Incentivizing Investment

Why Developing Countries Aren’t Developing

 

 

 

 

By Veronica Pugin
International Editor, CMC ‘12

Compared to today’s standards of living in developed countries, the majority of the world’s population has suffered from intense poverty. Why have some countries failed to follow the global trend of increasing GDP per capita? How come the two-thirds of the world living on less than $2 a day cannot raise their incomes just enough to meet their basic needs? Numerous social, cultural, political, and economic factors inhibit a country’s ability to develop. Yet two economic reasons stand out as the most significant impediments: the lack of institutions and the lack of incentives.

The Solow Growth Model states that a country’s GDP and total output depend on capital, technology, and labor and disregards other variables, such as population growth. While the model does a relatively decent job at assessing the output of stable and established economies, it provides an incomplete answer for developing countries. Beyond the corrupt leaders that tend to plague them, developing countries also suffer from the absence of institutional security. Nzinga Broussard, a Claremont McKenna professor of development economics, explains the key problem: “The question becomes, can these models be applied to developing countries, ignoring their institutions? I don’t think so.” 

Like Broussard, a majority of political scientists and economists agree that the establishment of consistent institutions most influences individuals’ productivity growth. On a more tangible level, developed countries have institutions to oversee contracts, uphold the rule of law, and stabilize currency value. Because this institutional security facilitates commerce and protects economic activity, developed countries enjoy ample opportunity for growth and productivity. The Solow Growth Model is simply too black and white for developing countries. 

Lacking such institutional protections, developing countries are risky bets for investors, firms, and skilled labor forces. In these cases, incentives – key to the influx of capital, labor, and technology – are either few or nonexistent. The culprits, according to Broussard, are the governments of developing countries. “The key thing to note about governments,” she says, “is that they shape incentives.” Without a strong foundation, the invisible hands of private investors are reluctant; governments need to take initiative to spur growth. But not all incentives are productive. Broussard notes that government-defined incentives can “encourage either productive behavior or rent-seeking behavior. Without enforceable property rights, it may not be in the farmer’s best interest to invest in his land.”

Most importantly, governments must provide incentives for and facilitate an increase in the skilled labor force. The absence of labor competition promotes stagnation, since people’s actions depend upon their expectations of other people’s actions. Just as a subsistence farmer might not transition to business or industry if he sees no competitive benefit, a citizen may choose not to adopt a new mode of technology if no one else in his market is doing so. Without any incentives, the few who do possess exceptional skills may exit the local market, resulting in the detrimental “brain drain” phenomenon. Governments must step in. To promote increased skill sets for workers, conditional cash transfers, which predicate welfare payments on recipients’ actions, may prove successful. As an added benefit, a more skilled labor force can supplement tax breaks in attracting foreign investment. 

Governments of developing countries must serve as the “Big Push” for growth to occur and then gradually reduce their influence by further encouraging this growth. Chile and South Korea stand out as miracle countries that successfully transitioned from developing to developed countries. So hope remains for the two-thirds of the world living on less than $2 a day – if sustainable growth has been achieved before, it can be achieved again.

By Veronica Pugin

International Editor, CMC ‘12

Compared to today’s standards of living in developed countries, the majority of the world’s population has suffered from intense poverty. Why have some countries failed to follow the global trend of increasing GDP per capita? How come the two-thirds of the world living on less than $2 a day cannot raise their incomes just enough to meet their basic needs? Numerous social, cultural, political, and economic factors inhibit a country’s ability to develop. Yet two economic reasons stand out as the most significant impediments: the lack of institutions and the lack of incentives.

Solow_Growth_ModelThe Solow Growth Model states that a country’s GDP and total output depend on capital, technology, and labor and disregards other variables, such as population growth. While the model does a relatively decent job at assessing the output of stable and established economies, it provides an incomplete answer for developing countries. Beyond the corrupt leaders that tend to plague them, developing countries also suffer from the absence of institutional security. Nzinga Broussard, a Claremont McKenna professor of development economics, explains the key problem: “The question becomes, can these models be applied to developing countries, ignoring their institutions? I don’t think so.”

Like Broussard, a majority of political scientists and economists agree that the establishment of consistent institutions most influences individuals’ productivity growth. On a more tangible level, developed countries have institutions to oversee contracts, uphold the rule of law, and stabilize currency value. Because this institutional security facilitates commerce and protects economic activity, developed countries enjoy ample opportunity for growth and productivity. The Solow Growth Model is simply too black and white for developing countries.

Lacking such institutional protections, developing countries are risky bets for investors, firms, and skilled labor forces. In these cases, incentives – key to the influx of capital, labor, and technology – are either few or nonexistent. The culprits, according to Broussard, are the governments of developing countries. “The key thing to note about governments,” she says, “is that they shape incentives.” Without a strong foundation, the invisible hands of private investors are reluctant; governments need to take initiative to spur growth. But not all incentives are productive. Broussard notes that government-defined incentives can “encourage either productive behavior or rent-seeking behavior. Without enforceable property rights, it may not be in the farmer’s best interest to invest in his land.”

Most importantly, governments must provide incentives for and facilitate an increase in the skilled labor force. The absence of labor competition promotes stagnation, since people’s actions depend upon their expectations of other people’s actions. Just as a subsistence farmer might not transition to business or industry if he sees no competitive benefit, a citizen may choose not to adopt a new mode of technology if no one else in his market is doing so. Without any incentives, the few who do possess exceptional skills may exit the local market, resulting in the detrimental “brain drain” phenomenon. Governments must step in. To promote increased skill sets for workers, conditional cash transfers, which predicate welfare payments on recipients’ actions, may prove successful. As an added benefit, a more skilled labor force can supplement tax breaks in attracting foreign investment.

Governments of developing countries must serve as the “Big Push” for growth to occur and then gradually reduce their influence by further encouraging this growth. Chile and South Korea stand out as miracle countries that successfully transitioned from developing to developed countries. So hope remains for the two-thirds of the world living on less than $2 a day – if sustainable growth has been achieved before, it can be achieved again.


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