreement (1980), and quotas to satisfy equity rather than efficiency. This
the International Coffee Agreement (1963 ). 1 Only is not to argue that there is not a case for com-
the Rubber and Coffee agreements still function. pensation, but that methods should be avoided
The basic problem with all agreements is getting which encourage overproduction or inefficiency. It
suppliers to abide by quotas to restrict output in may be better to let prices find their market level
the face of declining prices. Participants must and for the producing countries to be compen-
share a common purpose. The most successful sated by the beneficiaries under long-term agree-
'commodity agreement' of all in the world econ- ments, with the compensation used to encourage
omy is the Common Agricultural Policy of the some producers into other activities. Alternatively,
EEC. income-compensation schemes could be worked
Small fluctuations in the export earnings of de- out, especially in cases where export instability
veloping countries, arising from falling prices, are resulted from variations in domestic supply.
capable of offsetting the whole of the value of In practice, several alternative methods of price
foreign assistance to developing countries in any stabilisation have been tried or recommended, in-
one year. Approximately a 10 per cent fall in cluding buffer stock schemes, export restriction
export earnings would be equivalent to the annual schemes, and price compensation schemes and we
flow of official development assistance in 1991. must briefly examine these.
Stability of export earnings, it would appear, is at
least as important as foreign assistance. 2 In gener-
al, the instability of export proceeds is the joint • Buffer Stock Schemes
product of variations in price and quantity. Large
fluctuations in earnings may be causally related to Buffer stock schemes operate by buying up the
four factors: (i) excessive variability of supply and stock of a commodity when its price is abnormally
demand; (ii) the low price elasticity of supply and low and selling the commodity when its price is
demand; (iii) excessive specialisation on one or unusually high. The success of such schemes rests
two commodities; (iv) the concentration of ex- on the foresight of those who manage them.
ports in particular markets. An early study by Purchases must be made when prices are low rela-
Macbean (1966) examined these causal factors for tive to future prices and sold when prices are high
a selection of developing countries. He found relative to future prices. Clearly, buffer stock
schemes are only suitable for evening out price
1 For a comprehensive discussion of international commodity fluctuations. They cannot cope with persistent
agreements and commodity problem in general see Maizels downward trends in price without accumulating
(1992). large stocks of the commodity which must be paid
2 For a good summary of the measures of instability and the
empirical evidence of the effects of instability on the economies for - and presumably sold in the future at still
of developing countries, see Stein (1977). lower prices. In 1986 the buffer stock for tin ran
Trade and Development 383
into severe financial difficulties by trying to main- where both developed and developing countries
tain the price of tin 'too high' for 'too long'. Stor- produce the good in question, that 'assistance'
age schemes are also only appropriate for goods does not all go where it is most needed. In this
that can easily be stored, and for which the cost of event there is a stronger case for bilateral arrange-
storage is not excessive. ments over commodities between developed and
developing countries, rather than schemes which
embrace developed countries which subsequently
• Restriction Schemes reap the benefit.
relations are enjoyed by the producers in other ence and leverage that may accompany interna-
respects. The feeling of the developing countries tional assistance.
was well articulated at a meeting in Dakar in 1975 If the meaning of aid is taken literally (i.e. as a
of over 100 developing countries where it was free transfer of resources), Johnson (1967) has
declared that the recovery and control of natural shown than a unit of foreign exchange from ex-
resources held the key to their economic freedom, ports can never be as valuable as a unit of foreign
and countries were urged to draw up a joint plan exchange from aid. The reason is that exports do
to protect the prices of their exported commod- not provide additional resources for investment
ities. The classic example of cartelisation in recent directly, only indirectly by the opportunity pro-
years has been the action of the oil-producing vided to transform domestic resources into goods
countries of the Organisation for Petroleum Ex- and services more cheaply than if the transforma-
porting Countries (OPEC) in raising the price of tion had to be done domestically. Aid, on the other
crude oil by 800 per cent since December 1973. hand, both provides resources directly, and also
The producers of bauxite have similarly joined indirectly by saving the excess cost of import sub-
together to raise prices. This trend may be ex- stitution. The relative worth of exports compared
pected to continue. to pure aid can therefore be expressed as:
Developing countries are not only producers of
raw materials, however; they are also consumers, eX
(15 .1)
and what some countries gain with respect to the (1 + c)A
production and export of one commodity they
may lose with respect to the import and consump- where X is the value of exports, A is the value of
tion of another. Some developing countries, poor pure aid, and c is the proportional excess cost of
in all raw material production, may not benefit at import substitution. The relative worth of exports
all. It is not clear, except in the case of a few will rise with the excess cost of import substitu-
special commodities like oil, that cartelisation and tion, but it is clear that the worth of exports can
monopoly pricing of the product will necessarily never match the worth of an equal amount of pure
redistribute income from the developed to the de- aid (X = A) since c < (1 + c). The fact that aid
veloping countries taken as a whole. If this is so, may be tied to higher-priced goods makes some
bilateral commodity agreements between poor- difference to the argument but it can be shown
country producers and rich-country users are that the excess cost of import substitution and the
probably preferable as a means of ensuring that all excess cost of tied goods would have to be relative-
developing countries benefit from the general de- ly high for the worth of aid not to exceed the
sire in the world economy to help poor, primary- worth of trade. Let r be the ratio of the price of
producing countries. tied goods to the price of the same goods in the
free market. The relative worth of exports may
then be written as:
• Trade vs Aid
eX
'Trade not aid' has become a popular aphorism in ----X r (15.2)
developing countries in recent years. Let us now (1 + c)A
consider whether a unit of foreign exchange from
exports is really worth more than a unit of foreign Now exports will be worth more than aid if cr >
exchange from international assistance, or (1 + c). Different combinations of c and r could be
whether the slogan is more an understandable thought of which satisfy this condition but both c
reaction to the debt-servicing problems arising and r would have to be quite high, e.g. c = 2.0 and
from past borrowing (the benefits of which may r = 1.5.
have been forgotten) and to the political interfer- The more important consideration, however, is
386 International Trade, The Balance of Payments and Development
that the term 'aid' in the slogan 'trade, not aid' But even if a comparison of exports with the aid
should probably not be interpreted literally. The component of an equal amount of foreign assist-
comparison that developing countries are making ance showed exports to be worth more, however,
is not between trade and pure aid but either be- it is not clear that this is the correct comparison to
tween trade and the aid component of an equal make justifying the slogan 'trade, not aid'. Equa-
amount of foreign assistance, or simply between tions (15.3) and (15.4) assume that only the aid
trade and an equal amount of foreign assistance. If component of assistance saves the excess cost of
these are the comparisons being made in practice, import substitution. In fact, foreign borrowing on
two interesting questions arise. First, under what any terms saves the excess cost of import substitu-
circumstances will trade be more valuable? And tion. This being so, there are strong grounds for
second, which is the most appropriate comparison arguing that the comparison which should underly
to make? the slogan 'trade not aid' is a comparison of the
Consider first the comparison between exports worth of exports with the worth of foreign assist-
and the aid component of an equal amount of ance itself of equal amount, which provides re-
foreign assistance. If this is the comparison that is sources directly equal to Fg and indirectly equal to
being made by the developing countries, the John- Fe. The relative worth of exports compared to
son formula can be modified by letting A = Fg, foreign assistance can thus be expressed as:
where A is the aid component of assistance (seep.
343 ), F is the nominal amount of foreign assist- eX eX
ance, and g is the aid component as a proportion (15.5)
Fg + Fl; (g + c)F
of nominal assistance (i.e. the grant element). Sub-
stituting Fg for A in equation (15.1) gives the or, with tied assistance:
relative worth of exports compared to the aid
component of an equal amount of foreign assist- eX
ance as: ----X r (15.6)
(g + c)F
eX
(15.3) The conditions for the worth of exports to exceed
(1 + c)Fg
that of foreign assistance are clearly more strin-
gent than for the worth of exports to exceed the
or, if the aid is tied: worth of the aid component of an equal amount of
foreign assistance. Now, ignoring the potential ex-
eX cess cost of tying, foreign assistance is always
----X r (15.4) worth more than an equal value of exports as long
(1 + c)Fg
as there is some grant element attached to the
From (15.3) the value of exports will exceed the assistance (i.e. as long as g > 0).
value of the aid component of an equal amount of The values of g, c and r give a practical guide to
foreign assistance (X = F) if c > g(1 + c), and, any country of the relevance of the slogan 'trade,
from (15.4), if cr > g(1 +c). The relative worth of not aid', ignoring the secondary repercussions and
exports is greater, the higher the excess cost of the side-effects of the two resource flows. 1 The
import substitution, the higher the excess cost of values of g, c and r for most developing countries
tied aid and the lower the grant element of assist- are probably not such as to justify the slogan
ance. It is still the case, however, that c and r 'trade, not aid' on narrow economic grounds. As
would have to be quite high and g relatively low far as secondary repercussions are concerned,
for the worth of exports to exceed the worth of the however, there is the question of the productivity
aid component of an equal amount of foreign
assistance. 1 For some illustrative calculations see Thirlwall (1976).
Trade and Development 387
I Balance-of-Payments
Constrained Growth
tions to ease the constraint. The latter involves
mainly a consideration of the role of the Interna-
tional Monetary Fund in the provision of balance-
We have seen how the composition of the trade of of-payments support.
developing countries can lead to severe balance-of- Table 16.1 shows the recent balance-of-
payments difficulties, which can act as a constraint payments experience of the developing countries
on growth, and how vulnerable many developing as a whole and by continent. The poor countries
countries are to exogenous shocks which affect have always been in deficit, but the deficits
adversely both their export earnings and import fluctuate according to internal and external
payments. In this chapter we shall define formally economic circumstances. In the 1970s, for
the concept of a balance-of-payments constrained example, owing to the oil shock in 1973 (and later
growth rate and examine its determinants. We 1979), and the slowdown of world growth, the
shall then go on to consider the measures that deficits grew considerably despite a slowdown of
countries themselves may take to raise the growth internally which reduced the demand for
balance-of-payments constrained growth rate, and non-oil imports. In the early 1980s, the deficits
the assistance provided by international institu- contracted because most developing countries
388
The Balance of Payments, International Monetary Assistance and Development 389
were forced to adjust (i.e. deflate) in order to repay The current account balance-of-payments of a
debt out of diminished export earnings. Since the country, measured in its own domestic currency,
mid-1980s the deficits have increased again with may be written as:
some internal recovery and a greater willingness of
the international capital markets to resume (16.1)
lending. The deficit in 1991 stood at $94 billion,
financed by capital inflows of various types. Any X measures the quantity of exports and Pd is the
measured (ex post) deficit measures the extent to average price of exports, so that PdX is the value
which the country concerned has been able and of exports in domestic currency. M is the quantity
willing to finance the difference between the value of imports; Pr is the average (foreign) price of
of current payments and receipts. imports, and E is the nominal exchange rate mea-
Every country will have a growth rate con- sured as the domestic price of foreign currency
sistent with balance-of-payments equilibrium on which thus converts the value of imports measured
current account, and with its overall balance on in foreign currency (PrM) into a domestic currency
current and capital account. What determines the equivalent.
growth rate consistent with current account bal- The condition for the balance-of-payments to
ance on the one hand, and overall balance on the remain in equilibrium in a growing economy
other? If we specify the equilibrium equations, and through time is that the rate of growth of export
the determinants of import and export demand, earnings should equal the rate of growth of import
we can immediately see the major factors of im- payments, i.e.
portance, and we can appreciate in turn the
various policy measures taken by individual coun- (pd + x) = (Pr + m + e) (16.2)
tries and the international community to raise the
growth rate of less developed countries consistent where the lower-case letters represent rates of
with balance-of-payments equilibrium. 1 change of the variables.
Now let us consider what the growth of export
1 For the original development of this model, see Thirlwall and import volume depends on. Export demand
(1979). may be expected to depend primarily on the price
390 International Trade, The Balance of Payments and Development
of a country's exports relative to the foreign price some commodities from some small countries, but
of similar goods (expressed in a common cur- the proposition that demand does not matter
rency) and on the level of 'world' income which det- would not stand up to empirical scrutiny as a
ermines the purchasing power over a country's general rule.
goods. Similarly, import demand may be expected Import growth, likewise, depends firstly on how
to depend on the price of imports relative to fast import prices are changing relative to dom-
domestic substitutes and on the level of domestic estic substitutes, (taking account of exchange rate
income. If the price and income elasticities of de- changes), multiplied by the price elasticity of de-
mand for exports and imports are assumed to be mand for imports; and secondly on how fast
constant, we may write the export and import domestic income (as a proxy for expenditure) is
functions in the following (multiplicative) way: changing, together with the income elasticity of
demand for imports.
Since the growth of imports depends on the
(16.3) growth of domestic income, if we substitute ex-
pressions (16.5) and (16.6) into (16.2), (which
gives the condition for a moving balance-of-
PrE)1V
and M = ( pd Y" (16.4) payments equilibrium through time), we can de-
rive an expression for a country's growth of
income consistent with current account equilib-
where Z measures 'world' income; Y measures rium, which depends on certain key variables and
domestic income; 'Y] is the price elasticity of de- parameters. Substitution of (16.5) and (16.6) into
mand for exports (< 0); E is the income elasticity (16.2) gives:
of demand for exports (> 0); 'ljJ is the price elas-
ticity of demand for imports (< 0), and n is the Pd + 'YJ(Pd- Pr-e)+ E(z) = Pr
income elasticity of demand for imports (> 0).
Taking small rates of change of the variables in (16.7)
equations (16.3) and (16.4) we can see what the
so that
growth of exports and imports depends on:
2 Secondly, if the real terms of trade are chang- amounts to the same thing, to reduce the rate of
ing, the growth rate depends on the price elas- growth of income consistent with current account
ticities of demand for exports (l']) and imports equilibrium. For example, if in equation (16.8),
(1jl), which determine the magnitude of the import prices were rising at 10 per cent per
volume response of exports and imports to annum, while the price of exports was rising at
relative price changes. only 5 per cent per annum this would mean a
3 Thirdly, one country's growth depends on the lower y than if the terms of trade were constant. In
growth rates of other countries (z) - which theory this 'terms-of-trade effect' could be offset
illustrates nicely the mutual interdependence by a continual appreciation of the currency, i.e. by
of the world economy - but the rate at which a continual percentage fall in E; but very few
one country grows relative to others depends developing countries, if any, are in a position to
crucially on the income elasticity of demand appreciate their currencies even if they wanted to.
for its exports (E), which depends on the Terms-of-trade stability in real terms must depend
tastes of foreign consumers; the characteristics or rely on international commodity agreements
of goods, and a whole host of non-price fac- to stabilise the prices of the exports of developing
tors which determine the demand for goods in countries relative to the prices of the goods they
international trade. One of the major reasons import. Within this framework of analysis
why some countries have a healthier balance the rationale for terms-of-trade agreements is
of payments and a higher growth rate than apparent.
others is related to the characteristics of the It is not clear, however, that terms-of-trade de-
goods that they produce and export in world terioration is always a bad thing, because what
trade. happens to export earnings and import payments,
4 Fourthly, the growth rate depends on a coun- and hence to the balance-of-payments equilibrium
try's appetite for imports as measured by :n:, growth rate, depends not only on changes in rela-
the income elasticity of demand for imports. tive prices but also on the volume response of
The higher :n:, the lower the growth rate con- exports and imports to price changes. Since the
sistent with balance-of-payments equilibrium price elasticities, 11 and 1jl, are defined as negative,
on current account. it can be seen from equation (16.8) that if their
sum exceeds- 1, Pd < Prwill mean that y is higher
One can see in these factors the rationale for than would be the case if Pd;:::::: Pr· In other words,
agreements to maintain the terms of trade for the export and import volume response from
developing countries; for exchange rate policy; domestic export prices rising slower than import
for international Keynesianism to maintain the prices is sufficient to offset the fact that more has
growth of world income, and for policies to induce to be paid for a given volume of imports relative to
structural change, through export promotion or exports. If, however, the price elasticity of demand
import substitution, in order to raise the income for the exports of a developing country is low
elasticity of demand for exports and to reduce the because of the nature of the product in question
income elasticity of demand for imports. Let us (e.g. a primary product), and the price elasticity of
take up some of these issues in turn. demand for imports is also low because the im-
ports are necessities, the balance of payments will
worsen if the terms of trade deteriorate, and
• The Terms of Trade growth will have to be constrained for the pre-
servation of balance-of-payments equilibrium.
The effects of terms-of-trade deterioration (import In these circumstances, commodity agreements
prices rising faster than export prices, other things assume great importance and ideally it would be
remaining the same) is to worsen the balance of of benefit if the ratio of export prices to import
payments at a given rate of growth or, what prices could rise. We have already considered in
392 International Trade, The Balance of Payments and Development
the previous chapter various commodity schemes trade, but the sum of the price elasticities of de-
which attempt to stabilise export prices or to mand for exports and imports exceeds unity, what
change the relative price of exports and imports. then? This will worsen the balance of payments
We also noted that this will not necessarily stabil- and reduce the balance-of-payments equilibrium
ise export earnings if there are fluctuations in ex- growth rate. It is in these circumstances that ex~
port supply. The international response to this has change rate depreciation may become relevant,
been to devise schemes to compensate for loss of and is often resorted to. It can be seen from equa-
export earnings. The two major schemes in exist- tion (16.8) that if a country has a rate of price
ence are the IMF's Compensatory and Contin- increase above that of other countries (pd > Pr),
gency Financing Facility (see later) and the EEC this can in principle be compensated for by allow-
Stabex scheme which provides compensation to ing the exchange rate to fall continually (e > 0) by
countries for shortfalls of export earnings from the difference between Pd and Pr in order to hold
particular commodities exported to EEC countries 'competitiveness' steady. The conventional theory
(as already described). UNCTAD's Integrated of balance-of-payments adjustment, and the policy
Programme for Commodities would combine both pursued relentlessly by the IMF in countries ex-
approaches to the developing countries' 'com- periencing balance-of-payments difficulties, is one
modity problem' by setting up a Fund for financ- of downward adjustment of the exchange rate.
ing buffer stock schemes to support prices, and for Note well, however, that the ratidnale of such a
compensatory finance to maintain the value of policy presupposes a number of things: (i) that the
export earnings. source of the difficulties is price uncompetitive-
Another argument for stabilising the export ness; (ii) that the price elasticities are 'right' (i.e.
prices of developing countries and maintaining sum to greater than unity) for a depreciation to
their incomes is that price and income instability reduce the imbalance; (iii) that the real terms of
tends to depress the world economy at large and trade (or the real exchange rate) can be changed by
the developing countries with it, given the mutual devaluation. A fall in the nominal exchange rate,
interdependence of the world economy. Falling however, i.e. e > 0, may either lead to a fall in
prices and incomes in developing countries re- Pr(Pr < 0) or a rise in Pd(pd > 0), both of which
duces the purchasing power over industrial goods, would nullify the effect of the devaluation (see
inducing recession, while rising commodity prices equation (16.8)). A fall in Pr might come about if
may also induce recession, by raising the price of foreigners desired to maintain their competitive-
manufactured goods and inducing deflation in the ness as the devaluing country became more com-
developed countries. For the smooth growth of the petitive. A ·rise in Pd may come about as the
world economy, there is a lot to be said for domestic price of imports rises as a result of de-
attempting to stabilise primary product prices so valuation, which is then followed by a wage-price
that the purchasing power of the producers and spiral. Either way, within a short space of time,
exporters of these commodities grows in line with relative prices measured in a common currency
supply. One suggestion is that the new international may revert to their former level and devaluation
money called Special Drawing Rights (SDRs) (see will have been abortive in this respect. A study by
later) might be used to purchase primary products to Edwards (1989) has looked at the effectiveness of
stabilise their price in times of glut. devaluation in reducing a country's real exchange
rate. He takes 39 cases of devaluation in 25 de-
Note also that a once-for-all devaluation or conditional on devaluation. Tanzania's battle with
depreciation of the currency cannot put a country the IMF in 1979 provides an interesting case
on a permanently higher growth path consistent study. Secondly, the effect of currency devaluation
with balance-of-payments equilibrium. Currency is to make countries more competitive in the range
depreciation would have to be continuous (i.e. e > of goods that have been the source of balance-of-
0 permanently) for this to happen, unless devalua- payments difficulties in the first place. A devalued
tion can somehow induce favourable structural currency may be appropriate to encourage the ex-
changes at the same time. Countries must look port of new (manufactured) goods with a high
very carefully at the conditions prevailing before price elasticity in world trade, but it may be in-
embracing currency devaluation with equanimity, appropriate applied to the traditional range of
and as the panacea for the relief of balance-of- goods produced and exported with a low price
payment constrained growth. elasticity of demand. For example, if the country is
The studies that have been done of the effect of a large supplier and a price maker in world mar-
currency devaluation on the performance of the kets, currency devaluation coupled with a low
balance of payments generally find some improve- price elasticity will reduce export earnings. If the
ment, but the studies must be treated with some country is a price taker, devaluation will raise the
caution. Some of the studies do not hold other domestic price of the commodity and cause infla-
things constant in analysing the effect of the tion. It is true that production for export will
exchange-rate change, and none address them- become more profitable and may encourage a
selves to the question of whether the policy has greater supply response, but there are other less
enabled the country to grow permanently faster inflationary ways to encourage supply than de-
consistent with balance-of-payments equilibrium. valuation. An optimal exchange rate strategy for a
Cooper (1971) has examined the impact of 24 developing country needs to recognise the dual
devaluations in 19 developing countries. In 15 structure of most of the countries and to recognise
cases there was some improvement in the current that a single exchange rate for all commodities
balance within 12 months, but the magnitude of may not be appropriate. Either a dual exchange
the improvement was invariably small. In another rate is required, or some system of taxes and sub-
study, Bhagwat and Onitsuka (1974) examine the sidies to achieve the same effect. 1 Under a dual
experience of 50 devaluations in 46 countries. exchange rate system a fixed (official) rate could
They reach mixed conclusions. Exports appear on apply to primary commodity exports (and to
balance to have benefited, but imports apparently essential imports to keep their domestic price low)
grew faster after devaluation than before. They and a free (devalued) rate could apply to manufac-
stress also that effective devaluation was very tured exports with a high price elasticity of de-
often less than the nominal devaluation because ex- mand (and to inessential imports). With a foreign
porters raise domestic prices, and importers lower exchange shortage, the free rate would produce a
foreign prices in order to remain competitive. domestic price of foreign exchange well above the
Currency depreciation suffers a number of dan- official rate. The higher the free rate, or the greater
gers and drawbacks. By raising the domestic price the degree of devaluation, the greater the en-
of imported goods, it can be a highly inflationary couragement to manufactured exports and the
policy for an open economy which is heavily de- greater the discouragement to inessential imports.
pendent on imports. Sir Roy Harrod (1967) once The major administrative problem with dual ex-
described devaluation as 'the most potent known change rates is to separate the two markets, to
instrument of domestic price inflation which has ensure that export proceeds from primary com-
such sorry effects on human misery'. Many less
developed countries may feel inclined to agree as a
result of experience, and some countries have had 1 A classic early reference arguing the case for dual exchange
the courage to resist IMF support which has been rates is Kaldor (1964).
394 International Trade, The Balance of Payments and Development
Table 16.2 A Comparison of the Growth Experience of Countries Compared with the Growth Rate Predicted
by the Balance of Payments Constrained Growth Model
Import substitution is designed to lower the applied the model to a selection of countries with
import elasticity, but there is a limit to import interesting results. If it is assumed that relative
substitution, and the policy itself may lower the prices in international trade do not change (or the
export elasticity at the same time by creating a real exchange rate remains constant) then equa-
rigid and inefficient industrial structure. A much tion (16.8) reduces to y = Ezln = x!n, which is
more fruitful strategy, which has been pursued often referred to as the dynamic Harrod trade
relentlessly and successfully by several South East multiplier result because it is the dynamic ana-
Asian countries, is to concentrate on raising the logue of the static trade multiplier result Y = Xlm,
export elasticity, which at the same time may where Y is the -level of income, X is the level of
reduce the import elasticity if the goods produced exports and m is the marginal propensity to im-
for export also compete with imports. port. 1/m is the foreign trade multiplier. The
I
authors therefore consider how well the growth
experience of developing countries can be pre-
Application of the Balance-of- dicted from their growth rate of exports (x) di-
vided by the income elasticity of demand for im-
Payments Constrained Growth ports (rt). Table 16.2 shows the results.
Model It can be seen that the difference between the
actual growth experience (y) and the estimated
How well does the balance-of-payments con- balance of payments equilibrium growth rate (xln)
strained growth model outlined in equations is generally small. In other words, the rate of
(16.1) to (16.8) fit the growth experience of de- growth of exports relative to the income elasticity
veloping countries? Or, to put it another way, how of demand for imports is a good predictor of a
well does equation (16.8) predict the growth per- country's growth performance because, in the ab-
formance of the developing countries? Bairam sence of a continual positive rate of growth of
(1990), and Bairam and Dempster (1991), have capital inflows or improvements in the terms of
The Balance of Payments, International Monetary Assistance and Development 397
trade, this ratio sets the upper limit to growth. The Apart from the weight, EIR, attached to the two
average discrepancy (excluding Greece) is 0.8 per- export elasticities, 'Y] and E, the only difference
centage points. These results add weight to the between equation (16.12) and our earlier result in
idea and importance of export-led growth that we equation (16.8) is the addition of the last term
discussed in the last chapter. (c - pd) which measures the growth of real capital
inflows (the growth of the nominal flows, c, minus
the rate of domestic inflation, pd). A positive
• Capital Flows growth of capital inflows will allow a country to
grow faster than otherwise would be the case if it
So far we have assumed growth to be constrained was constrained to maintain balance-of-payments
by the necessity to preserve current account equilibrium on current account. On the other
equilibrium on the balance of payments. In prac- hand, it must be said that a continually positive
tice, of course, countries are allowed to run defi- rate of growth of capital inflows implies an ever
cits, sometimes for substantial periods of time, growing burden of debt, which is not sustainable
financed by capital inflows from abroad from a in the long run. Thus, running current account
variety of sources. The extent to which the value deficits to finance growth is not a long-run feasible
of imports can exceed the value of exports to option, and other long-run strategies must be pur-
finance a correspondingly higher level of income is sued related to the determinants of the growth rate
determined by the net level of capital inflows. consistent with current account equilibrium. 1
Thus we may write the equation for the overall
balance of payments as:
(16.10)
of development agency was given to the IMF's ments have given the developing countries a much
sister institution, the World Bank, established at louder voice than hitherto in the organisation and
the same time. Because the IMF was not allowed reform of the international monetary system.
to create money, John Maynard Keynes (the joint
architect of the IMF) used to complain that his
proposal for a bank had become a Fund, and • How the IMF Works
what was in fact a fund had been called a Bank!
Over the years, however, and particularly The IMF is basically a lending institution. It is a
recently, the role of the IMF has changed. It has source of three main forms of financial assistance,
increasingly become the bank manager of the poor or liquidity, to developing countries. First, there is
countries, and much more of a development the entitlement to drawings within the ordinary
agency, lending longer term to cover what are now facilities provided by the Fund. Secondly, there is
perceived as longer-term structural balance-of- entitlement to drawings made under special
payments difficulties. The role of the World Bank facilities, and thirdly there is the periodic issue of
has also been changing and now lends as a means Special Drawing Rights (SDRs).
of balance-of-payments support (the traditional Members' drawing rights, their share of SDR
preserve of the IMF) for what it calls programmes allocations, and indeed their subscription to the
of structural adjustment (see Chapter 14). The Fund and voting power are all based on quotas.
IMF, in turn, instituted in 1986 a Structural Every member must subscribe to the Fund an
Adjustment Facility (see later). The roles of the amount equal to its quota - 25 per cent in the
IMF and World Bank seem to be merging, in form of reserve assets and the remainder in local
recognition of the balance of payments as the currency. Initial quotas are based on a formula
major long-run constraint on the growth of output relating to the economic circumstances of individual
in developing countries. countries, such as living standards, importance in
The developing countries themselves have world trade etc., and are then modified in various
gained an increasingly powerful voice in the ways in the light of the conditions and quotas of
council chambers of the IMF, particularly since other countries. The United States has the largest
the breakdown of fixed exchange rates and the quota, amounting in 1992 to 26 billion SDRs out
convertibility of the dollar into gold in 1972. The of the total value of quota subscriptions of 135
developing countries have strong representation billion SDRs. When countries draw on the Fund,
on the 'Committee of Twenty' - the powerful they buy currency they need with their own cur-
inner cabinet of the lMF- and they now also have rency, and then, in repaying, they repurchase their
their own 'Committee of Twenty-Four'. There is own currency with foreign currency acceptable to
also a separate Development Committee which the Fund. The size of quotas comes under con-
was set up following a report from the Committee tinual review. Under the 9th General Review of
of Twenty in 1974 which argued that the Fund Quotas in 1990, a 50 per cent increase was insti-
should pay more attention to the needs of the tuted. The 10th Review of Quotas is due in 1993.
developing countries in making its recommen- The Fund may supplement its quota resources
dations and monetary arrangements. This was by borrowing any country's currency. This was
perhaps the first explicit statement from within the institutionalised by the General Agreement to
IMF itself that it should be concerned with issues Borrow (GAB) in January 1962, which was a four-
of economic development as well as stability. The year arrangement concluded with ten industrial-
Development Committee concerns itself with such ised countries. Since then, the General Agreement
issues as the access of the developing countries to to Borrow has been extended several times. The
the financial and goods markets of the developed Fund also borrows from the private capital market
countries; the flow of development assistance, and and makes bilateral deals with countries. In 1981,
commodity price stabilisation. All these develop- for example, an agreement was reached with Saudi
The Balance of Payments, International Monetary Assistance and Development 399
Arabia to provide the Fund with the equivalent of and other commodity prices between 1971 and
4 billion SDRs a year for at least two years, and in 1974. The strain on the balance of payments of the
more recent years there have been various short- non-oil-producing developing countries caused by
term borrowing agreements with national banks. these shocks called for a new blend of adjustment
The Fund also borrows to finance special fa- and finance. In 1978-9 there was another review
cilities as a means of recycling the balance-of- of conditionality, and a new set of guidelines was
payments surpluses of some member countries. issued. The new guidelines contained a number of
The Fund argues that while it has no desire to innovations. They encouraged members to come
supplant ordinary commercial banks in the recycl- to the Fund early before payments problems be-
ing process, its ability to advocate adjustment come acute. They recognised the need for longer
policies effectively and convincingly in deficit period adjustment. The guidelines also made clear
countries is enhanced by the capacity to make (and this was the most important innovation) that
substantial financial resources available to mem- the Fund, in helping members to design adjust-
ber countries. Thus, while the Fund continues to ment programmes, will pay due regard to the so-
place reliance on quota subscriptions as the main cial, economic and political characteristics of the
source of its finance, it is also in the market to country. There was official recognition for the first
borrow. Now that the IMF sees its role as provid- time that balance-of-payments difficulties associ-
ing larger amounts of financing over longer and ated with an acceptable growth of output may
longer periods for countries with chronically weak have as much to do with the structural characteris-
balance of payments in relation to their growth tics of countries as with relative price distortions
objectives, it will have an ever growing need for and excessive government expenditure. There is
resources. thus a new emphasis on policies to increase pro-
A country making use of the Fund's resources is ductivity and improve resource allocation. Supply-
generally required to carry out a programme of side policies include public sector policies on
balance-of-payments adjustment as a condition of prices, taxes and subsidies; interest rate policies
support. This requirement is known as con- etc., all of which affect the efficiency of resource
ditionality and reflects the IMF principle that allocation and supply potential. Conditionality, it
financing and adjustment must go hand in hand. was argued, must also be flexible and adaptable to
What constitutes balance-of-payments equilib- changing circumstances. 1
rium is not rigidly defined. It need not mean
current-account equilibrium, but the measure
must be defined free of restrictions on trade and • Ordinary Drawing Rights
payments in keeping with the underlying liberal
free trade philosophy held by the Fund. The Ordinary drawing rights from the Fund consist of
enforced programmes of balance-of-payments two elements: first the gold or reserve tranche
adjustment typically consist of currency devalua- which usually represents 25 per cent of a mem-
tion and restrictions on government expenditure ber's quota, which is equivalent to that part of its
and the money supply, coupled with the liberalisa- quota not paid in its own currency; and secondly,
tion of trade and monetary movements. These the credit tranche which is officially equal to 100
conditionality practices which were developed per cent of a member's quota, but can go beyond.
during the 1950s and 1960s, under pressure from The credit tranche is split into four parts, and
the United States, underwent a comprehensive re- access to higher tranches becomes progressively
view in 1968, and then were modified, almost as a more difficult and expensive. No conditionality is
matter of necessity, as a result of the disturbances
that characterised the world economy in the 1 For a comprehensive review of the evolution of the con-
1970s, starting with the breakdown of the Bretton ditionality practices of the Fund, see Guitian (1982), and Dell
Woods system and exacerbated by the rise in oil (1981).
400 International Trade, The Balance of Payments and Development
Table 16.3 Total Disbursements of the Fund, Repayments and Total Outstanding Credit (millions SDRs)
During period
Total disbursements 6 060 3 941 3 307 4 562 2 682 5 266 6 823 5 903
Purchases by facility 1 6 060 3 941 3 168 4 118 2128 4 440 6 248 5 294
Stand-by and first credit tranche 2 768 2 841 2 325 2 313 1702 1 183 1975 2 343
Compensatory financing facility 1248 601 593 1 544 238 808 2127 1 381
Extended Fund facility 2 044 498 250 260 188 2449 2146 1 571
Loans under SAF/ESAF arrangements 139 445 554 826 575 608
Special Disbursement Account resources 139 445 380 584 180 138
ESAF Trust resources 174 242 395 470
By region
Industrial countries
Developing countries 6 060 3 941 3 307 4562 2 682 5 267 6 823 5 903
Africa 1 018 842 647 955 701 1289 577 740
Asia 747 844 1282 804 469 525 1 714 1476
Europe 838 323 68 338 268 1960 1 516
Middle East 57 116 66 333
Western Hemisphere 3 401 1 933 1311 2 688 1174 3 119 2 572 1 838
Repurchases and repayments 2 943 4 702 6 749 8 463 6 705 6 399 5 608 4 770
Total outstanding credit provided
by Fund 37 622 36 877 33 443 29 543 25 520 24 388 25 603 26 736
attached to reserve tranche drawings, except Fund support for developing countries' balance of
balance-of-payments need. In the case of credit payments. They still are the most important single
tranche drawings, the conditions attached to the source of support, but since then other Fund facili-
first tranche normally consist of devising a pro- ties have become increasingly more important.
gramme demonstrating a reasonable effort to Total purchases in recent years from various
overcome balance-of-payments difficulties. Re- sources are shown in Table 16.3.
quests for purchases of currency in the higher cre- The total level of disbursements is seen to vary
dit tranches require substantial justification. The from year to year, but has averaged approximately
purchases here are almost always made under 5 billion SDRs over the period 1985-92. By re-
stand-by arrangements rather than directly, and gion, the major recipient has been the Western
certain performance criteria relating to govern- Hemisphere including mainly Latin America. Cre-
ment expenditure and money supply targets must dit and loans have to be repaid, however, and it
normally be met before resources are released. A can be seen that, in some years, repurchases and
strong programme is required designed to rectify repayments exceeded new disbursements e.g. the
balance-of-payments disequilibrium. period 1986-90. The total outstanding credit is a
Up to 1972, ordinary tranche (reserve and cre- massive 26.7 billion SDRs. In 1992, over 80 coun-
dit) drawings were the most important source of tries were in debt to the IMF.
The Balance of Payments, International Monetary Assistance and Development 401
tributions to various international buffer stock ultimately provided for a 50 per cent increase. The
schemes, such as have existed for tin and sugar. facility was funded by resources borrowed by the
Countries may draw up to 45 per cent of their Fund from members in strong payments positions,
quota. The facility was little used up to the end of amounting to 8 billion SDRs from 13 countries.
1976, with only 30 million SDRs drawn by five As a result, the amount of Fund assistance that
countries. Since then it has been more extensively members could obtain under stand-by arrange-
used, but as can be seen from Table 16.3 the sums ments doubled from 100 per cent and 140 per cent
involved have been relatively small. The con- of quota, respectively, to 200 per cent and 280 per
ditionality attached to drawings are the same as cent of quota. The stand-by arrangements using
under the CCFF scheme, namely co-operation these supplementary funds were allowed to cover
with the Fund to find appropriate solutions to periods longer than the traditional one year; the
balance-of-payments difficulties. loans were at market rates of interest, and had to
be repaid within seven years. The conditionality
attached was basically the same as that applied to
• Extended Fund Facility (EFF) higher tranche drawings.
To reduce the cost to low-income countries of
This facility was established in 1974 to allow de- using the SFF, a subsidy account was established
veloping countries to borrow beyond quota over in 1980, financed through voluntary donations
longer periods than are allowed under ordinary and the repayment of loans from the Trust Fund
drawing rights. The EFF arrangement gives mem- that was established in 1976 (and terminated in
bers assistance for up to three years with repay- 1981) to provide the poorest developing countries
ment provisions extending over a range of four to with concessional financial assistance provided by
ten years. Drawings under the EFF may be up to profits from Fund gold sales.
140 per cent of a country's quota over a three-year
period, but the conditions are stringent. The coun-
try must provide a detailed statement of policies
• Enlarged Access Policy (EAP)
and measures every twelve months. The resources
In March 1981 a policy of enlarged access to the
are provided in instalments with performance
Fund's resources was adopted whereby after all
criteria attached. None the less·, the facility repre-
supplementary financing had been committed and
sented an important and significant shift in em-
additional borrowing arrangements had been con-
phasis from viewing the balance of payments as a
sidered, the Fund would continue to provide
stabilisation problem, to recognising the balance
assistance on a scale similar to that under the SFF.
of payments as a fundamental long-term con-
The limit on borrowing is now 270 or 330 per cent
straint on growth with cannot be rectified, if at all,
of quota over a three-year period and a cumulative
in a short period of time. Access to the facility was
limit of 400 or 440 per cent of quota net of re-
improved in 1988. Drawings over the period 1974
purchases and excluding drawings under the Com-
to 1992 have amounted to approximately 25 bil-
pensatory and Contingency Financing Facility and
lion SDRs.
Buffer Stock Facility. Such drawings are subject to
the relevant policies of the Fund, including those
Facility (SFF)
This facility was established in 1977 to act as a
I Structural Adjustment Facility
(SAF)
temporary measure to assist countries facing large
external imbalances in relation to their quotas, In March 1986 the IMF's Structural Adjustment
pending the 7th General Review of Quotas which Facility was instituted to provide assistance on
The Balance of Payments, International Monetary Assistance and Development 403
system that prefers capitalism to socialism; which structural in nature relating to the characteristics
favours private investment over public investment; of the goods produced and traded. This implies a
which extols the virtues of free trade and the op- very different approach to balance-of-payments
eration of the price mechanism, and which encour- adjustment than one of continual devaluation, de-
ages the free flow of private capital to and from mand contraction and dismantling of the public
developing countries. All this colours to a certain sector. At the very least it calls for dual exchange
degree its diagnosis of balance-of-payments prob- rates, and for policies, using a judicious mix of
lems and their appropriate solution. Deficits are subsidies and controls, to alter the structure of
invariably seen as related to, or caused by, price production.
uncompetitiveness and excess monetary demand, The effects of the Fund's programmes on coun-
to be 'cured by' devaluation and demand contrac- tries' economic performance have been very
tion. But as Buira (1983) notes, in an authoritative mixed. Reichmann and Stillson (1978) examined
analysis of conditionality, the Fund still lacks a the effects of IMF programmes in both developed
comprehensive theoretical apparatus to deal with and developing countries in the period 1963 to
two basic questions regarding devaluation. First, 1972, comparing the two years after the imple-
how is the degree of overvaluation of a currency mentation of the programme with the two years
determined? And secondly, how is the optimal before. Taking the balance of payments as a whole
pace of adjustment from the overvalued to the (current plus capital account), of 75 cases ex-
equilibrium rate of exchange decided? Then in amined, only 18 cases showed a statistically signi-
keeping with the Fund's philosophy, devaluation ficant improvement and 4 showed an actual
and retrenchment are coupled with other measures worsening. In 29 cases when the inflation rate
which, from a balance-of-payments point of view, exceeded 5 per cent before the programme, the
work in the opposite direction; namely, the relaxa- inflation rate worsened in 6 cases and in 16 cases
tion of foreign exchange controls, the removal of there was no significant change. As far as GDP
import restrictions and the dismantling of sub- growth is concerned, of 70 cases examined the
sidies and price controls. The critics argue with performance improved in 33 cases, but deterio-
some justification that there is one law for the rated in 28 cases. A study by Donavan (1982) of
poor and another for the rich. While the poor the non-oil-developing countries for the period
countries must remove controls over foreign ex- 1971-80 reveals a similar pattern: some improve-
change and imports as a condition of assistance, ment in the balance of payments; mixed effects on
the rich countries continue to impose restrictions growth, and some tendency towards inflation.
against the imports of goods from developing Following a major analysis of over thirty IMF
countries. To support the liberalisation pro- stabilisation programmes supported by upper-
gramme, the country then has to depress aggregate tranche credits between 1964 to 1979, Killick and
demand sufficiently to accommodate devaluation his associates (1984) advocated what they call a
in the attempt to achieve balance-of-payments 'Real Economy Approach to Balance of Payments'
equilibrium, which leads to slow growth and or 'adjustment with growth', which would be a
unemployment. 1 The symptoms of balance-of- more flexible supply-orientated approach with de-
payments disequilibrium are tackled, but not the mand management subservient. One of the pur-
root causes of the perpetual tendency towards dis- poses of the Extended Fund Facility and the
equilibrium. As we argued in the previous chapter, Structural Adjustment Facility is to permit the
the balance-of-payments problems of most de- Fund to deal with structural disequilibrium, but as
veloping countries must be regarded as primarily far as the former Facility is concerned, the structural
adjustment programmes have been no different from
conventional demand management programmes built
1 For the adjustment experience of thirteen individual countries
in the 1970s see Dell and Lawrence (1980). See also Killick around monetary and fiscal contraction coupled
(ed.) (1982). with trade liberalisation and some production
406 International Trade, The Balance of Payments and Development
incentives. All performance criteria have been of countries to control imports from 'scarce cur-
based on traditional demand management instru- rency' countries, i.e. from those with surpluses.
ments (Buira (1983)). The most appropriate con- Lastly, the critics would argue that if the Fund
ditionality required for structural adjustment is genuinely concerned with development as well
programmes does not seem to have been fully as providing balance-of-payments support, it
worked out. The final point that needs making is could distribute all new issues of Special Drawing
the crucial role of the Fund staff in the design of Rights (SDRs) to developing countries to spend in
financial programmes. The power exercised by developed countries who, after all, if they did not
one or two staff technicians involved in the nego- earn their reserves by selling goods to developing
tiations can be considerable, but also very damag- countries in exchange for SDRs, would have to
ing if national policy-makers are not persuaded by earn them in some other way. We take up this
the arguments. Programmes entered into under matter later.
duress normally fail.
The most recent study of Fund stabilisation ex-
perience is by the structuralist development econ- • The Recycling of Oil Revenues
omist Lance Taylor (1988). He reports the results
of studies of eighteen countries done under the The major contributory factor to the balance-of-
auspices of the World Institute of Development paym'ents difficulties of developing countries in the
Economic Research (WIDER) in Helsinki. The 1970s was the massive increase in the price of oil,
principal finding of the authors of the country stu- which in turn gave the oil-producing countries
dies is that 'past policies could have been designed huge balance-of-payments surpluses. The price of
to better effect, and that programmes of the Fund/ oil rose from $1.80 per barrel in 1973 to $9.50 in
Bank type are optimal for neither stabilisation nor 1974, and rose by another $12 per barrel in 1979.
growth and income redistribution in the Third In 1981 the price went to over $30 per barrel, and
World'. This is a serious indictment of policy from at the time of writing it is $20. The immediate
some of the world's leading development econom- impact of a rise in the price of an inelastic com-
ists. There are alternative programmes to those modity like oil is to transfer income from the
implemented by the IMF, but they would be more consuming to the producing country. Unless there
interventionist, and be concerned more directly is an immediate transfer back, income and em-
with the targets themselves than with the precise ployment will contract in the consuming country.
instruments. There is a role for selective import This is· part of the balance-of-payments adjust-
controls, export subsidies, multiple exchange ment mechanism and will continue to the extent
rates, low interest rates etc. but these are all that the deficit in the consuming country is not (or
frowned on by the IMF. cannot) be financed by capital inflows. The pro-
Another criticism of the Fund is that it ignores ducers have counterpart surpluses. The concern is
'structural' surpluses on the balance of payments- whether the surpluses are used to finance the de-
the counterpart of 'structural' deficits - and critics ficits of the countries most in need.
argue that the burden of adjustment ought to be After the first oil price increase in 1973-4, the
shared more equitably between deficit and surplus bulk of the oil producers' (OPEC) surpluses were
countries, instead of the major part of the burden invested in certificates of deposit in the Eurodollar
being shouldered by debtor developing countries, market and in American and British government
as at present. If surplus countries do not attempt stocks. But since 1978, and after the further price
to adjust by expanding their own economies or rise in 1979, more of the surpluses have been used
appreciating their currencies, deficit countries directly to finance the deficits of developing coun-
ought to be allowed to discriminate against the tries on concessional terms.
goods of these countries. This would be a revival Several developmental agencies have been set
of the idea of 'scarce currencies', and of the right up by the oil producers to channel developmental
The Balance of Payments, International Monetary Assistance and Development 407
return on resources, the effect on resource alloca- Table 16.5 The Holding of SDRs, 1990
tion would be neutral between net users and net
holders. Thus the system at present instituted in- Holdings
volves resource transfers only to the extent that
the interest rate payable on the net use (holding) of Industrial countries 17 615
SDRs is lower than the market rate of interest Developing countries 2 739
of which:
(opportunity cost of capital), so that countries that
Africa 84
accumulate SDRs are effectively transferring re- Asia 904
sources to those countries that run them down. Europe 70
The interest rate originally payable on net use was Middle East 951
1.5 per cent, but this has been gradually raised Western hemisphere 730
through time, in order to make the SDR a more
Total allocation 20 354
acceptable asset to hold, and now both users pay,
and holders receive, a market rate of interest based Source: International Financial Statistics, Year book 1991.
on interest rates prevailing in the US, UK, France,
Germany and Japan. Net use still enables coun- their allocation. This does not necessarily mean a
tries to run larger balance-of-payments deficits resource transfer of this order of magnitude,
than otherwise would have been the case, and however. First, interest payable must be deducted.
eases the adjustment problem, but the grant ele- Second, whether transfer takes place to the group
ment attached to SDR use has now gone. The rules as a whole depends on whether all the currency
on use are that while a country may now use the acquired in exchange for SDRs is spent in coun-
whole of its SDR allocation, no country is obliged tries outside the group.
to hold more than three times its own cumulative There can be no doubt about the advantages of
allocation. But the obligation to accept SDRs the SDR system for the world as a whole, but there
involves the provision of currency in exchange. are several objections to the present distribution,
The idea is that SDRs should be used primarily to and grounds for believing that a redistribution of
meet balance-of-payments needs so that most SDRs in favour of the developing countries could
SDRs end up in the hands of surplus countries. improve world welfare. The advantages of SDRs
The accumulation of SDRs by a country is not compared with the gold and dollar standard are
necessarily an indication, however, that the self-evident. SDRs make possible orderly reserve
country has transferred real resources to the creation and rid the world of a system dependent
same extent. That depends on where the currency on supplies of gold and the balance of payments of
it surrenders in exchange for SDRs is spent. The reserve currency countries. SDRs cannot be de-
holdings of SDRs by groups of countries is shown monetised (like gold) or vanish as when dollar are
in Table 16.5. spent in the United States. They are also costless to
It can be seen from the table that the holding of produce, unlike gold, which requires real re-
SDRs in the industrial countries is over five times sources to be mined, refined, transported and
greater than in the developing countries. The in- guarded. Above all, SDRs represent the abandon-
dustrial countries have been net users of SDRs, as ment of the idea that attached to international
well as the developing countries. 1 The actual net money there must be a debtor. Acceptability by
use by the developing countries has been approx- others is the important thing, just as a nation's
imately 2.8 billion SDRs, or just over one-half of payments system depends on the acceptance of
unbacked paper money.
1 The difference between total allocations and total holdings The objections to the present distribution of
is accounted for by Other Holders and holdings by the Gen- SDRs should be equally axiomatic however. The
eral Resources Account of the Fund. Other holders include
the World Bank, the IDA and the Bank for International IMF quotas on which the allocations are based
Settlements. were not developed for the purpose of distributing
The Balance of Payments, International Monetary Assistance and Development 409
SDRs. They were developed for the purpose of change for the gold. Under a system of allocat-
assigning voting power at the IMF, for determin- ing fiduciary international money to developing
ing each member's contribution to the Fund's re- countries, industrial countries would earn their
sources, and for determining maximum borrowing new reserve assets through exports to any of the
limits from the Fund. The quotas were based on developing countries that spend the allocated
the degree of convertibility of each nation's cur- money; workers in development projects, such
rency, its national income, its original level of as in the construction of highways, schools, or
convertible currency holdings and its importance hospitals would receive goods and services
in world trade. There is no necessary relation, equivalent to the industrial countries' exports.
therefore, between the quotas and the criteria by The effect on the industrial countries would be
which one might wish to allocate new international the same in both cases; the effects on the de-
liquidity, such as the relative costs of balance- veloping countries would differ in that the de-
of-payments adjustment, the long-run demand for velopment projects may sooner or later help to
international reserves, and in particular the dis- increase the productivity of their people ... the
tribution of world income (given that SDRs repre- point is that the benefit from creating costless
sent a social saving compared to the use of gold). money must accrue to someone and who should
The balance-of-payments adjustment costs of de- be the beneficiary is necessarily an arbitrary
veloping countries are generally higher than those decision.
of developed countries, and this in itself consti-
tutes an economic argument for revising the As Triffin (1971) has argued, internationally
present allocation rules. The more important ques- agreed SDRs should serve internationally agreed
tion, however, is how the social saving should be purposes, one of which could be that the social
distributed. The present rules for allocation, in saving of SDR creation should accrue to the de-
effect, distribute the social saving to individual veloping countries. Machlup also argues that there
countries in proportion to their contribution to the are strong political arguments for combining
social saving created; that is, in proportion to the assistance to developing countries with reserve
demand for SDRs. If the supply of SDRs to indi- creation in one package given that it may be politi-
vidual countries equals their demand, no resource cally difficult to get countries to agree unilaterally
redistribution between nations will occur. But in to increase their level of foreign assistance.
the light of the present distribution of world in- The feeling that the social saving of SDRs
come, why should not the whole of the social should be distributed to the developing countries
saving be transferred to the developing countries? has spawned several proposals for a so-called link
As Williamson (1973) has argued, the degree of between development assistance and SDRs. If
egalitarianism needed to justify this course rather more resources are to be distributed to the de-
than neutrality is minimal. The developed coun- veloping countries on account of technical pro-
tries would be no worse off than if new gold had gress in the international payments industry, there
been discovered and then sold to them. Swapping would indeed seem to be several advantages in
SDRs for exports to the developing countries is establishing an aid link with the use of SDRs.
just another way of converting resources into re- First, if there was a regular expansion of SDRs a
serves. Machlup (1968) puts it this way: link would provide a useful mechanism by which
total development aid could be guaranteed to rise
Under the gold standard, industrial countries with the long-term growth of world trade and
earned increases in their gold reserves through production. At present there is no guarantee that
export to South Africa; workers in mines and aid will rise proportionately with world income.
refining plants (and, of course, also managers Aid programmes get chopped and changed ac-
and stockholders) received the equivalent of cording to the balance-of-payments situation of
what the industrial countries exported in ex- donor countries.
410 International Trade, The Balance of Payments and Development
Second, a link scheme would increase the pro- quotas to developing countries could be increased,
portion of total international aid that is untied. while retaining the quota structure as a basis for
Even if normal budgetary appropriations for aid SDR distribution. Alternatively, the developing
were cut as a result of the link scheme, the link countries could be allocated SDRs in excess of
would still yield a net benefit in that the real value their IMF quotas according to some agreed for-
of the aid would be increased through untying. mula. The direct approach, which was the essence
Moreover, the untying of aid through the link of the Stamp Plan, has much to recommend it
would not impose any reserve losses on the donor, compared with the more complex alternatives.
as when a country unties its aid unilaterally. All An organic link refers to the possibility of chan-
donor countries will gain reserves in exchange for nelling SDRs to the developing countries either via
the exports they provide to the developing countries. the developed countries directly, or via interna-
Third, if the link scheme operated through such tional institutions directly, or via both. UNCTAD
international financial institutions as the World (1965) first suggested the notion of an organic link
Bank or one of its affiliates, these multilateral whereby the IMF would issue Fund units to all
institutions would be provided with a regular member countries in return for national currencies
flow of resources without the necessity of entering deposited with the Fund, which could then be used
into time-consuming negotiations with national for purchasing World Bank bonds or for distribu-
governments. tion to the International Development Associa-
The historical origin of the link idea can be tion, thus providing additional (and cheap)
traced back to Keynes's plan for an International resources for multilateral development projects.
Clearing Union (ICU) with the power to issue Many other forms of organic links have since been
international money. The function of the ICU was suggested: e.g. the direct allocation of SDRs to
not only to be a world central bank but also to development agencies; the allocation of SDRs by
lend to international organisations pursuing inter- developed countries direct to the developing coun-
nationally agreed objectives, in particular, at that tries; and the allocation of SDRs by developed
time, for post-war relief work and the manage- countries to development agencies. The direct alloca-
ment of international commodities. The most re- tion of SDRs to development agencies probably has
cent spate of proposals for relating development the most advantages and the least drawbacks
assistance with international monetary reform, among the organic-link proposals. Development
however, started with the Stamp Plan in 1958 agencies would have accounts with the IMF to
(Stamp (1958)), which was for the issue of IMF which SDRs would be credited. The development
certificates to increase international liquidity, but agencies would then lend in the normal way.
distributable directly to the developing countries. When goods were purchased from exporters by
The developing countries would gain purchasing the developing countries, the IMF would then
power, and the developed countries would have to transfer the SDRs from the account of the develop-
e;;1rn the certificates by exports to the developing ment agencies to the account of the exporting
countries in the same way that they would have to country. The country would then pay its exporters
earn gold or dollars by exports. in its domestic currency. The scheme has the
The variety of link proposals that have been put advantage of being simple and could be intro-
forward since 1958 can be classified into three duced with minimal amendments to the IMF Arti-
types: proposals for (i) a direct link; (ii) an organic cles of Agreement.
link; and (iii) an inorganic (or indirect, voluntary) A tied version of the organic link which bears
link. As far as a direct link is concerned the sim- some similarity to the UNCTAD proposal was
plest method would be to allocate more SDRs Scitovsky's early plan (1966) that new international
directly to the developing countries in excess of currency should be issued to deficit countries
their long-run demand for reserves. This could be with unemployed resources which would relin-
accomplished in several different ways. The IMF quish domestic currency in exchange which could
The Balance of Payments, International Monetary Assistance and Development 411
then be lent to the developing countries but which cannot be accurately forecast in advance. This is a
could only be spent in the issuing country. This weak argument for two reasons. The same objec-
would serve several purposes. It would provide the tion can be levelled against all forms of untied aid
developing countries with unrequited imports at given bilaterally, and also against tied aid to the
no opportunity cost to the developed countries extent that tying is not 100 per cent effective.
and remedy the deficits of the developed countries There is never any necessary correspondence be-
at the same time. The idea of Scitovsky's scheme tween the financial burden of aid and the real
was to eliminate deflationary bias in the world resource burden of aid. It all depends on whether
economy, but it remains relevant as long as some the national governments which grant aid allow
countries exist with unemployed resources but the resources to be transferred, which depends
needing reserves. The main disadvantage to de- primarily on their policy towards the balance of
veloping countries compared with alternative payments. But in any case, the theory of democ-
schemes would be that the resource transfer in- racy and the concept of mandate extend to the
volved would be in the form of tied gifts. international sphere. As Haan (1971) has argued,
An inorganic link would involve the developed there is no reason why a government cannot be
countries in agreeing to make voluntary contribu- given a mandate to distribute international money
tions to the multilateral aid-giving agencies when- to the developing countries even though the im-
ever new SDRs were allocated. The contributions pact on the country may be uncertain.
would be in national currencies but would repre- A further objection is that the link is likely to be
sent a uniform proportion of each contributor's inflationary. If SDRs are replacing gold and dol-
SDR allocation. The drawback of the proposal is lars, however, there is no reason to suppose that
its voluntary nature and that one or two major SDRs will be any more inflationary for the world
countries may not contribute or might make their economy than the existence of gold and dollars. It
contribution dependent on their balance of pay- is true that developing countries will tend to spend
ments. This would introduce a great deal of uncer- new international money rather than add to their
tainty into the scheme. Also national governments reserves, but whether the resulting claims on the
would have to agree appropriations and this developed countries are inflationary or not de-
would create the same difficulties as regular pends on whether the developed countries are will-
foreign-aid appropriations. There would not seem ing to release resources to the extent of the claims
to be much advantage in an inorganic link. on them. The reaction of the responsible author-
Several objections have been raised against the ities will hardly depend on the source of the asset
link proposals but none are very convincing. Some creating the pressure. It is thus highly misleading
have argued against the link on the grounds that to argue, as Bauer (1973) does, that because, un-
the creation of reserves should be kept separate like ordinary aid, the direct nexus between SDRs
from the transfer of real resources. But this has and real resource claims is broken that corres-
never been the case historically. Resource transfers ponding measures to offset inflationary effects are
have always been involved in the acquisition of less likely. All sorts of unforeseen factors can dis-
gold and dollars. Since SDRs save real resources, it turb an economy. The (uncertain) claims arising
is entirely appropriate that in the process of re- from SDR distribution to the developing countries
serve creation the saving should be distributed to are likely to be trivial in comparison. The sums
the developing countries. involved are certainly trivial in absolute magni-
A second objection expressed against the link is tude, which further casts doubt on the inflation
that it would relinquish democratic control over argument. Even if the whole allocation of SDRs of,
the granting and distribution of assistance by say, $3 billion a year was distributed to the de-
national governments. Under the link scheme, the veloping countries, this would still represent only
distribution of the burden of assistance depends 0.16 per cent of donor countries' national income.
on where the SDRs are spent, which, it is argued, There are, in fact, several reasons for supposing
412 International Trade, The Balance of Payments and Development
that the link may reduce inflationary pressure in present received. If ever there was an instrument in
the world economy. SDRs could be less inflation- search of a policy it is SDRs.
ary than the dollar standard by substituting multi-
I
lateral control over international liquidity for
unilateral control by the United States, which, be- Questions for Discussion and
cause of the need for dollars, has not been subject Review
to anti-inflationary discipline normally present in
other countries. It may also be that fewer SDRs 1. What does the demand for a country's exports
will be created with a link than without. If the and imports depend on?
developed countries must earn their new reserves 2. Can the devaluation of a country's currency
they are likely to be more modest in their views on guarantee balance-of-payments equilibrium on
the need for more reserves. If countries must earn current account?
reserves there will also be some compulsion on 3. What is the case for a dual exchange rate in a
them to contain inflation in order to compete in developing country?
world export markets. 4. What factors determine the income-elasticity
A final objection raised is that the total of de- of demand for a country's exports?
velopment assistance is not likely to rise under the 5. Why are developing countries more prone to
link because governments will cut down on their balance-of-payments disequilibrium than de-
normal budgetary aid appropriations. Critics veloped countries?
argue that it is highly unlikely that develop~d 6. What criticisms have been levelled against the
countries would be willing to give extra atd IMF in its policies of support to developing
through the link but not in other forms. This countries?
objection can also be challenged. For one thing the 7. How could Special Drawing Rights be used
reserve effects of the two forms of assistance are simultaneously as an instrument of aid to de-
not the same. Conventional aid worsens the veloping countries and as a means of employ-
donor's balance of payments, whereas the link ment creation in developed countries?
scheme would improve the balance of payments of 8. How does the IMF's Compensatory and Con-
countries where SDRs were spent and thus im- tingency Finance Facility Work?
prove the reserve position. Second, governments 9. If some countries have deficits, others must
often wish to provide aid for specific purposes and have surpluses. How could these surplus
this desire would not be diminished by a link. countries be forced to bear more of the adjust-
Moreover, since it is very difficult for a country to ment burden?
know how much aid it is providing through the 10. What do you understand by the IMF's
link, it would be very difficult for a country to 'Supply-Side Approach to Devaluation' in de-
offset it. The link deserves much more considera- veloping countries?
tion in international monetary circles than it has at
References and Further
Read ing
413
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Author Index
428
Author Index 429
433
434 Subject Index
foreign exchange gap 304, 305, 307 distribution 31-4; growth and 34-5; and
forward linkages 185-6, 256-7 project appraisal 206-10
see also linkage analysis growth of national 164-6
France 78, 327 growth of world 395-6
free trade 366-7 national income accounting 224-5
freedom 9 per capita see per capita income
world distribution 13-18
General Agreement to Borrow (GAB) 322, 398 income compensation schemes 382, 384-5, 392
General Agreement on Tariffs and Trade income elasticity of demand 56, 372-3, 395-6
(GATT) 230, 377 income measure of unemployment 30-1
geographic determinism 87 income tax 285, 287
geographic dualism 129 income terms of trade 375
Germany 78, 320, 321 increasing returns 68-9
Ghana 287 incremental capital-output ratio (ICOR) 114-16,
Gini coefficient of distribution 14, 32, 33-4 256
Global Environment Facility 231 India 287, 363
green revolution 92 agriculture 95, 105-6
growth assistance to 333, 340
analysis of 66-7; see also production-function banks 281
approach population growth 150
balance-of-payments constrained 388-97 indirect taxes 286
balanced see balanced growth see also taxation
capital imports and 309-10 industrialisation' 14, 113, 186
credit-financed rate of 296-7 basic needs approach 51-2
development and 24 dual economy 93-4
dual-gap analysis 304-5 and growth 56-61
environment and 211, 212, 225-6 income distribution and 32
export-led 61, 136-9, 364-6 industry
immiserising 360 balanced growth 183
income distribution and 34-5 change in consumption 205
industrialisation and 56-61 interdependence with agriculture see agriculture
inflation and 288-99 inter-industry models 174, 176
poverty-weighted indices of 34-5 linkage analysis 256-63
regional differences 130-9 policy choice vs agriculture 178
Rostow's stages of 61-4 resource shifts to 77-8, 83-4
unbalanced 18 3-7 stages of development 54-6
structure of production 56, 57-60
Harrod growth model 175 infant mortality 42-6
head count index 12-13 inflation 274, 275
health 35-46 and credit-financed growth rate 296-7
hedonic prices 223 dangers of 297-8
hired labour 106 developing countries' experience 298-9
Hirschman compliance index 260-3 and growth 288-99
human capital valuation technique 223 Keynesian approach to financing
Human Development Index (HDI) 52-4 development 288-93
Quantity Theory 293-5
import-export gap 304, 305, 307 SDRs link to assistance 411-12
import substitution 369-71, 376-7 structuralist-monetarist debate 299-301
imports 364 as tax on money 293-4
capital 309-11 unbalanced growth 186-7
forecasting requirements 254-5 innovation 119-20
growth 357-60, 389-90 input coefficients 249-50, 259
role in development 186 input-output analysis 246-63
see also trade assumptions of 258-9
incentives 110-11 development strategy and 259-60
income 227 general solution of model 252-4
Subject Index 437