SeekerBlog

“That didn’t work, so let’s try it again”

Which of the following policies have helped developing countries reduce poverty?

1. investment in physical capital

2. investment in education

3. controlling population growth

4. loans to countries in financial crisis

5. forgiving foreign debts

If you answered “None of these policies have helped” you are correct – so far as those investments have been driven by foreign aid. The $1 trillion in aid shipped to developing countries over the past 50 years has produced almost no [good] results, but plenty of bad.

I was motivated to look into the growth vs. aid factors by the February 5, 2007 EconTalk interview of Nobel Laureate Robert Lucas by economist Russ Roberts. I can’t recommend this discussion too highly — where Roberts and Lucas range over the topics of growth, wealth, poverty, immigration, and foreign aid.

Lucas commented that “The living standards of ordinary people in eighteenth-century Europe were about the same as those of people in contemporary China or ancient Rome or, indeed, as those of people in the poorest countries in the world today.” [I'm quoting from Lucas' famous "Lectures on Economic Growth (2002)" as I don't have a transcript of the podcast].

The large relative GDP per capita differences we see today [ranging from 15:1 to 30:1] are all due to (1) compounding growth rates, and (2) the complete failure of policies intended to promote growth in the 3rd world.

In the discussion on foreign aid, both Lucas and Roberts referred favorably to William Easterly’s research and books. That sent me searching up background on Easterly’s work.

Easterly’s experience (bio) includes sixteen years as a development economist for the World Bank. He the author of the 2006 book “The White Man’s Burden: How the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good”. And of the 2001 book “The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics”.

To give you an idea of what Easterly learned from his first hand World Bank experience, here is an in-depth review of The Elusive Quest for Growth by Terry J. Fitzgerald, writing in the magazine of The Federal Reserve Bank of Minneapolis. I’ll just quote from Fitzgerald’s commentary on the second section of the book:

No panaceas

The second section, “Panaceas That Failed,” is unquestionably the centerpiece of the book. Here Easterly explains and critically analyzes the economic theories and policies that guided the World Bank and IMF over the past half century. In doing so, he discredits widely held beliefs about what factors drive economic growth-including the importance of investment in physical capital, investment in education, controlled population growth, adjustment loans to countries in crisis and debt forgiveness. In Easterly’s view the IFIs have precious little to show for the more than $1 trillion in aid that has been sent to poor countries over the past 50 years guided by these strategies.

This section opens by analyzing the efficacy of policies targeted to investment in physical capital. The economic genesis of this approach is the Harrod-Domar model, which essentially posited that investment spending determined growth in gross domestic product. This theory, combined with a famous vision of investment-fueled economic “takeoffs” proposed by W. W. Rostow in 1960, resulted in the financing-gap approach to development. Under this approach Western donors should fill the financing gap between a country’s own savings rate and the level of investment required for the economy to take off and achieve the desired targeted growth rate.

Easterly carefully documents the failure of this approach: Foreign aid usually did not increase growth—or even investment, for that matter. A great irony is that Evsey Domar, co-founder of the Harrod-Domar model, disavowed the theory back in 1957, saying that it made no sense as a theory of long-run growth. Despite this and the fact that a great deal of empirical evidence has long refuted the theory, Easterly notes that the Harrod-Domar model has become “the most widely applied growth model in economic history.”

With self-deprecating humor, Easterly acknowledges his own role in the faulty policy process. He recalls visiting Russia in 1990 and saying to a companion, “This place will be booming in no time!” Then he points out that Russia has had negative growth every year since. At another point he writes, “We IFI economists used the financing-gap approach even when it clearly wasn’t working. … The idea seems to be, ‘That didn’t work, so let’s try it again.’”

Why did the financing-gap approach fail? Easterly’s answer to each of the policy failures discussed—financing-gap theory is just one of many—is (again) that the problem was not a failure of economics, but rather a failure to properly apply basic economic principles. And the principle that Easterly relentlessly rides throughout the book is that people respond to incentives. In this case, that means that giving aid did not change the incentive for people in Third World countries to invest in the future. Getting incentives “right” is, according to Easterly, the crucial consideration for promoting growth.

An important theoretic argument against the importance of physical capital accumulation as a determinant of long-run growth was provided in the seminal work of Nobel Laureate Robert Solow in the late 1950s. Easterly provides an illuminating discussion of the impact of Solow’s contribution to modern growth theory. Solow’s key observation was that due to decreasing returns to physical capital—eventually more machines aren’t that useful—technological change must be the key source of economic growth. (See the September 2002 Region interview with Solow.)

Next Easterly turns to education. Despite the widely held belief that education is the key to human and economic development, Easterly reports that “the growth response to the dramatic educational expansion of the last four decades has been distinctly disappointing.” He acknowledges his own surprise at this result but cites extensive evidence that fails to confirm the importance of education as a cause of economic growth.

For example, Easterly reports that while schooling did increase in the East Asian countries experiencing growth miracles, educational attainment actually increased more in sub-Saharan Africa, which experienced dismal growth. Furthermore, he notes that Eastern Europe and the former Soviet Union compared favorably with Western Europe and the United States in years of schooling attained, yet per capita incomes in those countries were substantially lower. (Easterly also cites the work of Peter Klenow, a Federal Reserve Bank of Minneapolis economist, who finds that variations in human capital growth—such as education—explain less than 10 percent of the variation in growth rates across countries.)

Why did the education initiative fail? If you said “people respond to incentives,” you are now playing on Easterly’s field. In this case, erecting school buildings and requiring attendance does nothing to change the incentive to invest in education. Just as with physical capital investment, there must be clear incentives for individuals to invest in education. This policy failure is a striking example of how unreliable intuition can be when it comes to formulating economic policy.

Easterly discusses other development approaches: population control efforts, “adjustment lending” and debt forgiveness. For each he provides vivid and extensive documentation of how each of them has failed, despite their intuitive appeal. For example, he reports that there is little evidence that controlling population growth increases per capita income. And the recent support of debt forgiveness by Bono of the rock group U2, the Dalai Lama and Pope John Paul II does not persuade Easterly of the value of this policy given its dismal failure over the past 20 years.

It is always easy to look back and criticize the policies of the past, and Easterly himself acknowledges that this is a bit unfair to these institutions. In fact he is more sympathetic to IFIs than are a number of other outspoken critics, including Joseph Stiglitz, former World Bank chief economist. He defends the need for the World Bank and the IMF to “subsidize the world’s poor, and … [bail] countries out of short-term crises. …” One of the valuable contributions of this section is that it demonstrates the important interplay between theory and data that is at the heart of economics. Unfortunately, in this case it seems the feedback mechanism from the data back to the policymakers was short-circuited for too long, or perhaps the institutions themselves had bad incentives (another Easterly point).

I agree with Easterly that it is essential to get the incentives right. Exactly how that is accomplished is rather complicated. Readers who have already investigated “The Logic of Political Survival” will have an excellent idea why foreign aid [delivered in the traditional manner] produces negative incentives much like the “resource curse” of oil or diamonds.

The Bush “Millennium Challenge Account” is probably a step in the right direction.

I’ll give the “last word” on Easterly’s work to David Ignatius, concluding his review of “The White Man’s Burden...” for The Washington Post’s Book World:

…With all of Easterly’s aid-bashing, one might imagine that he is a conservative promoter of market solutions. But some of his most powerful criticism is reserved for the Planners who advocated “shock therapy” free-market reforms in Eastern Europe and the former Soviet Union. Free markets can’t be imposed from outside, he insists, citing the example of the inefficient Soviet-era plants that survived their entry into the market era via their communist bosses’ genius for bartering and cronyism. “The Soviet-trained plant managers at the bottom outwitted the shock therapists at the top,” he writes. He finds a similar failure of free-market diktats in Latin America. The best era for Latin American growth was 1950 to 1980, the heyday of state intervention, while growth slowed in the market-reform years of the 1990s. As a result, Easterly argues, “the backlash against free markets is unfortunately now gaining strength in Latin America.”

So what works? Easterly’s argument is that if it’s imposed from the outside, almost nothing works — in either the economic or political sphere. It’s no accident, he argues, that the great East Asian economic success stories of recent decades — Japan, China, Taiwan, South Korea, Thailand — all took place in countries that were never successfully colonized by the West. These nations evolved their own cultures, rules and disciplines and built an indigenous foundation for rapid economic growth. The region’s laggard is the one nation that was colonized: the Philippines.

Easterly’s dissection of the interventionist impulse of the Planners is powerful. His enthusiasm for the bottom-up successes of the Searchers is less so. He’s looking hard for something encouraging to say, but it’s a measure of the potency of his corrosive analysis that the good news isn’t very convincing.

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