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The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics. (Book Review).

By William Easterly.

Cambridge, MA: MIT Press, 2001. Pp. xiii, 342. $29.95.

According to Robert Lucas (1988, P. 3), the problem of economic development is at one level "simply the problem of accounting for the observed pattern, across countries and across time, in levels and rates of growth of per capita income." Economists have been attacking this problem for decades. The last two decades of research on economic development have focused on how technical progress responds to economic incentives, while earlier research had shown the importance of technical progress, as opposed to factor accumulation, in driving sustained, long-run economic growth. Easterly, in his book The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics, combines the existing growth theory tool kit with his own experiences as a policy economist in the World Bank and his empirical research on economic growth to analyze the poverty of nations in the East and the South. He also looks hard at the causes for the failure of government policies and international aid in pulling these nations out of poverty and then suggests alternative solutions.

The book illustrates clearly how fairly abstract economic models can be put to use in real-world policy analysis. Thus, for any student who is being introduced to the economic growth literature, this book is essential reading. It would convince her that the growth literature is not just about fancy dynamics, differential equations, and saddle paths but has something useful to say about both the positive and the normative aspects of the world around us. For the same reason and since the book raises new economic questions, it is invaluable to advanced students as well as researchers in theoretical and empirical growth. It would also be an extremely useful textbook for students in public policy schools. In economics departments, however, this will usefully complement formal growth textbooks, such as Jones (1998) at the undergraduate level and Barro and Sala-i-Martin (1998) and Aghion and Howitt (1998) at the graduate level.

Easterly begins by arguing that economic growth almost always is associated with poverty reduction. In other words, contrary to the much emphasized equity-efficiency trade-off, the poor have had a positive share in the growth experience of almost any country. In order to make this point, he cites empirical research, mainly by many of his World Bank colleagues. For example, one of the studies cited has found that a 1% increase in the per capita income of a country translates into a 1% increase in the incomes of the poorest 20% of its population.

After establishing the importance of growth in poverty reduction, Easterly goes on to analyze the failure of certain economic strategies that have been used extensively over a long period of time in attempting to foster long-run growth. The policy of encouraging investment found support in some of the old pre-1950 growth models, pioneered by Harrod and Domar and popularized by government economists and international lending agencies. These models made a very simple prediction: "GDP growth will be proportional to the share of investment spending in GDP" (p. 29). Based on a target growth rate, foreign aid and government policy to bolster investment in physical capital were used to attack the gap between saving and desired investment. The belief in the success of such policies was strengthened in the 1960s by the importance attached by Rostow (1960) to the "takeoff into self-sustained growth" (p. 31), one of his five stages of economic growth. This takeoff required a large increase in investment. Easterly looks at cross-country data to show that there is an empirical relationship neither between aid and investment nor between investment and growth. Therefore, foreign aid based on the finance gap has not delivered any results. In fact, it has created wrong economic incentives.

Why has accelerated investment not resulted in substantially faster economic growth? In order to answer this question, Easterly first explains Robert Solow's contribution to our understanding of economic growth (Chapter 3). Through numerous interesting illustrations, he explains why, in the presence of diminishing returns to capital, technological progress is necessary for long-run growth. He also discusses how a simple growth-accounting exercise reveals the importance of technical progress in economic history. Easterly uses insights of Solow to explain why "capital fundamentalism" has failed to step up growth in poor countries, that is, why, in the presence of a stagnant technology, the effectiveness of investment, as capital runs into diminishing returns, is extremely limited.

From investment in physical capital, Easterly moves on to analyze the usefulness of the economic strategy of promoting human capital formation (Chapter 4). Again, while the numbers show great improvements in enrollments, their effect on income growth has been limited. He argues that education is a necessary but not a sufficient condition for growth. "The creation of skills in people will respond to incentives to invest in the future. ... Enrollment in formal schooling may be a poor measure of creation of skills" (p. 84).

It has also long been thought that controlling population growth, by preventing excess population from overwhelming an economy's productive capacity, would lead to poverty reduction. Easterly shows that there is no correlation between population growth and per capita income growth (Chapter 5). Also, he is very critical of the active role played by the World Bank and developing-country governments in the implementation of population control measures and the excessive subsidization of contraceptives. Easterly simply argues that in the absence of the incentives for birth control, these expenditures and efforts were wasteful.

There are a couple of chapters specifically focusing on the failure of foreign aid (Chapters 6 and 7). One of the primary functions of multilateral development institutions is to provide aid to poor countries. Their performance is evaluated by the amount of financial aid they give out. This results in easy terms and conditions tied to aid as well as providing aid to the most indebted countries. However, the most indebted countries are the ones that misuse foreign aid. Thus, we get a vicious cycle of aid and debt as well as wrong incentives for developing-country governments. Therefore, it is not surprising that five decades of foreign aid have not produced any tangible results. Easterly suggests that governments should write aid proposals for an aid competition in the same way we write proposals for research grants. He questions the wisdom of conventional debt forgiveness policies and believes that an effective debt relief program has to meet two basic conditions: (i) "there has been a proven change from an i rresponsible government to a government with good policies", and (ii) "it is a once-for-all measure that will never be repeated" (p. 136).

After having critically analyzed the causes for the failure of the traditional policies meant to foster economic growth, the author turns to new solutions. One of the main points he makes in this book is that people (whatever the stage of development of their country) respond to incentives. Unless the poor have "good incentives to grow out of poverty" and unless the government makes a conscious effort to create such incentives and takes care to see that it does not destroy such incentives that already exist, generating economic growth in any developing country is going to be difficult. In this context, where are the barriers to development, and what are the appropriate government policies?

A large number of barriers to development stem from the presence of increasing returns and other externalities, especially in the case of knowledge creation and acquisition (Chapter 8). Knowledge also leaks out, thereby providing opportunities for poor countries to exploit while simultaneously reducing the incentives for the creation of new knowledge and investment in the acquisition of existing knowledge. In this context, there is discussion, with illustrations, about the possibility of vicious cycles and virtuous circles, generally termed "multiple equilibria" in the literature. Initial conditions matter a great deal under these circumstances. Easterly argues how the government, through public investment to cross knowledge thresholds, by subsidization of knowledge and capital accumulation, and by acting as a coordinating agent in private investment decisions, can play an important role in moving an economy from a "bad" to a "good" equilibrium. In this chapter, there is also some attention drawn to the role of "matches" in the presence of complementarities. This discussion is based on Michael Kremer's (1993) "O-Ring" theory of development. Easterly uses the theory to explain the geographical clustering of skills. Further, he uses it to analyze why low-value products are produced by skill-scarce countries. Easterly writes, "If they (unskilled workers) have equal probability of ruining the product in either case, it is better to risk ruining a low value product with no processing (the flax) rather than a high value product already embodying a lot of processing (the linen)" (p. 161).

Easterly then focuses on how growth is driven by the process of "creative destruction." The possibility that new techniques of production will render old techniques unprofitable, obsolete, and useless can reduce the perceived incentives for innovations and lead to the erection of barriers to the acquisition and creation of new technology. These factors result in forces internal to poor countries that impede their economic growth. Governments in these countries should attack this problem by promoting foreign investment, subsidizing capital imports embodying new technology, and subsidizing research and development in technology creation and adoption.

Having suggested alternative policies, Easterly is careful in pointing out the important role of luck in growth (Chapter 10). In this context, he writes, "For the poor, the cycle of good and bad luck takes on a tragic cast, because they have so little to fall back on" (p. 214). However, he emphasizes that growth is not completely random and reiterates that the government has an important role to play in this area.

The focus then shifts to how bad governments can kill growth and to economic and institutional reforms aimed at the elimination of bad economic policies (Chapters 11 and 12). Bad policies can result in high inflation, high exchange rate premia, high budget deficits, and so on. These can have a negative impact on growth through their incentives in favor of unproductive activities. Bad governments can, through policies such as putting an upper bound on nominal interest rates in the presence of high inflation, cause falling and ultimately negative real interest rates, which in turn can lead to the destruction of the banking system, a serious disincentive against accumulation of physical and human capital. Other kinds of bad economic policies include protectionism and the introduction of other kinds of distortions. Easterly discusses some of the empirical studies in this area. Of course, bad governments even fail to provide basic infrastructure and services. Easterly then discusses one major type of institutional failure, namely, corruption, which has been shown empirically to have negative consequences for growth. Again incentives matter, and corruption changes the incentives in favor of unproductive rentseeking activities and against the production of real goods and services. Easterly provides some numbers to give readers a sense of the enormity of the problem. Next, he discusses the corruption ratings of countries based on different definitions of corruption. He discusses the determinants of corruption, such as the extent of ethnic division of society, the importance of foreign aid, the rule of law, the quality of bureaucracy, red tape, and so on. Policies to control corruption are also discussed. In fact, the presence of distortions in the market can accentuate corruption, and economic reforms can therefore reduce corruption.

Finally, there is some discussion about the negative effects of polarization and inequality on growth (Chapter 13). Distributional conflicts in unequal societies impede growth. For such societies, democratic governance and central bank independence have been suggested as possible solutions.

The book is extremely well written, clear, and filled with humor. At the same time, it is a serious and substantial piece of original work. Even though the arguments presented draw quite a bit from the existing empirical and theoretical growth literature, the contribution of the book is that it presents complex ideas in a fairly simple way and then applies these ideas, through numerous illustrations based on the author's own policy experiences, to practical development problems. The balance between theory, empirics, and policy in this book is extraordinary. A book of this kind has been long overdue, and Easterly goes a long way in filling this void.

I would, however, like to point out a few weaknesses or shortcomings of this book. First, the author has completely ignored the issue of redistribution that should accompany any growth process. Even though a 1% increase in the income of the rich is normally associated with the same percentage increase in the income of the poor, there are huge differences between the absolute income increases of the rich and the poor. The evidence clearly shows that the share of the poor in the overall pie does not generally change. Since some redistribution policies can clearly have an adverse effect on the incentives for growth, an important task for many developing countries is to design redistributive policies that minimize the damage to achieving their growth objectives.

Easterly has argued that "capital fundamentalism" and the consequent policy of encouraging investment have not worked. He provides reasons for this failure. However, anyone who has lived in or even visited a third-world country will be aware of the structural bottlenecks arising primarily from the severe lack of proper infrastructure. In other words, there is still a need for certain kinds of investments in infrastructure and, therefore, for aid to finance them. To group all investments together in this context is not fully appropriate. Toward the end of the book, there is only very brief mention of bad governments that fail to deliver proper infrastructure and social services. However, I seriously believe that some of this could have been tied to the chapters on investment and foreign aid.

Next, I have some concerns about Easterly's arguments against the active role played by the World Bank and developing-country governments in the subsidization of contraceptives and implementation of other population control measures. Here, I argue that the maximization of individual self-interest may not lead to socially optimal outcomes since there is a negative externality at work. This externality is that of overcrowding and congestion, particularly in South Asia. Such issues can never enter the calculus of individual incentives. Also, population will be a problem only in developing countries that are overcrowded. However, not all developing countries are overcrowded. Therefore, the effectiveness of population control measures must depend on the existing density of population. As far as empirical evidence is concerned, Barro and Sala-i-Martin (1998) do provide evidence that there is a statistically significant, negative effect of the fertility rate on the growth rate of per capita income. This is not true of the population growth rate, though, which implies that the nature of the population growth also matters.

There is also very little discussion of the role of financial institutions and policies to foster financial development. It is well known that credit market imperfections are a serious obstacle to development, more so in countries where assets are very unequally distributed. The beneficial effects of the existence of sophisticated financial markets on investment and growth have been stressed by King and Levine (1993).

Finally, given the author's experience as a World Bank economist, it would have been interesting to have his views on the implementation of economic policy reforms, especially the role played by international institutions like the World Bank and the political economy factors that lead (or fail to lead) to these reforms. The author talks about institutional reforms; however, I am not sure how such reforms can be brought about, and I find the author's discussion of such issues somewhat vague.

Despite these shortcomings, the book is brilliant, and I highly recommend it to all growth and development economists.

References

Aghion, Philippe, and Peter Howitt. 1998. Endogenous growth theory. Cambridge, MA: MIT Press.

Barro, Robert, and Xavier Sala-i-Martin. 1998. Economic growth. Cambridge, MA: MIT Press.

Jones, Charles. 1998. Introduction to economic growth. New York: W. W. Norton.

King, Robert, and Ross Levine. 1993. Finance, entrepreneurship and growth: Theory and evidence. Journal of Monetary Economics 32:513-42.

Kremer, Michael. 1993. The 0-ring theory of economic development. Quarterly Journal of Economics 108:551-75.

Lucas, Robert. 1988. On the mechanics of economic development. Journal of Monetary Economics 22:3-42.

Rostow, Walt Whitman. 1960. The stages of economic growth: A non-Communist manifesto. Cambridge, UK: Cambridge University Press.
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Author:Mitra, Devashish
Publication:Southern Economic Journal
Article Type:Book Review
Date:Apr 1, 2002
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