Old and New Development Economics: A Reassessment of Objectives
ABSTRACT: The “new development economics” (also called behavioral development economics) consists of microeconomic experimentation based on behavioral economics and randomized controlled trials. This approach would illuminate the close relationships between preferences, culture, and institutions and point to new political opportunities. This paper describes and analyzes the new development economics’s main components and argues that the new development economics is just like the old development economics in terms of its central assumptions, objectives, and recommendations. Despite the growing recognition that social, cultural, and institutional factors profoundly affect decision-making, old and new development economists generally lean toward the extreme reductionism of the neoclassical paradigm. It is observed that research on the essence of economic development has been neglected or treated inadequately in the school’s literature. It is suggested that the findings of the Austrian theory of dynamic efficiency, based on human action’s creative and entrepreneurial feature, may allow the development economics to overcome its analytical challenges.
JEL Classification: B41, B53, O11, O12, L26, P14
Victor I. Espinosa ([email protected]) is Professor of Economics at the Department of Business Administration, Universidad Autónoma de Chile, Providencia 7500912, Chile. Óscar R. Carreiro ([email protected]) is Professor of Economics at the Department of Entrepreneurship, Universidad Francisco Marroquín, Madrid 28033, Spain. Acknowledgement: The author would like to thank Jesús Huerta de Soto and Philipp Bagus, and the two anonymous reviewers for their constructive comments and suggestions.
The progress of underdeveloped countries depends on the supply of capital available to build the necessary infrastructure for industrialization and the rapid modernization of the economy. The emerging countries themselves cannot generate the required capital because of the poverty trap, which inexorably condemns them to low incomes. The less developed world inhibits entrepreneurial prospects, restricting local markets and strengthening the poverty trap. International trade is inefficient and often detrimental to emerging countries’ advancement, as it fosters a widening income gap with rich countries. Foreign aid is crucial to escape from extreme material deprivation and ascend the ladder of economic growth. Government interventions play a crucial role in carrying out the needed changes and achieving the pathway to higher levels of equality and prosperity.
These ideas are the core theoretical framework of old development economics, which has become the dominant political and public discourse (Arndt 1987; Meier 1984, 2005; Boettke and Horwitz 2005; Boianovsky 2018; and Alacevich 2018). However, the scientific validity of old development economics has been widely questioned by some heterodox development economists (see, for instance, Bauer and Yamey 1957; Bauer 1976, 2000; Easterly 2014; and Espinosa 2020):
- If the poverty trap is valid, how does humanity not continue to live in caves?
- Given that all the currently rich countries were once poor, how was capital accumulation able to develop?
- If trade increases income inequality between countries, how can the rapid development of emerging economies such as Ireland, Poland, Estonia, Israel, Hong Kong, and Singapore be explained?
- If international trade is harmful, why are the wealthiest countries the most open to international trade?
- If foreign aid is vital for economic development, how did the currently rich countries develop without such aid?
- If global economic planning plays a crucial role in the path to higher equality and prosperity levels, why are the wealthiest countries in the world precisely those with the most significant economic freedom?
Although there is a consensus that development supposedly means moving from one type of economy to a more advanced one, the inconclusiveness of the leading old development theories has shown the field’s “inability to adjust the demands of the main tasks of the day, that is, the elaboration of policies that favor the development in the least developed countries” (Alacevich and Boianovsky 2018, 2). As Romer (2009, 126) discerns, development economics must review its fundamentals on “how to contribute to better policy in developing countries … at a time when many economists are skeptical.”
In the eyes of a new generation of development economists, old development economics’s efforts, albeit necessary, showed that its macroeconomic approach does not come to any relevant conclusions about the poor’s economic lives (Coyne and Boettke 2006; Banerjee and Duflo 2011; Coyne 2013). Thus, it was concluded that the central focus of research and teaching in development economics should be at the microeconomic level of social, cultural, and institutional factors that help explain real-life human behavior. The new development economics (NDE), also called behavioral development economics (BDE), analyzes underdevelopment problems using psychological models of quasi-rational decision-making and preference formation, rather than the homo oeconomicus models (Thaler 2000; Demeritt and Hoff 2018). These economists consider randomized controlled trials (RCTs) in experimentation as the best way to advise governments on policy design in all its details to reduce poverty.
This paper argues that the old and new development economics share the same main assumptions, objectives, and recommendations. Despite the growing recognition that social, cultural, and institutional factors profoundly affect decision-making, old and new development economists generally prefer the neoclassical approach of extreme reductionism. The research on the essence of economic development has been neglected or treated inadequately in the development economic literature. This approach does not recognize economic development as the by-product of achieving social cooperation and coordination driven by human action under the division of labor. Consequently, the old and new development economics analysis is narrowed to testing the superficial problems of economic underdevelopment. The paper proposes that the Austrian theory of dynamic efficiency, based on the creative and entrepreneurial potential of human action, would be adopted as a way for the new development economics to overcome the analytical challenges of its macroeconomic approach. More specifically, it is recommended that dynamic flesh-and-blood entrepreneurship be placed at the core of development theory, which would redesign its objectives of policy analysis and institutional change in underdeveloped economies.
The paper proceeds as follows. The first two sections explain the objectives and tenets of the “old” development economics and the “new” development economics’s theoretical core, respectively. Then, the “Austrian” theory of dynamic efficiency is presented as a solution to the analytical challenges of development economics. The final section discusses the future of the discipline.
THE CRISIS OF DEVELOPMENT ECONOMICS
In the 1940s, 1950s, and 1960s, economic thinking about economic development was confined mainly to the United Nations’s (UN) international organizations. At the same time, some pioneering work began to emerge in this field, including Rosenstein-Rodan (1943, 1944, 1961a, and 1961b), Nurkse (1952, 1953), Prebisch (1950), Myrdal (1956, 1957, and 1968), Singer (1949, 1950), Lewis (1954, 1966), and Hirschman (1958). These books and papers “crystallized what, over the next two decades, became the conventional wisdom about economic development” (Arndt 1987, 49).
The “old” development economics relied on dual models, in which a traditional sector, mainly agricultural, was contrasted with a modern industrial sector. According to development pioneers, poverty was the result of vicious circles caused by the interaction of various economic phenomena on the supply side (low per capita income, low propensity to save, insufficient capital, and low productivity) and on the demand side (low purchasing power, insufficient market size in the modern sector, lack of investment, and low average productivity). They concluded that the free market did not lead to the desired pattern of economic development. For this reason, the state ought to direct the modernization process by diverting resources from traditional and “backward” activities to selected modern activities. To break the vicious circles, they proposed increasing the size of the market (to take advantage of economies of scale), channel existing resources into the modern sector, and generate more incentives for saving, such as controls on demand for consumer goods.
The old development economics’s backbone was the Harrod-Domar model, strongly influenced by John Maynard Keynes (Boianovsky 2018). According to the Harrod-Domar model, GDP depends directly on the investment ratio and inversely on the capital-output ratio. Two groups of theories that emphasized the state’s role in initiating and coordinating a massive investment effort in the industry (big push) were developed from the Harrod-Domar model: the theories of balanced growth and unbalanced growth.
On the one hand, balanced growth results from an equitable distribution of investment among the different consumer-goods sectors, which can then take advantage of the interdependencies between them to accelerate growth. On the other hand, unbalanced growth results from the concentration of investment in those industries believed to be more apt to promote growth in other sectors. These sectors are the ones with the greatest forward-chaining (in consumer goods industries) and backward-chaining (in capital goods industries) effects.
Thus, two of the key characteristics of the “old” development economics can be highlighted: 1) the recourse to central planning in the selection of the most productive “modern” activities; 2) the resortion to intervention in the economy to coordinate the diversion of resources toward these activities, either by trying to promote most of them in a balanced way or by focusing on those sectors believed to have tremendous growth potential.
Prominently, Rosenstein-Rodan (1943) defined the theoretical and political issues that became the core of the new discipline of development economics in the postwar years.1 First, he emphasized the impact of overpopulation on the low productivity levels of developing countries. Second, he discussed the institutional and cultural elements that make it difficult for a developing country to industrialize. Third, he argued that capital accumulation and industrialization are essential to eliminating poverty but that it is difficult for entrepreneurs to establish new factories due to capital shortage in developing countries. Fourth, he highlighted the need for global planning to overcome coordination problems and promote economic development. Without the government’s increase in “effective demand,” investment opportunities would stall, and poverty would be perpetuated indefinitely. In sum, Rosenstein-Rodan laid the foundations of the poverty trap theory: the idea that poverty is an insurmountable obstacle that can only be overcome with political intervention and a big push.
Rosenstein-Rodan’s influence was manifold and important. First, Nurkse (1952) formalized the poverty trap theory due to supply and demand events. On the demand side, if incomes are low, the market’s size is too small to stimulate private investment. Shortage of investment means low productivity and continued low income. On the supply side, if incomes are low, consumption cannot be diverted toward capital formation and accumulation—shortage of capital results in low productivity, which perpetuates low incomes. Thus, the vicious circle is complete: a country is poor because it was too poor to boost entrepreneurial investment.
Second, Rosenstein-Rodan’s poverty trap thesis suggested a widening inequality gap between developed (rich) and underdeveloped (poor) countries, based on enormous differences in these two distinct groups’ per capita incomes (Prebisch 1950). Therefore, emerging countries should somehow increase national investment.
Third, if tax revenues are insignificant, developing countries’ governments will not perform economic planning accurately. How to get the necessary capital in developing countries? Lewis (1954), based on the Harrod-Domar model, proposed an unlimited supply model, where policies aimed at increasing aggregate rates of saving and investment help overcome the poverty trap. If domestic saving is very low, it should be complemented by external savings in foreign aid.2 Thus, international organizations should quantify the aid for each country, and with this money, the governments of less developed countries will promote industrialization and self-sustaining development (Hirschman 1958). Finally, global planning is a “heroic” attempt to overcome “cultural stagnation or regression” of the poverty trap (Myrdal 1956, 65).
Economists of the early development theory shared a commitment to planning and the conviction that economic problems would yield to the actions of benevolent states endowed with sufficient supplies of capital and armed with good economic analysis (Leys 1996). They designed development plans for newly independent countries and the not yet independent African colonies based on raising rural productivity and transferring underutilized labor out of agriculture into industry. However, the hope of achieving economic growth through policies based on development theory soon began to unravel: “By the end of the 1950s, … the original optimism that this approach would yield rapid results had begun to evaporate, and the limitations of development economics as a theory of development were beginning to be exposed” (Leys 1996, 8). Dissatisfaction with the development policies’ results led to the rise of new theories based on the Prebisch-Singer thesis, advanced independently by Raúl Prebisch and Hans Singer in the late 1940s.
The Prebisch-Singer thesis is that over time poor countries will have to export more of their primary commodities to maintain their levels of imports from the rich countries. This is because prices in advanced economies rise more quickly than those in more backward ones. Differences in income elasticities of demand strengthen this effect: demand for finished goods rises with income, but demand for primary goods varies less with income. Therefore, underdevelopment results from the prevalent economic structure and the international division of labor.
The Prebisch-Singer thesis is the backbone of two different development theories: structuralism and dependency (see, for instance, Toye and Toye 2003). Structuralists argue that the only way poor countries can develop is through state intervention in economic performance. Because trade is reduced by the erection of all kinds of political barriers and an overvaluation of the domestic exchange rate, the production of domestic substitutes of formerly imported industrial products is encouraged. Poor countries have to push industrialization and have to reduce their dependency on trade with advanced economies. The logic of the strategy rests on the “infant industry argument,” which states that young industries initially do not have the economies of scale and experience to compete with foreign competitors and thus need to be protected until they can compete in the free market.
Dependency theory is a more radical follow-up of structuralism. Dependency theorists also think that underdevelopment is mainly caused by the peripheral position of the affected countries in the world economy. However, they believe that the only way out of dependency is to search for autarky and create a socialist economy.
This belief explains why economists such as Singer warn that poverty is a consequence of colonialism and imperialist capitalism. While international trade is pernicious to developing countries, “the establishment of a socialist planned economy is an essential condition for attaining economic and social progress in underdeveloped countries” (Baran 1957, 416).
Unfortunately, as John
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