The Quality Of Growth
By Vinod Thomas
Director, World Bank Institute
October 1, 1999
Prepared for delivery at the IMF Conference on Second Generation Reforms
The last decade of the century witnessed striking progress in the developing world. But it also saw dismal setbacks, even in countries that had the fastest rates in economic growth. The extraordinary reversals have taught us much about developing rapidly--and about faltering. Foremost in what makes the difference: the quality and distribution of human development, the efforts to protect the environment, the effectiveness of globalization and financial regulation, and the quality of institutions and governance. These ingredients, essential for the quality and sustainability of growth, are the focus of this report.Revisiting Development Lessons
At the beginning of this decade, three World Development Reports examined some of the biggest issues in development. The 1990 report on poverty recommended a twofold strategy for reducing poverty--broad based growth, combined with better access to social services. The 1991 report on the challenge of development looked at the actions that seemed to set good performers (fast growth and social progress) apart from poor performers, elaborating a market-friendly approach, and reappraising the roles of state and market. The 1992 report on the environment advocated a twofold strategy for sustainable development--reinforcing the positive links between development and protection of the environment, and breaking the negative links between economic growth and the environment. Subsequent reports reviewed health, infrastructure, labor, transition, the role of the state, knowledge, and globalization. The next one returns to the topic of poverty.
These and other studies emphasized policy and institutional changes conducive to sustained development. They supported reforms in developing and industrial countries to invest more in education and health, to reduce barriers to trade and investment, to dismantle domestic price controls in agriculture and industry, and to reduce fiscal deficits. The 1990s and the longer record confirmed that these actions are essential for sustaining rapid economic growth. They also confirmed that sustained economic growth is essential for reducing poverty. The ups and downs of the 1990s do not challenge these fundamental links (Chapter 1).
But the record showed that measures for the quality and sustainability of growth by government and other players lagged behind those for market liberalization. That imbalance, rooted in the emphasis and capacity in country policymaking and the advice of external agencies, is proving to be a far more serious obstacle than previously imagined in reaping the potential benefits of liberalization. The millennium is an opportune time to re-assess the development record and set out these new lessons from experience.
Thinking on development has undergone sea changes in the past 50 years. But the changes are by no means total. Nor is there full agreement at any time on what is most important. And interpretations of the same notion vary. For example, some think of the Washington consensus as a policy prescription to liberalize markets. The market-friendly approach of WDR91 was thought of as market-plus, involving both liberalization and a strong, positive role for the state and other stakeholders. Differing interpretations aside, what matters is the emphasis of policy advice and decisions. On this score, we have learned much about the importance of market liberalization as well as about the limits of the market and the roles of governments and other stakeholders in complementing it.
Expectations based on experience have often been borne out, but many times they have not. As we look at the past 50 years, there were various points when the definition and ingredients of success seemed clear. Early predictions touted the success of such resource-rich countries as Burma, the Philippines, or those in Africa, and decried the failure of such resource-poor economies as Korea or Singapore. Later came expectations of rapid development through market liberalization in the transition and other economies. Even in the industrial world, the slowdown of productivity growth in North America and Europe, contrasted with the marked success of Japan, prompted calls for a change in the growth paradigms in the 1980s.
Sometimes, changes in global and local circumstances revise priorities and blunt the impact of actions. Heavy industrialization might have seemed the best way forward at the turn of the last century. Development of information technology seem to be the key to success at the turn of this one. And as new insights move into practice, they reveal issues that might not have been anticipated. Take market liberalization where we learned the importance of the institution-building needed to make markets work, or the limits of markets in containing global financial instability.
It is in this spirit of continuous enquiry and feedback to frame development thinking that this report is written. It reaffirms the crucial contribution of market-friendly policies, but focuses on key missing ingredients, controversial issues and new evidence. It is not designed to be a comprehensive textbook of development, but a selective examination of cutting-edge issues which are being inadequately dealt with in practice.Principles for Development
What do the varied development outcomes tell us? Economists have focused development actions almost exclusively on economic growth, an input and at best an indirect proxy for social and environmental improvements which are direct proxies development. Experience shows growth to be a partial measure of social progress, and a misleading indicator of environmental well-being.
Perhaps most important, the growth we have seen is inadequate for reducing poverty. Developing countries have grown at a rate higher than industrial countries. China and India registered successively higher growth rates in each decade in each of the past three decades. Meanwhile, the percentage of people in poverty declined from some 50 percent to less than 30 percent today. But the number of poor increased from less than a billion to 1.2 billion in 1998. The reasons for the rise: populations continued to increase rapidly, growth has not been sustained, and inequalities have grown.
To achieve growth that sustains its impact on poverty and the environment requires more than market liberalization. It requires positive actions--not just by governments alone, but by other stakeholders. We see now that many countries and external agencies followed only part of the needed approach, relying on policies that featured trade liberalization and domestic deregulation. These policies seem to pay off in faster growth, at least in the short term. But the distribution and volatility of growth, and the quality and sustainability of growth, have not been adequately addressed. This experience is the basis for three principles.
First, for development to be comprehensive and sustainable, it needs to augment the value of three sets of assets (Chapter 2):
The first two constitute true development objectives, while the third is a means rather than an end. Ironically, most attention usually goes to physical and financial capital (the means), rather than to human, social, natural, and environmental capital (the ends). By focusing on physical and financial capital, countries can be tempted into public policies (tax exemptions, direct capital subsidies, easy access to logging rights) that subsidize physical and financial capital, leading to a race to the bottom, and an addictive policy trap that is loaded with vested interests and very hard to escape. That is why it is better to balance the accumulation of these three sets of assets than to pursue short-term growth single-mindedly through the accumulation of physical and financial capital.
How do growth policies contribute to the accumulation of these assets? Some positively, and some negatively. Investments in education, while helping to generate growth, also contribute to the accumulation of human and social capital, as we see in Chapter 3. Policy incentives to attract short-term foreign capital, while facilitating investment in physical capital, may distort the rates of return against human and natural capital. Raising short-term growth through the overexploitation of forests, by contrast, runs down natural capital and environmental sustainability, as set out in Chapter 4. Gross domestic savings was about 25 percent of GDP in the developing world in 1997, but corrected for the depletion of natural capital (such as forests), the genuine domestic savings were only 14 percent (WDI 1999). Consider this: the forest fires in Indonesia probably had a greater effect on long-term poverty than did the financial crisis, but they have attracted little attention.
Second, for growth to reduce poverty, it has to be relatively stable not volatile, and its benefits have to be widely spread. The volatility and inequality of growth in the 1990s have been especially harmful to the poor, with external shocks throwing millions of near-poor back to permanent impoverishment. Legitimate aims of development policy thus include reducing the volatility of growth, enhancing financial risk management, and reducing the sensitivity of the poor to changing economic fortunes (Chapter 5).
The income gains from globalization have been borne out by the experience of the past decade. So have the downside risks of inadequate regulatory and supervisory frameworks and the overall lack of preparedness in participating in the global economy. Volatility also comes from the responses of external players, which often can be irrational. Clearly both domestic and global policy frameworks affect the volatility from globalization.
Third, in addition to macroeconomic stability, institutional structures for good governance underpin all other actions. To take one pervasive example, the stability of investments depend crucially on a country's vulnerability to all forms of corruption. The impact of growth more generally depends on how corruption erodes the benefits that would go to society at large. Poor governance and corruption are found to be highly regressive in their effects. Investing in improving the capacity for better governance therefore cuts across all else as a priority for better performance (Chapter 6).
This review shows the impact of ignoring these principles, but they are not all that matters. In many parts of the world, social upheaval, civil strife, political unrest, and wars derailed progress in the 1990s. A fifth of the developing world's people live in conditions of conflict or post-conflict. Afghanistan, Iraq, Iran, Nigeria, Sierra Leone, Sudan, and Yugoslavia are just a few of the countries whose fortunes in the past two decades have been dictated more by sociopolitical crises than economic policies. Nearly two dozen countries--with half a billion people--are analyzed here because of their highly unstable sociopolitical conditions. How to manage risk and conflict and to mitigate exogenous shocks and social tensions are areas in which systematic study has just begun-- areas outside the scope of this report.
Our understanding of the political economy of reforms--economic and social--is also rudimentary. The reason for unsound policies and weak institutions is not always a lack of understanding or false notions on the part of policymakers, but often the political difficulties of making changes. Interest groups constrain feasible reforms, with a wedge between policy design and policy implementation. How best to counteract these forces through greater participation and program ownership is another important topic outside the scope of the report.
Other global and cross-border issues--capital flows, population pressures, labor migration, and environmental crises--continue to affect domestic outcomes. The number of the world's people will rise from 6 billion today to nearly 8 billion in 2025, even with a slower average rate of 1.5 percent a year. The desired number of children for most families in India is now two, a remarkable change in attitude and population policies. Despite this slower growth, many countries face large increases in population that will undermine sustainable development. Global warming, environmental degradation, and the loss of biodiversity continue to worsen as people put more pressure on limited resources. These issues, while important for understanding country outcomes, are not dealt with in detail here.Taking Four Overlooked Actions
The distribution and quality of growth are rooted in national and global policy reforms. The lessons of development, especially those of the past decade, show that the quality of growth is best when four generally missing elements are integrated with (rather than added onto) growth strategies:
1. Looking beyond quantity to the quality and equitable distribution of education. Access to education is not enough. Its quality and equity--measured by girls' education, access for the poor, and the distribution of education need special attention. Also needed are supportive labor market policies and social protection. Governments have to ensure, but not necessarily provide, the quality and equitable distribution of social services. They also have to ensure the better use of the human capital of the poor by attending to the distribution of land and other assets people needed to benefit fully from better education and health.
2. Combining incentives, investments, and institutions to sustain growth and the environment. Environmental degradation has worsened, a consequence of growing poverty, increasing population, domestic and global pressure on scarce resources, short-term economic growth unmindful of environmental consequences, and neglect of local and global commons. The costs of environmental pollution and resource overexploitation are enormous--the losses in some cases, irreversible. Few countries have confronted the underlying causes of environmental and resource degradation: market failures, poor information, and pernicious incentives. But growth does not have to ruin the environment. A stronger combination of incentives, investments, and institutions--domestic and global--can make environmentally sustainable growth a reality.
3. Dealing with global financial risks. Global financial integration has undeniable benefits. But, it also makes developing countries more vulnerable to sudden swings in investor sentiment. In addition to maintaining sound macroeconomic policies, actions are needed to strengthen domestic regulation and financial supervision--as well as information infrastructure and corporate governance. Meanwhile, countries may want to be cautious when opening their capital accounts, making sure that special incentives are not provided for short-term flows--and to consider reserve requirements and taxes for those flows. International policy coordination, prudential regulation and supervision, and lender-of-last-resort activity can provide liquidity and emergency financial assistance.
4. Improving governance and fighting corruption. The traditions, norms, and institutions governing the interactions of people, markets, organizations, and state matters a lot for sustained economic growth and for broader development outcomes. Civil liberties, participatory processes, and the political system can make the difference between a stagnant and a thriving society. Corruption entails heavy social costs, keeping poor people poor. Bad economic policies, weak legal frameworks and regulations, and a lack of professionalism all feed corruption. How to counter it? With active civil societies and strong public oversight.Political economy of quantity versus quality
One reason for higher growth rates to have been insufficient in preventing a rise in poverty is the poor distribution and quality of education--and of opportunities more generally. If we believe that abilities are distributed normally regardless of incomes, a highly skewed distribution of educational opportunities would be highly damaging for growth and poverty reduction. Industrial countries are taking the lead here with the United States having the most equitable distribution of education. A few countries such as Korea and Sri Lanka have reduced the inequality in education from 0.5 three decades ago to 0.2 today (as measured by the gini coefficient, where 1 denotes perfect inequality, and zero denotes perfect equality). Despite modest improvements, Mali and India still show extreme inequality at 0.9 and 0.7 respectively (Chapter 3).
Another reason is that environmental distress offsets the otherwise positive impact of growth on welfare. It has worsened in high-growth developing countries. And the human cost of this delay is borne disproportionately by the poor. The health costs of air and water pollution translate into the inability of children to go to school and the failure of workers to perform their jobs.
Yet another reason: the sequencing of liberalization and the volatility and quality of capital determine the sustainability of growth and the impact on the poor--even if short-term growth can be faster, subsidies that race to the bottom in attracting volatile, short-term capital do more harm than good. The same can be said for hasty, giveaway privatization that add little value. Regulatory frameworks that have to accompany liberalization and keep these quality parameters in mind.
And one of the biggest reasons for growth (or the lack of it) to be lopsided is pervasive corruption. Liberalization and excessive regulation would seem to take away from the heavy hand of government and the incentives for corruption. But this has power far from automatic. Liberalizing economies such as Russia and China are experiencing (or at least discovering) increasing corruption and that corruption hurts the poor the most.
Despite this evidence, almost all countries have first gone for macroeconomic stabilization and liberalization aimed at raising growth rates. Such qualitative aspects as education's distribution or environment's well-being was explicitly postponed--to be addressed later, if at all. The evidence today shows how costly this quantity-first and quality-later approach is for human welfare. Should countries address the quality dimensions along with the effort to raise growth? Yes, for two reasons.
First, the qualitative dimensions make or break sustained growth. If the distribution of basic education is high skewed, broad-based growth and poverty reduction are not possible. Second, the qualitative aspects directly determine whether welfare improvements accompany growth. For example, a high incidence of air and water pollution or the degradation of natural resources can be far more costly to the well-being of poor than the effects of many economic policies.
The questions in practice is how greater priority can be accorded to the quality dimensions--and how they are financed. Some observations:
Reformers could still find a reason for starting with the quantity of growth and attending to quality later--on grounds that the window of opportunity for liberalization must be captured first and not doing so would allow the opponents of liberalization to postpone reform. But as democracies spread and countries invest in capacity, they are likely to own reforms much more, and be in the driver's seat. In a mature and participatory setting, a country would not want to postpone the more important qualitative aspects to a time when the costs of addressing them will have multiplied.Shifts toward a comprehensive development framework
Two broad categories of development strategies were recommended at the turn of the 1990s. A first set of actions, such as trade and price liberalization and improved fiscal management, was recommended strongly--and generally implemented with positive results, though with large variations. A second set of actions was relatively neglected, because they either were not recommended strongly enough or were opposed by special interests. These included the quality and distribution of education and other assets, the protection of the environment, an effective regulatory framework, and governance, civil liberties, and institutional reform.
The evidence here offers little support for going all out for short-term economic growth (as a stylized Kuznets curve might imply) before turning to the equality of human development, the sustainability of the environment, and the transparency of the bureaucracy. That sequencing--whether it be liberalize-first and regulate-later, or privatize-first and ensure-competition-later, or grow-first and clean-up-later, or grow-first and seek-liberties-later--is far too costly. Regulatory actions, environmental management, and anticorruption measures must go with liberalization--to manage financial risks, ensure predictability, and sustain results, even if that means sacrificing some short-term growth.
These aspects need to be part of the policy package not add-ons to an already crowded agenda. That means other stakeholders will have to augment the actions by governments. And that means a shift in emphasis to:
In sum, the report advocates a broadening of the development framework: from a sole focus on short-term economic growth to a qualitative agenda involving human, social and environmentally sustainable development; and from exclusive reliance on government as the agent of change to all segments of society.
At the turn of the century, development challenges of poverty, environmental degradation, financial distress and corruption have never been greater. The opportunities of openness, knowledge, and new technologies too have never been more plentiful. But these opportunities will not automatically benefit the poor and future generations. Two paths lie ahead--one with business as usual, leading to a worsening picture, and the other with a sharper, collective focus on the challenges, leading to a better future. Which will we take?