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The misconceptions of “development economics”

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1985
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Deepak Lal

Ideas have consequences. The body of thought that has evolved since World War II and is called “development economics” (to be distinguished from the orthodox “economics of developing countries”—see box) has, for good or ill, shaped policies for, as well as beliefs about, economic development in the Third World. Viewing the interwar experience of the world economy as evidence of the intellectual deficiencies of conventional economics (embodied, for instance, in the tradition of Marshall, Pigou, and Robertson) and seeking to emulate Keynes’ iconoclasm (and hopefully renown), numerous economists set to work in the 1950s to devise a new unorthodox economics particularly suited to developing countries (most prominently, Nurkse, Myrdal, Rosenstein-Rodan, Balogh, Prebisch, and Singer). In the subsequent decades numerous specific theories and panaceas for solving the economic problems of the Third World have come to form the corpus of a “development economics.” These include: the dual economy, labor surplus, low level equilibrium trap, unbalanced growth, vicious circles of poverty, big push industrialization, foreign exchange bottlenecks, unequal exchange, “dependencia,” redistribution with growth, and a basic needs strategy—to name just the most influential in various times and climes.

Development economicsis used to denote economics with a particular view of developing countries and the development process, in contrast to the mere application of orthodox economics to the study of developing countries. For a discussion of this topic, see A.O. Hirsch-man’sEssays in Trespassing, (Cambridge, 1981).

Those who sought a new economics claimed that orthodox economics was (1) unrealistic because of its behavioral, technological, and institutional assumptions and (2) irrelevant because it was concerned primarily with the efficient allocation of given resources, and hence could deal neither with the so-called dynamic aspects of growth nor with various ethical aspects of the alleviation of poverty or the distribution of income. The twists and turns that the unorthodox theories have subsequently taken may be traced in four major areas: (1) the role of foreign trade and official or private capital flows in promoting economic development, (2) the role and appropriate form of industrialization in developing countries, (3) the relationship between the reduction of inequality, the alleviation of poverty, and the so-called different “strategies of development,” and (4) the role of the price mechanism in promoting development.

The last is, in fact, the major debate that in a sense subsumes most of the rest, and it is the main concern of this article; for the major thrust of much of “development economics” has been to justify massive government intervention through forms of direct control usually intended to supplant rather than to improve the functioning of, or supplement, the price mechanism. This is what I label the dirigiste dogma, which supports forms and areas of dirigisme well beyond those justifiable on orthodox economic grounds.

The empirical assumptions on which this unwarranted dirigisme was based have been repudiated by the experience of numerous countries in the postwar period. This article briefly reviews these central misconceptions of “development economics.” References to the evidence as well as an elucidation of the arguments underlying the analysis (together with various qualifications) can be found in the author’s work cited in the accompanying box.

Denial of “economic principle”

The most basic misconception underlying much of development economics has been a rejection (to varying extents) of the behavioral assumption that, either as producers or consumers, people, as Hicks said, “would act economically; when the opportunity of an advantage was presented to them, they would take it.” Against these supposedly myopic and ignorant private agents (that is, individuals or groups of people), development economists have set some official entity (such as government, planners, or policymakers) which is both knowledgeable and compassionate. It can overcome the defects of private agents and compel them to raise their living standards through various dirigiste means.

Numerous empirical studies from different cultures and climates, however, show that uneducated private agents—be they peasants, rural-urban migrants, urban workers, private entrepreneurs, or housewives—act economically as producers and consumers. They respond to changes in relative prices much as neoclassical theory would predict. The “economic principle” is not unrealistic in the Third World; poor people may, in fact, be pushed even harder to seek their advantage than rich people.

Nor are the preferences of Third World workers peculiar in that for them too (no matter how poor), the cost of “sweat” rises the harder and longer they work. They do not have such peculiar preferences that when they become richer they will not also seek to increase their “leisure”—an assumption that underlies the view that there are large pools of surplus labor in developing countries that can be employed at a low or zero social opportunity cost. They are unlikely to be in “surplus” in any meaningful sense any more than their Western counterparts.

Nor are the institutional features of the Third World, such as their strange social and agrarian structures or their seemingly usurious informal credit systems, necessarily a handicap to growth. Recent applications of neoclassical theory show how, instead of inhibiting efficiency, these institutions—being second-best adaptations to the risks and uncertainties inherent in the relevant economic environment—are likely to enhance efficiency.

Finally, the neoclassical assumption about the possibilities of substituting different inputs in production has not been found unrealistic. The degree to which inputs of different factors and commodities can be substituted in the national product is not much different in developed or developing countries. Changes in relative factor prices do influence the choice of technology at the micro level and the overall labor intensity of production in Third World economies.

This article is based on the author’s The Poverty of Development Economics, Institute of Economic Affairs, London, 1983, where supportive evidence for his arguments can be found. An American edition is to be published in 1985 by Harvard University Press—Editor.

Market vs. bureaucratic failure

A second and major strand of the unwarranted dirigisme of much of development economics has been based on the intellectually valid arguments against laissez-faire. As is well known, laissez-faire will only provide optimal outcomes if perfect competition prevails; if there are universal markets for trading all commodities (including future “contingent” commodities, that is, commodities defined by future conditions, such as the impact of weather on energy prices); and if the distribution of income generated by the laissez-faire economy is considered equitable or, if not, could be made so through lump-sum taxes and subsidies. As elementary economics shows, the existence of externalities in production and consumption and increasing returns to scale in production, or either of them, will rule out the existence of a perfectly competitive Utopia. While, clearly, universal markets for all (including contingent) commodities do not exist in the real world, to that extent market failure must be ubiquitous in the real world. This, even ignoring distributional considerations, provides a prima facie case for government intervention. But this in itself does not imply that any or most forms of government intervention will improve the outcomes of a necessarily imperfect market economy.

For the basic cause of market failure is the difficulty in establishing markets in commodities because of the costs of making transactions. These transaction costs are present in any market, or indeed any mode of resource allocation, and include the costs of excluding nonbuyers as well as those of acquiring and transmitting the relevant information about the demand and supply of a particular commodity to market participants. They drive a wedge, in effect, between the buyer’s and the seller’s price. The market for a particular good will cease to exist if the wedge is so large as to push the lowest price at which anyone is willing to sell above the highest price anyone is willing to pay. These transaction costs, however, are also involved in acquiring, processing, and transmitting the relevant information to design public policies, as well as in enforcing compliance. There may, consequently, be as many instances of bureaucratic as of market failure, making it impossible to attain a full welfare optimum. Hence, the best that can be expected in the real world of imperfect markets and imperfect bureaucrats is a second best. But judging between alternative second best outcomes involves a subtle application of second-best welfare economics, which provides no general rule to permit the deduction that, in a necessarily imperfect market economy, particular dirigiste policies will increase economic welfare. They may not; and they may even be worse than laissez-faire.

Foretelling the future

Behind most arguments for dirigisme, particularly those based on directly controlling quantities of goods demanded and supplied, is the implicit premise of an omniscient central authority. The authority must also be omnipotent (to prevent people from taking actions that controvert its diktat) and benevolent (to ensure it serves the common weal rather than its own), if it is to necessarily improve on the working of an imperfect market economy. While most people are willing to question the omnipotence or benevolence of governments, there is a considerable temptation to believe the latter have an omniscience that private agents know they themselves lack. This temptation is particularly large when it comes to foretelling the future.

Productive investment is the mainspring of growth. Nearly all investment involves giving hostages to fortune. Most investments yield their fruits over time and the expectations of investors at the time of investment may not be fulfilled. Planners attempting to direct investments and outputs have to take a view about future changes in prices, tastes, resources, and technology, much like private individuals. Even if the planners can acquire the necessary information about current tastes, technology, and resources in designing an investment program, they must also take a view about likely changes in the future demand and supply of myriad goods. Because in an uncertain world there can be no agreed or objective way of deciding whether a particular investment gamble is sounder than another, the planned outcomes will be better than those of a market system (in the sense of lower excess demand for or supply of different goods and services) only if the planners’ forecasts are more accurate than the decentralized forecasts made by individual decision makers in a market economy. There is no reason to believe that planners, lacking perfect foresight, will be more successful at foretelling the future than individual investors.

Outcomes based on centralized forecasts may, indeed, turn out to be worse than those based on the decentralized forecasts of a large number of participants in a market economy, because imposing a single centralized forecast on the economy in an uncertain world is like putting all eggs in one basket. By contrast, the multitude of small bets, based on different forecasts, placed by a large number of decision makers in a market economy may be a sounder strategy. Also, bureaucrats, as opposed to private agents, are likely to take less care in placing their bets, as they do not stand to lose financially when they are wrong. This assumes, of course, that the government does not have better information about the future than private agents. If it does, it should obviously disseminate it, together with any of its own forecasts. On the whole, however, it may be best to leave private decision makers to take risks according to their own judgments.

This conclusion is strengthened by the fact, emphasized by Hayek, that most relevant information is likely to be held at the level of the individual firm and the household. A major role of the price mechanism in a market economy is to transmit this information to all interested parties. The “planning without prices” favored in practice by some planners attempts to supersede and suppress the price mechanism. It thereby throws sand into one of the most useful and relatively low-cost social mechanisms for transmitting information, as well as for coordinating the actions of large numbers of interdependent market participants. The strongest argument against centralized planning, therefore, is that, even though omniscient planners might forecast the future more accurately than myopic private agents, there is no reason to believe that ordinary government officials can do any better—and some reason to believe they may do much worse.

It has nevertheless been maintained that planners in the Third World can and should directly control the pattern of industrialization. Some have put their faith in mathematical programming models based on the use of input-output tables developed by Leontief. But, partly for the reasons just discussed, little reliance can be placed upon either the realism or the usefulness of these models for deciding which industries will be losers and which will be winners in the future. There are many important and essential tasks for governments to perform (see below), and this irrational dirigisme detracts from their main effort.

Redressing inequality and poverty

Finally, egalitarianism is never far from the surface in most arguments supporting the dirigiste dogma. This is not surprising since there may be good theoretical reasons for government intervention, even in a perfectly functioning market economy, in order to promote a distribution of income desired on ethical grounds. Since the distribution resulting from market processes will depend upon the initial distribution of assets (land, capital, skills, and labor) of individuals and households, the desired distribution could, in principle, be attained either by redistributing the assets or by introducing lump-sum taxes and subsidies to achieve the desired result. If, however, lump-sum taxes and subsidies cannot be used in practice, the costs of distortion from using other fiscal devices (such as the income tax, which distorts the individual’s choice between income and leisure) will have to be set against the benefits from any gain in equity. This is as much as theory can tell us, and it is fairly uncontroversial.

Problems arise because we lack a consensus about the ethical system for judging the desirability of a particular distribution of income. Even within Western ethical beliefs, the shallow utilitarianism that underlies many economists’ views about the “just” distribution of income and assets is not universally accepted. The possibility that all the variegated peoples of the world are utilitarians is fairly remote. Yet the moral fervor underlying many economic prescriptions assumes there is already a world society with a common set of ethical beliefs that technical economists can take for granted and use to make judgments encompassing both the efficiency and equity components of economic welfare. But casual empiricism is enough to show that there is no such world society; nor is there a common view, shared by mankind, about the content of social justice.

There is, therefore, likely to be little agreement about either the content of distributive justice or whether we should seek to achieve it through some form of coercive redistribution of incomes and assets when this would infringe other moral ends, which are equally valued. By contrast, most moral codes accept the view that, to the extent feasible, it is desirable to alleviate abject, absolute poverty or destitution. That alleviating poverty is not synonymous with reducing the inequality of income, as some seem still to believe, can be seen by considering a country with the following two options. The first option leads to a rise in the incomes of all groups, including the poor, but to larger relative increases for the rich, and hence a worsening of the distribution of income. The second leads to no income growth for the poor but to a reduction in the income of the rich; thus the distribution of income improves but the extent of poverty remains unchanged. Those concerned with inequality would favor the second option; those with poverty the first.

Thus, while the pursuit of efficient growth may worsen some inequality index, there is no evidence that it will increase poverty.

Surplus labor and “trickle down”

As the major asset of the poor in most developing (as well as developed) countries is their labor time, increasing the demand for unskilled labor relative to its supply could be expected to be the major means of reducing poverty in the Third World. However, the shadows of Malthus and Marx have haunted development economics, particularly in its discussion of equity and the alleviation of poverty. One of the major assertions of development economics, preoccupied with “vicious circles” of poverty, was that the fruits of capitalist growth, with its reliance on the price mechanism, would not trickle down or spread to the poor. Various dirigiste arguments were then advocated to bring the poor into a growth process that would otherwise bypass them. The most influential, as well as the most famous, of the models of development advanced in the 1950s to chart the likely course of outputs and incomes in an overpopulated country or region was that of Sir Arthur Lewis. It made an assumption of surplus labor that, in a capitalist growth process, entailed no increase in the income of laborers until the surplus had been absorbed.

It has been shown that the assumptions required for even under-employed rural laborers to be “surplus,” in Lewis’ sense of their being available to industry at a constant wage, are very stringent, and implausible. It was necessary to assume that, with the departure to the towns of their relatives, those rural workers who remained would work harder for an unchanged wage. This implied that the preferences of rural workers between leisure and income are perverse, for workers will not usually work harder without being offered a higher wage. Recent empirical research into the shape of the supply curve of rural labor at different wages has found that—at least for India, the country supposedly containing vast pools of surplus labor—the curve is upward-sloping (and not flat, as the surplus labor theory presupposes). Thus, for a given labor supply, increases in the demand for labor time, in both the industrial and the rural sectors, can be satisfied only by paying higher wages.

The fruits of growth, even in India, will therefore trickle down, in the sense either of raising labor incomes, whenever the demand for labor time increases by more than its supply, or of preventing the fall in real wages and thus labor incomes, which would otherwise occur if the supply of labor time outstripped the increase in demand for it. More direct evidence about movements in the rural and industrial real wages of unskilled labor in developing countries for which data are available has shown that the standard economic presumption that real wages will rise as the demand for labor grows, relative to its supply, is as valid for the Third World as for the First.

Administrative capacities

It is in the political and administrative aspects of dirigisme that powerful practical arguments can be advanced against the dirigiste dogma. The political and administrative assumptions underlying the feasibility of various forms of dirigisme derive from those of modern welfare states in the West. These, in turn, reflect the values of the eighteenth-century Enlightenment. It has taken nearly two centuries of political evolution for those values to be internalized and reflected (however imperfectly) in the political and administrative institutions of Western societies. In the Third World, an acceptance of the same values is at best confined to a small class of Westernized intellectuals. Despite their trappings of modernity, many developing countries are closer in their official workings to the inefficient nation states of seventeenth- or eighteenth-century Europe. It is instructive to recall that Keynes, whom so many dirigistes invoke as a founding father of their faith, noted in The End of Laissez-Faire: But above all, the ineptitude of public administrators strongly prejudiced the practical man in favor of laissez-faire—a sentiment which has by no means disappeared. Almost everything which the State did in the 18th century in excess of its minimum functions was, or seemed, injurious or unsuccessful. It is in this context that anyone familiar with the actual administration and implementation of policies in many Third World countries, and not blinkered by the dirigiste dogma, should find that oft-neglected work, The Wealth of Nations, both so relevant and so modern.

For in most of our modern-day equivalents of the inefficient eighteenth-century state, not even the minimum governmental functions required for economic progress are always fulfilled. These include above all providing public goods of which law and order and a sound money remain paramount, and an economic environment where individual thrift, productivity, and enterprise is cherished and not thwarted. There are numerous essential tasks for all governments to perform. One of the most important is to establish and maintain the country’s infrastructure, much of which requires large, indivisible lumps of capital before any output can be produced. Since the services provided also frequently have the characteristics of public goods, natural monopolies would emerge if they were privately produced. Some form of government regulation would be required to ensure that services were provided in adequate quantities at prices that reflected their real resource costs. Government intervention is therefore necessary. And, given the costs of regulation in terms of acquiring the relevant information, it may be second best to supply the infrastructure services publicly.

These factors justify one of the most important roles for government in the development process. It can be argued that the very large increase in infrastructure investment, coupled with higher savings rates, provides the major explanation of the marked expansion in the economic growth rates of most Third World countries during the postwar period, compared with both their own previous performance and that of today’s developed countries during their emergence from underdevelopment.

Yet the dirigistes have been urging many additional tasks on Third World governments that go well beyond what Keynes, in the work quoted above, considered to be a sensible agenda for mid-twentieth-century Western polities:

the most important Agenda of the State relate not to those activities which private individuals are already fulfilling, but to those functions which fall outside the sphere of the individual, to those decisions which are made by no one if the State does not make them. The important thing for governments is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all.

From the experience of a large number of developing countries in the postwar period, it would be a fair professional judgment that most of the more serious distortions are due not to the inherent imperfections of the market mechanism but to irrational government interventions, of which foreign trade controls, industrial licensing, various forms of price controls, and means of inflationary financing of fiscal deficits are the most important. In seeking to improve upon the outcomes of an imperfect market economy, the dirigisme to which numerous development economists have lent intellectual support has led to policy-induced distortions that are more serious than, and indeed compound, the supposed distortions of the market economy they were designed to cure. It is these lessons from accumulated experience over the last three decades that have undermined development economics, so that its demise may now be conducive to the health of both the economics and economies of developing countries.

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