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Policy Research Bulletin

October-December 1997
Volume 8, Number 4

Emerging issues in development economics

For policymakers and analysts alike, the old debate between the extremes of state and market is no longer relevant. The challenge in the next century will be identifying and implementing policies that support the synergy between the two to accelerate development.

The World Bank and the MacArthur Foundation sponsored a five-day workshop of leading economists in Washington, DC, last summer to discuss the areas in which we are least prepared to meet that challenge. The purpose of the workshop was to begin exploring the agenda for development economics in the early twenty-first century.

The conference opened with an agenda-setting discussion of new themes and problems expected to appear with increasing frequency and in ever-more intractable forms. Subsequent sessions focused on ways to support and enhance knowledge, equality, and institutions. From this broad base, many key research areas were identified. These include the advantages—and problems—of knowledge as a public good, the reinforcing interactions between political and economic inequality, and ways to establish "market" incentives in government agencies to promote accountability and efficiency. A few of the many issues addressed at the conference are described here.

The future of development economics
In moving beyond the old state-versus-market debate, economists are trying to understand how markets and governments behave in practice, where the simplifying assumptions of theory are seldom met. Limited government capacity and individual ingenuity in manipulating public programs for private gain discredited the postwar view that governments could directly replace the private sector to correct market distortions. The pendulum swung toward reliance on the efficiency of markets, and most countries have begun to reduce the scope of government and return production to the private sector. But development economics is searching for a middle ground, a pragmatic arrangement that adequately reflects the structure of markets and governments, and the incentives, abilities, and behavior of economic agents, policymakers, and civil servants.

The new directions in development economics differ from older theories in three important ways. First, the limits of markets are now recognized, and there is acceptance of the notion that given imperfect information and incomplete markets, government intervention can be Pareto improving—that is, it can lead to a reallocation of resources that will make some better off without making others any worse off. Second, the importance of knowledge—and of the knowledge gap that exists between the developing and the industrial worlds—is now explicitly recognized. Third, the function of institutions and preferences is now emphasized.

Conference participants agreed that the new theories of development imply new policy prescriptions and a need for policymakers to go beyond the "Washington consensus" of free trade, stable macroeconomic policy, and minimal government interference. Policy must reflect the fact that markets may not emerge on their own—and may be suboptimal if they do. Trade liberalization, for example, will not result in lower prices if rents are expropriated by monopolist distributors; privatization will not improve welfare if government monopolies are simply replaced with private ones. And participants acknowledged that in addition to the traditional challenges, governments now must cope with unprecedented acceleration of technological change and the distributional consequences of globalization.

Conference participants noted that development economics must pay more attention to institutions and the incentives for individuals in these institutions, and to the interaction between economic policies and their social and political context. Policy that does not explicitly recognize institutional constraints is likely to be ineffective and may have adverse effects—as financial liberalization in countries with insufficiently developed capital markets has shown. Participants pointed out the need for research to reveal the underlying mechanisms that allow dysfunctional institutions to persist. They also called for research on the internal organization of government, to look at rewards, sanctions, and sociocultural incentives, as well as the effect of devolving resources and responsibilities from central to regional and local governments.

Another conclusion of the participants was that the lessons of the past several decades should be reflected in the distribution of development aid in the twenty-first century. Although there is evidence that foreign aid has helped some countries grow, much aid has been ineffective. If the benefits of aid are heightened by good economic policy and dissipated by poor economic policy, as has been posited, the policy prescription is clear, one speaker asserted: development institutions should provide aid to poor countries with good economic policies. Another implication, however, is that we can learn from history without repeating it: research should investigate the circumstances under which governments have developed and adopted good policies and determine whether there is any role for development assistance in accelerating that process.

Conference participants agreed that the new development theories suggest a need for research that is "closer to the ground," in which researchers write about what they see rather than responding to other researchers' papers. Research may need to begin with case studies to gain insights into market function and failures and individual responses to policy incentives. Participants also pointed out the need for more longitudinal studies based on panel data methods, to capture variation over time and provide some evidence on causality, and for fewer cross-sectional studies. But a speaker warned against making ambitious inferences from empirical work as was done in the past, when the fact that peasants change their behavior in response to price changes, for example, was taken as confirmation of the classical model. Objectivity, insight, and open communication are key.

Knowledge and development
The acquisition of knowledge and information is becoming increasingly critical to economic growth as scientific and engineering findings proliferate and take on ever-greater importance in the production of goods and services. As information grows exponentially and as its incorporation in production processes becomes increasingly complex, the ability to acquire, adopt, and adapt new knowledge will be an important determinant of economic growth.

Conference participants warned that recent moves away from publicly supported research and public dissemination of scientific findings are likely to be deleterious to most developing countries. The range of policy questions in development economics is wide, and much information and analysis is expensive to generate. Although many countries face similar policy questions, few can afford the expense of rigorous analysis of them. And the incentives for investing in such analyses may be slight. Once generated, information often becomes a public good—its producer can neither force all who acquire it to pay for it nor capture the value it confers on those who use it.

The World Bank has a significant role to play in disseminating knowledge, conference participants agreed. They believe that the Bank should finance policy research that no single national government has the incentive to fund. The Bank can collect comparable data and analyze reliable evidence worldwide on policies and their effects. The Bank was also urged to systematically document indicators on countries' institutions, finances, and economic performance, creating a database that would allow policy analysts and Bank staff to assess a country's status relative to others and to identify areas in which unusually poor performance suggests a need for attention.

Collection and dissemination of data, empirical policy analyses based on that information, and dissemination of the findings in developing countries were seen as areas in which the Bank's research program is likely to be uniquely important. In an era of information overload in industrial countries, participants believe that the Bank should direct attention to screening the wealth of information it produces, making it relevant to users, and directing it to appropriate audiences in the Bank's client countries.

Inequality and economic performance
Conference speakers noted that inequality can impede economic performance in several ways. First, inequality is generally associated with greater political instability, which discourages investment. Second, inequality may reduce the ability of social groups to arrive at mutually acceptable compromises. These "bargaining failures" may occur because of disagreement over the distribution of gains from proposed policies (with wealthier groups vetoing changes in rules that would hurt them financially) or because common problems of asymmetric information are exacerbated by inequality that reduces interaction among potential groups and communities. Third, inequality may discourage the evolution of efficiency-enhancing norms, such as trust and the predisposition to commitment.

Finally, inequality may limit the effectiveness of incentive devices, such as changes in prices or fines, which may have unintended regressive or adverse effects. A small increase in diphtheria immunization fees, for example, might be imposed to increase revenues so that the immunization program can extend its coverage into new areas. But in the face of serious inequality, even that small rise in fees might prevent the poor from getting the shots, usage might decline sufficiently to cause a drop in revenues, and outbreaks of diphtheria might actually increase.

The distribution of wealth affects the way a society is organized, which can affect economic performance. The distribution of wealth and such assets as land determines the form of contracts into which agents enter, which affects incentives for effort and the level of output. The distribution of wealth may also affect economic performance through the nonmarket institutions that emerge where markets have not. These nonmarket institutions do more than simply replicate the effects of the missing markets—they create new production mechanisms and change the way in which the economy is organized. The informal insurance networks common in developing countries, for example, may increase social segmentation. The poor have always had to rely on this type of informal mechanism, but the rich exit such networks to avoid having to support the poor, eroding the networks' efficacy.

Redistribution programs may do little to reduce inequality. Research has shown that, throughout the world, a large share of transfers go to the middle class and the elite. A disproportionate share of education financing, for example, goes to secondary schools and universities, which the poor seldom attend. Education spending directed to primary schools does raise socioeconomic mobility over time, participants noted, but there is little evidence of intertemporal benefits from other social transfer policies.

Institutions and development
In recent years development economists have recognized that the formal adoption of appropriate policies is futile if a country's institutions do not have the capacity and the incentives to ensure that the policies will be adequately implemented. Conference speakers addressed many different institutional issues, including formal versus personalized exchange agreements, the organization and operation of government, the institutions that support inequality and those that support redistribution, the case for government intervention in a representative democracy, and the determinants and effects of corruption.

The new focus on institutions should encourage researchers to examine an important but neglected area of development economics—ways to improve government performance. One speaker discussed research in India and elsewhere that has shown that governments can increase their effectiveness by focusing on four main areas:

Information and procurement systems can be enhanced by streamlining record-keeping, reducing delay and red tape, providing higher-level officials with better information about local conditions, limiting the scope for discretion by lower-level officials, and eliminating the information monopoly held by the government. Decentralizing government can improve the monitoring of public officials, and it can alter the allocation of bargaining power between officials and the beneficiaries of public programs, thus reducing corruption and enhancing benefits without increasing fiscal outlays. Increasing managerial autonomy and accountability and establishing appropriate incentives can increase output. This has occurred in China, for example, where managers of state-owned enterprises determine how much to produce and how to produce it. Staffing can be improved by basing hiring procedures on training and experience, establishing worker incentive systems, setting up training programs, and rationalizing staff size and allocation across districts.

One institution that is widespread in developing countries is personalized exchange arrangements—transactions based on the participants' knowledge of each other's reputation, behavior, and assets. Increasing the number of impersonal transactions is necessary to garner the benefits of economies of scale, division of labor, and, ultimately, economic growth. Given the importance of a large number of transactions, should policymakers try to replace personalized exchange arrangements with formal, contract-based transactions?

One speaker addressed this question through a review of the British experience with credit markets in India. Before the British arrived, farmers relied on a small number of local lenders, who were willing to be flexible about repayment by generally reliable farmers in order to maintain them as future customers. Under the British, civil courts enforced credit contracts, lenders competed for farmers, and lending expanded. But lenders no longer had an incentive to help farmers in times of crisis; as a result, many farmers were forced to default on their loans in bad seasons and lost the land posted as collateral. This greatly increased the problem of rural landlessness in India. The experience was cited as a warning to Bank operations staff and to policymakers not to move too hastily to replace local institutions, but first to investigate their functions for the full range of participants and in the full range of circumstances.

It is only in recent years that the World Bank has explicitly addressed the problem of corruption. Now that corruption is receiving more scrutiny, however, analysts have come to recognize that we know relatively little about its effects. In East Asia levels of both economic growth and corruption have been high, one speaker noted, and some have argued that bribery may have helped "grease the wheels" of growth there. In contrast, in Russia corruption appears to have slowed growth, as regulation increased in response to the high level of bribes paid to circumvent regulation. Research is needed on which aspects of development are most affected by corruption, and on which reforms are most effective in reducing it.

Looking ahead
With a mandate to begin to define a research agenda in development economics, the conference was not intended to be comprehensive. Participants noted important issues that deserve more analysis: competition and regulatory policy, legal institutions, population policy, environmental issues, gender, social and political stability, ethnic conflicts, the role of external shocks in generating macroeconomic instability, and the macroeconomic effects of differences in microeconomic structure and function between developing and industrial economies. The conference did identify aspects of a challenging research agenda—some of which are already reflected in the Bank's plans for future research.

Participants agreed that development economics should have a new emphasis. As one speaker noted, it must go beyond ideology to take a balanced view of the state and markets; it must go beyond standard economics to take institutions and norms into account; it must go beyond economics to learn from other social sciences; and it must put more emphasis on empirical research that develops the stylized facts of the newly emerging economies, institutions, and societies to guide conceptualization and policy.


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