Economics Question: Does Poverty Force People to Spend More?

Is being poor self-reinforcing because it forces one to spend more on stuff a little bit at a time over time, as opposed to saving up and/or forking over a large sum at once, and eventually spending less?

I don’t consider myself “poor,” but I do have a personal situation that illustrates the question:

I have dental problems. That’s no secret — I’ve talked about it, and other people have talked about it, both to my face and behind my back (no, Sully, it’s not “meth mouth” — I’m not a druggie).

I’ve had these problems for years, and have taken steps toward getting them corrected. A couple of years ago, for example, I had all of my top teeth pulled and got a denture. That ended up costing around a thousand bucks.

The denture only got used for awhile. My remaining bottom teeth are so fragile that if I wear the denture, it breaks them … and I haven’t been able to afford to address the bottom teeth yet.

Essentially, I need another thousand bucks worth of dental work (at a minimum — if I go to one of the $299 denture places, they’ll extract my remaining teeth for $30 a pop, so $600 for two dentures since the old one has long since ceased to fit due to gum shrinkage, and $340 for the extractions).

Since I don’t have a thousand spare bucks to get all that done, I spend money on benzocaine gel, over-the-counter pain relievers and decongestants (I’ve noticed that usually the most painful times are when I’m congested — I guess the sinuses press on the tooth nerves), occasionally on antibiotics, etc.

I can attest with certainty that I’ve also missed out on opportunities to make more money due to this problem. Not only am I embarrassed to be seen this way (which means that I no longer do public speaking engagements, which have been an occasional income source in the past), but I spend probably a week out of each month in severe, sometimes literally blinding, pain that reduces my personal productivity.

And, like I said, I don’t consider myself “poor.” Granted, I personally make little enough that even if I consented to fill out tax returns I’d have little or no liability; and granted, until very recently about half (sometimes more!) of what I made went to a child support obligation; but my significant other makes fairly good money, nobody’s starving at my house, and we do live beyond the bare necessities.

I suspect that laying out a thousand bucks at a whack is a pretty big deal for most people, and out of the question for the truly “poor.”

I also suspect that this is self-reinforcing because various things nickel-and-dime the truly poor to death and stop them from getting out of the hole.

A newer car would set them back three grand, but they can’t manage that … so they trickle out $50 or $100 a month repairing the old clunker because they absolutely have to have it to get to work.

Or they mow two or three yards a week and know they could make good money running a full-time lawn service, but they can’t fork over for the additional equipment and other startup costs, so they just keep on working at Taco Bell.

Or any health problem — mine above is just an example — costs them X days in lost income from being off work each year, but they can’t get the cash together to get it correctly addressed, so they spend a little bit at a time on pain reduction and such and just try to muddle through.

I assume that this is a well-described economic phenomenon, but I thought I’d bring it up for comment. It’s pretty much a matter of needing to post something to the blog, and the only thing on my mind being this damn toothache. So anyway, discuss.

Is Socialism an Ex Ante Rationalization?

A while back, I asked if libertarian political theory was an ex post rationalization used simply to justify the cause of freedom without actually explaining why it worked. It seems reasonable to ask a similar question of socialism: is socialist political theory* simply a rationalization for pursuing a certain course of action?

At first blush, the answer is no. Socialist theory is pretty robust and generally accepted as sound. For example, one tenet of socialism is the redistribution of wealth, wherein it is theorized that poverty can be eliminated by taking money from rich people and giving it to those classified as poor. This proposition is so self-evidently true that it borders on being tautological.Yet, every time the redistribution of wealth is put into practice, it generally tends to not eliminate poverty. Of course, poverty can never be eliminated if it is defined in relative terms. But, even when poverty is defined absolutely, there are still some who persist in living in poverty, and no government program is apparently able to change that fact.

Thus, it is to be concluded that socialism is nothing more than an ex ante rationalization. How else to explain its unmitigated and predictable failure? Incidentally, the reason why socialism continues to fail in practice is simply due to the fact that the theory is predicated on artificial class constructions, and can therefore never truly and properly account for individual motivation. It should be note, though, that libertarian political theory accounts for individual motivation but is still incapable of explaining why humans do what they do.

At any rate, the easily observed fact of the matter is that socialist political theory has little grasp of reality, and continues to fail miserably. It only use is in convincing people that there is a reason to try collectivism in spite of its miserable and repetitive failures.

* Please note that “socialist political theory” is a broad term that covers any political movement that generally tends toward increasing government power instead of limiting it. This stands in contrast to libertarian political theory, which refers to any political movement that attempts to limit government power instead of increasing it.

Still No Sympathy for the Poor

Here’s Bryan Caplan:

What about the “losers”? Bite your tongue. When you call lower-income people “losers,” you’re falsely assuming that we’re all racing for the same finish line: material success. But to a large extent, lower-income people are just racing for other finish lines. Leftist outrage over income inequality is therefore deeply misguided. To a large extent, incomes differ because priorities differ. And if the poor don’t consider their lack of riches a big deal, why should anyone else?

As I wrote before, most poor people are where they are because of the choices they’ve made in their life. In fact, it is fair to say that, all things being equal, they don’t want to be rich. They would rather have whatever they have instead of wealth.
Note that this isn’t some deep psychological analysis, but rather a tautology: by their fruits ye shall know them. You can tell that most poor people want to be poor (or, more accurately, have what they have instead of wealth) by the mere virtue of the fact that they are poor. At this point in time, the markers of poverty are fairly well-known, and so only the astonishingly ignorant do not know what is needed to avoid poverty.
Thus, most poor people know that their past actions would likely lead to poverty, yet they made them anyway. Since they knowingly made those decisions, they are no more deserving of anyone’s pity than child who sticks his finger on a hot stove after being told not to do so.
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Welfare

I’ve been meaning to comment on this for a very long while:

Many people think life without the welfare state would be chaos. In their minds, nobody would help support the less fortunate, and there would be riots in the streets. Little do they know that people found innovative ways of supporting each other before the welfare state existed. One of the most important of these ways was the mutual-aid society.

Mutual aid, also known as fraternalism, refers to social organizations that gathered dues and paid benefits to members facing hardship. According to David Beito in From Mutual Aid to the Welfare State, there was a “great stigma” attached to accepting government aid or private charity during the late 18th and early 19th centuries. Mutual aid, on the other hand, did not carry the same stigma. It was based on reciprocity: today’s mutual-aid recipient could be tomorrow’s donor, and vice versa.

One critique of libertarianism is that it has no regard for poor people, as if only the government is capable of showing concern for poor people. Of course, governments have historically ignored the plight of the poor, and thus it is an historical anomaly in the first place that the government even offers any aid to poor people.

That aside, the historical norm, at least in America, is that poor people were generally helped by mutual aid societies. Or, stated another way, welfare was primarily a market function. In keeping with this, the market served admirably in this capacity, encouraging poor people to engage in thrift and to comply with certain social norms. In many ways, then, mutual aid societies are superior to their state-run alternatives because they encourage positive behaviors instead of subsidizing counterproductive behaviors.

The current system does indeed leave much to be desired. It does not go far enough in tying aid to productive behaviors. Even with the recent reforms, there are still some who successfully game the system. Welfare workers are understaffed, preventing them from policing recipients as they should. Recipients, then, are able to get money without having to work or in some way improve their life. The government is, in many ways, impotent to address this problem because there are many interest groups who would charge the government with targeting minorities by requiring that they change their culture. In essence, the government is hamstrung by multiculturalism.

As such, the current form of welfare is not only expensive, but it is considerably inferior to its free market alternative because it cannot offer near the same amount of accountability that market-based forms of welfare do. Thus, the libertarian doctrine that welfare should not be a state activity is actually quite reasonable for the free market has actually done a better job at charity than the government has.

What the 'Long Tail' used to refer to

More back to the future in a way.  Income, poverty and general distribution issues used to be bigger topics in both academic research as well as the media and public discourse.  I once had a whole class just in how to measure poverty.  Seems to be a resurgence in the whole topic.

American Community Survey income distribution for households in the Pittsburgh MSA looks like this:

HOUSEHOLD INCOME IN THE PAST 12 MONTHS (IN 2010 INFLATION-ADJUSTED DOLLARS)

Universe: Households

2010 American Community Survey 1-Year Estimates

Pittsburgh, PA Metro Area
Estimate Margin of Error
Total: 978,959 +/-8,063
Less than $10,000 75,445 +/-4,207
$10,000 to $14,999 60,079 +/-3,254
$15,000 to $19,999 62,736 +/-3,285
$20,000 to $24,999 65,678 +/-3,660
$25,000 to $29,999 55,960 +/-3,892
$30,000 to $34,999 58,099 +/-3,570
$35,000 to $39,999 47,868 +/-2,885
$40,000 to $44,999 48,436 +/-2,846
$45,000 to $49,999 41,672 +/-3,031
$50,000 to $59,999 83,244 +/-4,605
$60,000 to $74,999 100,043 +/-4,547
$75,000 to $99,999 115,755 +/-5,690
$100,000 to $124,999 67,399 +/-3,740
$125,000 to $149,999 33,898 +/-2,113
$150,000 to $199,999 32,787 +/-2,388
$200,000 or more 29,860 +/-2,590

Household financial choice of the hapless households of India

In February 2010, I had the opportunity to visit Pudhuaaru KGFS in Thanjavur. This is a remarkable project which helps us see the interface between households and the financial system in a wholly new light.

What a difference 17 months makes! On that visit, I had found a little tenuous Reliance CDMA cover at one place in Thanjavur city. On
this visit, I found 3g or Edge cover in many remote places. On that visit, the ride from the airport at Tiruchirapalli to Thanjavur took
two hours. This time, it got done in 30 minutes on the new NHAI road, with a peak velocity of 110 kph. While there are many reasons to be gloomy about the problems that India faces, some things are moving along merrily.

The KGFS approach to households and finance

KGFS emphasises the very important idea that for households to correctly engage with the financial system, this relationship must be
(a) rooted in high quality advice, (b) which is grounded in a state of strong information about the household. The first is achieved by
focusing on the incentives of the front line staff, by pushing them to think about household financial choice in its entirety instead of
thinking about one product at a time, and by having no sales commission.

The removal of asymmetric information matters in many ways. On one dimension, if credit is extended to the household, a state of high information helps ensure better credit decisions. But more generally, across an array of financial products, when the advisor knows a lot about the household, the advisor would be able to synthesise an appropriate mix of sophisticated financial products which add up to an improvement in household welfare. In time, the advisor will increasingly lean on an expert system to help him do this better: it’s a good approach today and it will get better in coming years.

I think there is enormous value in this approach. I believe that KGFS is doing a great job of building this kind of information about
households in their present rollout (which involves going into really small villages at three locations, in Thanjavur, in Uttarakhand and in Orissa).

The typical KGFS front-end is a three-man branch in a village, where the three employees live in that very village. Remote villages
in India are an environment of radical transparency. The households are relatively trusting. The three people in the outlet know an
incredible amount about the households that surround them. Households and dwellings in small villages are rather stable: there is relatively little action through migration / change in financial conditions, etc. If there was ever an environment where asymmetric information is being removed, it is this.

The line between household finance and small business finance cannot be drawn. An adaptation of the KGFS approach can be quite
effective with small business also: the KGFS branch would obtain a full picture of the firm, and deliver a portfolio of financial
services to it.

A nice feature of the places where KGFS branches are being rolled out is the lack of alternatives. At a time when Indian financial
regulation does not do much to check the behaviour of conventional financial distribution, a few high pressure sales agents can queer the pitch for the KGFS staff. By being in remote places that are being ignored by distributors, the KGFS staffpeople have the luxury of dealing with households without the households being tugged by various high pressure sales tactics of rival sales agents.

Urban households are being mistreated by finance

I also realised some limitations of this approach. Looking forward, India is urbanising. At first blush, it may appear that there is a big
problem with the utilisation of finance in rural India. But there are big problems with the utilisation of finance in urban India.

The urban middle class and upper class is deluged with sales pitches by a variety of sales agents of financial firms. But these
agents are almost always mis-selling, given their drive to push a product (through commissions) and given their lack of knowledge about the household’s overall financial problem. Almost all financial products that are pushed in India (i.e. sold and not bought) seem to be mis-sold. I also feel that when the conversation between a sales guy and the household is about a product and not the overall household financial choice, it is almost always leading to the wrong answers. It’s tantamount to a salesman who sells a drug without knowing anything about the patient.

What is out there, in urban finance, is a scandal, and I am embarrassed to be an accessory to the crime (in however peripheral
fashion). While in Thanjavur, I got the odd sense that at its best, a rural household that’s well connected to a local KGFS outlet is doing
better on utilising the power of finance, when compared with most urban households who are victims of the sales practices that are
mainstream in Indian finance.

In this sense, the real problem for India is not the tawdry state of financial inclusion of the very poor in remote places. The real
problem for India — one that influences the bulk of Indian GDP and the households that matter greatly for India’s growth — is the tawdry state of financial planning of the typical urban household.

The KGFS approach is valuable and important to the places where it’s being rolled out. But the burning challenge is that of fixing the
mainstream. The mode of India is not brutally poor and isolated; it is middle class urban. Improving the interface between middle class and urban households, and the financial system, matters on a GDP scale.

An unrelated rumination: How important is rural deprivation in thinking about India?

The discussion above is a recurring theme in Indian economics. A variety of incentives (development journals, first world aid agencies, government rhetoric) make it fashionable to emphasise rural deprivation. But India is changing and the sweet spot has shifted. The emphasis on poverty and rural is increasingly off-centre. To stay relevant, and do the most important things in today’s India, we have to keep our eye on the ball.

To fix intuition, it’s useful to look at the distribution of annual household income, over April 2010 to March 2011, from the CMIE
household survey
of 143,000 households:

Percentile Household income
10 45,700
20 59,900
30 72,800
40 90,000
50 112,200
60 142,500
70 180,000
80 240,000
90 348,500

As an aside, I think it’s useful for anyone who thinks about India to memorise these nine numbers. Or at least memorise these three
numbers: the 25th percentile is Rs.66,000; the median is Rs.112,200 and the 75th percentile is Rs.208,500.

Middle India today has a household income from Rs.66,000 a year (at the 25th percentile) to Rs.208,500 a year (at the 75th
percentile). The old-style Indian story of rural deprivation is (roughly speaking) about the 20% of households who are below Rs.59,900 a year (and the size of that group is shrinking). The main story of India is about the remainder.

An emphasis upon exotic poverty is as misplaced, in thinking about today’s India, as an emphasis on designer clothes. Perhaps a bit
worse, looking forward, since the extremeties of deprivation are being extinguished by growth, while designer clothes are a superior
good.

Urban households are a much harder problem

So it’s natural to ask: How can the KGFS approach be applied to urban India? When dealing with the urban poor and middle class, it
seems that things are much harder.

Rural households tend to be more trusting, particularly in an environment of ethnic homogeneity and the repeated game that prevails in the village setting. But in urban India, households are more skeptical given the lack of ethnic ties and given the greater
experience with people who have finked in prisoner’s dilemmas.

Rural households tend to be a stable household in a stable dwelling place. Urban households tend to be physically mobile with greater fluctuations in the household composition.

Until deeper reforms on consumer protection take place in Indian financial regulation, urban households will be constantly tugged by unscrupulous sales agents of financial firms pushing products based on high pressure tactics Even if a KGFS tried to be patient and thorough, the very presence of such high pressure sales tactics would contaminate what a KGFS and its ilk can do.

It is relatively easy to construct information about the economic environment of a farming household (though seasonality and revenue volatility is a serious concern). I feel it may be relatively hard to even put together a picture of an urban household, particular when there is informality of labour supply coupled with entrepreneurship. This makes it difficult to do financial planning for such households.

On the other hand, in urban India, the revenue per household would be higher, and perhaps households could be persuaded to pay for advice qua advice. Or, the government could move on giving out advice vouchers to households, thus spurring the rise of an unconflicted advice industry.

Summary

I think KGFS is a great approach and it will be fascinating to watch them execute their agenda in the really remote places of
India. What they are doing is path-breaking and important. This should help us set our sights higher on the problems of urban India. I
have traditionally felt gloomy, in the knowledge that most households in India are being scammed by the agents selling financial
products. As I look at KGFS, I find myself thinking: Can’t we do something like this in mainstream India? I think this is an
important question to ask. At the same time, there are some visible hurdles which suggest that this will be hard.

Credits

I am grateful to Bindu Ananth, Ramesh Ramanathan, S. G. Anil Kumar, Kshama Fernandes and K. P. Krishnan for many conversations which helped in improving this post.

Foreign aid and development economics

The aim of main research agenda of development economics in the last century was to provide an evolving approach to curing the persistence of poverty and underdevelopment in world’s least developed and developing countries. High economic growth in developing countries in the last decades has changed many developing nations into middle-income countries. For instance, real economic growth rate in China and India from 1960 onwards averaged 6.67 percent and 3.49 percent, respectively. In 2010, China and India were already classified as lower middle-income countries, belonging to the same income group as El Salvador, Armenia and Philippines. In the recent year, China’s GDP per capita was higher than GDP per capita of many high-growing developing nations such as Ukraine, Nambia, Armenia and Bosnia and Herzegovina, and roughly at the same level as Algeria. Over the last decade, the economic growth in developing countries accelerated, driven by an increase in global commodity prices, robust investment rates, expansionary monetary policy and a growing domestic consumption. The economic growth in a majority of African states stagnated, consequently leading to a decrease in the overall standard of living. Between 1960 and 2009, average real GDP growth was negative in countries such as Congo, Democratic Republic (-2.26 percent), Liberia (-1.51 percent), Niger (-1.02 percent), Zambia (-0.52 percent) and Zimbabwe (-0.02 percent) with many other African countries with little or no growth in the second half of the 20th century. The stagnation of income per capita in countries such as Sierra Leone is largely the result of civil war and severe political instability, creating domestic violence and the persistence of poverty, malnutrition and AIDS/HIV prevalence. From the second half of the 20th century onwards, international aid donors have contributed significant amounts of foreign developmental assistance in various forms such as medical care and vaccination against polio, AIDS/HIV, measles and malaria, direct cash transfers and physical infrastructure. Despite significant official and unofficial developmental assitance from international aid donors, dispersion of real income per capita, measuring the level of cross-country convergence or divergence of income per capita, the gap in economic development widened in the course of the last century. In 2010, the percentage of countries with the level of real GDP per capita $1,500 or below equaled almost 20 percent (link).

The rise of development economics in the 20th century was a natural response to growing disparities in income per capita between rich and poor countries. In the framework of neoclassical theory, development economics emerged from a neoclassical growth theory, pioneered by the famous Solow-Swan model. In the simplest possible form, the growth of output per capita depends on the capital per worker and the initial level of output under stable rate of national saving and capital depreciation. Assuming diminishing returns to scale and constant rate of population growth, the increase in capital per worker would increase the output per worker that would, hence, approach its steady-state equilibrium. Theoretical notions of the Solow-Swan model were tested against the empirical data on economic growth. The key assumption of the neoclassical growth model is that poor countries would tend to catch-up rich countries, assuming higher output growth in poor countries. The convergence of income per capita would imply a neg relationship between the initial level of output per capita and output growth over time. Thus, countries with lower levels of output per capita in the initial period would experience faster rates of output growth. Consequently, the output per capita and the standard of living would approach to the level in rich countries. The empirical tests of the Solow-Swan model failed to confirm the theoretical hypothesis since economic growth rates in 20th century in developed countries were higher compared to developing countries. The divergence of income per capita led to the subsequent modifications of the Solow-Swan model. In fact, the main criticism of the model points out that the model itself failed to capture the role of technological progress in determining the level of output per worker. The mysterious growth episode in Japan and other East Asian nations posed a difficult question. How can a country with low initial level of output per worker at the end of the WW2, exceed the productivity level in rich countries? The obvious answer is that Solow-Swan growth model failed to capture the role of technology shocks which violate the assumption of diminishing capital returns, what could explain why initially poor countries subsequently converged to the level of productivity in rich countries and then exceeded the level. The phenomenon, known as growth residual, has subsequently reduced the predictive power of the Solow-Swan model since a considerable share of economic growth was not ascribed to capital and labor inputs but rather to the persistent role of technological change.

Policy implications from Solow-Swan model imply that the essential requirement to boost economic growth in a country with low initial level of output per capita is to increase the amount of capital per worker, namely by boosting public and private investment in infrastructure. From 1950s onwards, World Bank had repeatedly boosted the growth of infrastructure by facilitating developmental assistance into world’s least developed countries. According to the neoclassical growth theory, higher capital-labor ratio would provide additional investment stimulus, thereby increasing the employment-to-population ratio. Proponents of the foreign aid provided the rationale for higher foreign aid spending by the analogy of post-WW2 Europe when Marshall Plan provided $13 billion, or roughly $100 billion in today’s prices, to Western European economies to recover the physical infrastructure which had been destroyed during WW2. Marshall Plan intervention was rather short, quick and finite. The efficacy of foreign aid in Africa is questionable since little or no growth occured in many African states such as Burundi, Benin, Zimbabwe and Congo. Official forecasts from the United Nations from 1950s onwards, based on the famous Harrod-Domar growth model (link), often assumed a rapid increase in the level of GDP per capita in response to the increase in investment rates. The forecasts, based on the theoretical assumption of diminishing capital returns, predicted a persistent convergence of GDP per capita to the level sustained in richer countries. The fact that the launch of extensive investment in infrastructure resulted in further economic stagnation of many African states, has questioned both the validity and quality of prescriptions laid by the mainstream development economics.

The philosophy of the mainstream development economics was sharply criticized in the light of the fact that foreign aid failed to alleviate poverty and made the growth of African economies slower. The efforts by the World Bank have been diverted from correct diagnosis of the developmental issues in African states to repeated initiatives such as the commitment of the international community to increase the share of foreign aid to least-developed countries to at least 1 percent of the GDP. The criticism of the mainstream development economics was already formulated in 1958 when Mont Pelerin Society organized the 9th meeting and development economics seminar where professor Herbert Frankel of the Nuttfield College put forth the criticism of foreign aid and the failure of development economics:

The lesson that flows from it is that it does pay to go to these remote areas and find out what the problem is, instead of assuming that one knows the problem before one begins. Until recent years, people have simply assumed in many of these territories in Africa, that there were no real, positive signs of enterprise among the indigenous population, which was supposed to be so uninstructed or inert that it was not able to fend for itself, experiment for itself, or improve itself. It was not realised that a reason why there was this apparent lack of initiative in the population was that there were serious customary or legal obstacles to the exercise of ordinary enterprise, even on a small scale.

Given the lack of the comprehensive diagnosis of the causes of underdevelopment in African countries, the mainstream development economics failed to capture the appropriate assumptions in the theoretical models of economic development, upon which developmental assistance was justified. A more reasonable theoretical solution to the economic stagnation and social conflict in Africa has been put forth by the human capital theory. In its broadest and most general form, the theory stated that the economic stagnation of African countries is a consequence of the lack of skills and investment in education that could provide the necessary input to increase the economic growth and, subsequently, alleviate the issues of AIDS/HIV, malaria, child malnutrition and domestic violence. There is no doubt that the growth of education initiatives in Africa has sent many children to school. In addition, many universities in Western Europe and the United States have expanded the initiative and offered students from African states preferential admission criteria in various forms such as graduate fellowships, student grants and lower required standardized test scores, to boost admission rates of African nationals at U.S. universities. The efforts of developed countries to bring educational initiatives to Africa encouraged school participation as well as international opportunities of African citizens to study abroad, even at world’s most prestigious and highly-ranked universities. Notwithstanding the importance of education in creating the stock of human capital for the wealth of nations, educational initiatives should address the essential obstacles that creates the failure of African expatriates to return to home countries, hence, bring skills, knowledge and various other forms of human capital, which are essential to the process of long-run growth, the issues of labor market distortions in African countries. These distortions crucially impede the ability of young African graduates to matching jobs in regional labor market.

What the mainstream development economics failed to take into account is the institutional paralysis which prevails in a majority of African countries, plagued by the destructive tribal institutions based on widespread corruption, bribes and domestic violence as means of achieving political power. The prevalence of hybrid institutions, marred by the complete absence of the rule of law and judicial institutions that could facilitate efficient contract enforcement and the protection of private property rights, is not only a severe obstacle to higher economic growth but also the apparent mechanism that captures the set of explanatory features that could possibly account for what caused the misdiagnosis of the African development dilemma. Back in 2002, African Union estimated that each year, corruption costs African economies more than $148 billion or 25 percent of Africa’s GDP. The significance of corruption in state structures in Africa manifests itself in poor quality and provision of public services, the absence of judicial independence from political regimes, cumbersome contract enforcement and unprotected private property rights. Such distortions impede the level of trust and provide evolving incentives to subvert the institutional independence into political cronyism, in which corruption substitutes the tax system through bribes and extortion as methods of lowering transaction costs in overcoming the malfunctioning of the judicial system. In 1978, Erwin Blumenthal of the central bank of the Federal Republic of Germany, warned the international community that “Zaire’s political system is so corrupt that there’s no prospect for Zaire’s creditors to get their money back.” (link)

The advancement of country’s economic prospects requires not only transparent, sound and efficient regulations but, more importantly, highly efficient civil service. In 2010, Transparency International published Corruption Perception Index (link) by measuring the persistence of corruption in public sectors across the world. The findings showed that the vast majority of poor African countries were plagued by extensive and extortionate corruption and ranked in the bottom 20 percent of the distribution. Comparing the level bureaucracy against GDP per capita reveals the amplified evidence of the negative correlation between the efficiency of civil service and the GDP per capita. The ease of doing business in Africa in countries such as Botswana, Ghana, Mauritius and South Africa is remarkably easier with predictable, stable and efficient regulation, compared to countries such as Burundi, Burkina Faso, Côte d’Ivoire etc. where highly burdensome administrative procedures in doing business hamper capital formation and restrain productive investment in health-care, education and private-sector infrastructure that could provide the impetus to economic growth.

The relationship between the amount of foreign aid, received by the least-developed countries, and the scope of corruption as a rough approximation of the institutional quality in the least-developed states, could provide the answer to the question whether international donors consider the scope and significance of corruption in allocating the amount of foreign aid. The experience from the last century of development policy, suggest that international donors actually allocated more foreign aid to the countries, suffering from severe state failure, widespread corruption, government failure and the complete absence of judicial independence that could provide a system of checks and balances and the necessary restraint on the violiation of private property rights, extortion and violence by the political elites. In 1999, Alberto Alesina and Beatrice Weder (see “Do Corrupt Governments Receive Less Foreign Aid,” American Economic Review, 92(4), pp. 1126-1137) found that, contrary to arguments of aid supporters, foreign aid is not used to reward good governments since more corrupt governments received more foreign aid and official development assistance from international donors. The most striking evidence, presented by Alesina and Weder, suggests that U.S donors seem to neglect the persistence of corruption in allocating foreign aid to poor countries while, on the other hand, Scandinavian donors deem the persistence of corruption as highly important, hence, rewarding governments with lower extent of corruption.

In the following graph, I estimated the impact of corruption on official development assistance in the sample of 41 least-developed countries in 2008. In the model, I set the official development assistance to be determined by the scope of corruption in least-developed countries. The official development assistance is expressed as a share of representative country’s gross national income (GNI) for it provides a better measure of aid dependence than foreign aid per capita since the size of population is controlled by the main assumptions of the model. The data on official development assistance were download from World Bank’s World Development Indicators (link). The data on the extent of corruption in least-developed countries were provided by Transparency International’s 2008 Corruption Perception Index (link). The extent of corruption varies from 1 to 10, where lower values indicate more persistent corruption. I estimated whether countries with more corrupt governments receive a higher share of foreign aid from international donors. On the basis of 41 least-developed countries, sample estimates suggest that a 1 point improvement in corruption perception index tends to decrease, on average, the share of foreign aid in gross national income, on average, by 2.37 percentage points. Sample estimate of the slope coefficient is statistically significant at 5 percent level. Even though, the variation in corruption perception index accounts for 5.51 percent of the variation in official development assistance, the influence of the extent of corruption on the share of foreign aid in gross national income is not spurious but systematic and persistent.

Corruption and official development assistance
Source: World Bank, World Development Indicators, 2010. Transparency International, Corruption Perception Index, 2008.

The estimate suggests that international donors indeed reward more corrupt governments by increasing the share of official development assistance. In 2002, African Union estimated that corruption was costing the African continent $150 billion per year. The estimates of the total cost of corruption provide an ample evidence that, over the last century, international donors consistently allocated foreign aid to more corrupt governments, creating aid-dependent economies, prone to bloated bureaucracies and extractive institutions which subsequently led to the stagnation of income per capita in the last decades. An ample criticism of foreign aid initiative was put forth by Dambisa Moyo (link) in the WSJ two years ago: “The most obvious criticism of aid is its links to rampant corruption. Aid flows destined to help the average African end up supporting bloated bureaucracies in the form of the poor-country governments and donor-funded non-governmental organizations.

The consequence of rootedness of corruption and extractive political institutions in African tribal cultures can be, in a considerable part, drawn upon the colonial heritage that spread throughout the African continent from 19th century onwards. The colonial experience across the African continent (link) served not only as a conquest of newly discovered areas but, moreover, also as an experiment of developing political and economic institutions on the basis of European influence. The colonial heritage in Africa was mainly derived from the European occupation of African lands. Hereto, the presence of European colonizers in Africa provided a long-lasting foundation of the institutional lessons from which the African states went forth.

Given the heterogenity of the European perspectives on institutional development, the colonial period in Africa left a long-lasting impact on the economic and political development in Africa. Africa’s richest countries, namely Botswana, South Africa and Mauritius, were influenced tremendously by the colonial heritage. In Botswana and South Africa, the colonial influence of English and Dutch on further economic development was mainly derived from setting strong institutional foundations of economic development such as the rule of law, judicial independence and limited government compared to other African states. Apart from the setting of formal institutions, fostering contract enforcement and the integrity of the political institutions, English and Dutch colonizers provided the establishment of cultural setting not prone to fraud, extortion and extractive institutions. Favorable institutional conditions furthered the advertance of trust and institutional efficiency, which are deemed essential in fostering the development of financial markets. Even the German presence in Namibia from 1884 to 1915 during Deutsch-Südwestafrika (link) fostered, to a certain extent, independent judiciary, relatively sound institutions and cohesive framework of the rule of law. As a result, Nambia retained the status of one of the least corrupt countries in Africa, known for relatively high degree of economic freedom in a regional comparison with other African states.

While the influence of German, English and Dutch colonizers was largely beneficial to African countries from the perspective of economic growth and development over the last century, the presence of French, Italian and Belgian colonizers arises serious concerns over the prospects of economic development across the African continent. The myraid of violence, in countries such as Congo Dem. Rep. and Somalia, which ultimately led to civil wars and the settlement of extractive institutions, largely reflects the innate ability of the colonial policies to provide the necessary conditions for the institutional integrity, the rule of law and stringent property rights that could underline the basis of economic development by restraining the power and domination of political elites and their ability to expropriate private property rights in pursuit of extractive monopoly rents from natural resources. That easily explains why countries such as Congo, Zambia, Nigeria and Zimbabwe, in spite of vast reserves of natural resources, were seized by the state capture of political elites. The colonial presence largely determined the size and scope of aid dependency in African states. The most plausible and persuasive explanation of the impact of European colonial policies in African countries was presented by Daron Acemoglu, Simon Johnson and David Robinson (see “Disease and Development” Journal of European Economic Association, 1(2/3), pp. 397-405):

European colonists were much more likely to develop institutions of private property, encouraging economic and social development, in places where they settled. In contrast, in places where they did not settle, they were more likely to opt for extractive institutions, designed to extract resources without investing in institutional development. In these places, institutions were highly centralized, with political power concentrated in the hands of small elites and with almost no checks on this elite. The property rights and more general rights of the majority of the population were not protected.

The political and economic circumstances of the European institutional legacy in African states imparted aid dependency on those countries where the combination of tribal institutions, hostile to free enterprise and judicial restraint of political dictatorships, and unequivocally detrimental colonial policies dominated the development of political and economic institutions, setting the rules of the game. Therefore, the inability of many African societies to establish sensible and effective institutions resulted in the political capture of the state by the elites. The monopoly power of the political elites, enforcing anti-growth public policies, led to consistently poor economic outcomes, plagued by high rates of poverty and infectious diseases such as polio, malaria and measles.

The challenge of development economics is not to design aid schemes, which inevitably lead to aid dependency, marred by persistent corruption and political fraud, but to ascertain correct diagnosis of why foreign aid repeatedly resulted in the poor economic outcomes and the consequent stagnation of income per capita in many African states in 20th century. The failure of African societies to establish a rigorous system of incentives, which could significantly improve economic outcomes, is not a response to market failures (which deemed highly of early development economics) but a result of severe government failure to establish effective institutions of the rule of law, contract enforcement and stringent property rights. These institutions are the broadest foundations of economic development and the only viable alternative to political nepotism and the power of elites which, as poor development outcomes in Africa show, ultimately impose extractive institutions, causing the persistence of poverty and underdevelopment.

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Poverty

There are two kinds of poverty: relative poverty and absolute poverty. One could define the latter as lacking certain qualities of life; for example access to a minimum of 1600 calories per day, shelter to keep you warm and dry, and clean clothing appropriate for your climate and culture. There are many people who are absolutely poor. It’s possible to abolish that kind of poverty. It is not possible to abolish relative poverty. Some people will always have much much more than other people; we call these latter “poor”, often without distinguishing them from the absolutely poor.

Why do the Poor Choose to Live in Cities?

In the recent edition of Yale Economic Review (link), Ed Glaeser, Matthew Kahn and Jordan Rappaport ponder one of the most difficult and challenging puzzles of urban economics:

The 2000 U.S. Census shows that the average poverty rate in American cities drops significantly , from about 20% to 7.5%, as you move from the CBD of a city to its suburbs. How can we tell that this connection between city residence and poverty comes from treatment – that is, cities make people poor – rather than from selection, where the poor disproportionately move to central cities? Here, the data support selection: although ghettos may exacerbate poverty, poor people move disproportionately to the center of the cit- ies, either when switching homes or moving to a new metropolitan area... Given the high proportion of the urban poor who are Black, one might think that inner-city poverty is really just another example of the segregation of minorities. However, [the authors] found that poor Whites have roughly the same central city – suburb poverty gap as Blacks, so it is unlikely that race plays an important role in the centralization of the poor.

Poverty, Income Inequality and Economic Development

Financial Times reports (link) on the new measure of poverty proposed by economists from Oxford University. The authors suggested the modification of current measure of poverty which, defined by the World Bank in annually published World Development Report, is currently set at the threshold of $1.25 per day or less. The new measure proposed by economic researchers from Oxford University sets the definition of poverty in a more sophisticated framework based on the household availability of access to clean water, education, health care and other durable and non-durable goods. The new method, called Alkire-Foster approach, incorporates the qualitative elements into the measurement of poverty.

Using the new method, the authors examined poverty rates in four Indian provinces and evaluated the approach in comparison to the existing income method which had been used in economic and policy analysis by the World Bank and other institutions of economic development. The authors found a significant divergence of poverty rates when measured in both methods. For instance, under Alkire-Foster approach, the poverty rate in Indian state Jharkhand is 50 percent higher compared to the rate of poverty measured under the income method. On the other hand, the authors of the new poverty measure have shown that in some Indian provinces such as Uttaranchal (link), the official measure of poverty highly over-estimates the effective poverty measure as defined by Oxford’s Poverty and Human Development Initiative. The multidimensional worldwide poverty index is also availible on the web (link).

The intuitive question arising from the data and empirical research on poverty is whether higher economic growth in less developed countries boosts the growth of income per capita and what is the role of institutional characteristics in economic development. The authors of the above-mentioned measure of poverty have shown that despite abundant economic growth in past years and falling income poverty rates, the share of population without access to clean water, sanitation and minimum required nutrition remained unchanged. The percentage of malnourished children in India decreased from 47 percent in 1998-98 to 46 percent 2005-06.

The theoretical and empirical literature on economic growth suggests that there is an inverse U-relationship between inequality and income per capita known as Kuznets curve (link). The intuition behind the relationship is simple. At the very low levels of income per capita, income inequality is low. Alongside the course of growing income per capita, income inequality steeply increases and, after reaching a maximum, it decreases as countries achieve higher levels of income per capita. The rate of income inequality is closely related to the evolution of economic policies over time. Wagner’s law, discussed in one of the previous posts, states that government spending over time increases due to long-run income elastic demand for public goods and capture of the democratic system by the particular interest groups that pose a permanent pressure on the growth of government spending and resist the reversals of government expenditures by trading votes.

There’s a wide array of disagreement among economists on the effect of income inequality on economic growth. Back in 2001, Joseph Stiglitz re-examined the East Asian economic miracle and concluded that the evidence from the period of high economic growth in East Asian countries suggests that income redistribution has a positive effect on economic growth (link). Stiglitz’s argument is based on the income distribution in East Asian countries during the economic miracle. East Asian countries have been known for relatively even distribution of income demonstrated by high Gini index and relatively high income tax rates.

On the other hand, the empirical investigation of the initial conditions in East Asian countries before the economic miracle shows that the political influence of interest groups had been relatively weak compared to Western Europe after the World War 2 when the productivity growth stalled from early 1970s onwards. The relative weakness of interest groups and a stable judicial system, inherited from English common law tradition, enabled high economic growth in the longer run given an enduring stability of property rights protection and the rule of law. In such conditions, income redistribution had relatively little effect on economic growth since the empirics of East Asian miracle suggests that the sizable proportion of growth in East Asian countries (Malaysia, Singapore, Korea and Taiwan) had been driven by technological progress, investment and export orientation. Considering export orientation, Rodrik et. al (2005) provided the evidence (link) on the positive effect of high-quality export orientation on economic growth. The productivity growth in East Asian countries between 1975 and 1990 had been a pure example of economic miracle defined by the share of growth that could not be explained by the contribution of labor and capital input. In Taiwan and Hong Kong (link), total factor productivity accounted for about 60 percent of output per capita growth. Between 1975 and 1990, in Singapore, output per capita had increased by 8.0 percent. Consequently, the resulting outcome of almost two decades of robust productivity growth had been a significant decrease in national poverty rates (link). The lowest poverty rate, as defined by the measures of home authorities, is in Taiwan where 0.95 of the population live below the poverty threshold.

The basic set of policies that alleviate extreme poverty such as providing access to clean water, nutrition, medical protection against HIV/AIDS and basic sanitary standards have a positive effect on the economic growth and the standard of living. However, the major cause of persistent under-development in Subsaharan and Tropical Africa is mostly the lack of institutional enforcement of property rights, the rule of law and independent judiciary. In spite of billions of USD of direct foreign aid, countries such as Zambia, Sierra Leone, Mali and Rwanda endure in persistent poverty and under-development. Esther Duflo, this year’s recipient of John Bates Clark Award, has shown in several studies how field experiments can enlighten the understanding of incentives in least developed countries (link). Understanding the significance of incentives in reducing poverty is crucial to further examination of the relationship betwen income inequality and economic growth.