Explaining differences in economic growth and development

Savings and Investment

Investment in manufactured capital requires savings – or financial capital: Some of a country's current output might not be immediately consumed, but rather set aside and spent on assets that will increase productivity in the future. So one reason why a country may do well is if it has high levels of savings and investment.

Investment in industrial manufactured capital, however, is not the only important kind of investment. Investments in agriculture, through improvement of seeds, irrigation, and the like have also often contributed to growth. Nations can also invest in human capital by improving their country's systems of education and health care. Workers who are skilled and healthy are more able to be productive. Many economists stress that education in science and technology, in particular, is likely to have significant effects on growth.

However, additions to capital do not automatically lead to growth. Unwise development projects have sometimes led to waste or even harm. Inappropriate factories have sometimes been left to rust, while misguided irrigation projects have sometimes destroyed fields through salinization. Investment must be well directed in order to have long-term benefits. Governments have often been the culprits when major investment schemes have gone awry; but, in different cases, governments have also been the designers of very successful, country-wide investment policies.

Technological Innovation and Entrepreneurship

Countries often enhance productivity by adopting technology that was originally developed elsewhere. They may obtain this technology by buying machinery, by having their workers or engineers trained in foreign countries, or by welcoming foreign-owned businesses that will introduce more advanced technologies. Other countries have jumped ahead in economic growth by nurturing strong domestic programs of research and development, often supported by government funds.

Advances in technology in China and India have been particularly interesting. According to conventional economic wisdom, such labor-rich developing countries should follow their natural comparative advantage and export relatively low-tech, labor-intensive goods. Yet these countries have deliberately broken into international markets in sophisticated products such as high-tech electronic equipment and computer software, exporting goods and services that embody a far higher level of technology than one might expect from them. This pattern may be a crucial factor in explaining their strong economic growth.

Along with investment in capital, change in the social organization of production is one of the hallmarks of development. For a country to experience change someone, somewhere, must be willing to "do something different." This has often been an advantage of private entrepreneurship. The prospect of earning profits can be a strong motivation for an innovator to gather together the necessary resources and inputs to start a new production process, even while knowing that he or she also faces a substantial risk of failure.

Sometimes development can be assisted by ensuring that financial capital gets to the people who have "good ideas." Recently, some development projects have focused on distributing "micro-credit" to very small-scale entrepreneurs, often women, so that they can build up their businesses. In other cases, foreign companies are welcomed to a country because it is believed that their experience in organizing production, marketing, and the like (as well as the capital and technology they may bring) will cause domestic resources to be put to fuller use. It is hoped that their risk-taking example and their management knowledge will have positive "spillover" effects on domestic businesses.

Advances in management and organization can, however, be short-circuited by bad policies, whether active or passive. In some cases, business innovation has been discouraged by government imposition of very high tax rates or excessively burdensome regulations. Governments may also discourage entrepreneurship by failing to create good infrastructure such as roads and communication facilities, or to invest in the health and education of their citizens, or when they have tolerated traditions of bribery or other corrupt practices.

At the same time, some governments have played crucial roles in encouraging organizational innovation. Many currently high-income countries used industrial policies to boost development, by selecting certain industries to receive special governmental support. A massive industrial push, on the scale seen, for example, during Japan's industrialization, or currently in China and India, is an operation that is generally both too large and too risky to be accomplished solely by private, decentralized businesses.

Macroeconomic Policy and Trade

Since there would be little point in increasing production if what is made cannot find a market, the level of aggregate demand in an economy is also important for growth. Macroeconomic policies to stabilize aggregate demand—and particularly, to prevent or aid recovery from recessions—are thus also crucial. Many nations, however, have suffered from bad macroeconomic policies which, though often intended to promote growth, have actually damaged the economy. A common policy error is to use excessive government spending to stimulate demand. Large budget deficits can offer short-term stimulation, but if continued almost always lead to severe inflation, which undermines stability and growth. On the other hand, strict budget-balancing policies, often forced on developing countries by international lending agencies, can undercut essential investment in human capital and infrastructure. Striking a good macroeconomic balance is often difficult for countries struggling to cope with the many difficulties involved in development.

Access to international markets for inputs, and for places in which to sell products, has also been an important factor in increasing production and aggregate demand. England built up its manufacturing industry in part by relying on its colonies for cheap inputs, and selling its manufactured goods to them. Countries like Japan and South Korea broke into the ranks of more advanced economies by developing powerful export industries. China is now following this same path. A growing export market provides steadily increased demand for production, boosting GDP. It also provides foreign exchange to purchase investment goods and gain access to new technologies.

Export dependence, however, can also be a trap that stifles economic development when countries depend on products for which world demand is limited. Producers of agricultural exports, in particular, often suffer when world terms of trade turn against them, so that the value of what they can sell on the world market drops relative to the value of what they want to import. Successful industrializers have also tended to make use of strategies of infant industry protection and import substitution—limiting the penetration of trade in some parts of their economies—to build and diversify their industrial base. Once again, the issue is not just what a government chooses to do, but how it does it. The strategies just mentioned have worked when applied well, and not worked otherwise.

Natural Resources

Natural resources are an important asset for development, but the overexploitation of natural resources can lead both to environmental degradation and to economic distortion. Large expanses of arable land, rich mineral and energy resources, good natural port facilities, and a healthy climate may make it easier for a country to prosper, while a poor natural endowment, such as a climate that makes a country prone to malaria or drought, can be a serious drag on development.

But here again, as mentioned before the historical record includes some surprises. Hong Kong and Singapore have prosperous trade-based economies, even though they have very scant domestic resources, with little land or energy of their own. Resource-rich Russia, on the other hand, is struggling. Countries like Nigeria have found that oil reserves, seemingly a source of wealth, can easily be misused with very damaging effects on development. Uncontrolled oil revenues can lead to massive corruption and waste, while other sectors of the economy are starved of investment and resources, as available resources go primarily towards oil production. And since oil is a depletable resource, the country can eventually run out of oil and find itself worse off than before.

Foreign Capital

What happens if a country is not able to finance the investments it needs to develop out of its own domestic savings? In this case, grants, loans, or investments from abroad might finance investments in manufactured or human capital. The sources of foreign capital for development can be either public or private.

Public aid for development can take the form of either bilateral assistance or multilateral assistance. Bilateral development assistance consists of grants or loans made by a rich country government to a poorer nation. Many developing nations also receive multilateral development assistance from institutions such as the World Bank and regional development banks such as the Inter-American Development Bank. Countries may also borrow from the International Monetary Fund (IMF), particularly during times of crisis.

Private foreign investment is carried out by private companies or individuals. Foreign direct investment (FDI) occurs when a company or individual acquires or creates assets for its own business operations (for example, a German company building a factory to produce televisions in Mexico). FDI may or may not actually increase capital stock in the recipient nation, since it can include acquisitions of existing capital. Private flows also include loans from private banks.

caption Figure 1: Net Capital Flows to Developing Countries, 1997-2005. In recent years, official flows have diminished, and in 2005 flowed towards the industrialized world. Meanwhile private loans and investments have risen dramatically. Official flows and bilateral aid grants together are less than one fifth of private flows. Source: World Bank, 2006, Global Development Finance: The Development Potential of Surging Capital Flows, Table 1.)

In recent years, private capital flows have become increasingly important in supplying financial capital to developing countries, as shown in Figure 1. Net private flows to developing countries, including both FDI and loans, have risen as investors have sought high returns in "emerging markets." Figure 1 also includes a line for workers’ remittances, since funds sent home by emigrant workers are an important source of income and foreign exchange for many countries. Studies have shown that these remittances are often spent on household investments in education, health, and small-scale entrepreneurship. Their importance has also been increasing. Meanwhile bilateral aid grants have risen only slightly, while multilateral flows turned negative in 2005. This was largely due to multi-billion dollar repayments sent by middle-income developing countries (including Argentina and Brazil) to the IMF. This analysis should not be taken to overstate the importance of foreign investment, however. For most countries, the volume of investment financed by domestic funds is still considerably higher than FDI—on the order of ten times as much, on average.

The empirical evidence concerning the contribution of public and private foreign capital economic growth is, however, very mixed. Some of the countries that are still among the poorest have also been the heaviest recipients of concessional aid. In some cases, aid went to corrupt leaders who spent it on luxury living rather than on benefits for their people. Many poor countries are now highly indebted, and spend more on debt service than on health care for their own populations.

Welcoming foreign businesses also can have a downside. When a large, powerful transnational corporation moves into a developing country, not all of the effects are necessarily positive. Foreign enterprises may "crowd out" local initiatives, by competing with them for finance, inputs, or markets. They may also be disruptive politically or culturally. Some of the most oppressive actions in development history (such as peasants being forcibly turned off their land, or union organizers repressed with violence) have come about through alliances of large transnational corporations with corrupt governments.

Financial, Legal, and Regulatory Institutions

Recently, policymakers have come to a greater appreciation of the role played by financial, legal, and regulatory institutions (which fit into the category of social capital) in encouraging—or discouraging—growth. Very poor countries sometimes have banking and legal systems that do not reach very far into rural areas, and provide credit only for the well-connected, making financing difficult for small businesses and entrepreneurs. The Japanese banking crisis of 1989, which sent the country into recession, brought renewed attention to issues of banking regulation and corporate governance. The experience of Russia, which experienced a fall in gross domestic product (GDP) of over 40% during its emergence from communism in the 1990s, highlighted the need for markets to be based in a good institutional framework.

Countries that have been successful in maintaining growth generally have effective systems of property rights and contract enforcement, which allow entrepreneurs to benefit from their investments, as well as effective corporate and bank regulation. Even in the case of property rights, however, the conventional wisdom does not always hold. China and Vietnam, for example, have been able to attract significant amounts of investment even though, being at least nominally still communist countries, they do not have a system of private property rights. Nevertheless they are able to assure firms that they will benefit from their investments by other means.

Some developing nations suffer from severe corruption, internal conflict, and other factors that make it difficult for effective institutions to take root. Political instability leads to economic inefficiency, difficulty in attracting foreign investment, and slow or no growth. This in turn means that less savings are available for future investment, reinforcing the problems. Breaking this vicious cycle is essential for development, but can be very difficult in practice.

Further Reading



Disclaimer: This article is taken wholly from, or contains information that was originally published by, the Global Development And Environment Institute. Topic editors and authors for the Encyclopedia of Earth may have edited its content or added new information. The use of information from the Global Development And Environment Institute should not be construed as support for or endorsement by that organization for any new information added by EoE personnel, or for any editing of the original content.

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Institute, G. (2007). Explaining differences in economic growth and development. Retrieved from http://www.eoearth.org/view/article/152710

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