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Can rich countries meaningfully help…

NCH London | July 10, 2018

Can rich countries meaningfully help developing countries improve their standards of living?

By Tony Wong

NCH Essay Competition 2018 First Prize winner

According to neoclassical economic theory, developing countries would experience economic growth over time, accompanied by improvement in standards of living such as healthcare and education. In reality, many developing countries have been stuck in underdevelopment for a considerable period of time despite continuous intervention by rich countries. Moreover, some have even questioned the effectiveness of the current form of foreign assistance. By evaluating the current forms of intervention such as sending foreign aid and encouraging trade openness, I argue that these interventions are ineffective and hampered by institutions in developing countries. Theoretically, rich countries can use foreign policy to influence institutions in the developing countries to ensure a corrupt free government. Improving aid effectiveness and fairer trade agreements would also lead to improved standards of living. However, it is difficult to see how rich countries are willing to install these changes, given the benefits they gain from the current ineffective interventions.

Intervention by rich countries in developing countries may not have achieved its desirable effects as they are often limited by both the economic and political institutional settings in developing countries. For instance, developing countries with undesirable economic institutions such as lack of property rights would deter firms and landowners from investing because there is no protection under an unstable legal system. On the other hand, the prevalence of dictatorship is an undesirable political institution; this encourages monopolistic activity and rent extraction which lead to inefficient distribution of resources. Ultimately, poor economic and political institutions deter citizens from engaging in entrepreneurship or economic transactions, leading to a persistent low income and standards of living.

Not only does poor institutions lead to poverty traps, they also hamper the effectiveness of foreign intervention by rich countries. One prominent example is aid. Conventionally, aid is distributed via government, which acts as an intermediary and allocates these resources to local communities. However, with corrupt governments, aid is highly likely to be embezzled by government officials, rather than to improve infrastructure, living and health conditions which promotes development. In essence, foreign aid props up corrupt government by providing them with “freely usable cash”. According to the Transparency International, Mobutu is estimated to have looted Zaire (now known as Democratic Republic of Congo) US $5 billion, which is the same amount President Sani Abacha has looted from Nigeria. Poverty and underdevelopment cannot be solved when aid is channelled to a few elites instead of promoting development and providing public services.

It is crucial to note that institutions are not to blame for the entirety of foreign intervention ineffectiveness; aid in its existing form is limiting the effectiveness. Although foreign aid is often conditional on general form-based targets on structural improvement, the fact that these targets are open to interpretation is in itself a limit to its effectiveness. Countries heavily dependent on aid could meet these conditions by simply selecting easy targets within the form-based targets that have limited value, such as how institutions are organised, rather than the effects of policies government pursue. Since recipient countries are rewarded by achieving easy form-based targets, they have no incentive to select more difficult targets that substantially improve standards of living.

Moreover, it is unlikely that the main purpose of aid is used to improve standards of living in developing countries. Most foreign aid is tied with conditions to enhance the economic interests of donor country’s multinational corporations, by requiring the recipient country to purchase their equipment, arms and materials. A recent research by Griffiths (2014) demonstrates that financial outflows such as spending on donor’s exports and interest paid from developing countries are on average more than double the inflows of aid and foreign direct investments into the country. This suggests that aid is unlikely to remain in the recipient country for long, and instead is more similar to a subsidy to the donor country’s domestic producers.

Another channel of foreign intervention is trade liberalisation. Conventionally, countries have tried to improve the living standards of developing countries through imposing Structural Adjustment Programmes by the World Bank. However, the periphery (developing countries) not only failed to benefit from these programmes, they have worsened standards of living; in 1970s, 10% of Africans lived in poverty; now it has risen to 70%. This is because the goods exported by the periphery (developing countries) are generally low-value added and have low-income elasticity, whereas the goods exported by the core (rich countries) are generally high-value added and have high-income elasticity.

When disposable income rises, the demand for high-value added goods will increase faster than low-value added goods due to the disparity of income elasticity and value added in their exports. The increase in demand for high-value added goods will naturally raise their prices, hence the prices of low-value added goods will fall relatively. This means that the periphery has to give up more exports to receive the same amount of imports from the core, meaning that their terms of trade will fall over time. While the core becomes better off, the fall in terms of trade can only lead to a fall in standards of living when purchasing power decreases.

The analysis above illustrates that for any intervention by rich countries to be meaningful, it must first target institutional changes in developing countries. In this regard, richer countries can engage in meaningful intervention by leveraging their economic power and exert diplomatic pressure to introduce changes. Changes such as guaranteeing property rights allow citizens to convert land into collateral against which they can borrow and invest to start businesses, which creates a multiplier effect through employment which raises standards of living.

Over time, changes in institutions would be associated with a more efficient distribution of economic resource. Under inclusive economic institutions brought about by foreign pressure and influence, resource-rich developing countries can sell their rights to resource extraction to private enterprises. This would not only raise government revenue, which can be used in infrastructural and welfare improvement, the resource extraction is also likely to be more efficient under private enterprises. Without the dependence on resource revenues, governments will increase dependence on taxation which ties in citizens’ demands more closely to government’s actions. The ultimate benefits would be both first-order and second-order; involving an improvement in public services that help lift living standards, as well as increased employment that boosts individual income and material wellbeing.

While improving institutions has the most potential, rich countries can also make their existing intervention mechanisms more meaningful to enhance its desired effect of raising living standards. When sending foreign aid, rich countries need to adopt altruistic motives instead of commercial motives to meaningfully help developing countries. Without commercial motives tied with aid, developing countries can make use of the aid effectively without outflowing back to the donor country to subsidies their multinationals. Donor countries can adopt a more decentralised approach whereby aid is to local communities instead of the government. However, a moral hazard arises because donor countries are unable to ensure that recipients are making use of the aid efficiently, as they may abscond with the money. To ensure that aid is used effectively, donor countries can take advantage of the close ties among community members, whereby recipients will monitor each other’s actions to ensure aid is not embezzled by individual members. Furthermore, dynamic incentives can be introduced, where the size of aid is increased over time as substantial improvements have been made, incentivising recipients to use aid effectively. Doing so would circumvent the problem of government as an ineffective intermediary. In addition, local communities that have superior knowledge would be more likely to direct aid to where it yields the highest marginal improvement, which can improve its effectiveness in raising living standards.

With respect to trade, rich countries can introduce meaningful improvement by recognising the potential disparity in the nature of goods produced and the income elasticity of demand, and encouraging the creation of a trade bloc among developing countries. This form of trade would arguably work better as there is a smaller disparity in income elasticity, meaning it is less likely trade will result in the deterioration of terms of trade for developing countries. Instead, developing countries would be able to more fully enjoy the benefits of specialisation. Over time, as living standards improve, developing countries will in turn demand more high value-added goods produced by richer countries. In short, richer countries can not only help improve the income of developing countries, but these improvement could even bring back benefits to them in the long term.

In theory, there is no doubt that rich countries can help developing countries raise their standards of living by improving their institutions to distribute and use aid more effectively to their own citizens. Rich countries can also redesign the forms of aid and influence the trade patterns of developing countries that enable them to achieve economic development and higher standards of living. Nevertheless, when one considers the current net benefits that rich countries enjoy from these ineffective interventions, it becomes less clear why richer countries would be motivated to introduce meaningful institutional changes or make concessions to help developing countries improve their standards of living per se.

 

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