Growth Problems in Developing Countries

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Growth Problems in Developing Countries

• Kristin Forbes
• MIT-Sloan School of Management
• February 2, 2006

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Overview

• Context Why this is so important
• The Washington Consensus
• A failure? Or good start?
• Role of inequality in growth
• An old (but still heated) debate
• Is this the right focus?
• Are we focusing on the wrong thing?
• Role of poverty and wealth distribution
• Role of mobility opportunity

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Context Why This is So important
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GDP Per Capita in 1980

• Source World Development Indicators, World Bank

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GDP Per Capita in 2003

• Source World Development Indicators, World Bank

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Inequality in China
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The Washington Consensus
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Key Tenets

• Countries should maintain fiscal discipline
• Education and health are high-priority
  expenditures indiscriminate subsidies are to be
  condemned
• Taxes should be levied on a broad base,
  w/moderate marginal tax rates
• Interest rates should be market determined avoid
  negative real interest rates
• A competitive real exchange rate is the first
  essential element of an outward-oriented economic
  policy
• The second element is import liberalization.
  Tariffs are far better than licenses and quotas,
  and limited tariff dispersion
• Foreign direct investment is viewed with
  considerable favor
• Privatization of public enterprises has been
  viewed with favor
• Deregulation is an important step in the
  modernization of economies that carry heavy
  burdens of detailed state control
• Property rights are fundamentally important

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Evaluation

• An abysmal failure?
• As evidenced by Argentina? False!
• Or a good startbut missing key components?
• Role of institutions (low levels of corruption,
  fair effective judicial system, etc.)
• Role of inequality/income distribution/mobility

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Role of Inequality
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An Old Debate

• Early work A positive relationship between
  inequality and growthespecially for developing
  countries
• Kaldor (1978) higher inequality initially
  important in development to raise aggregate
  savings to finance investment
• Kuznets (1955) as country initially develops,
  inequality will increase as small share of labor
  force moves from low-productivity agriculture to
  high-productivity industry
• Therefore, countries faced a tradeoff steps to
  reduce inequality might hamper growth

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Sea Change in the 1990s

• Country experience
• East Asia low inequality ? high growth
• Latin America high inequality ? low growth
• Cross-Country Growth Regressions A negative
  effect of inequality on growth
• Alesina and Rodrik (1994), Birdsall, Ross and
  Sabot (1995), Clarke (1995), Persson and
  Tabellini (1991)
• Specific Channels Why inequality has a negative
  effect on growth
• Lowers investment in human capital
• Increases political Instability
• Supports development of institutions that favor
  elite
• Lowers domestic demand and slows
  industrialization
• If true, a great result steps to reduce
  inequality will also have the additional benefit
  of raising growth

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The More Recent Debate

• Serious flaws in analysis using cross-country
  growth regressions
• Omitted variables bias, data comparability across
  countries, unrepresentative samples
• Results not robust
• Positive relationship between inequality and
  growth in within-country growth regressions
• Forbes (2000)
• Recent country examples US, China
• Closer look at models
• Many depend on other factors level of
  development, aggregate wealth, political
  institutions
• Many predict multiple equilibria
• Non-linear relationship (Banerjee Duflo, 2003)

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Is This the Right Focus?

• Previous focus income inequality
• Income can vary across years life cycle
• Inequality can increase even as everyone gets
  better off
• Focus on inequality in wealth distribution
  instead of income distribution
• Even harder to measure
• Focus on absolute levels of poverty instead of
  inequality
• Examples China, India (?)
• Poverty is the real enemy
• Evidence on inequality and happiness
• Focus on specific policies relationship to
  inequality, poverty growth, rather than direct
  link between inequality growth
• Promoting basic education inequality ? , poverty
  ? growth ?
• Higher income taxes inequality ? , poverty ?
  and growth ?

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Is This the Right Focus?

• Income mobility?
• Belief that can move up or down income ladder
• Improves toleration of inequities in income
  distribution
• The American Dream
• Becoming a Chinese dream?
• Perceived mobility/opportunity?
• Possibly even more important than actual mobility

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Final Thoughts

• Growth and development is difficult
• Can get a lot right, but just one thing wrong can
  derail progress
• Debate on inequality, distribution and growth
• Increased focus and priority
• Inequality does matter, but relationship with
  growth probably indirect
• Should not focus on inequality at expense of
  poverty
• Still more to learn role of mobilitypossibly
  even more important than inequality