Class 1 Development Theories and Role of Finance 2018

Development Theories in the ‘40s and ‘50s 1 Harrod-Domar Growth Model In the West, economic theory of growth was developed in its simplest form using the following formula.. Growth Rate

Development Finance, MPP, VJU

Prof Koji Fujimoto

Class 1 Development Theories and Role of Finance

Development theories have been developed since World War II but have not necessarily established academic integrity Nevertheless, this topic can be discussed, at least, from three different aspects as shown in Figure 1 below

As Figure 1 suggests, “development theories” encompass economic theories and development theories, which have been developed throughout the developed world, and represent developmental problems and issues that LDCs often confront, and development approaches/strategies that the donor community usually invents to tackle the problems and issues and therefore the LDCs exercise

To obtain a bird-eyes view of development theories, it is worthwhile to review them in chronological order

Figure 1 Development Economics and Development Theories

Conventional Economic

Theories (incl Economic

Growth Theories)

Development Theories (incl

Development Economics)

Various Development Issues/Problems in the

LDCs

Development Policies and Approaches/Strategies Employed throughout the

World

LCDs: n ướ c kém phát tri ể n

2

1 Development Theories in the ‘40s and ‘50s

(1) Harrod-Domar Growth Model

In the West, economic theory of growth was developed in its simplest form using the following formula

ΔY/Y = I/Y × ΔY/I = I/Y ÷ ΔK/ΔY,

where I/Y is Investment Ratio and ΔK/ΔY or I/ΔY is Incremental Capital Output Ratio (ICOR) ICOR measures the increment in capital required in order to produce an additional $1 worth of output A large ICOR value is not preferred to because it indicates that the economy is inefficient

The above formula is understood as follows as well

Growth Rate of GDP (g) = Investment Ratio × Inverse Ratio of ICOR

= Investment Ratio ÷ ICOR,

in other expressions,

ICOR = I/Y ÷ g = Investment Ratio/Growth Rate of GDP

The Harrod-Dormer Growth Model claims that in the closed economy

‘Investments’ are financed by ‘Savings’, and, therefore, the maximum economic

growth rate can only be attained by utilizing savings fully

(2) The Big Push (Balanced Growth) by Rosenstein-Rodan

Rosenstein-Rodan argued for a “big push”:

The theory of growth is very largely a theory of investment… A minimum quantum of investment is a necessary condition for successful development Launching a country into self-sustaining growth is a little like getting an airplane off the ground There is a critical ground speed which must be passed before the craft can become airborne… A big push seems to be required to jump over the economic obstacles to development There may be finally a phenomenon of indivisibility in the vigor and drive required for a successful development policy Isolated and small efforts may not add up to a sufficient impact on growth An atmosphere of development

=> nh ớ tên

I/Y: Investment Ratio Y= GDP= GNP= GNI dentaY/Y= Growth Rate ICOR

mô hình đơ n gi ả n nh ấ t

Development Finance, MPP, VJU

Prof Koji Fujimoto

may only arise with a minimum speed or investment size

The essence of the argument for a big push is that various investment decisions are not independent and have high risks because of the uncertainty about whether their products will find a market On the other hand, if an investment occurs on a wide front, then what may not become true in the case of a single investment project will become true for the complementary system of many investment projects: the new producers will be each other’s customers, and the complementarity of demand will reduce the risk of not finding a market Simultaneous industrialization of many sectors of the economy could be profitable for them all, even though independently no one sector would be profitable industrializing alone Governments therefore need to coordinate activities under a broadly based investment program to “jump” over the economic obstacles to development

(3) The Vicious Circle of Poverty by Ragnar Nurkse

“A poor man may not have enough to eat; being underfed, his health may be weak; being physically weak, his work capacity is low, which means that he is poor, which in turn means that he will not have enough to eat; and so on.” A situation of this sort, relating to a country as a whole, can be summed up in the trite proposition:

“a country is poor because it is poor.” (See Biography of A Subject, p.62)

The supply of capital is governed by the ability and willingness to save; the demand for capital is governed by the incentives to invest A circular relationship exists on both sides of the problem of capital formation in the poverty-ridden areas

of the world

On the supply side, there is the small capacity to save, resulting from the low level of real income The low real income is a reflection of low productivity, which

in its turn is due largely to the lack of capital The lack of capital is a result of the limited capacity to save, and so the circle is complete

On the demand side, the inducement to investment may be low because of the limited buying power of the people, which is due to their limited real income, which again is due to low productivity The low level of productivity, however, is a result of the limited amount of capital used in production, which in its turn may be

low income

Low saving > Low investment

low capital Accumulation

Supply side

Demand side

4

caused at least partly by the limited inducement to invest

The implication of the Vicious Circle of Poverty Model is the Balanced Growth Approach in development And, as a matter of fact, Nurkse’s analysis of capital accumulation puts the emphasis on “balanced growth.”

(4) Two-Sector Model by William Arthur Lewis

This model is one of the best known and, therefore, the most important development theories that students of development studies have to learn The Lewis two-sector model, originally developed in the mid-’50s, became the general theory of the development process in surplus-labor Third World nations during most of the ‘60s and through the early ‘70s

(The attached excerpt from Todaro’s Economic Development Tenth Edition

pp.115-118 explains the Lewis Model.)

(5) Stages of Economic Growth Model by Walt Whitman Rostow

Under the circumstances of a sterile intellectual environment, fueled by the cold war politics of the ‘50s and ’60s, Rostow’s “Stages of Growth Model” appealed to scholars, politicians, and administrators alike

Rostow focused on change through “five stages” in modern economies, writing

in the opening chapter of The Stages of Economic Growth:

This book presents an economic historian’s way of generalizing the sweep of modern history… It is possible to identify all societies, in their economic dimensions, as lying within one of five categories: the traditional society, the pre-conditions for take-off into self-sustaining growth, the take-off, the drive to maturity, and the age of high mass consumption

The Traditional Society

The economy is dominated by subsistence activity Output is consumed by producers; it is not traded Trade is barter where goods are exchanged directly for

Development Finance, MPP, VJU

Prof Koji Fujimoto

other goods Agriculture is the most important industry Production is labor intensive using only limited quantities of capital Technology is limited, and resource allocation is determined vary much by traditional methods of production

The Pre-conditions for Take-off

Increased specialization generates surpluses for trading There is an emergence of a transport infrastructure to support trade Entrepreneurs emerge as incomes, savings, and investment grow External trade also occurs concentrating on primary products

A strong central government encourages private enterprises

The Take-off

The “take-off” is defined as requiring all three of the following conditions: (i) a rise in the rate of productive investment from, say, 5% or less to over 10% of the national income; (ii) the development of one or more substantial manufacturing sectors, with a high rate of growth; and (iii) the existence or quick emergence of a political, social, and institutional framework that exploits the impulses to

expansion in the modern sector and the potential external economy effects of the take-off that gives growth an ongoing character The prospect of the take-off

suggested the possibility that developing nations would eventually move to

self-sustained growth, and external aid would no longer be required

(Excerpted from Meier’s Biography of A Subject and Todaro’s Economic

Development)

The Drive to Maturity

The economy is diversifying into new areas Technological innovation is providing a diverse range of investment opportunities The economy is producing

a wide range of goods and services and there is less reliance on imports Urbanization increases Technology is used widely

The Age of High Mass Consumption

The economy is geared towards mass consumption, and the level of economic activity is very high Technology is extensively used but its expansion slows The service sector becomes increasingly dominant Urbanization is complete Now, multinationals emerge Income for large numbers of persons transcends basic food, shelter and clothing Increased interest in social welfare

6

2 Development Theories from the Late ‘50s throughout the ‘60s

(1) Unbalanced Growth by A.O Hirschman

Hirschman criticized the balanced growth doctrine by saying “If a country were ready to apply the doctrine of balanced growth, then it would not be underdeveloped in the first place.”

Hirschman argues for a strategy of unbalanced growth that would promote a few key sectors with forward and backward linkages that would create disequilibrium and then induce decisions in other sectors to correct the disequilibrium An industry creates a backward linkage when it demands inputs from an upstream industry Forward linkages reduce the costs of downstream users

of the investment’s products and ease their supply

(2) The Vent-for-Surplus Theory of International Trade by Hla Myint

The assumption of full employment in traditional trade models, like that of the standard perfectly competitive equilibrium model of microeconomic theory violates the reality of unemployment and underemployment in developing nations A conclusion could be drawn from the recognition of widespread unemployment in the Third World This conclusion is that underutilized human resources create the opportunity to expand productive capacity and GNP at little or no real cost by producing for export markets products that are not demanded locally This is known

as the vent-for-surplus theory of international trade First formulated by Adam Smith, it has been expounded more recently in the context of developing nations by Hla Myint

(The attached excerpt from Todaro’s Economic Development Tenth Edition (pp

609~610) explains the Vent-for-Surplus Theory of International Trade vis-à-vis development of the developing countries.)

(3) Two-Gap Model by H B Chenery and M Bruno

This model is based on a structuralist concept of development and incorporates explicit limits on the rate of increase of domestic saving, investment, and exports

The model focuses in particular on the savings and foreign exchange constraints to development The shortage of domestic savings limits the capital accumulation in the developing country The shortage of foreign exchange limits the country’s

production possibility

saving gap foreign Exchange Gap

Fund ODA: officeal Dev Assistant Foreign Aid

2 condition =>

Development Finance, MPP, VJU

Prof Koji Fujimoto

capacity to import If the growth in GNP depends on the importation of goods that cannot be produced at home, then the country’s growth rate will be constrained by its access to foreign exchange These two gaps, the savings gap and the foreign exchange gap, might be filled by foreign aid

It might be thought that, according to neoclassical analysis, an increase in domestic savings should also relax the foreign exchange constraint through the release of resources for import-substitute industries for necessary imports, and exports may confront a highly inelastic demand

The foreign exchange constraint could bite before the savings constraint The

“two-gap model then become a “financing gap” model that claims to show the high potential productivity of foreign aid in providing exchange and thereby enabling otherwise redundant domestic savings to be used in investment (Chenery and Bruno; Chenery and A Strout)

The gap between required and available savings and between required and available foreign exchanges can be filled by an inflow of foreign loans and/or grants from governments of wealthy countries The inflow of public foreign capital

is equivalent to an inflow of savings from abroad: wealthy countries transfer their savings to investment opportunities in the poor countries By relaxing the savings and foreign exchange constraints, the inflow of foreign capital can yield an increase

in national income that is several times the cost of the foreign loan

This model can be explained in terms of macro-economic equations (the Output Approach and the Expenditure Approach)

Y = C + I + (X – M) - (1)

where Y is GNP, C is Consumption, I is Investment, X is Exports and M is Imports

The equation (1) can be rewritten as

Y + M = C + I + X - (2)

The left side of the equation (2) shows availability of domestic resources and the right side shows uses of domestic resources

From the distribution side (the Income Approach),

Y = C + S - (3)

where S is Saving

required investment => I

Available Saving => S

I - S = M- X (import - real export

8

From the equation (2) and (3), we can obtain

M – X = I – S - (4)

The left side is the foreign exchange gap and the right side is the savings gap The equation (4) shows that the foreign exchange gap is equivalent to the savings gap

on an ex-post basis In other words, it is not guaranteed that the equality holds on

to an ex-ante basis

(4) Economic Growth Approach (International Development Approach)

After WW II, to aid war-torn Western Europe the Marshall Plan (European Recovery Program), which lasted for 4 years from 1948~51, of the U.S was implemented The European economies were reconstructed and economic growth

of those countries resumed Success of the aid program was largely attributable to reconstruction of physical economic infrastructure Subsequently, the U.S and the World Bank initiated to help develop the Third World by concentrating their aid on economic infrastructure development, believing that infrastructure development would result in successful economic development of developing countries This approach of aid can be characterized as the Economic Growth Approach

3 Development Theories in the ‘70s throughout the ‘80s

(1) Dependency (Dependence) Model

During the ’70s, international-dependency models gained increasing support, especially among Third World intellectuals, as a result of growing disenchantment with both the ‘stages’ and ‘structural-change’ models Essentially, international dependency models view developing countries as beset by institutional, political, and economic rigidities, both domestic and international, caught up in a dependence and dominance relationship with wealthier countries

The dependency model is an indirect outgrowth of Marxist thinking It attributes the existence and continuance of underdevelopment primarily to the historical evolution of a highly unequal international capitalist system of wealthy country- less wealthy country relationships Whether because wealthy nations are intentionally exploitative or unintentionally neglectful, the coexistence of wealthy and poor nations in an international system dominated by such unequal power of relationships between the center (the developed countries) and the periphery (the LDCs) renders attempts by poor nations to be self-reliant and independent difficult

Development Finance, MPP, VJU

Prof Koji Fujimoto

and sometimes even impossible Certain groups in developing countries (including landlords, entrepreneurs, military rulers, merchants, salaried public officials, and trade union leaders) who enjoy high incomes, social status, and political power constitute a small elite ruling class whose principal interest is in the perpetuation of the international capitalist system of inequality and conformity by which they are rewarded Directly and indirectly, they serve (are dominated by) and are rewarded

by (are dependent on) international special-interest power groups including multinational organizations such as the World Bank and IMF, which are tied by allegiance or funding to the wealthy capitalist countries The elites’ activities and viewpoints often serve to inhibit any genuine reform efforts that might benefit the wider population and in some cases actually lead to even lower levels of living and

to the perpetuation of underdevelopment In short, the neo-Marxist/neocolonial view of underdevelopment attributes a large part of the Third World’s continuing and worsening poverty to the existence and policies of the industrial capitalist countries of the Northern Hemisphere and their extensions in the form of small but powerful elite or comprador groups in the less developed countries Underdevelopment is thus seen as an externally induced phenomenon, in contrast to the linear-stages and structural-change theories’ stress on internal constraints such

as insufficient savings and investment or lack of education and skills Revolutionary struggles or at least major restructuring of the world capitalist system are therefore required to free dependent Third World nations from the direct and indirect economic control of the developed world and domestic oppressors (See Todaro’s Tenth Edition, pp.122~124)

Dependency relationships are said to be found, in the Third World, in a variety

of forms such as “foreign capital,” “elites in LDCs,” “technologies of industrialized countries,” “terms of trade” and “cultural, social and institutional factors.”

In 1974, the UN Special Assembly resolved “New International Economic Order: NIEO.” This was the united demand of the Third World to the industrialized countries, though it was not put into practice and effect

(2) Neo-classical Approach (Neo-classical Economic Growth Theory) by Robert M Solow

A cornerstone of the neoclassical free-market argument is the assertion that liberalization of national markets draws additional domestic and foreign

10

investment and thus increases the rate of capital accumulation In terms of GNP growth, this is equivalent to raising domestic savings rates, which enhances capital-labor ratios and per capita incomes in capital-poor developing countries Traditional neoclassical models of growth are a direct outgrowth of the

Harrod-Domar (R.F Harrod & E.D Domar) and Solow models, which both stress

the importance of savings

The Solow neoclassical growth model in particular represented the seminal contribution to the neoclassical theory of growth and later earned the Nobel Prize

in economics It expanded on the Harrod-Domar formulation by adding a second factor, labor, and introducing a third independent variable, technology, to the growth equation Unlike the fixed-coefficient, constant-return-to-scale assumption

of the Harrod-Domar model, Solow’s neoclassical growth model exhibited diminishing returns to labor and capital separately and constant returns to both factors jointly Technological progress became the residual factor explaining long-term growth, and its level was assumed by Solow and other growth theorists

to be determined exogenously, that is, independently of all other factors

More formally, the Solow model used the standard aggregate production function in which

where Y is gross domestic product, K is the stock of physical capital, L is the stock of labor, A is the “technical change” or “total factor productivity (TFP)

“α” represents the elasticity of output with respect to capital (the percentage increase in GDP resulting from a 1% increase in capital)

This function is usually measured statistically as the share of capital in a country’s national income account Since α is assumed to be less than 1 and private capital is assumed to have paid its marginal product so that there are no external economies, this formulation of neoclassical growth theory yields diminishing returns to capital and labor

When the production function above is differentiated by time factor, it is shown as below

△Y/Y = △A/A + α ×△K/K + (1-α) ×△L/L

where △Y/Y is the national income growth rate, △A/A is the rate of technological improvement, α is the share of capital in national income,

đạ o hàm