IB Economics/Development Economics/Growth and Development Strategies

5.4 Growth and Development Strategies

Harrod-Domar growth model

1930s concept that explains why economies do not grow as fast their potential growth rates
Assumes fixed capital-labour ratios and low savings ratios due to poverty cycle

LEDCs have abundant supply of labour and the lack of physical capital holds back economic growth/development
More physical capital will generate economic growth

Actual income determines the savings ratio, which determines the disposable income for investment, which then affects the rate of economic growth
Savings rate, plus capital productivity, minus capital depreciation, equals rate of economic growth
Potential growth rate is not achieved automatically (needs Keynesian intervention) if saving is not enough (or not enough confidence in the banking system to offered commercial loans)
Change in savings ratio or increased productivity will lead to an economy realizing more of their potential (more efficient)

Problems of the H-D model

Economic growth and economic development are not the same; growth is a necessary (but not sufficient) condition for development
Difficult to stimulate the level of domestic savings, particularly in the case of LEDCs where incomes and confidence in the banking system are low
Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later
Law of diminishing returns suggests that as investment increases the productivity of the capital will decrease and the capital to output ratio rise

Lewis' Structural change/dual sector model

1954 idea: assumed many LEDCs had dual economies with both a traditional agricultural sector (subsistence nature, characterized by low productivity, low incomes, low savings and much unemployment) and a modern industrial sector (technologically advanced with high levels of investment operating near an urban environment)
Development was held back by lack of savings and investment; key to development was to increase savings and investment
Theorized that 'pull factors' from the modern industrial sector would attract workers from the rural areas (these firms, whether private or public, could offer wages that would offer a higher quality of life than remaining in the rural areas)
As the level of labour productivity was so low in traditional agricultural areas, people leaving the rural areas would have virtually no impact on output (amount of food available to the remaining villagers would increase as the same amount of food could be shared amongst fewer people; possibly offering a surplus which could be sold)
Those in the urban areas would earn increased incomes, generating more savings and providing funds for entrepreneurs for investment; the growing industrial sector required labour and provided incomes that could be spent and saved, generating demand and providing funds for investment
Income generated would trickle down through the economy

Problems of the Lewis Model

Productivity of labour in rural areas is almost zero may be true for certain times of the year; however, during planting and harvesting the need for labour is critical to the needs of the village
Constant demand for labour from the secondary industrial sector is questionable. Increasing technology may result in labour saving and actually reducing the need for labour. Additionally, if the industry declines, demand for labour will fall
Trickle down has been criticised; higher incomes earned in the industrial sector will not necessarily be saved and invested. If the entrepreneurs and labour spend their new incomes rather than save (preferably in banks), funds for investment and growth will not be available
Rural-urban migration in many LEDCs has been far larger than the secondary industrial sector can provide jobs; urban poverty has replaced rural poverty

Types of aid

OFFICIAL AID

Official Development Assistance (ODA) is transferred either as bilateral aid between governments or as multilateral aid through agencies such as the World Bank or the UN

OECD's Development Assistance Committee (DAC) defines ODA as: flows to developing countries and multilateral institutions provided by official agencies, including state and local governments, or by their executive agencies, each transaction of which meets the following tests:

it is administered with the promotion of the economic development and welfare of developing countries as its main objective, and
it is concessional in character (lower rate/perhaps none interest, easier credit terms and repayment schedule, sometimes repayable in local currency; targeted toward a certain 'theme', i.e., poverty reduction or trade expansion) and contains a grant element (not expected to be paid back: food, medical and emergency aid) of at least 25%
ODA has grown from $22 billion to $60 billion between 1960 and 1990
Aid has fallen from 0.5% of donor GNP in 1960 to 0.3% in 1990
The US is the largest donor (in nominal/real terms) with $11.3 billion in 1991

Represents ~0.2% of GNP

Japan is the second largest with $10.9 billion in 1991

UN agreement of 0.7% of GNP (1970)

Sweden gives ~1% of GNP

The World Bank lent $6 billion in 1990
UN agencies gave $4 billion, and provided the largest amount of technical assistance through the United Nations Development Program (UNDP), United Nations Environmental Program (UNEP), United Nations Industrial Development Organization (UNIDO), International Labour Organization (ILO), World Health Organization (WHO)
Unofficial aid is transferred through non-governmental organizations (NGOs):

NGOs gave $6 billion in 1990, the same amount as the World Bank
NGOs tend to attack poverty directly by working with local groups to achieve LOCAL AGENDAS rather than imposing their own agenda
LEDCs with large populations have received less because donors have a greater impact by donating to smaller countries which then become more dependent
It is estimated that less than 10% of overall aid goes directly to programs to help the poor such as health care/health education, basic literacy education, AIDS prevention, agricultural extension, microcredit schemes, immunization and vocational training, and clean water and sanitation (these are all project typically taken on through NGO aid)

BILATERAL & MULTILATERAL FOREIGN AID

Bilateral Foreign Aid

Bilateral aid tends to be distributed directly between two countries according to political interests:

The US mainly directed its aid toward containing communism
The EU helps former colonies, especially African countries
Islamic members of OPEC concentrate on Islamic countries, but this source of funding has faded rapidly with the sharp declines in oil revenues
Communist bloc countries used to give to communist countries such as Cuba, Mongolia, and Vietnam, but aid from this source has disappeared

Multilateral Foreign Aid

Most LEDCs have a current account deficit created by the import of high value added capital goods which cannot be matched by the low value added exports - aid provides an alternative to FDI as a way to create a capital account surplus
The first aid plan was the Marshall Plan (no longer available) provided by the US which was motivated by a combination of national security fears, economic interests and humanitarian concerns
This aid was available to European countries with acceptable development plans for physical capital investment
It expanded to include new technical assistance programs: available to invest in human capital
Plans and projects were generally excellent making the Marshall plan so successful that private capital was attracted

The success of the Marshall Plan led to the formation of the development assistance committee of the OECD (25% US) which provided money for:

Capital and human capital investment (education)
Improving health and sanitation
Relieving poverty through rural regeneration, and assistance to women

World Bank

Large donor countries such as the US or Japan or EU tend to dominate multilateral aid agencies such as the World Bank (created at the Bretton Woods conference in 1944)
The World Bank does not give grants (gifts of money) but borrows at the prime rate from MEDCs and relends at a slightly higher rate to LEDCs and must be repaid:

90% of loans are for projects (physical capital); 10% for programmes
US traditionally selects leader

IMF

Large donor countries also tend to dominate the IMF (also created at the Bretton Woods conference in 1944)

The IMF is designed to support the system of international currencies
It only gives loans to countries experiencing balance of payments difficulties
The loans are conditional on the imposition of a structural adjustment programme (SAP) which often requires: reductions in government budget deficits, a slower rate of money expansion (lower inflation) and devaluation
European governments traditionally select leader

GRANT AID, SOFT LOANS

Grant aid:money not expected to be returned

Used primarily for food, medical and emergency aid

Soft loans: loans with a lower interest rate (perhaps none), easier credit terms and repayment schedule, sometimes repayable in local currency; targeted toward a certain 'theme', i.e., poverty reduction or trade expansion

Relatively easy to renegotiate a different repayment schedule if a country is having difficulty with debt service

TIED AID

Bilateral aid is often tied: aid money can only be used to purchase goods and services from the donor countries
Historically, the proportions were: France 60%, Britain 75%, Italy 90% - while Japan does not officially tie aid, it often reaches unofficial agreements which do tie aid
The proportions which are tied have dropped steadily and average 25% for many countries
Services are tied in the form of technical assistants being sent out from the donor country:

They are designed to provide the technical and managerial skills which may be missing in the LEDCs
An estimated 100,000 consultants from MDCs are working in African countries, many are doing jobs which could be done by local people

Conditionality

Loans and aid from large agencies is often conditional on changes in government policy in the recipient country

IMF's SAP is a good example of this, encouraging: less protectionism/lifting restrictions in trade; currency devaluation; exports of primary agricultural commodities ("cash crops"), metals and minerals; increased FDI; privitization of nationalized businesses; removing subsidies and price controls; reducing social expenditures and government expenditures in general to have a balanced budget; charging for education and health services; reducing corruption; and making government more responsive to the people (Washington Consensus)

One condition is often that funds are used to buy goods and services from the donor country

Resulting in aid money actually flowing back into the donating country

Export-led growth/outward oriented strategies

Tariffs are reduced or eliminated, and imports rise
Domestic production is displaced and unemployment rises in domestic industries that compete with imports
Costs for intermediate goods fall leading to an increase in exports and a fall in unemployment in the external sector
Countries specialize in the sectors in which they have a comparative advantage

Export promotion benefits

There is more rapid growth in both GDP and GDP per capita
Technology transfer takes place through imports of capital goods
Exports of manufactured goods rise compared to primary sector exports
Gains from trade: lead to a higher standard of living
Specialization allows economies of scale and rapid learning by doing
Even if growth is more uneven, the huge increase in productive capacity will lead to rapid investment and linkage adjustment in other sectors (backward and forward integration)

Export promotion costs

MEDC tariffs and quotas block imports of labour intense manufacturing goods where LEDCs have a comparative advantage
Growth is more uneven
Vertical integration is lost, workers may be confined to assembly and some fabrication
There is a risk that new technology may render a sector obsolete
There may be an overemphasis on natural resource exports which could lead to deteriorating terms of trade

Import substitution/inward-oriented strategies/protectionism

Tariffs are imposed and imports fall
The first to be protected are final stage assembly and simple consumer goods
Over time, parts fabrication and more sophisticated manufacturing is protected
Domestic production increases and unemployment falls
Capital and intermediate goods become more expensive, otherwise why would tariff barriers be needed to promote sales of domestic equivalents?
Costs rise for exports, exports fall, and unemployment rises in the export sector

Benefits from import substitution

There is greater vertical integration within industries (both upstream and downstream)
Research, development, engineering, design, fabrication, assembly, marketing, and financing provide a richer variety of jobs
There is greater integration amongst industries (both backward and forward linkages)
Learning by doing takes place
There is less dependence on other countries, therefore less specialization and more evenly distributed development in the economy

Costs of import substitution

Infant industries never grow up because the lack of international competition leads to higher costs
With few imports of capital goods, there is virtually no technology transfer
The export sector collapses so there are no gains from trade
Economies of scale cannot be achieved because the market is too small
Balance of payments problems lead to a reduction in imported capital which is often needed for industrialization to proceed:

Producers are cut off from new technology in international markets.

The poor gain little, the major beneficiaries are the wealthy and the MNCs operating behind tariff walls
Government tends to subsidize capital, and currencies are held artificially high to encourage the use of imported capital and intermediate goods:

Industry becomes less labour intense, leading to unemployment.

Exporters of primary goods (the poor) are hurt: because LEDCs face perfectly elastic demand, they have to lower their prices to compensate for the higher currency value.

Import Substitution vs Export Promotion

Is it better for industrialization to proceed through replacing imported goods with domestically produced goods, or is export promotion more likely to lead to faster growth because of the gains from trade through specialization?

Commercial loans

Commercial loans are loans that involve buying and selling (commerce) activities, that are concerned with making a profit.

Fair trade organizations

Micro-credit schemes

Small loan amounts for a small time period often with weekly/bi-weekly payments due at a low percentage interest, often tied with entrepreneurial education (used to purchase a sewing machine, a handloom, a cow), taken out by consumers deemed uncreditworthy by commercial banks
Low default rates
Access to credit is a human right and one way to break the poverty cycle

Grameen Bank (Muhammad Yunis) Nobel Prize 2006

Foreign Direct Investment (FDI)

FDI by MNC/TNCs usually comes in a bundle including: equity and debt financing, management expertise, technology transfer, technical skills training, and access to overseas markets:

Product life cycles have reinforced the need to maintain technical superiority in order to advance, thus MNCs are extremely reluctant to un-bundle the package: they fear the technology will be exposed to a competitor who will reach the life cycle window faster

LEDC governments are attracted by the FDI bundle:

Learning by doing: is accelerated which can enable the country to cope with a technologically advanced future
Technology transfer: while embodied in a process, also includes information and the technical skills needed to adapt, install, operate and maintain capital equipment systems
Managerial shortage: LEDC govts understand the acute shortage of local managers capable of organizing and operating large scale industrial projects
Intra firm exclusion: LEDC govts realize that access to international markets is severely limited because markets are dominated by intra and inter firm transactions (50% of Canada's imports and exports are intra firm sales), MNC/TNCs are needed to gain access to this system
Marketing expertise: MNC/TNCs have preferential agreements with customers due to volume, length of time in the business, the use of standardized contracts and standardized products, it may take years for LDC producers to understand let alone break into international markets
Supply side bottlenecks: can be reduced through FDI by MNC/TNCs
National gaps in savings, foreign exchange, taxes, technology and human skills can all be filled by MNCs:

Labour: they can create jobs, develop managerial skills, and provide technical education of labour,
Capital: they can transfer technology and provide much needed physical capital
Tax revenue can be earned on the exports of natural resources which can be used to fund construction of much needed infrastructure

Foreign currency flows in from the MNC/TNC investments, and from the private earnings on the exports

Sustainable Economic Development

The process which maximizes the net benefits of economic development while maintaining the services and quality of environmental and natural resources forever

This involves:

Using natural resources at rates less than or equal to the natural rate of regeneration
Using non-renewable resources in a manner which permits recycling of materials and substitutability between natural resources and technological change

Economic development and resource usage are complementary but after a certain point development will reduce one or more of the functions of certain resources resulting in a tradeoff
Using forestry as an example:

The wood can be harvested and sold
Or the trees can be left uncut so the forest can act as a waste assimilation system or a region to absorb rain to prevent flooding
Or the trees can be left and the area used as a park for recreation

How can we make less use of natural and environmental resources:

Create a low growth, austerity economy?
Develop a high tech economy in which growth is based on very low resource usage and high technological progress?
Use renewable resources on a sustainable basis and recycle non-renewable resources?

We need to develop environmentally friendly technologies and ensure they are made available to developing countries.
Top priority must be given to:

Adequate sewage disposal and safe water
The elimination of burning fires for cooking: they cause smoke pollution both within buildings and around urban areas and contribute to deforestation
We must remove subsidies that encourage excessive use of forests, fossil fuels, irrigation water, and chemical sprays
Clarify rights to own resources
Help local communities to take ownership of their common resources:

Local participation in setting and implementing environmental policies
Teach them how to make long term decisions and investments

Develop realistic policies and strategies which:

Permit low cost monitoring and enforcement for developing countries
Use market systems of punishments and rewards rather than regulation
Restrict the power of rich resource owners and large institutions