Hungry for solid solutions

December 21, 2001

The greatest prize for humanity would be an end to poverty but there is no easy answer, writes James Mirrlees.

Fifty years ago, health, peace and poverty reduction were the world's priorities, but while health has seen considerable improvements, peace and the relief of poverty remain challenges, particularly for economists. Only one Nobel memorial prize - to Arthur Lewis and Theodore Schultz in 1979 - has been awarded for work on third-world economies, although an award has been given for the economics of growth. The economics of poverty reduction is both too easy and too difficult for it to earn prizes: too easy in that there are a number of obvious things to be said; and too hard because we have yet to ascertain why some economies grow vigorously for long periods and others stagnate.

On any reasonable definition, the proportion of the world's people that is poor is substantially lower than it was 50 years ago, particularly in the East and, to some extent, in South Asia. We can examine the history of this economic growth and see what has happened, but that is not the same as knowing how to make it happen elsewhere.

In these fortunate economies, increases in capital investment, labour skills and allocation of resources appear to have spurred growth. Advances in science and technology have also contributed to growth - just over 2 per cent per annum. About 8 per cent of growth has come from increases in and more efficient use of basic economic resources.

Increased capital and an improved and expanded labour force may be necessary for economic growth, but they are not sufficient. Countries also need good investments - people who can find good prospects and turn them into reality.

We can make vague and glib statements about the conditions necessary for effective growth. Good institutions, such as laws and government and financial institutions, help. The problem is to define what they are. Adequate incentives appear to make a great difference. The impact of the institutional framework, and the incidence of taxes and other influences on material rewards, is now the major focus in economic growth studies.

But why can some economies sustain continual large changes, while others cannot? There is probably no simple answer. In recent decades, most economic models suggest that capital investment in itself does not have a great effect on an economy's long-term growth rate. That may be one reason why the obvious answer to poverty - economic aid - is not popular. This is a mistake. It is an attractive idea that poverty can be cured by some simple, almost costless action that will make economies grow. Low-cost solutions appeal, and some economies have grown vigorously and for a long time with little economic aid. We cannot, however, expect that to happen everywhere.

In reality, there has been little foreign economic aid. Few rich countries have given as much as 1 per cent of their national income; the average is far less. Moreover, statistics grossly overstate the real amount of aid because much of it has been given in the form of loans. We see the negative effects of this aid when countries have to pay back their loans at higher rates than anticipated. Aid that is tied to poor projects has merely resulted in a net charge on the recipient. Moreover, not even countries that have received real aid - as opposed to loans - have always done well. Poverty can be relieved by giving aid, but only when it is given in large enough quantities.

The campaign to cancel the debt obligations of the poorest countries is a campaign to provide aid. If, at last, people in richer countries were prepared to give some aid, giving it in proportion to indebtedness is probably not the best criterion. It should be given where it will be most effective and not simply to make it easier for the recipient government to pay for more arms. It is immensely important when giving government aid to assess the impact of that payment on the government's other budgetary decisions. Whether conditions or the threat of sanctions can control this is a key issue.

I do not believe that loans have been a mistake, but they have taken the wrong form. If repayments depended on a project's returns or on a country's national income at the time of repayment, the recipient would be insured, to some extent, against the slings and arrows of the world environment or project experience. Lender incentives might be weakened, but the benefit of the implied insurance would be great. The lender to a country should take a share in the country.

But how much should repayment be reduced in bad times and increased in good? Economic theory can propose an answer. A detailed analysis still needs to be done, but it appears that the answer could involve a complete cancellation of repayments when national income drops below an agreed level. The possibility of debt reduction or cancellation should be part of the contract. In effect, that is what is happening when people lend to countries at high interest rates. The lenders anticipate a substantial risk of default.

It is perhaps too much to hope that richer countries would sign up to an economic aid programme consisting of substantial pure economic aid (with no repayments), for education, health and agricultural development; and investment aid with conditional repayments. But economists at least should look at such possibilities and continue to regard growth and development as key areas. We shall see more Nobel prizes for these subjects, but most of us would think the elimination of poverty a more satisfactory reward.

Sir James Mirrlees was awarded the Nobel memorial prize for economics in 1996.

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