Sunday, November 15, 2009

William Easterly's The Elusive Quest for Growth - Chapter 2

The post WWII era brought about an economic model that was misused for decades and is now considered defunct. Evsey Domar and Roy Harrod independently developed economic models that explained how aid could increase development in poor countries. Their combined work is known as the Harrod-Domar model. A summary of the theory states that to achieve a desired growth rate, a country must have a particular level of investment. But most poor countries have a low savings rate and can’t provide internal investment high enough to achieve desired growth. Thus, aid is given to fill this so-called financing gap. So countries get proper investment levels, enjoy growth and leave poverty in the dust. Or so it goes.
Easterly opens with the example of Ghana in its years of independence and explains the sense of hope that economists and Ghanians had in the 50s. He writes that President Kwame Nkrumah had a plan, banking on the idea that investment leads to growth, “to build a large hydroelectric dam on the Volta River, which would provide enough electricity to build an aluminum smelter” (26). In turn, alumina would be processed in a new refinery, which would be supplied by a new bauxite mine. The dam was also going to provide a fishing industry and irrigation capability. Our author points out that aluminum production did grow 1.5% per annum for 23 years, but all other aspects of the project were a failure and the people of Ghana are just as poor today as they were fifty years ago.
Easterly describes the failure of Ghana because he wants readers to understand that increased investment is not a lone predictor of growth. He notes the foolishness of economists for using the H-D model for nearly 40 years after the author of the model renounced it, saying that it isn’t meant to describe growth, but being based on situations involving unlimited labor supply, that it shows an increase in machines in the short run will provide growth.
He continues to argue that the H-D model is used in a flawed manner because economists assume countries receiving aid will increase savings to ensure their ability to repay loans. However, as Easterly points out, most aid recipients saved less after receiving aid. He attributes this to the idea that aid recipients are provided with no incentive to save, they just want to spend.
Finally, Easterly argues that there are two tests that must be passed before a country provides aid to another. “First, there should be a positive statistical association between aid and investment. Second, aid should pass into investment at least one for one: an additional 1 percent of GDP in aid should cause an increase of 1 percent of GDP in investment” (37). He shows that this doesn’t necessarily happen in many aid transactions. In the end this model fails to accurately predict which recipients will sustain growth. Thus, the idea should be scrapped and economists should begin building up incentives to invest in poor countries.
I am in absolute agreement with Easterly in this chapter. I believe in incentives and not freebies (with interest). It is ridiculous to consider that poor countries have an unlimited supply of labor and that machines are the only constraint. The population may be willing and hopeful to receive jobs, but there is a definite intelligence gap that exists between poor countries and rich countries where the investment would come from. This is not to insult the poor, but realistically workers can’t just begin working on any new technological machine thrown their way. The labor supply that economists should look at is the group of people who are unemployed but have the technical knowledge to begin using technology pumped in from the West. Combining the ideas that technical education takes time and the H-D model is for the short-run, aid creating quick growth is a somewhat silly concept.
I appreciate Easterly’s repetition of stating that incentives are absolutely necessary. I can say from personal experience (as can anyone), that I always make decisions based on which option provides the most incentives. Poor people and their governments around the globe are just the same; they react to incentives. Thus, as economists continue to search for solutions to poverty, they must emphasize the use of incentives and forget the notion of giving away relatively free aid.

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