Unit 3: The Strategy of Economic Development: Institutional Pathways
Reference: Nurkse, Ragnar (1961). Problems of Capital Formation in Underdeveloped Countries. New York: Oxford University Press
Vicious Circle of Poverty
Vicious circle of poverty refers to a phenomenon wherein a poor country remains in the poverty trap due to its initial low levels of income. As low income level implies a small capacity to save (most of the income is spent on consumption), there is a lack of sufficient capital formation or investment in the country. Due to lack of investment in machinery, infrastructure and other capital goods, the productivity of labor remains low. This prevents them from earning higher incomes and thus the overall income level of the country remains perpetually low.
Then how can a poor, subsistence farming economy may achieve higher flow of real income capable of being directed to capital formation? Foreign investment is necessary to bring initial improvement in productivity and real income, that will increase domestic saving and break the cycle of vicious poverty.
Demonstration Effect
Even though the absolute incomes of most poor countries have increased in the last few years, their relative incomes remain lower. The capacity to save depends on real income.
There is an interrelatedness in individual consumption functions. Higher income groups are generally shown to save a larger proportion of their incomes.
But this result does not hold true when we consider changes through time, or national income as a whole.
Eg: A man earns $1500 and saved $120 in 1919
earns $2000 and saved $100 in 1941
(both in terms of constant prices)
Even though this individual was richer (in real terms) in 1941 his savings rate reduced from 8% to 5%.
This is often due to a phenomenon called “demonstration effect” which says that the amount of individual savings depends not just on real income but also on the relation of income to superior level of income of other people nearby. Which basically means that a person wants to maintain the same lifestyle as the people nearby them and therefore their savings rate will be impacted by consumption functions of other people who are earning more than them.
Some reasons behind demonstration effect:
- Growing awareness of advanced living standards.- New goods often become necessities, which are often imported in poor countries. Mere knowledge of the existence of these new superior goods increases the aspirational standard of living.
- Widespread imitation of western consumption patterns reduces the willingness to save in poor countries.
Demonstration effect on propensity to save:
- This attraction to higher standard of living is a handicap for late comers in economic development as it makes it difficult to mobilize resources for real capital formation without the increment being immediately consumed, rather than re-invested
- - Demonstration effect may be stronger in less poor countries as groups in extreme poverty may not be able to even afford superior goods even after diverting savings
- - There is a difference between “ability to save” and “willingness to save”. Demonstration effect makes people less willing to save and more willing to consume
The vicious cycle of poverty is bad in itself but it is made worse by the demonstration effect. It causes changes in productivity and income level and also affects Balance of Payments.
Some solutions to this problem:
- - Some countries might opt for a model of economic isolation ton reduce demonstration effect. But the cost of isolation is very high wrt political relations, economic stagnation etc. Hence this is called the “Defeatist solution”
- - International/interregional income transfers
Reference: Albert O. Hirschman, Ch. 3: Linkages in Economic Development in Rival Views of Market Society and Other Essays
Hirschman’s critique of Harrod Domar model:
- - It focuses too much on capital output ratio and on the availability of savings (both domestic and international) as determinants of growth.
- - Natural resources, other factors of production and entrepreneurship are taken as given and only consideration is in their allocation
He contended that development depends not only on allocation of existing resources but “calling forth and enlisting for development, the resources that are hidden, scattered or badly utilized”.
He places value on investment decisions not only for their immediate contribution to output but because of impulses such decisions are likely to impart to further investment. This is called “linkages“.
Linkage means when an investment decision triggers further investment into another area.
He proposes economic strategy to be based on dynamic considerations, based on linkages, to compliment state efficiency.
Backward and Forward Linkage
Backward linkage happens when the direction of stimulus towards further investment flows from the finished goods back to the input or machines used to make it. It arises due to normal entrepreneurship behavior and state policies that favor forex savings and an integrated industrial structure.
Forward linkage happens when the existence of a given product line A acts as a stimulant to the establishment of another line B, in which it can also be used as an input. It arises due to efforts of existing producers to increase and diversify the market for their goods.
Backward linkage dynamic is very important for newly industrializing countries. Their industrialization model was to give last touches to semi-processed imports and then work their way backward to setup the full process. It sometimes leads to “vertical integration” of family firms or groups.
This model for newly industrializing countries was called “import substituting industrialization“. This is unlike early industrialized nations, where all stages worked in a balanced and integrated manner.
Consumption Linkage
Consumption linkage is defined as the stimulus towards domestic production of consumer goods that will be undertaken as newly earned incomes are spent on such goods. These may be first imported as incomes start rising and that will give incentives to domestic producers to increase investment and output. Consumption linkage is the initial step in import substituting industrialization.
Fiscal Linkage
When the government extracts the flow of income accruing to exporters or imposes tariffs on imports- in order to finance public investment projects, it is known as fiscal linkage. Government takes advantage of some existing source of economic growth to stimulate growth elsewhere. Unlike backward and forward linkage, the new investment in fiscal linkage could be in a completely new field or sector.
Direct fiscal linkage is extraction (and subsequent expenditure) of revenue through export taxes.
Indirect fiscal linkage is raising (and disposal) of fiscal revenue through impot tariffs.