Arnold Kling  

Economic Growth Gauntlet

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Fredrik Erixon tosses down the gauntlet.


The reason countries are poor is not that they lack
infrastructure – be it roads, railways, dams, pylons,
schools or health clinics. Rather, it is because they lack
the institutions of the free society: property rights, the
rule of law, free markets, and limited government.
  • In a majority of poor countries, the average poor
    person is typically unable to own and transfer
    property. Courts of law are slow, expensive and
    corrupt.

  • Government plays a large role in the economy and
    government policies undermine incentives to engage
    in mutually beneficent economic activities.

He argues that economic aid is counterproductive, because it reinforces corrupt governments. Thanks to Global Growth Blog for the pointer.


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COMMENTS (13 to date)
Sloth writes:

Yet more evidence that politicians need to be forced into taking principles of economics. Too many people think that throwing money around can solve any problem without thinking about what incentives that creates.

Tom Kaminski writes:

I'm very thankful for this post. When I started reading all the stuff about Tony Blair and Bob Geldoff and the need for more African aid, I thought, hasn't anyone been paying attention to what has happened in Africa for the last 50 years?! Hasn't anyone read Lord Bauer or Hernando de Soto? How can people think that sending more money to African governments is going to have a different effect? What are they thinking?! Oh well, political correctness and public relations trump solid policy and solid economics once again. tk

Ann writes:

I used to think that poor countries simply needed a little (or a lot?) of capital to get them going, but that just doesn't fit the evidence.

I was in Asia in the mid-1990s and saw how Western businessmen were willing to crawl and beg for the chance to build developing-country infrastructure through build-operate-transfer projects. Western businesses will fully finance roads, power plants, whatever the country needs, for a promised 18% return spread over many (20 or more) years. The return has to be a bit on the high side, but not excessive, and the infrastructure gets built quickly and efficiently.

The catch? Businesses want a reasonable chance of actually getting paid back. They're not willing to spend a billion dollars building a power plant, only to have the government "renegotiate" once the plant is complete.

Businesses might be a bit slower to flock to Africa, given its track record. But if governments put in place modern legal, political and economic infrastructure, the rest will take care of itself.

Sloth writes:

One could argue that the lack (or even removal) of personal property rights is responsible for most famine related fatalities. It makes me think of the Great Leap Forward where efficient farmers who had a stake in what they produced were eliminated in favor of communal farming, and the deaths that followed.

Roger writes:

PJ O'Roarke's book "Eat the Rich" describes Tanzania as the country that holds the world record for the amount of aid received since WWII, yet it's Africa's poorest country. The leader of the country for almost 50 years was a dedicated Marxist and ran his country into the ground. When he retired, he apologized! Also, I used to work with a lady from Kenya who told me that African families working int he US transfer around $50 billion/year back home, far more than we could ever persuade Congress to give. Yet, what has it accomplished?

J Bennett writes:

Tom K., your thoughts are my thoughts....this post reflects Hernando DeSoto's work in "The Mystery of Capital." In other words, without the basic STRUCTURES of capitalism, you can't HAVE capitalism. The tragedy is that these miserable development failures (whether in the Third World or in the former Soviet Union) get pinned on capitalism rather than on where they belong...corrupt and/or ignorant political leaders.

I would also commend William Easterly's book, "The Elusive Quest for Growth," published 2001, which is extremely relevant to all of the Live8 stuff. It was a real eye-opener...Easterly's essential premise is basic economics: People respond to incentives. And the "incentives" in the vast majority of development projects have been all wrong. The history of development is a real tragedy...

William Woodruff writes:

Ann,


Yes, Africa must take, and in many of her countries does take the blame for its wars (hmmm, we have those in the developed world, too) corruption (Enron, anyone) and government support (need I mention the US Government represents 15% of GDP).

But honestly, we need to look, as well in the mirror for some of the roots to Africa's problems.
America and the EU spout "free trade" yet, support its farmers to the tune of hundreds of Billions of Euro and Dollars every year, making it impossible for African farmers to obtain a fair prices for its goods on world markets. Then, the US and Euro shutter their borders to African exports. Where is the free access to African sugar (the US places a firm quota on all foreign sugar), fruit (we and the EU protect fruit and grain producers) and the list could go on and on....

Farmers, producers and businesses who benefit from these protectionistic measures love the idea of African debt relief, because it does not address on of the root causes of structural problems on the continent.

William

Sloth writes:

William: You are missing the basic point though. Africa would become better of as a continent regardless of what anyone else does if private property rights existed. The gains from trading inside the continent alone would make everyone better off as food would move from good agricultural areas to bad ones, and other goods would work the opposite way.

Without ownership there is no incentive to invest in capital stock. With corrupt governments that don't allow trade across borders there is no feasible way to specialize. Even worse, with governments that have no problem with killing their own citizens, there is no real hope for a stable economy.

You can blame "western" countries for ruining Africa, but no matter what politicians here do Africa as a whole will not improve until the leadership changes.

M. Strowbridge writes:

America would be better off without rent control, agricultural subsidies, trade restrictions (except in national security cases), non-market-tradable environmental sanctions, domestic disaster relief, and bizarre tax rules, but a Third World country is a different animal. The Washington consensus -- the idea that limited government necessarily leads to greater growth than intrusive government -- is too simplistic. It roughly explains why the West did better than the Warsaw Pact, and why many Third World kleptocracies are so poor, but it doesn't explain everthing. Russia, since its independence, and Argentina have stagnated with liberalized economies. Conversely, China has grown under heavy-handed government regulation and, if I recall correctly, a high level of government spending for such a poor country. The right recipe for economic growth is complicated.

From Brad Sester:

June 14, 2005
How to explain China's success?

If China were growing slowly, there would be no shortage of potential explanations.

Free labor market in China? Not even close. The household permit system is an enormous impediment to free labor mobility within the renminbi currency union. And China has its share of linguistic differences as well.

A free internal market in goods? Sort of. But local authorities often seem to try to rig local markets to favor local producers. There is no shortage of what Europeans call "state aid" at the local level.

A functioning equity market? Not really. Set aside the fact that China's domestic stock markets are in a deep slump. Stock market slumps happen everywhere. There is little other evidence of functioning equity markets. Firms raised very little capital on the stock market over the past couple of years. And most listed firms are controlled by the state. There certainly is no market for corporate control.

A market-based banking system? Not really. Deposit rates are capped at very low levels to protect the financial health of the banking system. Lending rates are no longer controlled, but the quantity of loans that the banks can offer certainly is. Credit is certainly not allocated in an open market. The four biggest banks are all owned by the central government; the fast growing joint stock commercial banks are generally owned by local authorities.

A free market in land? Not at all. China is still a communist country. Land is the property of everyone, or no one ...

An economist looking for distortions that might inhibit economic growth would have no trouble finding them. The puzzle: despite all these distortions, China has grown very rapidly. And it still is.

What does this tell us?

It seems that there are four potential explanations for China's growth.

1) State intervention in the economy (or certain forms of state intervention at certain stages in the development process) is less of an impediment that is often argued.

That is the lesson Putin seems to have drawn. And it is not just Putin. Joe Stiglitz argues that China's success demonstrates the limits of "Washington Consensus" politics. And it is not just left-leaning economists either. There are plenty of other defenders of Chinese intervention -- at least in certain markets -- outside of China.

Foreign businessmen operating in China generally don't object to massive government intervention to keep the RMB from rising (It should be noted that many economists also support various forms of exchange rate pegs, though not necessarily pegs designed to keep a country's currency undervalued for an extended period of time). I don't hear real estate developers here in the US complaining about the intervention by foreign governments in US credit markets (all the bonds purchased with growing dollar reserves), intervention that is contributing to low interest rates and the real estate boom. State intervention certainly helps some even if hurts others. In China, state intervention often seems to help at least certain types of business at the expense of Chinese labor, and other interests inside China.

2) China's markets are far more flexible than they seem.

Internal migration is controlled in theory but not in practice, so China has its own "undocumented" internal migrants, migrants who cannot generally work in the state sector and thus are available for private employment. In addition to the formal banking system, informal networks help growing private firms obtain credit.

3) High savings rates and high investment rates can overcome a multitude of other sins.

In a macroeconomic sense, China is defined above all by very high rates of domestic savings and domestic investment (something it shares with other Asian "tiger" economies). Domestic savings per se does not always lead to domestic investment -- high levels of savings can be used to build up bank accounts abroad. But in China -- and elsewhere in Asia -- domestic savings generally has been used to finance high levels of domestic investment. Moreover, a history of macroeconomic stability means most savings are kept in local currency denominated bank accounts -- a huge advantage.

4) High savings, high investment rates and undervalued exchange rate can overcome other sins.

The undervalued exchange rate creates an incentive for domestic firms to test themselves in foreign markets, and foreign firms to use the country as a base for production to serve their home markets. In the process they bring access to key distribution networks, and needed technology and know-how. An undervalued exchange rate that keeps local labor "cheap" on a global scale is in effect the bribe the country pays to attract foreign expertise.

Personally, I suspect high savings rates and high investment rates are the most important factors. Avoiding major currency overvaluations is also important -- though I am not sure China's current undervaluation (explanation 4) is as necessary as many argue.

The biggest question -- implicitly raised by Guy de Jonquieres in today's Financial Times, though he focuses more on other Asian economies -- is whether China's current model is sustainable. My strong sense is that the answer is no. 30% y/y export growth implies that China's exports would more than double every three years. $600b in exports becomes $1300b in 2007, and $2800 b in 2010. I suspect China now has become big enough that it needs to contribute to global (consumption) demand, not just global supply. How and when that transition will come, however, remains a huge question.

Posted by brad at June 14, 2005 08:56

Roger writes:

People make too much of China. Sure the growth rate is high, but look at their starting point. When Deng Xiao Ping freed farmers to grow what they wanted and make a profit from it in the mid '80s, the entire country was on the verge of starving to death, kept alive by enormous grain shipments from the US. Per capita income was about the lowest in the entire world. If your per capita income is $200, you can triple it, 300% growth, and still be dirt poor. China will have to grow at 8% a year for many years in order to equal just 3% growth in the US for one year.

China is an exception in many ways. Ethnic Chinese across Asia, from Thailand to the Philippines, generated almost all of the growth in the region. When China opened up its economy, these expatriates poured money into their home country, thereby starting and continuing to fuel its growth. But China lacked the institutions to protect those new investments. No problem; none of the countries in Asia in which the ethnic Chinese have succeeded so well had sound institutions either. The ethnic Chinese always resorted to family connections, political connections and bribery to protect their investments. They had to because the government could not or would not. They have used the same approach in China and it has worked well for them.

The fact that the government has spent billions of dollars at the same time that the economy has grown doesn't necessarily prove that such spending generated the growth. Remember: correlation does not prove causation. The "investments" by the Chinese government have been tremendous wastes. In fact, I would argue that the economy has grown in spite of the government investment, not because of it.

Can the Chinese model continue for long? Probably not. Just as the structural problems of the Japanese and German economies, the darlings of the '80s, caused them to hit a brick wall, those of China will do the same. But the Chinese appear to be more flexible and open to change. I think they will respond quickly to problems and fair better.

Tony writes:

Of course, in a monolithic libertarian world, it must be only one cause (how much property rights are respected and liquid), and certainly not many different complex causes.

And the amount of money that has been donated in the past, no matter how much $ went to corrupt leader's swiss bank accounts or was just based on US or USSR foreign policy trying to buy support, is evidence of "infrastructure" in Africa that has failed to lead to economic success.

spencer writes:

while you are on this subject maybe you ought to look at the work of MIT's Daron Acemoglu the newest winner of the John Bates Clark Metal,
awarded every other year to the top economist under 40. His work focuses on the interaction of political and social institutions on the economy.

He is now working on the interaction of public health and economic growth.

Roger writes:

Tony,
China began its growth with the death of Mao Tse Dung and the institutional reforms of Deng Xio Ping. Deng freed people, primarily farmers, to use their property as they wished and earn a profit. In other words, he strengthened property rights. All of the rest is pretty insignificant. Concerning aid and government spending, it's all dwarfed by private investment from ethnic Chinese around the world. If you could regress the investment of ethnic Chinese, Chinese gov spending, and aid on the growth of the Chinese economy, I have no doubt that only investment by ethnic Chinese would prove significant. Why did the ethnic Chinese invest in China after Ping came to power and not before? The answer has to be that they knew they could protect their investment somehow, not to mention the fact that Mao would not permit private investment at all.

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