Lecture notes: Economics of Development Introduction

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The neoclassical counterrevolution

In the 1980a and 1990s, it became common that international organizations such as UNDP and UNCTAD took on board the market ideology propagated by the World Bank and IMF controlled by the developed countries. In many countries, for instance, in Africa it was called for privatization of public companies and dismantling of governmental regulation. These views were supported by economists at foremost well-known American universities, who argued that the bad performance in the developed economies depended on inefficient public regulations. Fields in economics such as public choice became popular at the universities using classical approaches in neoclassical economics to analyze different forms of public failure and argued in favor of an increased role of market allocation.

While scholars belonging to the dependency school in development economics argued that the lack of development in poor countries depends on their colonial heritage, advocates of the neoclassical counterrevolution argued that underdevelopment results from poor resource allocation due to incorrect pricing and too much state intervention by developing- nation governments.

Because of their association with the World Bank, IMF and key US government agencies, it is sometimes referred to these ideas as the Washington Consensus. Dani Rodrik characterizes the Washington consensus in ten points (Table 11.1 p. 530) and there is not anything in these points that indicates the importance of eliminating absolute poverty. Obviously, the basic idea is that a high economic growth rate will take care of poverty. He also compare the ten points with the development strategy applied by the most successful Asian countries such as South Korea and Taiwan and find that the state has had a broader role in these countries than encapsulated by the Washington Consensus.

I think T/S conclusion that in an environment with widespread institutional rigidity and severe socioeconomic inequality, both markets and governments will typically fail. It is a matter of assessing each country on a case-by-case-basis.

Contemporary explanations of how to attain development

Development strategies and reduction of poverty and inequality

According to modern perspectives on development, contemporary theory of development should emphasize the problem how a society escape from absolute poverty and how inequality is reduced. It is obvious that bringing people out of poverty should be crucial, but why is inequality important.

There are at least three reasons:

1) Inequality is inefficient as it reduces saving (the middle class has the highest propensity for saving). The saving of the small group of very rich is proportionally small as the use money for luxury consumption, travels abroad and capital flight. Furthermore, investments are also hampered as a majority of the people cannot provide the collateral necessary for getting loans. With regard to investments in human capital, inequality creates a bias towards higher education, while development often is better served by increased investments in higher quality of primary and intermediate education.

2) Inequality destroy social capital such as trust relationships and solidarity by promoting rent seeking by a small elite using bribes and corruption leading to cronyism.

Yet, there are economists arguing that some inequality is necessary for development as equality tends to reduce the incentive for working hard. If you know that there is a possibility for increasing your income, to get a position with higher salary, then you are prepared to increase your productivity. The counter argument is that there is a wealth effect involved in social engineering directed to the determination of the optimal inequality with regard to working incentives. Inequality implies for the majority of the population with the lowest incomes that they cannot afford to buy food with the nourishments, and have the housing conditions, necessary for a healthy life. Due to poor health, they will not work more but less than in a situation with a more equal distribution of wealth.

3) The third reason for considering inequality in a development strategy is that it is not fair. At this point, Rawl’s notion of the “veil of ignorance” should be mentioned. He outline a laboratory experiment, where a group of people is told to imagine that they do not know their future income and wealth. Thus, all have the same probability to belong to those with the lowest incomes or to those with high incomes. Under these conditions, they are asked if they would prefer an income distribution that was more equal or one that is less equal than those they see around themselves. If the degree of inequality had no influence on the incomes, than most of the people would probably choose a distribution that is almost equal.

Obviously, it seems reasonable to rank developing countries with regard degree of development using properties of the Lorentz curves. How can this be done? (highly unequal countries have a large Gini coefficient and vise-versa). Modern explanations of how development is attained are more concerned about difficulties to reduce inequality and escape poverty traps than the classical explanations.

There are empirical evidence of how efficient the two linear stages approaches to development discussed before are to promote development.

1) Modern sector enlargement in a two sector economy like in Lewis’ model, where the modern sector is growing constantly but wages in both the traditional and the modern sector are constant. This development strategy has been practiced in East Asia by countries such as China, South Korea and Taiwan.

2) Modern sector enrichment growth, where the growth is limited to a fixed number of people in the modern sector when, at the same time, the number of workers in the traditional sector and their wages have been constant. This is the type of development has been practiced in many African and Latin American countries.

3) The traditional sector enrichment, where growth has benefited workers in traditional sectors with little growth in the modern sector. This is typical for countries that have given priority to fighting poverty at a low growth rate and low per capita income (Sri Lanka and Kerala in India).

In 1), absolute incomes are increased and absolute poverty is reduced, but as the Lorenz curves are crossing (figure 5.9) there is no clear evidence of changes in inequality. In 2), inequality is increased and no change in poverty. 3) The growth (relatively lower) results in higher incomes with a more equal distribution of income (figure 5.7)

It is sometimes held that rapid growth is bad for the poor, as they will be bypassed by structural change. This argument is supported by 2), which has no effect on poverty, while 3) with lower growth rate improves the situation of the poor. Furthermore, advocates of the inverted U Kuznets curve are arguing that in early stages of economic growth when the per capita income still is low, the distribution of incomes will be worsen; only at later stages it will be improved (figure 5.10). With Lewis model in mind, increased inequality at early stages, probably, depends on few jobs with relatively high productivity and wages in the modern sector. If we look more specifically at investments in human capital and supply and demand of skilled labor in the modern sector, we also have an explanation of why equality increases at later stages of the development process. At the early stages, skilled labor demanded by the modern sector is short in supply pushing wages in this sector upwards, while at later stages the supply of skilled workers reducing the number of unskilled.

However, few development economists would argue that the Kuznets curve is inevitable, but depends on type of development strategy chosen. This is evident from the differences between 2) and 3) above.

It is sometimes argued that redistribution from the rich to the poor will reduce economic growth as the poor save less. However, figure 5.13 does not support this conclusion. It reflects the fact that the low inequality East Asia is growing faster than the high-inequality Latin America and Sub-Saharan Africa and changes in the Gini-coefficient was small within the groups between 1960 – 1990. With regard to savings, there is empirical evidence that the middle-class has the highest saving rate, and reduction of poverty is synonymous to social mobility increasing this class. Moreover, when poor increase their incomes they save and invest in education of their children and in improved health. Altogether has a positive effect on economic growth.

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