PERSISTENT UNDERDEVELOPMENT

- The Hausman-Rodrick – Valesco (HRV) Framework

BY

SHOBANDE OLATUNJI

Department of Economics

Caleb University, LagosCaleb University, LagosCaleb University, LagosCaleb University, Lagos Email:shobandeolatunji@yahoo.com

Supervised By:

L. Oladele Oderinde

Department of economics

Caleb University, Lagos oladeleoderinde@yahoo.com

OUTLINE

Page

Introduction…………………………………………………………………….……………………......1

Literature Review………………………………………………………..………….…….………...…...2

Growth Diagnostics Framework, Hausman, Rodrik Valesco Analysis…………………...…...……...3-4

Methodology…………………………………………………………….…………………………...….5

Economic Policy Implication of Hausman Rodrick Valesco Framework……...……………….….....6-9

Recommendation………………………………...…..……………………………………...………....10

Summary / Conclusion…………………………...………………………………………….…...….....10

References………………………….…………………………………………………….…………….11

INTRODUCTION

In undeveloped countries particular manifestations of economic backwardness are low saving culture,

lack of investments, coupled with low productivity, economic ignorance, values and poor capital

formation. The backdrop of low income as resulted in powerlessness, hopelessness, meaninglessness,

dependence and isolation. This low income nations embraces bareness, backwardness, unemployment,

gargantuan corruption, urban decay, incompetency in governance, poor management, greed indolence,

degradation, selfdom, profligacy, prostitution, excessive mammal labour, eyes service, lip service,

child labour, un-patterned education fuel securities, underdeveloped infrastructural and conservative

time orientations are some of the critical error.

Sadly enough, all poor nations failed to analyzed development in physical capital which include assets,

materials resources, land resources, finance capital and others quantitative or objective resources.

However, development anywhere requires the removal of major sources of unfreedom poverty as well

as tyranny, poor economic opportunities as well as systematical deprivation neglect of public facilities

as well as intolerance or over activity of repressive state. Despite unprecedented increase in overall

opulence, the contemporary world denies elementary freedom to vast numbers – perhaps even the

majority of the people.

In still other cases, the violation of freedom results directly from denial of political and civil liberties

by authoritarian regime and from imposed restriction on the freedom to participation in the social,

political and economic life.

This paper uses a growth diagnostics approach ala Hausman, Rodrick, and Valesco (HRV) to identify

the most binding cons traits to small low income, mineral rich and transition economy. We attempt to

review past economic theories and policies in other to draw lessons for the future. In particular, our

prescriptions need to be based on a solid understanding of recent experience.

The paper also clarifies the primary objective of the growth diagnostic approach, view, limitation and

application.

LITERATURE REVIEW

Since the earliest day of social science, there had been considerable investigation into the causes of

economic development. However, the problem of economic development of poor countries of today’s

is one of the most widely discussed topics by scholars of our time. Experts in various field in

Economics, Political, Social and Engineering have held different view about the nature of

underdevelopment and poverty, its causes and remedies. Attempt had been made to summarize the

findings and conclusions, relevant methodological issues, pertinent theories of the previous studies

carried out on the topical issue closely related to the scenario.

To start with, Professor W.W. Rostow has sought an historical approach to the process of economic

development. He distinguishes five stages of economic growth viz;

1. Traditional society

2. The preconditions for takeoff

3. The takeoff

4. The drive to maturity and

5. The age of high consumption,

While Harrod-Domar models of growth is interested in discovering the rate of income growth

necessary for a smooth and uninterrupted working of the economy. Solow Model which was named

after Professor R. M. Solow build his model as an alternative to Harrod-Domer with assumption of

fixed production but continuous production function. Linking output with input. John Ron Neumann,

the German Mathematician also attempt to link production and consumption dynamism as a

framework for economic growth.

The theory of Big push which is associated with Professor Paul Rosenstein Rodan also claimed that

‘launching a country into self sustaining growth is a little like an airplane off the ground but there is a

critical ground speed which must be passed before the craft can become airborne’. The theory state

that bit by bit will not launch the economy successful rather than mobilizing minimum amount of

investment as a necessary condition for growth.

In all, as we attempt to demonstrate the important contribution of Hausman Rodrik – Velasco

framework, we must have it in mind that the above stated theories are relevant and had been proved

workable in some part of the economy of the world but it’s crucial vital, and mandatory to discuss its

relevant and implication to economy policy.

GROWTH DIAGNOSTIC FRAME WORK

- Hausman, Rodrick, Valesco Analysis

Development economists should stop acting as categorical advocates (or detractors) for specific

approaches to development. They should instead be diagnosticians, helping decisionmakers choose the

right model (and remedy) for their specific realities, among many contending models (and remedies).

In this spirit, Ricardo Hausmann, Andres Velasco, and I have developed a “growth diagnostics”

framework that sketches a systematic process for identifying binding constraints and prioritizing

policy reforms in multilateral agencies and bilateral donors. Growth diagnostics is based on the idea

that not all constraints bind equally and that a sensible and practical strategy consists of identifying the

most serious constraint(s) at work. The practitioner works with a decision tree to do this. The second

step in growth diagnostics is to identify remedies for relaxing the constraint that are appropriate to the

context and take cognizance of potential second-best complications. Successful countries are those that

have implemented these two steps in an ongoing manner: identify sequentially the most binding

constraints and remove them with locally suited remedies. Diagnostics requires pragmatism and

eclecticism, in the use of both theory and evidence. It has no room for dogmatism, imported

blueprints, or empirical purism.

Concept of Social Constraints

No doubt, shortage of capital is a serious setback but not only an obstacle to economic development.

As Nurkse has clear analysis, Economic has to do with attitudes, human endowments, political

condition and historical accidents. Broadly speaking, underdeveloped countries possess social

institutions and display different attitudes.

In such a society, relations are personal and patriarchal rather than universal. People influence by

kinship or status as determined by caste, clan or creed.

Social attitude towards education is further inimical to economic progress. Purely academic

education, which trains people for government and clerical jobs. There is prejudice against manual

work which is despised and ill-rewarded. Consequently, there develops a natural distaste for practical

work and training that leads to technological backwardness.

Concept of Human Resource Constraints

According to Hausman et al, underdeveloped human resources are important obstacles to economic

development in LDCs. Such countries like Nigeria, Brazil, Slarador lack in people possessing critical

skill and knowledge required in all of the economy. Underdevelopments of the human resources are

manifest in low productivity, factor immobility, and limited specialization.

Some LDCs have a dearth of critical skills and knowledge, physical capital, whether, indigenous or

imported, cannot be productively utilized. As a result, machines breakdown and wear out soon,

materials and components are wasted, the quality of production falls and cost rise.

Monetary Fiscal Instability

Development of banking facilities and saving institutions, reorganization of agricultural and industrial

credit, integration and improvement of money market, growth of a sound central banking, closing free

markets in gold and silver, replacement of hoards and above all, currency reformation are essential

tools for development.

Hausman et’al explained that deficiencies attacking underdeveloped economies are lack of good

monetary apparatus of economically backwardness countries.

High Cost of Finance

Growing international awareness that poverty anywhere is a danger to prosperity everywhere must be

shared everywhere. Developed countries consider it to be their moral duty to help their less fortunate

brethren in underdeveloped countries. But this realization on the part of the developed is never

spontaneous.

Hausman et’al argued that foreign and forms various DCs in form of loans, assistance and outright

grant from various governmental and international organizations are danger to its economy because

they are high cost of financing.

METHODOLOGY

We propose a decision tree methodology to help identify the relevant binding constraints for each

country. While our methodology does not specifically identify the political costs and benefits of

various reform strategies, its focus on alternative hypotheses will help clarify the options available to

policymakers for responding to political constraints. We are concerned mainly with short-

run constraints. In this sense, our focus is on igniting growth and identifying constraints that inevitably

emerge as an economy expands, not on anticipating tomorrow's constraints on growth.

Hausmann-Rodrik-Velasco Growth Diagnostics Decision Tree Factors affecting growth can be

grouped into two categories: High cost of financing domestic investment Bad international finance

Bad local finance Low private return to domestic investment High taxes or expropriation risk High

externalities, spillovers, or coordination failures Low productivity, too little technology Low human

capital, inadequate infrastructure, poor communication or transportation Factors affecting growth can

be grouped into two categories: High cost of financing domestic investment Bad international finance

Bad local finance Low private return to domestic investment High taxes or expropriation risk High

externalities, spillovers, or coordination failures Low productivity, too little technology Low human

capital, inadequate infrastructure, poor communication or transportation.

ECONOMIC POLICY IMPLICATION OF HAUSMAN RODRICK VALESCO FRAMEWORK

- Case Study of Brazil and El Salvador

For a long time, development policy focused on promoting saving and capital accumulation. The

thinking was that low growth was caused by insufficient increases in factors of production, particularly

physical capital. But in recent years, the focus has shifted to increasing human capital through better

health and education.

Can the poor growth performance in Brazil and El Salvador be explained by low saving and too little

emphasis on education? On the face of it, these two factors make a compelling argument because these

countries have both low savings and investment rates and relatively low education attainment. For this

story to be plausible, however, we should be able to observe high returns on capital and education. If

domestic savings are scarce, high foreign debt or a large current account deficit would signal that the

country is making extensive use of foreign savings. There would also be a strong willingness to

remunerate domestic savings through high interest rates.

Both are true of Brazil, and its growth has, in fact, moved in tandem with the external constraint in

recent years, suggesting that growth is limited by the availability of savings. But El Salvador has not

come close to using up its access to foreign savings. Nor does it remunerate domestic savings at high

rates. Indeed, El Salvador has the lowest lending rates in Latin America, while Brazil has the highest.

Perhaps the most telling indicator that El Salvador is not constrained by a lack of savings is that a

dramatic boost in remittances has not been converted into investment. This suggests that the country

invests little, not because it cannot mobilize resources (though savings are low) but because it cannot

find productive investments. Thus, it seems that El Salvador is a low-return country and Brazil a high-

return country.

Education levels in the two countries reveal a similar contrast. If education represented a significant

constraint on growth, one would expect high earnings for those few who do get educated. Average

schooling of the labor force is low in both countries, but educated Brazilians enjoy some of the highest

salaries in Latin America. In contrast, El Salvador is below the regional average when it comes to

returns on education. Hence, weak education is not a principal source of low growth in El Salvador,

but it may be a part of the story in Brazil.

The bottom line is that the challenge for El Salvador is to identify the reasons for the low returns on

investment, while for Brazil it is to explain why domestic savings do not rise to exploit large returns to

investment.

El Salvador: dearth of ideas. Low investment in El Salvador may be due to distortions that keep

private returns low despite high social returns, particularly if social returns are not easily transferred to

the individual level. Insufficient reward for individual risk taking can have many causes. The main

potential ones are high taxes, macroeconomic imbalances, weak contract enforcement and property

rights, and political uncertainty. Investment and growth can also be stifled by shortcomings in

infrastructure, labor policy, and the exchange rate. But none of these are significant concerns in El

Salvador.

Instead, the country's binding constraint is a lack of innovation and demand for investment. What we

have in mind here is not innovation in the way this term is used in advanced economies. Rather, it is

the ability to develop higher-productivity activities and nontraditional products that can be produced

profitably at the local level. El Salvador has experienced sharp declines in its traditional sectors

(cotton, coffee, sugar), but it has not been able to compensate with new ideas in other areas. The

absence of such ideas explains why growth, investment, and expected returns on investment are low.

A lack of "self-discovery" seems to be the binding constraint on El Salvador's growth. Encouraging

more entrepreneurship and the development of new business opportunities should therefore be at the

center of its development strategy.

Brazil: too many ideas, not enough money. In contrast, Brazil has more ideas than it has funds to

invest. Although the country suffers from an inadequate business environment, a low supply of

infrastructure, high taxes, high prices for public services, weak contract enforcement and property

rights, and inadequate education, our framework discards them as reform priorities. If these factors

represented significant constraints on growth, they should depress investment by keeping private

returns low—and yet private returns on investment are high in Brazil. Investment is instead

constrained by the country's inability to mobilize enough domestic and foreign savings to finance

investment at reasonable rates.

An improvement in Brazil's business environment would make investment even more attractive. But it

would not address the savings problem, thus exacerbating the binding constraint—a lack of available

capital for investment. This example demonstrates why reforms that may seem to enhance growth—

lowering taxes, reducing public sector prices, and improving infrastructure and education—could

lower public savings and end up having the opposite effect.

Brazil has been trying to cope with the paucity of domestic savings by both attempting to attract

foreign savings and remunerating domestic savings at very high real rates. Over time, the country has

borrowed so much from abroad that it has been perceived as being on the brink of bankruptcy. When

that external constraint is relaxed and more capital becomes available—say, because of an increase in

the general appetite for emerging market risk or because of higher commodity prices, as has happened

recently—the economy is able to grow. But when the external constraint tightens, real interest rates

increase, the currency depreciates, and growth declines.

This scenario suggests that the underlying problem is the conflict between the large demand for

investment and inadequate domestic savings. A more sustained relaxation of the constraint on growth

would therefore involve increasing the domestic savings rate. However, this is easier said than done.

Brazil's share of public revenue, at 34 percent of GDP, is by far the highest in Latin America and one

of the highest in the developing world. Yet public savings have been negative, and, despite high (and

distortionary) taxes, Brazil's fiscal balance is precarious. High taxes and low savings reflect high

spending and social transfers and reduce the disposable income of the formal private sector. Resources

are not used to increase public savings, and the positive effect that high interest rates may have on

private savings is offset by their negative effect on public savings because they increase the cost of

servicing public debt. High taxes and negative savings also reflect high entitlements, waste, and a

large inherited debt. This setup forces the country to choose among high taxes, high public sector

prices, low investment in infrastructure, and low subsidies for human capital.

All of these things are bad for growth because they depress private returns to capital. Yet returns are

high, and investment is constrained mainly by a lack of funds. If high taxes and limited public goods

were the binding constraint, private returns on investment would be low and the equilibrium between

savings and investment would occur at a lower return to capital. This distinction is important because

it goes to the heart of whether reform should emphasize policies to encourage aggregate savings (for

instance, fiscal consolidation) or private returns (for instance, lower taxes).

So what should Brazil focus on? It could increase national savings by reducing government

entitlements and waste. The direct effect would be higher aggregate savings, lower interest rates, better

public debt dynamics, and lower intermediation margins, as well as a potentially positive effect on

foreign savings. Lowering the burden of pensions through social security reform may be an effective

way to achieve this. But such measures may not be politically feasible at this time.

In the absence of this first-best policy, the question is whether a progrowth strategy can instead be

based on an apparently antigrowth set of measures, such as higher taxes and public prices, and lower

infrastructure and human capital subsidies. Our analysis suggests that it can. The microeconomic

inefficiencies of high taxes and suboptimal spending are not binding because reducing these

inefficiencies would increase returns to capital but would not generate the means to exploit new

investment opportunities. If the country can move to a faster growth path and if waste does not grow

with GDP, it may outgrow its burdens and gradually improve its tax and spending system as fiscal

resources become more abundant. In this respect, Brazil's current strategy, which emphasizes fiscal

consolidation and reducing public debt, may be the best way to go, despite its microeconomic

inefficiencies.

More Effective

Because across-the-board reforms are politically difficult and have often failed to achieve growth, we

have offered an approach that targets the most binding constraints. An important advantage of our

framework is that it encompasses all major development strategies and clarifies when each is likely to

be effective. As the discussion shows, different circumstances send different diagnostic signals. An

approach to development based on these signals is likely to be much more effective than one based on

a long list of institutional and governance reforms that may or may not be targeted at the most binding

constraints on growth.

RECOMMENDATION

Hausman et’al Growth Diagnostic aim at transformation of LDCs economy through implementation of

economic reform including price liberalization, privatization, opening of the economy to foreign

competition and establishing market institutions. Macroeconomic policies will remain provident, debt

level will become manageable and a free floating exchange rate.

SUMMARY/CONCLUSION

In all, Hausman, Rodrik and Valesco has proposed a pragmatic way of identifying the main reasons

why investment is low in underdeveloped countries and possible transformation strategies. He noticed

that LDCs face macro stability problematic, exchange rate, management, unstable and stubborn fiscal

problem coupled with financial sectors instability, weak institution, corruption, low productivity, lack

of immoral market failure, the Hausman et al asserted that Aids is effective if policies and institutions

are good. Therefore, aid cannot buy reform nor grant in exchange for substitution trading in

exploitation.

REFERENCES

Bosworth, B. and S. M. Collins (2003) ‘The Empirics of Growth: An Update’,

unpublished paper, 7 March, Washington, DC:

Brookings Institution.

Collier, P. and D. Dollar (2001) Globalization, Growth and Poverty: Building an

Inclusive World Economy. new York: Oxford

University Press for the World Bank.’

Hausmann, R., K. Pritchett and D, Rodrik (2004) ‘Growth Accelerations’, mimeo,

Cambridge, MA: Harward University.

Hausmann, R., D. Rodik and A, Velasco (2004) ‘Growth Diagnostics mimeo. Cambridge, Ma:

Harvard University.

Lora, E. (2001) Structural Reforms in Latin America: What has

been reformed and How to Measure it. December.

Washington, DC: Inter-American Development

Bank.

Summers, L. (2003) ‘Godkin Lectures’. Cambridge, MA: John F.

Kennedy School of Government, Harvard

University.