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“Capital” and “Investment” in Developing Countries

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1971
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Andrew M. Kamarck

We have all discovered at one time or another that human beings seem to have little trouble in maintaining two sets of mutually contradictory beliefs at one and the same time. To go further: it is quite common, not only in religion, but elsewhere, to find human beings professing a belief but acting in a manner that is consistent only with its opposite. It appears to me that much of economic development theory may be a good example of inconsistency in thought and of conflict between theory and practice. Being primarily interested in economic policy and the concrete problems that have to be dealt with in the course of economic development, it has become more and more evident to me that there is a substantial difference between what experienced development economists now know and what they do, particularly in building models and in training students. Dudley Seers, in fact, has gone so far as to say that “… economists are very little use working on the problems of under-developed countries, until they have done so for some years, and then only if they are unusually adaptable … there is so much for the economics graduates to unlearn—and unfortunately the abler the student has been in absorbing the current doctrines, the more difficult the process of adaptation.”1

The Orthodox Theory

The dominant and orthodox economic theory emphasizes capital formation as the main factor in development of the developing countries. This theory is taught to most students and is the basis of most comprehensive economic development plans prepared by developing countries. Tinbergen, for example, recommends that the first step in development planning should be a macroeconomic study of the general process of production and investment along the lines suggested by Harrod-Domar models or by similar, more complicated models.2 In the Harrod-Domar model, growth in production is the result of a propensity to save and a fairly stable aggregate capital-output ratio.

Capital, in this theory, is usually defined (or rather it is usually implicitly assumed) as the value of the stock of physical capital goods (i.e., durable assets—machinery, equipment, roads, or docks—with an average life of over one year plus the annual change in business inventories).

The central position of investment in material capital is also the theoretical basis of the operations of the international financing agencies, such as the World Bank Group, the Inter-American Development Bank, the Asian Development Bank, and so on. When we point with pride to our accomplishments, the volume of money that we have provided to finance an increase in the stock of material capital in the developing countries is in the center of the stage for all to applaud. This preoccupation with physical capital goods is imbedded in the World Bank’s practice, policy, and “theology.” For example, the Bank’s Articles of Agreement make financing the import component of the investment in a project the normal method of finance for the Bank. What the Bank’s Board of Directors recognizes as the “proper” object of finance for the Bank is material capital goods imported from abroad needed for a “high-priority” project. A substantial part of the economic battles in the Bank turn around this point. If, in a country, for one reason or another, the import of real resources to supplement local savings is not sufficiently embodied in machinery or equipment, or if the durable capital goods the country does import are not used by the project that deserves financing, the Bank staff has to show that there are “exceptional circumstances” to justify either the finance of local currency expenditure or a “program” loan, or adopt some round-about method to achieve the Bank’s objective.

The Bank in recent years has entered the new fields of education and family planning projects. But in these projects also Bank finance is normally provided mainly for the construction of durable assets—schools or hospitals or health centers.

There are good reasons why the definition of investment as expenditure on material capital goods has been adopted and used by economists. It descends from English classical economics and was strengthened by Keynes’ General Theory with its emphasis on fixed capital investment. As Joan Robinson points out, Keynes’ General Theory “… analysis was framed in terms of a short period in which the stock of capital and the techniques of production are given.”3 Within this given structure of the economy, the definition of investment expenditure on fixed capital was quite sufficient. It is not only a simple definition, easy for anyone to understand, but, until recently, for the major purposes of economic policy in the developed countries it was a perfectly adequate and useful definition.

In addition, this definition fitted in perfectly with the growth of the art of preparation of national accounts—it is in fact ideal for this. In the standard UN System of National Accounts, investment consists of fixed capital formation and increase in stocks and is measured by “expenditures on tangible assets….”4

A Shifting Focus

However, in recent years in the developed countries, the focus of interest of some economists has shifted to longer-run problems of growth and the definition has started to become less comfortable to live with. In the developed countries, since World War II, a number of studies appear to have found that economic growth has been greater than could be fully explained by growth in capital and labor. Some studies have in fact indicated that growth of the capital stock and labor force accounts for only a fraction of the total growth of gross national product (GNP) and that the “unexplained residual factor”—improved resource allocation, technological change, improvement in the quality of human resources—accounts for as much as 50 to 85 per cent of total growth. Simon Kuznets has stated:

… while the results would clearly vary among individual countries, the inescapable conclusion is that the direct contribution of man-hours and capital accumulation would hardly account for more than a tenth of the rate of growth in per capita product—and probably less. The large remainder must be assigned to an increase in efficiency in the productive resources—a rise in output per unit of input, due either to the improved quality of the resources, or to the effects of changing arrangements, or to the impact of the technological change, or to all three.5

But, whether these studies are true for developed countries or not—in the developing countries it is clear that development depends on much more than material capital. At best, the provision of capital for material capital goods may account for about 50 per cent of economic growth in a developing country within the middle range of income. The economic analyses of developing countries prepared by World Bank country economic missions repeatedly bring out the importance of other factors in addition to investment in material capital goods to secure development.

Two Examples

For example, a report on Upper Volta shows that that country’s principal problem in economic development is the devastating effect of disease on agricultural productivity—malaria, bilharzia, river blindness, and tuberculosis reduce the amount of labor available at times critical for growing crops. What this means is: in Upper Volta, economic development at present is strongly dependent on health expenditures on medicine, other medical supplies, doctors, nurses, and research. But health expenditures, except for a small amount for bricks and mortar and some medical equipment, in the conventional analysis are not classified as investment—they are current expenditures.

Another example: cocoa is still the dominant element in Ghana’s economy and the development of cocoa production is why Ghana has the second highest GNP per capita in tropical Africa. Of the total increase in capacity of Ghana’s cocoa trees between the 1950s and the 1960s of about 50 per cent, the development and use of insecticides by increasing the survival rate of young trees accounted for about one third or 100,000 tons of the total annual output of cocoa. The rest were new plantings. Under the conventional definition of investment the new plantings were investment; the expenditure on insecticides was not.

Technical Assistance

Technical assistance to the developing countries has grown faster than other types of assistance and now amounts to almost $2 billion a year. It has grown in response primarily to the actual experience of the needs of the developing countries. It is exceedingly important.

But where does it fit into present theory? For the Development Assistance Committee countries, technical assistance is an important part of their “Official Development Assistance.” In the balance of payments of the recipient country it shows up as a debit or receipt of services in the current account and as a credit or unrequited transfer in the transfers on capital account. In the national accounts of the recipient country it shows up not as investment but as consumption. (This might seem a good reason for taxpayers in developed countries to revolt—here is a clear case of economic aid financing “consumption” in the developing countries. But, in fact, often technical assistance is among the most popular aid activities because, in spite of its economic classification, it is seen to be directly contributing to development.) The activities that are covered by technical assistance are not conventionally classed as “investment” except for any expenditure on the incidental equipment involved. Any expenditure made by the recipient government on technical cooperation is a noninvestment expenditure—it is a current expenditure of the government—that is to say, it is classed as the kind of expenditure that by the accepted theory should be held down in order to free funds so that “savings” can be increased in order to finance investment in material capital.

Other Examples

Again, while it is highly likely that economic development in many countries could be speeded up if the rate of population growth declined, the bulk of expenditures on family planning programs are classified as “current expenditures” and therefore “bad,” and not as “investment,” which alone is seen to be “good.”

The Green Revolution in agriculture that has resulted in very large increases in output of wheat and rice in some developing countries was the outcome of expenditure of money that mostly went for salaries of research workers; only a small fraction was spent on what economists classify as “investment,” i.e., durable capital goods. In our conventional economic theory, only the expenditure on the buildings erected to house the research workers and any permanent improvement in the structure of the fields are classified as capital. The countries applying the discoveries of the Green Revolution increase expenditure on agricultural extension agents (i.e., “current inputs”), on fertilizers, on pesticides, on improved seeds. When output goes up by 300 or 500 per cent, under our conventional theory suddenly it is the material capital goods that have become more productive. Through the capital-output ratio, this auxiliary or secondary expenditure is given the credit for the increase in agricultural output, whereas everyone knows that what really counted was the research brains that were applied to the problem.

One Conclusion

One conclusion that can be drawn from all this is that one simply accepts the fact that investment in material capital is merely one of the factors involved in economic development and that current expenditures on health, education, agricultural extension, family planning, research, management training, etc. may be equally important or even more important than investment in capital. Many economists who are working with the problems of development do come up with this solution—but it is awkward. For example, Ahron Wiener has put the matter concisely:

“The growth of a developing economy comes about by the fusion of investment factors with the relevant non-investment factors, relating mainly to human resources, organization, and institutions; development of the former without the latter will result in spending budgets without concurrent growth. These non-investment factors develop in mature economies to a great extent spontaneously, in response to capital investment. In developing countries, their development has to be planned and consistently nurtured.

… planners in the developing countries … find the path of capital investment to be an easier way to ‘execute’ a programme than the thorny path of transformation. However, it is only by transformation that conditions can be created that will make investments operative and, what is equally important, that will awaken in an economy that had not been growth-oriented before, its capacity for spontaneous growth, i.e., its development potential. Until such a capacity emerges, a country cannot hope to achieve an economic “take-off.”6

Seeking Theoretical Foundation

The difficulty with this eclectic “allowance for many elements” approach is that it does not make a coherent theory. It does not provide a guide to action in a particular country except that of the “judgment” of different people and there is no way to ensure that the same judgment decision will be reached by different people who have had somewhat different experiences and background. One can recognize that some current expenditures are “development” expenditures and therefore “good,” but this approach provides no help in the most important economic policy question developing countries face—what is the optimal allocation of a country’s current income among the different expenditures that are regarded as helping in economic growth? The advantage of the capital investment theory, to the extent it is applicable, is that through the calculation of rates of return one can have a rational allocative process.

The difficulty is primarily that “investment” is defined as “expenditure on durable goods,” whereas the most useful definition of investment in the developing countries would appear to be “any expenditure that results in income in the future.” The product of such investment is capital. Such a definition has good, solid theoretical foundation for it. It is essentially based on the definition worked out by some of the founding fathers of modern economics who worked mostly on capital theory.

With the principal problem in developed countries up to World War II that of full employment, and with the growth of systems of national accounts as a policy tool to help guide the necessary policies, restricting the definition of investment to expenditure on durable capital goods was more practicable and sufficiently met the needs of economic policy in the developed countries. But even the argument that this definition is consistent with actual business practice is now weakened: where is the real investment in IBM—in its factories or in its organizations of able and talented people? The rapid recovery of Germany and Japan after World War II showed that the most important part of the capital of these two countries was not in the material capital goods that had been destroyed but in the institutions and trained people.

As we have seen even in the developed countries, as the major policy interests have shifted away from control of the cycle to growth or to the elimination of poverty pockets, economists are beginning to find the existing definition crippling. Consequently, some economists have proposed classifying at least part of the expenditures on education as investment in human capital. H.G. Johnson has proposed that we go back to the concept whereby “investment” would be “…defined to include such diverse activities as adding to material capital, increasing the health, discipline, skill, and education of the human population, moving labor into more productive occupations and locations, and applying existing knowledge of discovering and applying new knowledge to increase the efficiency of productive processes.”7 P.T. Bauer, B.S. Yamey, P.D. Henderson, Paul Streeten, and other development economists have made similar suggestions in the past.

Theodore Morgan has proposed giving up the use of the term “investment” and “consumption” in the design of development plans and economic policy and set up instead “… a hierarchy of uses for resource units, from those whose social returns are highest to those that are lowest…. For any given place and time it is unlikely that a perfectly wise policy board will find a gap in the hierarchy, with ‘investment’ above and ‘consumption’ below. Those outlays will probably be intermingled along the scale, some conventional ‘consumption’ uses of resources may be at or near the peak.”8

In actual fact, in the World Bank when we make a decision as to the economic worth of an individual project, the economic appraisal techniques we apply are based essentially on the broader definition of investment suggested above and not on the “material capital goods” definition. In calculating the internal rate of return or the cost/benefit ratio of a project the so-called “current” and “capital” expenditures are both included on the cost side and compared with the flow of benefits, with both sides of the accounts suitably discounted over time. The narrower definition of investment comes into play only after the project passes the economic test and a decision has to be made for determining the eligibility of particular expenditure items for Bank financing. Even so, a large number of projects include provision for financing “investment” that goes beyond the “material capital goods” category. But then when we and the government pass to the national or macrolevel, only the expenditure on material capital goods is included in our investment accounts.

The Fisherian Definition

In my view, it is now time for economists working on problems of developing countries to accept fully the Fisherian definition of investment—that is, that investment is any outlay made today for the purpose of increasing future income—whatever the asset, tangible or intangible, a piece of machinery or a piece of productive knowledge, a passable road or a functioning family planning organization, that is purchased with the outlay. A short-run investment is one that pays off in a short term—a long-term investment is one where the return comes in over a longer period. The whole apparatus of investment decision can be applied to this as it is applied now to the purchase of durable goods.

Once this is accepted, a lot of the problems that have been bothering us will fall into place. The various subterfuges that people have had to adopt in recent years in trying to get around the existing theory will no longer be necessary. (For example, in 1960 when Professor E.S. Mason and I were advising Uganda on an economic development program we included in the program not only the conventional capital investment expenditures but also “Special Recurrent Expenditures” to cover programs mainly in agriculture and education that we regarded as having special development significance over the five years concerned. This was regarded as quite unorthodox but it was also clear the income of companies and corporations. Clearly, all other things being equal, this should be good policy. The taxable income of corporations has, of course, to be defined—and this means defining what is “investment.” If “investment” is defined, as it usually is, as the purchase of durable capital goods, then only the annual tranche of depreciation can be deducted from the year’s current gross receipts in the process of ascertaining what is the taxable income.

“… But if we define a capital expenditure as any outlay today for the purpose of increasing future income, then it is clear that some of our most important forms of business investment are not in hardware but to us that the “recurrent” expenditures that we included in the development program were more productive than much of the conventional capital investment expenditures that no one worried about.)

The Private Sector

So far, most of my remarks have applied mainly to the public sector and public investment policy. The conventional approach through government tax policy may also distort private economic decisions. The developing countries, in most instances, have copied the industrialized countries in passing income tax laws taxing in research and development, the training and further education of technical, scientific, and managerial employees, learning by doing, and advertising.”9 All these categories of investment are fully expended for corporate income tax purposes and are thereby given a subsidy of nearly 50 per cent in the United States, for example, by comparison with investment in hardware. The economic consequences of this are that the tax depreciation laws are not likely to have the same effect on a railroad or steel manufacturer that they have on a pharmaceutical, cigarette, or management consulting firm whose investment in knowledge (including advertising) may be more important than their expenditures for hardware.

Some Difficulties

There are, however, some major difficulties in adopting this new definition of capital and investment. The first is inertia—which is not to be underrated. It has taken a number of years to get countries to adopt national accounting and to produce national accounts. Making a major change in definitions in this would not be easy—it would require retraining a large number of people, and getting people to readjust their thinking—which is even more difficult.

A second problem is that of measurement. The present definition of “capital” is much easier to measure and this makes “investment” easier to measure too. In many developing countries, investment estimates are compiled by taking the trade figures on imported equipment and machinery and adding to them estimates of construction, or applying a factor to them to represent construction. Under the new definition “investment” would be considerably harder to estimate. Much more care and economic analysis would also be needed, of course, to ensure that what would be counted as investment was truly expenditure leading to income flows in the future rather than consumption. But, the estimates would be more meaningful in relating investment to development and in providing a guide to policy.

Another problem for the World Bank and other suppliers of capital in shifting to the new definition is that banks, donors, and laymen like to see material capital goods for the money they invest. This is why it is always easier to raise money to build buildings for a university than it is to raise endowments to pay sufficient salaries to build up an excellent faculty.

Confusion Should Be Eliminated

But if economic theory is to be really useful in guiding the developing countries to make good development plans, the “capital goods = capital” confusion should be eliminated once and for all. This should also help to eliminate the gulf that has developed in recent years in development economics—between those economists and econometricians, on the one hand, who regard quantification of economics so important that they insist on trying to quantify even though what they turn out may prove irrelevant for policy, and those economists who, living with day-to-day problems of economic development, find the existing theory irrelevant and so resort to “judgment,” intuition, or other essentially nonobjective factors. The new (or rather older) definitions of “capital” and “investment” in developing countries will put investment back into the center of development as the driving force. It should make decision-making a more rational process again.

The present situation in which economists spend their time measuring what is easy to measure (durable capital goods) instead of trying to measure what is more difficult but what really matters, is like the story of the drunk who had lost some money. He hunted for it under a street light because the light was better rather than looking for it in the dark alley where he had really lost it. If economists truly want to be useful and find ways to help development for the developing countries, we have to look where the problems are, and not where it is easiest to look.

The difficulties are real difficulties and they cannot be ignored. Also, as I indicated, in the developed countries the prevalent definition for purposes of full employment policy does appear to be useful and it is not likely that it would be given up in order merely to adopt a definition useful for the developing countries. As the developing countries become industrialized, they too may find the conventional definition useful. The conclusions that appear to me to be most reasonable at this time are:

  • The conventional definition of investment and capital should always be clearly labeled as covering only durable capital goods (plus the annual changes in business inventories, of course). The term “fixed capital formation,” perhaps, should always be used for this.

  • It should be recognized that, particularly in the developing countries, fixed capital formation is only one part of total investment and that other expenditures that can be shown to result in a sufficient rate of return or satisfactory cost/benefit ratio are also justifiable parts of total investment deserving of finance and of inclusion in growth and planning models.

  • In time, a new set of definitions and conventions should be worked out and adopted in the national accounting systems.

Dudley Seers, “The Limitations of the Special Case,” The Teaching of Development Economics, ed. by Kurt Martin and John Knapp, Chicago, Aldine Publishing Company, 1967, pp. 4-5.

Tinbergen, Jan and H.C. Bos, Mathematical Models of Economic Growth, New York, McGraw-Hill, 1962, p. 10.

Joan Robinson, The Accumulation of Capital, London, MacMillan, 1965.

UN, System of National Accounts, 1968, p. 26.

Modern Economic Growth, Yale University Press, New Haven and London, 1966, pp. 80—81.

Ahron Wiener, “Development Consultant,” The Truman International Conference on Technical Assistance and Development, Hebrew University, Jerusalem, May 25, 1970, pp. 6-7.

H.G. Johnson, “Comments on Mr. John Vaizey’s paper,” OECD Study Group in the Economics of Education, The Residual Factor and Economic Growth, Paris, OECD, 1964, p. 221.

Theodore Morgan, “Investment versus Economic Growth,” Economic Development and Cultural Change, Vol. 17, No. 3, April 1969, p. 404.

Smith, Vernon L., “Investment Behavior—Discussion,” A. E. R. Papers and Proceedings of the Eighty-Second Annual Meeting of the American Economic Association, Vol. LX, No. 2, May 1970, p. 29.

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