Terry J. Fitzgerald - Senior Economist and Vice President
Published September 1, 2003 | September 2003 issue
By William Easterly
Over the past 50 years inflation-adjusted income per person in the United States has tripled. Most of us expect a similar increase over the next 50 years, though perhaps incomes will only double if we face some unexpected adversity. We take for granted that a steady rise in material well-being is a basic fact of life.
But steadily rising income per person is a fairly recent phenomenon. Throughout most of human history there was virtually no increase in the standard of living for most people. As Nobel Laureate Robert Lucas puts it in his book Lectures on Economic Growth (2002), "The living standards of ordinary people in eighteenth-century Europe were about the same as those of people in contemporary China or ancient Rome or, indeed, as those of people in the poorest countries in the world today."
While there were technological improvements and increases in production, population grew at roughly the same rate, leaving output per person largely unchanged. Living standards, and incomes, for "ordinary people" in a society are determined by their ability to produce valued goods and services. The start of the 19th century marked the beginning of a new epoch in human history, the importance of which cannot be overstated. For the first time the growth in humanity's ability to produce exceeded population growth, and living standards began to steadily rise. This period is commonly referred to as the Industrial Revolution.
Unfortunately, the Industrial Revolution has not occurred uniformly around the world. Western Europe and its offshoots were the first to experience steady growth. Since then Japan and several other Far East countries have experienced dramatic increases in income per person. Large parts of Latin America, China, India and Indonesia have also experienced sustained growth to varying degrees, though the rising income levels in these countries remain well below Western standards.
Still, the Industrial Revolution has yet to take hold in large parts of the world, most notably in sub-Saharan Africa and some other tropical countries. This observation is the launching point for William Easterly's captivating book The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics.
Easterly's analysis of the quest for growth in developing countries is divided into three sections. The first provides a brief, but compelling, motivation for "Why Growth Matters." The second section, "Panaceas That Failed," provides a fascinating discussion of failed efforts by the World Bank and the International Monetary Fund to promote growth in poor countries. Here Easterly provides harsh criticism of the policies that these international financial institutions (IFIs) have pursued over the past 50 years. His basic premise is that the failure of these policies was not a failure of economics, but rather a failure to apply basic economic principles—most notably that people respond to incentives. His overriding theme throughout the book is that good policy must provide the right economic incentives, and he documents the failure of the IFIs' policies to do so.
The third section of the book, "People Respond to Incentives," discusses many of the major ideas in the modern economics literature on growth, and the author offers his suggestions for policies that will more likely foster economic growth in developing countries. While this section lacks the clarity and punch of the preceding sections, it still provides thoughtful and interesting insights into the nature of economic growth and the ingredients required for sound economic policies.
Easterly's background as a World Bank economist and his active research career provide him with a rare perspective. They also make him an especially well-informed expert on both the theory and practice of economic development—little wonder that his insights on World Bank policies are so compelling. The author makes full use of his experience by intertwining discussions of theories of economic growth with first-hand accounts of how those theories have played out in practice.
The Elusive Quest is targeted to a broad audience, not primarily economists, and it is written in a personal, sometimes humorous, narrative style. Easterly's fine storytelling and personal experiences provide a nice counterbalance to the analytic discussions of theory and statistics.
The book appropriately opens by depicting the human toll of poverty and the need for its reduction. The devastating effects of poverty in the village of Gulvera, Pakistan, are described in painful detail, and Easterly then broadens the focus to poverty worldwide. As part of this discussion, Easterly addresses a common complaint about development economics. Economists are sometimes criticized for focusing their attention on gross domestic product per capita, or income per person, as a measure of the material success of an economy. Easterly explains why they do: "We experts don't care about rising gross domestic product for its own sake. We care because it betters the lot of the poor and reduces the proportion of people who are poor. We care because richer people can eat more and buy more medicines for their babies."
Still, an important empirical question is whether national economic growth raises the incomes of those in poverty, not just those who are already well off. Here Easterly provides the reader with an overview of the evidence on poverty and growth and reports that the answer is a clear yes. (Throughout the book the author offers readers numerous direct references should they wish to peruse the evidence on their own.) And in a statement that may rankle some, Easterly provocatively offers that "growth has been much more of a lifesaver to the poor than redistribution." Indeed, recent research by Xavier Sala-i-Martin of Columbia University—released after The Elusive Quest's publication—finds that poverty has declined dramatically worldwide over the past three decades as incomes have risen. Yet, not all would concede Easterly's point.
The second section, "Panaceas That Failed," is unquestionably the centerpiece of the book. Here Easterly explains and critically analyzes the economic theories and policies that guided the World Bank and IMF over the past half century. In doing so, he discredits widely held beliefs about what factors drive economic growth-including the importance of investment in physical capital, investment in education, controlled population growth, adjustment loans to countries in crisis and debt forgiveness. In Easterly's view the IFIs have precious little to show for the more than $1 trillion in aid that has been sent to poor countries over the past 50 years guided by these strategies.
This section opens by analyzing the efficacy of policies targeted to investment in physical capital. The economic genesis of this approach is the Harrod-Domar model, which essentially posited that investment spending determined growth in gross domestic product. This theory, combined with a famous vision of investment-fueled economic "takeoffs" proposed by W. W. Rostow in 1960, resulted in the financing-gap approach to development. Under this approach Western donors should fill the financing gap between a country's own savings rate and the level of investment required for the economy to take off and achieve the desired targeted growth rate.
Easterly carefully documents the failure of this approach: Foreign aid usually did not increase growth—or even investment, for that matter. A great irony is that Evsey Domar, co-founder of the Harrod-Domar model, disavowed the theory back in 1957, saying that it made no sense as a theory of long-run growth. Despite this and the fact that a great deal of empirical evidence has long refuted the theory, Easterly notes that the Harrod-Domar model has become "the most widely applied growth model in economic history."
With self-deprecating humor, Easterly acknowledges his own role in the faulty policy process. He recalls visiting Russia in 1990 and saying to a companion, "This place will be booming in no time!" Then he points out that Russia has had negative growth every year since. At another point he writes, "We IFI economists used the financing-gap approach even when it clearly wasn't working. ... The idea seems to be, 'That didn't work, so let's try it again.'"
Why did the financing-gap approach fail? Easterly's answer to each of the policy failures discussed—financing-gap theory is just one of many—is (again) that the problem was not a failure of economics, but rather a failure to properly apply basic economic principles. And the principle that Easterly relentlessly rides throughout the book is that people respond to incentives. In this case, that means that giving aid did not change the incentive for people in Third World countries to invest in the future. Getting incentives "right" is, according to Easterly, the crucial consideration for promoting growth.
An important theoretic argument against the importance of physical capital accumulation as a determinant of long-run growth was provided in the seminal work of Nobel Laureate Robert Solow in the late 1950s. Easterly provides an illuminating discussion of the impact of Solow's contribution to modern growth theory. Solow's key observation was that due to decreasing returns to physical capital—eventually more machines aren't that useful—technological change must be the key source of economic growth. (See the September 2002 Region interview with Solow.)
Next Easterly turns to education. Despite the widely held belief that education is the key to human and economic development, Easterly reports that "the growth response to the dramatic educational expansion of the last four decades has been distinctly disappointing." He acknowledges his own surprise at this result but cites extensive evidence that fails to confirm the importance of education as a cause of economic growth.
For example, Easterly reports that while schooling did increase in the East Asian countries experiencing growth miracles, educational attainment actually increased more in sub-Saharan Africa, which experienced dismal growth. Furthermore, he notes that Eastern Europe and the former Soviet Union compared favorably with Western Europe and the United States in years of schooling attained, yet per capita incomes in those countries were substantially lower. (Easterly also cites the work of Peter Klenow, a Federal Reserve Bank of Minneapolis economist, who finds that variations in human capital growth—such as education—explain less than 10 percent of the variation in growth rates across countries.)
Why did the education initiative fail? If you said "people respond to incentives," you are now playing on Easterly's field. In this case, erecting school buildings and requiring attendance does nothing to change the incentive to invest in education. Just as with physical capital investment, there must be clear incentives for individuals to invest in education. This policy failure is a striking example of how unreliable intuition can be when it comes to formulating economic policy.
Easterly discusses other development approaches: population control efforts, "adjustment lending" and debt forgiveness. For each he provides vivid and extensive documentation of how each of them has failed, despite their intuitive appeal. For example, he reports that there is little evidence that controlling population growth increases per capita income. And the recent support of debt forgiveness by Bono of the rock group U2, the Dalai Lama and Pope John Paul II does not persuade Easterly of the value of this policy given its dismal failure over the past 20 years.
It is always easy to look back and criticize the policies of the past, and Easterly himself acknowledges that this is a bit unfair to these institutions. In fact he is more sympathetic to IFIs than are a number of other outspoken critics, including Joseph Stiglitz, former World Bank chief economist. He defends the need for the World Bank and the IMF to "subsidize the world's poor, and ... [bail] countries out of short-term crises. ..." One of the valuable contributions of this section is that it demonstrates the important interplay between theory and data that is at the heart of economics. Unfortunately, in this case it seems the feedback mechanism from the data back to the policymakers was short-circuited for too long, or perhaps the institutions themselves had bad incentives (another Easterly point).
In the third and final section, "People Respond to Incentives," Easterly describes many of the important economic ideas underlying the growth literature and offers his own recommendations on how best to foster growth in developing countries. He provides thoughtful discussions of issues ranging from increasing returns, poverty traps and externalities to creative destruction, corruption and luck. Readers interested in gaining insight into some of the main conceptual ideas underlying theories of economic growth will appreciate these discussions.
This section of the book, however, is less focused than the earlier chapters, and Easterly's policy recommendations are unsatisfying in their generality and their multitude. The cornucopia of policy recommendations (all of them centered on "getting the incentives right") include: Subsidize all forms of knowledge and capital accumulation; be careful about how government intervention affects incentives; create a favorable climate for new generations of businesspeople and entrepreneurs; avoid bad policies such as high inflation, high black market premiums, high budget deficits and restrictions on free trade; set up quality institutions that eliminate red tape; create a meritocratic civil service; eliminate incentives for corruption; ensure central bank independence; and create institutions that directly mitigate polarization between factions. And this is a partial list.
Easterly's recommendations all seem reasonable, but he provides the reader with little sense of what considerations are most important, and what factors are secondary. What are the priority strategies? In short, Easterly appears to lack a clear theory of what generates economic growth, so his recommendations seem to suggest a shotgun approach: Try these things and perhaps some of them will hit the target. Even then some of his recommendations are so vague—such as creating good institutions—it would be difficult to know precisely how to implement them.
Of course, no definitive theory of economic growth has been forthcoming from economists or others, and Easterly can hardly be blamed for that. However, recent academic literature is filled with quantitative assessments of the importance of various factors and policies for economic growth. Economists continually compare competing theories against the data to see whether they can account for the observed disparity in income levels, growth rates and the well-known growth miracles and disasters. Had Easterly summarized those findings and put his policy suggestions into that kind of framework, he would have helped the reader assess which of his numerous recommendations might be of primary importance.
And a few quibbles. Easterly contradicts himself in his discussion on the importance of luck. At one point he suggests that differences in long-term growth rates could be random, yet later he argues that "long-term trends are determined by more fundamental factors." Next, in his discussion of increasing returns, Easterly claims that "with increasing returns, capitalist economies are inherently unstable." It is not clear what evidence Easterly has for that statement, or what economies he is comparing capitalist economies with. Many economists would disagree with the notion that capitalist economies are inherently unstable relative to noncapitalist economies. Finally, Easterly is clearly sympathetic to an activist role of government "getting incentives just right," and describes the requisite policy prescriptions as a very precise and delicate matter. It's a debatable point: Other economists contend that growth does not require precise policies designed by the government, but is more a matter of eliminating activities and policies that clearly subvert growth, such as government corruption, the protection of special interest groups and monopoly rights, and a host of policies that restrict free trade.
Nonetheless, these criticisms should not discourage any reader interested in economic development and policy from reading this otherwise excellent book. The first two sections provide a fascinating historical account of IFI policies and their failures, while the final section provides insight into modern theories of economic growth and their implied policy recommendations.
Finally, you may wonder how the World Bank reacted to such a critical book written by one of its employees. Easterly answers that question in an updated preface:
... many readers have asked if my statement in the original prologue that "my employer ... the World Bank ... encourages gadflies like me to exercise intellectual freedom" was really accurate. Well almost. It should be modified to "the World Bank ... encourages gadflies like me to find another job."
Easterly is currently employed as a professor of economics at New York University and is a senior fellow at the Center for Global Development and Institute for International Economics in Washington, D.C.