Strategies Influencing Growth and Development
Development economics is a branch of the subject concerned with identifying an appropriate development strategy (a combination of objectives and policies) to promote growth and development. Some economists argue that harnessing the power of free market forces (market oriented strategies) is the best path to development, while others argue for a greater role of state planning (interventionist strategies). Some countries use a combination of both, together with other strategies, including accepting foreign aid and help from non-governmental organisations (NGOs) which are mainly charities or not for profit organisations.
Trade liberalisation – This involves dismantling protectionist measures and exposing the domestic economy to global competition. After world war two, much of the world adopted communist state planning, with very little trade with the capitalist world. The emphasis was on self sufficiency and replacing imports with domestic goods (import substitution). Some countries like India, which gained independence from an imperial power also adopted this approach.
The case for trade liberalisation rests on the theory of comparative advantage. It also argues that exposing the domestic economy to global competition will, in the long term produce dynamic efficiency gains, because protectionism enables industries to avoid introducing better methods of production and more innovative products.
Trade liberalisation also allows the country to adopt an export-led growth strategy; accessing world markets for the goods where it has a comparative and competitive advantage. China is a good example of export led growth following the country’s membership of the World Trade Organisation.
Promotion of foreign direct investment (FDI) – Many developing countries try to attract inward investment from multi-national companies. This can contribute to both growth and development, particularly if it is accompanied by technology transfer and training of the workforce. China has been particularly successful at this, particularly by insisting on joint ventures with foreign companies to ensure that there is a technology transfer. This can enable the country to go on to develop its own companies in those industries. China now has a booming car industry of its own, for instance.
But not all developing countries are in a position to negotiate such favourable joint ventures, especially if they are smaller, less powerful countries. In some cases FDI simply enables a multi-national company to exploit very cheap labour and pay very little tax in the host country. In some cases, the foreign companies may also be attracted by low environmental standards, so that toxic waste can be disposed of more cheaply than in developed countries.
Removal of subsidies – In many developing countries governments spend substantial sums on subsidising essential goods such as fuel, food, electricity and water supply. This may help to alleviate absolute poverty but many economists believe it hinders rather than promotes development, for the following reasons:
- They divert scarce tax revenue from being spent on things like health and education, that would better help development (there is an opportunity cost).
- Subsidies are poorly targeted. Not everyone needs help to pay for essentials. It might be better to give a means-tested cash benefit to those who need it instead.
- Subsidies encourage corruption. For instance in Venezuela, cheap petrol and diesel is smuggled out of the country and sold at a higher price.
Floating exchange rates – In some developing countries, governments try to maintain an artificially high exchange rate, often by using exchange controls. This may help to keep down the prices of imported goods, but it can also make the economy internationally less competitive. A floating rate can assist development by helping to make exports more competitive. But it may also mean a sharp rise in prices of imported goods, adding to poverty in the short run.
_Privatisation _– In some developing countries much of the economy is state owned. Privatisation may lead to greater efficiency and therefore contribute to growth and development, but not if it leads to a private monopoly replacing a state monopoly. Privatisation needs to be accompanied by appropriate d-regulation and competition. If the industry is a natural monopoly, such as water supply, it may need to be regulated to prevent exploitation of consumers.
Microfinance – Most banks are not interested in lending to individuals who want to borrow very small sums of money (often less than the equivalent of £100) to start a small business. Microfinance, sometimes provided by charities, but increasingly by commercial lenders can fill that gap. But these lenders charge high interest rates, to cover the high risk of default, and it can result in more indebtedness if borrowers are badly advised or do not have a sensible business plan.
_Development of human capital _– Government spending on education is likely to contribute significantly to development in the long run, as it raises productivity and makes the country more attractive for FDI. Studies also show that educating girls pays a higher dividend than boys, because educated women are more likely to seek employment than uneducated women, and will also choose to have fewer children.
_Protectionism _– Some countries have successfully industrialised and achieved high levels of development through protectionist policies. The U.S.A, Japan and Germany are outstanding examples from the 19th century. But more recent evidence suggests that protectionist strategies limit development as there is little incentive to improve competitiveness and achieve dynamic efficiency gains. For instance, India has lagged behind countries like S Korea and China, both of whom adopted trade liberalisation strategies, whereas India went for import substitution in the 20th century.
Managed exchange rates – A developing country may try to keep its exchange rate below the free market level, in order to make exports more competitive. This carries the risk of inflation and high import prices, which may cause social unrest if it leads to high prices for essentials and produces more poverty. Alternatively, it may try to maintain an overvalued currency. This will keep import prices down and may enable the country to import investment goods more cheaply. But it will mean high interest rates to maintain the exchange rate, which could damage growth and development.
Buffer stock schemes – Developing countries that rely on exports of primary products face the problem of price volatility. This is particularly true for agricultural products, where harvests can vary because of weather and pests. This in turn makes farmers’ incomes unpredictable from year to year, which makes long term planning and investment difficult, and hence impedes development. A buffer stock scheme is illustrated in Fig 1 below:
PE and QE are respectively the long run equilibrium price and output. But suppose that actual output can fluctuate between__ QW__ and QX. This means that price will fluctuate between PW and PX.
In order to reduce price (and income) volatility, a buffer stock scheme is set up, with the aim of keeping prices within the range P1 to P2. These are called the intervention prices (respectively the ‘ceiling’ and ‘floor’ prices).
Suppose there is an abundant harvest in Year X, so that QX is produced. In order to push price up to the ‘floor’ price, the buffer stock manager has to take quantity QV __to __QX off the market and put it into storage.
In Year W there is a crop failure and only QW is produced. The buffer stock manager has to release from stocks quantity QW to __QZ __in order to push price down to the ‘ceiling’.
Buffer stock schemes have a number of difficulties:
- They tie up capital as money is needed to buy up stocks when there is a glut.
- Unless all producers in all countries that grow the crop are part of the scheme, there is a potential free rider problem; producers outside the scheme benefit from higher prices when output is put into storage without contributing to the cost.
- If the long run average price is falling, because of improved technology and crop yields, the buffer stocks will become unmanageable large and the scheme may collapse.
_Infrastructure _– The network of roads, rail, air and sea ports, telecommunications, water and power supply are all vital to development. The most developed countries tend to have much better infrastructure than less developed ones. One reason for China’s rapid development is the vast amount of resources that the state has put into big infrastructure projects, such as motorways, ‘bullet trains’, power stations and airports. This has been achieved through a mixture of public and private investment, but with a lot of central planning.
_The Lewis model _– W Arthur Lewis argued that encouraging migration from the countryside to cities could promote development. Lewis argued that productivity is higher in manufacturing and services (mainly found in cities) compared to agriculture. Forced migration happened in the U.K. during the industrial revolution as landowners appropriated common land, forcing agricultural workers to find employment in factories in the rapidly growing towns and cities.
But there is little evidence that government policy to encourage migration or promote industrialisation achieves more rapid development. Migration will happen naturally if urban incomes are higher than incomes in rural areas. There is a risk that forced migration will simply create urban poverty and overcrowding if governments encourage migration at a pace that cities cannot absorb.
Fair trade – An increasing number of NGOs now run fair trade schemes, which guarantee producers a ‘fair’ price (above the free market level), enabling farmers to receive higher incomes and investment in community schemes such as schools, water supply and hospitals. Fair trade also aims to stop exploitative working conditions and child labour.
Products such as coffee and bananas are now widely seen sold in supermarkets in developed countries under the Fairtrade label. The extent to which fair trade contributes to development is questionable, however. Critics argue that it may slow development in the long run, since it perpetuates developing countries reliance on low productivity industries. Without fair trade, these countries may be encouraged to industrialise faster. Also, fair trade, by raising prices for some producers leads to expansion of output and a collapse in the prices received by producers not part of such schemes.
Development of primary industries – Countries with large endowments of valuable natural resources can avoid the ‘resource curse’ if the resources are appropriately managed. Kuwait, Norway and Australia are good examples. Some of the revenues from natural resources can be invested by the state in sovereign wealth funds (often used to purchase overseas assets) and provide an income for future generations. Investing the revenues abroad also helps to prevent the exchange rate from rising, leading to ‘Dutch disease’.
_Tourism _– The promotion of tourism has been a major feature of development strategies in recent decades. It benefits from a high income elasticity of demand and therefore it is a growth industry as incomes rise. Higher incomes in China, for instance have resulted in many millions of Chinese tourists travelling abroad each year.
Promoting tourism is an attractive option for many developing countries as it employs large numbers of low skilled workers and can generate large invisible export earnings. Many of them also have natural advantages such as a warm climate, historical sites and spectacular scenery.
But the unregulated expansion of tourism can create problems. Ugly development and environmental degradation are major issues. Luxury foreign owned resorts may not source many local products and can lead to political and social tensions, particularly if tourists do not respect local customs and values.
_Foreign aid _– Since world war two, a transfer of income from rich to poor countries has been an important part of the global strategy to promote development. It involves governments, NGOs (such as OXFAM and Save The Children) and intergovernmental organisations such as The World Bank
The case for foreign aid rests to some extent on the problems of the ‘savings gap’ and the ‘foreign currency gap’ that make it difficult for poor countries to finance investment.
Aid can be given in a number of ways:
GRANTS – These can be given as cash or in goods or services. For instance the donor country might finance and construct a hospital.
_LOANS _– These are usually below market rates of interest and called soft loans.
TIED AID – This means that the aid has to spent on goods or services provided by the donor country. This may have more to do with subsidising exports from the donor country than helping the recipient country. The U.K. no longer gives tied aid.
MULTILATERAL AID – This is aid that is paid by governments to international organisations such as The World Bank, which then distributes it to recipient countries.
Economists are divided in their views about the long term benefits of aid. Critics argue that a lot of aid money is wasted because of corruption in recipient countries; it can be siphoned off and end up in private bank accounts. A lot of aid also gets diverted into spending on weapons rather than what it was intended for.
Some aid infrastructure projects are inappropriate because the recipient country may lack the necessary technical skills or resources to maintain them.
Giving food as aid is particularly criticised because it can destroy markets for local farmers and create aid dependency.
Aid given as loans can create indebtedness. This is particularly likely to occur if the loans were not put to a productive use, as it would not then generate additional income to pay back the loan and interest.
Debt relief – Many developing countries have had a crippling debt burden. This has been most severe in the very poorest countries, the so called Heavily Indebted Poor Countries (HIPCs). There are 36 HIPCs, of which 30 are in Africa and the rest in Asia and South America.
There was a strong moral case for writing off much of this debt. In some cases the interest payments alone swallowed over half of a country’s export earnings, creating an even worse problem of poverty.
Some economists are critical of debt relief. They argue it creates a moral hazard; it sends the wrong message to debtor countries, who may borrow recklessly again in the expectation of more debt relief. It also means the debtor countries may be less likely to implement economic reforms to prevent it happening again.
The Role of International Organisations in Development
_The World Bank for Reconstruction and Development _– It is usually referred to just as ‘The world Bank. It was set up after world war two, along with the IMF. It funnels multi-lateral aid to poorer countries, mainly in the form of long-term soft loans for infrastructure or health or education projects. It is criticised by some economists because the aid is often granted in return for the country adopting more market oriented development policies which may result in more control over the country’s economy and resources by big western multinational companies.
The International Monetary Fund (IMF) – The IMF provides short term assistance to countries which have a severe shortage of foreign exchange and are in danger of defaulting on repayment of debt. It is not only the poorest countries that have had to borrow from the IMF. Britain did in the 1970s and Greece has had to borrow large sums since the financial crisis in 2008.
Again, critics argue that the IMF only gives loans if the recipient adopts very harsh austerity policies, such as cuts in public spending, tax increases and devaluation of the currency that pushes up prices of imported food and other essentials.
Non-governmental organisations (NGOs) – These include charities such as OXFAM and Christian Aid and non-profit organisations such as fair trade schemes. They can make a limited contribution to development through funding aid projects, but they also act as pressure groups on rich countries. For instance, these charities were very influential in the discussions which led to the debt relief programme adopted in 2000.
- Identify five policies that could contribute to a market-oriented development strategy.
- Your answer should include: trade liberalisation / foreign direct investment; privatisation / floating exchange rate / microfinance / removal of subsidies