1 DEVELOPMENT THEORY AND THE ECONOMICS OF GROWTH Jaime Ros University of Notre Dame June 1999 DRAFT 2 Contents Introduction 1. The book’s aim and scope 2. Overview of the book 1. Some stylized facts 1. Incomes per capita across the world 2. Growth rates since 1965 Appendix 2. A mature economy: growth and factor accumulation 1. The Solow model 2. Empirical shortcomings 3. Extensions: technology and human capital 4. Endogenous investment rates Appendix 3. Labor surplus economies 1. The Lewis model 2. Are savings rates correlated with profit shares? 3. Surplus labor and the elasticity of labor supply 4. Efficiency wages and underemployment Appendix 4. Increasing returns, external economies, and multiple equilibria 3 1. Increasing returns to scale and efficiency wages 2. Properties and extensions 3. Empirical evidence Appendix 5. Internal economies, imperfect competition and pecuniary externalities 1. The big push in a multisectoral economy 2. Economies of specialization and a Nurksian trap 3. Vertical externalities: A Rodan-Hirschman model 6. Endogenous growth and early development theory 1. Models of endogenous growth 2. Empirical assessment 3. A development model with increasing returns and skill acquisition 7. Trade, industrialization, and uneven development 1. Openness and growth in the neoclassical framework 2. The infant industry argument as a case of multiple equilibria 3. Different rates of technical progress 4. Terms of trade and uneven development Appendix 8. Natural resources, the Dutch disease, and the staples thesis 1. On Graham's paradox 2. The Dutch disease under increasing returns 3. Factor mobility, linkages, and the staple thesis 4. An attempt at reconciliation: Two hybrid models Appendix 9. Growth and the pattern of specialization 1. Determinants of the pattern of specialization 4 2. Trade specialization and growth 3.Industrial policy, transitory shocks and growth 4. Trade, investment and growth: an empirical analysis Appendix 10. Development, income distribution and inequality traps 1. Stylized facts 2. Economic inequality and income 3. The effects of inequality on growth 4. Inequality traps at middle income levels Appendix 11. Structural constraints: domestic and foreign exchange bottlenecks 1. Domestic constraints: Kalecki's dual economy model 2. The wage-goods constraint, inflation and the structuralist controversy 3. Foreign exchange constraints and two gap models 4. Foreign exchange constraints on domestic supply 12. Debt traps and demand-constrained growth 1. An open economy Harrod-Domar model 2. Demand-constrained growth paths 3. Longer run adjustments: factor accumulation and effective demand 4. The debt crisis and macroeconomic instability in Latin America 13. In defense of development economics 1. The empirical case: closing arguments 2. Multiple equilibria and the big push: some misinterpretations 3. Openness and development traps 4. Towards a unified and extended research program References 5 INTRODUCTION One way to describe this book is as a collection of essays in 'trespassing' between two disciplines: development economics and growth theory. This way of stating it raises immediately a puzzle that motivates the book. For as most external observers would probably agree, these two fields should be one and the same, with no need for trespassing at all. At least, they should be interacting closely with one another. The trouble is, of course, that they are not. Growth theory and development economics have for a long time been distant cousins, and occasionally even hostile to one another. Most of this introduction is about why this is so. The rest of the book is an effort to show why they should be interacting more closely: many insights of development economics are not only very valuable but can be made perfectly intelligible to researchers working on the economics of growth, and that some of the formal contributions of orthodox growth theory can be put to good use in clarifying unsettled (and sometimes obscurely formulated) issues in development theory. In recent years, after two decades of quasi-inactivity in the field, the economics of growth has become again the subject of intense theoretical and empirical research. Broadly speaking, this renewed effort has taken two different directions. Some have adapted and extended the neoclassical growth model as formalized by Robert Solow (1956) and others in the mid fifties, while retaining the assumptions of constant returns to scale and exogenous technical progress. Others have taken more radical departures from the neoclassical model by bringing in increasing returns to scale and attempting to model technological change. This last is the new brand of endogenous growth theory. In both cases, and this is perhaps the most novel feature of the reawakened field, these efforts try to explain the process of economic growth in developed and developing countries alike within a unified analytical framework. Important questions such as: Why are some nations poorer than others and why the economies of some countries grow so much faster than others, are now at the center of the research agenda of mainstream growth theory. This contemporary revival of growth economics, or at least most of it, has proceeded on the rather astonishing premise that before the mid 1980s the only answers to those questions were to be found in the neoclassical growth model. The premise is astonishing for at least two reasons. First, because some fifty years ago a then new field of economic theory emerged aiming to answer similar questions, to address issues about the persistence of underdevelopment and to search for remedies to overcome poverty. Development economics as it appeared in the 1940s and 1950s in the writings of Rosenstein-Rodan, Nurkse, Prebisch, Hirschman, Leibenstein, and others, stressed the barriers to industrialization and capital formation in underdeveloped countries. Successful development required the overcoming of various inhibiting factors, including the presence of externalities and some form of increasing returns to scale. The nature of the issues addressed made the new field relying on a paradigm built upon notions of imperfect competition, increasing returns and labor surpluses not properly integrated, or 6 altogether alien, to the then established body of economic theory, but which today are used extensively. Second, and somewhat ironically, the Solow model was not meant primarily to answer those questions but rather to provide a solution to some difficulties in growth theory at the time (Harrod's knife edge stability and the adjustment of the warranted to the natural rate of growth in the Harrod-Domar model). Having the neoclassical growth model explain differences in income levels and growth rates across countries requires a number of additional assumptions that Solow himself probably did not have in mind: in a nutshell, that countries differ among themselves only in their initial capital-labor ratios, savings rates and population growth rates. This is perhaps one reason why development economics had already taken a distinctive approach a decade before the rise to dominance of the neoclassical growth theory. Whether one could make fruitful empirical generalizations about the economic experience of developing countries or not, it was clear that the stylized facts on which traditional growth theory focused — with its emphasis on the stability of the capital- output ratio, savings rates and income shares — had little relevance to the experience of developing countries. Lewis (1954), for example, had tried to account for the trend increase, rather than the stability, of saving and investment rates in the course of economic development. Given its purposes, growth theory tended to adopt a very high level of aggregation; often an economy with one sector producing one good. The striking and persistent presence of dualism (technological and organizational) in underdeveloped countries, led development economics to operate at a lower level of aggregation, with at least two sectors using different technologies. Growth theory soon became concentrated on the analysis of steady states in which most or all economic variables expand at the same rate. Because this analysis did not fit well the experience of developing countries, development theory had to focus instead on disequilibrium states and the process of transition from one steady state to the other. As Rosenstein-Rodan (1984, pp. 207-208) argued: "...an analysis of the disequilibrium growth process is what is essential for understanding economic development problems. The Economic Journal article of 1943 attempted to study the dynamic path towards equilibrium, not merely the conditions which must be satisfied at the point of equilibrium." This does not mean that development theory was uninterested in steady states. It became concerned, however, with a particular kind of steady state quite alien to conventional growth theory: low level equilibrium traps which are, as the name suggests, equilibria that are locally stable (small departures from it generate forces that bring the economy back to the equilibrium state) but globally unstable, so that large shocks can cause a cumulative departure from the original equilibrium. Leibenstein (1957, p.187), for example, stated: "The crucial aspect of our theory has to do with an explanation of why the subsistence equilibrium state should possess stability in the small but not in the large." 7 This leads us finally to an important aspect. To the classics of development theory,