Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 19 - Plight of the Bottom Billion

Student: Okay, so today Professor Rae is not going to be here and so we’re going to watch two videos instead, one of him and second one is of Paul Collier talking a little bit about his book, but also about recent research that he’s done, especially on governments and commodities. We’re going to start with the first video and then go straight into the Paul Collier video; so enjoy.

Professor Douglas W. Rae [on video]: Hi there. As you know I’m in Washington today, and Jim Alexander has been kind enough to preside over the Monday class, and I want to get in twenty minutes or so of background thoughts taking us from the SELCO case, where the question was how to organize the distribution of distributed electrical generating to bottom billion areas of India. From that very specific set of questions to the much larger question about understanding the plight of the world’s bottom billion, and the available strategies for trying to be helpful to them.

The main text for this class and the next is Paul Collier’s Bottom Billion, which is, while not a page turning thriller like White Tiger, is a very solid, serious, and substantial piece of scholarship by somebody who has been engaged both with the best of growth economics as a scholar, and with the practical work of the World Bank, where he was head of research for a good long time. The default assumption in thinking about the bottom billion is to begin with the world demographic transition and the thought that most of these people are the products of stage two and stage three demographies; where birthrates were vastly higher than death rates, and so you had a huge surge in population and you found–and many people in those societies found themselves in the same predicament as the protagonist in White Tiger, as being one of way too many candidates for every job and having little or no market power, and consequently, little or no income.

Collier’s take is to say, “Well let’s just grow incomes.” It’s not a bad approach, and he’s perfectly aware of the objections I’m going to make to it in the next few minutes, but let’s just catalog what it means. The gross domestic product is at once too broad and too narrow, as a measure of value generated by the economy. For example, if a housekeeper and her employer, or his, marry one another and he or she continues to keep the house but now on the basis of a spousal relationship the cash goes away and the value is deducted from the GDP, while in fact, nothing has much changed. Or suppose a crime wave hits a society and enormous damage is done to property by crime, it requires repair; those repairs get recorded in GDP and can easily be mistaken for an improvement in the condition of people living there. Further, people buy better locks, video cameras, perhaps even weapons, and those too are recorded as improvements, when in fact they really aren’t improvements. Or take disease. A–one society is relatively healthy and has relatively lower medical expenses than the other, yet the second, the one with the high medical expenses, would be accounted as better off. Finally, to get just how mechanical this measure is, if for any reason we were prepared, the government say, was prepared to pay people to dig holes and then fill them back up with the same dirt and pay them a salary for that, we would have increased GDP. Those are ways in which the measure is too inclusive.

There are others ways in which it is not inclusive enough. It doesn’t include–the saying “The best things in life are free,” well that may not be entirely true, but some of the good things in life are free, and those need to be measured in an accounting of how well off a society is. The leading substitute measured these days for GDP per capita is the human development index as put forward by the World Bank and parallel institutions, which gives–which takes GDP per capita as one part of the story, adds to it longevity, and then supplements that by adding a measure of education so you get a somewhat broader measure that captures the surge we see in Hans Rosling’s wonderful data animation as lives become longer and prosperity greater. So one thing to do is just tinker with the measure.

There’s a second set of issues that have to do with the value of income. I’ve got some childlike drawings here to share with you. If we represent the dollar income of Mr. A on the horizontal axis and of Ms. B on the vertical axis, then GDP for these two people is calculated just by adding the one to the other with no attention to the distribution between them, so that all the points on this indifference curve would correspond to the same GDP as one another, and all the points on this indifference curve would likewise so correspond. Well that’s okay, there’s nothing wrong with that, except if you want to infer from it the value shared by A and B in the use of that income.

A generally accepted hypothesis is that the value of income, and economists would use a term utility, let me just stick with value–the value of income first increases and then decreases at the margin, so that you get an S shaped curve like this. On the horizontal axis we have how much income people get, and on the vertical axis how much value they derive from it. Now imagine down here around point A where people have precious little income, so little that they cannot feed and clothe, and lodge themselves. Well think of a setting like an American city and imagine doubling your income, annual income, from $25 to $50. Well that would move you a little ways along the horizontal axis but it wouldn’t lift you up the vertical axis because it’s not going to make a difference until you get to some threshold where you actually begin to get increasing returns from rising incomes, as in the zone I’ve labeled B here.

Then eventually incomes like Richard Medley, whom we met a month ago or Paolo Zanonni, who we’ll meet in a couple of weeks, at their incomes the–so wide a range of material needs are already satisfied that the marginal dollar gets less and less valuable. The implication of this for the relationship between GDP per capita on the one side and a judgment of how well a society is doing on the other is that there’s–we should probably have some egalitarian bias in the way we interpret the numbers. Where most people get to the level that I’m pointing at here, where the diminution of marginal value really sets in, where most people get to that, that’s kind of where you want to be, and Collier’s emphasis on the bottom billion responds to that.

The SELCO project, for example, which we saw a moment–saw–well actually I’m speaking just an hour after class, which we saw in Wednesday’s class, is aimed at trying to bring people up that steep part of the curve, maybe not very far but a little ways, by judiciously providing the opportunity to purchase electric light or electric power for such other purposes as running a sewing machine or preparing goods of some kind for sale. The common sense response to this S curve is to pay special attention to people who are near its bottom and try to find ways to help them push themselves up the curve.

Now as a sidebar let me just mention John Rawls, who published in 1971 a classic book, a book that will be read hundreds of years from now, I imagine, called A Theory Of Justice, and Rawls asked people to imagine that they were behind what he called a veil of ignorance, and the idea of the veil of ignorance is roughly that you have no idea who you are. It’s a little like Adam Smith’s device in Theory Of Mortal Sentiments. But the question is, if you had no idea who you were before we set up the basic institutions for a country, or for the world if we think of it on a global scale, what would be your way of structuring alternative arrangements so that you could find one that you thought was best from–for you from behind this veil of ignorance and on which you could agree with everyone else behind the same veil? His idea, stated way too simply, is that you should maximize the welfare of the least advantaged group in society. The intuition is that that group would be unskilled labor; and that doesn’t mean that you should knock down inequalities necessarily. Indeed, if allowing bankers, engineers, and entrepreneurs to reap substantial and very unequal benefits from their work will ultimately read down to the benefit of this unskilled labor stratum, then that’s great.

A Rawlsian picture of the indifference curves which before utilitarianism just run at minus 45º here, Rawls’ are L shaped, and so if we’re here, so that this person is way better off than this person, we try to move to a higher indifference curve from the point of view of the less advantaged person; and symmetrically here we try to move in this direction, so that the L shaped indifference curves, if there were just two people in the society would drive us to seek the highest one, and it would have a powerful middle-of-the-road bias to it, but it wouldn’t have so powerful an egalitarian kick that it would knock down equality to an extent which hurt even the less skilled parts of the workforce. Societies–and we know societies that have reached that level, in my judgment Castro’s Cuba is just such a case and I know it fairly well; North Korea, which I know much less well, appears to be such a case.

Okay so that’s all by way of background, and now I just want to talk rather briefly about the introductory series of traps in Collier’s book, and the traps are his way of summarizing things that can go very wrong for a country and put it way behind the rest of the world in economic growth. Now as background, Collier is really thinking about what we would call “emerging market countries.” He’s not thinking about Germany, Japan, Canada, or the states. He’s thinking about India, Bangladesh, Kenya, Zimbabwe, Bolivia, and Mexico, countries which are just finishing the world demographic transition, and are relatively late entrants as full players in capitalist development. The majority of them–and Collier gives very little stress to this, and he probably should give more–the majority of these countries were colonial sites for European powers, and India is just such a case, for example–and the British Empire was enormous. Other countries were subject to the Dutch, the French, and other–and the Spanish, and the Spanish actually are quite important, European powers which treated them as subordinate economies and structured their governments to the advantage of the metropolitan country.

Trap one may be, be a colonial site, and be set back by it. The other side to that story is that the colonial powers sometimes left something good behind. The extraordinary quality of technical education in India, for example, is in part an outgrowth of British education and the systematic inculcation of British educational values. Wouldn’t want to go too far stressing that, but it’s there somewhere. Okay so the Collier traps; the first one is what he calls a conflict trap, and according to him 73% of the bottom billion live in countries which are now in civil wars or have recently been in civil wars. That’s a stunning number, and the world which occupies the front page of every major newspaper–Somalia, Iraq, the incredible mess in Afghanistan, many other less dramatic cases, these are all countries where civil strife has defined life to a considerable degree in let’s say the last twenty-five years. Well the–Collier spends some time asking the causes of that. He rejects the common sense popular explanation is ethnic conflict. He says that ethnic conflict is actually quite a lot less important than simple poverty. That countries with very low GDP per capita are greatly–at much greater risk of civil war than countries with higher GDP per capita, and that countries with growing GDP are more secure than those with static GDP, particularly static GDP at a low level.

Not much news in that but it’s actually very important because if you think about the logic of capital development–capitalist development, and you take either the Coase Theorem or de Soto’s development of the Coase Theorem seriously, which I do and I urge you to, it’s built on the foundation of the Westphalia nation state system, which came into being in the middle of the seventeenth century. Where civil wars are still in progress that system isn’t there; a civil war is indicative of a failed state, and a failed state can’t perform the capitalizing functions of government which are so central to the story de Soto tells us, and about which I think he is very right. The palliatives for this are not obvious. One thing we’ve pretty much learned is that third party interventions in civil wars, by and large, are not terribly successful.

The second of his traps is the natural resource trap, where the standard case would be oil, but it could be any other commodity that is exported at great value with–and which can be harvested and processed and shipped without developing a huge economic infrastructure, or a nimbly functioning internal market. The gist of this one hinges on what he calls Dutch disease and the idea here is that when the Dutch began to export North Sea oil at great profit to their–to the value of their currency the inflation in the value of the currency made their other export products less and less competitive and caused a kind of lethargy in the country. That’s one piece of it.

The other piece, which I think is actually more important, has to do with the relationship between democratic rule and oil or other export products. If you’ll look carefully at page forty-three of Collier’s book, he tells a story which is actually, it’s a fairly subtle story and I think it’s a true story, and the gist of it is that where an economy functions largely by exporting something like oil, that the impact of democratic government on the economy is to reduce the rate of growth. Whereas, in economies where that form of export production is not important, democratic government and the rule of law relates to an increasing rate of economic growth. His slightly smart aleck term for this is survival of the fattest, and if you look at the behavior of classic oil states, they seem to respond to this and once you have an authoritarian government with an oil export economy much of what happens is ugly. A good part of the ugliness we see in Russia these days, for example, is made possible, some might say inevitable, by its powerful export resources in petroleum and natural gas.

The land lock trap, and here the classic case that will concern us will be Bolivia, where we’ll do a case two weeks from now about trying to improve water resources in a major Bolivian city, and being land locked is a bad thing. It’s not hard to capture the intuition of that because commerce with distant states historically is largely done by marine transportation and absent ports of your own you depend on ports of other countries, so that, for example, Switzerland depends on Italian and German ports, and Uganda or Rwanda would depend on Kenyan ports, and it’s probably a better idea to depend on port systems like those of Italy, or Germany, than like those of Kenya because they’re far more developed. But there’s another side to this story, which is that, as Collier points out, having rich countries for neighbors means you have large markets which don’t require ocean going shipping, so that, for example, Germany and Italy are not just in the way of exports from Switzerland but become markets for those exports and breed a great deal of wealth.

Indeed Collier shows that a 1% increase in GDP per capita in a neighboring state correlates generally with about .4% of an increase in GDP in the land locked country.

We’re almost done here. The last one is bad states are really bad for economies. This one is a no-brainer. There are two main ways for states to be bad. By being weak and unable to enforce the rule of law, tune into tonight’s 6:30 world news, and I prophesy five days in advance that there will be an account of death and destruction in Afghanistan, where the Taliban challenged the state for control of territory and our soldiers try to bring a degree of order under almost impossible conditions; so weak states, failed states, the famous case of Somalia with its pirates would be another case. Iraq after the–after our intervention was for a period a failed state and it gives every indication of remaining either a failed state or a–why don’t I not prophesy about Iraq; I don’t need to have a dog in that fight.

The other bad government story is kleptocracy, and where the government or the elites at the top of the government use it as a means for collecting rent from the rest of society. It is extraordinarily destructive to the economy because it takes away all the conditions which allow people to make investments and execute business projects and sell products in a sufficiently predictable way to grow the economy. The other clip you’re about to see is Paul Collier himself in a TED talk explaining, no doubt better than I can, what it is that The Bottom Billion is about. I look forward to seeing you on Wednesday.

Paul Collier: So can we dare to be optimistic? Well the thesis of The Bottom Billion is that a billion people have been stuck living in economies that have been stagnate for forty years, and hence, diverging from the rest of mankind. So the real question to pose is not “can we be optimistic,” it’s “how can we give credible hope to that billion people?” That, to my mind, is the fundamental challenge now of development. What I’m going to offer you is a recipe, a combination, of the two forces that changed the world for good, which is the alliance of compassion and enlightened self interest. Compassion because a billion people are living in societies that have not offered credible hope. That is a human tragedy. Enlightened self interest because if that economic divergence continues for another forty years, combined with social integration globally, it will build a nightmare for our children. We need compassion to get ourselves started, and enlightened self interest to get ourselves serious.

That’s the alliance that changes the world. So what does it mean to get serious about providing hope for the bottom billion? What can we actually do? Well a good guide is to think what did we do last time the rich world got serious about developing another region of the world? That gives us, it turns out, quite a good clue, except you have to go back quite a long time. The last time the rich world got serious about developing another region was in the late 1940s. The rich world is you, America, and the region that needed to be developed was my world, Europe. It was post-war Europe. Why did America get serious? It wasn’t just compassion for Europe, though there was that. It was you knew you had to, because in the late 1940s, country after country in central Europe was falling into the Soviet block, and so you knew you had no choice. Europe had to be dragged into economic development. What did you do last time you got serious? Well yes, you had a big aid program, thank you very much, that was Marshall Aid, we need to do it again, and aid is part of the solution.

But what else did you do? Well you tore up your trade policy and totally reversed it. Before the war, America had been highly protectionist; after the war you opened your markets to Europe, you dragged Europe into the then global economy, which was your economy, and you institutionalized that trade globalization through founding the General Agreement on Tariffs and Trade; so total reversal of trade policy. Did you do anything else? Yes, you totally reversed your security policy. Before the war your security policy had been isolationist; after the war, you tear that up, you put 100,000 troops in Europe for over forty years; so total reversal of security policy. Anything else? Yes, you tear up the eleventh commandment: national sovereignty. Before the war you treated national sovereignty as so sacrosanct that you weren’t even willing to join the League of Nations; after the war, you found the United Nations, you found the Organization for Economic Cooperation and Development, you found the IMF, you encouraged Europe to create the European Community; all systems for mutual government support. That is still the waterfront of effective policies–aid, trade, security, governance.

Of course the details of policy are going to be different because the challenge is different, it’s not rebuilding Europe, and it’s reversing the divergence of the bottom billion so that they actually catch up. Is that easier or harder? We need to be at least as serious as we were then. Now today I’m going to take just one of those four, I’m going to take the one that sounds the weakest, the one that’s just motherhood and apple pie: governance; mutual systems of support for governance, and I’m going to show you one idea and how we could do something to strengthen governance, and I’m going to show that that is enormously important now.

The opportunity we’re going to look to is a genuine basis for optimism about the bottom billion, and that is the commodity booms. The commodity booms are pumping unprecedented amounts of money into many, though not all, of the countries of the bottom billion. Partly they’re pumping money in because commodity prices are high, but it’s not just that; there’s also a range of new discoveries. Uganda has just discovered oil at about the most disastrous location on earth. Ghana’s discovered oil; Guinea has got a huge new exploitation of iron ore coming out of the ground; so a mass of new discoveries. Between them, these new revenue flows dwarf aid. Just to give you one example, and gold ore alone is getting $50 billion dollars a year in oil revenue. The entire aid flows to the sixty countries of the bottom billion last year were $34 billion, so the flow of resources from the commodity booms to the bottom billion are without precedent. There’s the optimism. The question is how is it going to help their development? It’s a huge opportunity for transformation of development. Will it be taken?

So here comes a bit of science, and this is a bit of science I’ve done since The Bottom Billion, so it’s new. I’ve looked to see what is the relationship between higher commodity prices of exports and the growth of commodity exporting countries, and I’ve looked globally. I’ve taken all the countries in the world for the last forty years, and looked to see what the relationship is, and so the short run–the first five to seven years is just great. In fact its hunky dory, everything goes up. You get more money because your terms of trade have improved, but also that drives up output across the board, so GDP goes up a lot, fantastic. That’s the short run. How about the long run? Come back fifteen years later–well the short run it’s hunky dory, but the long run it’s humpty dumpty. You go up in the short run, but then most societies historically have ended up worse than if they’d had no booms at all. That is not a forecast about how commodity prices go, it’s a forecast of the consequences, the long-term consequences for growth of an increase in prices.

What goes wrong? Why is there this resource curse, as it’s called? Again, I looked at that, and it turns out that the critical issue is the level of goverannce, the initial level of economic governance when the resource booms accrue. In fact, if you’ve got good enough governance, there is no resource boom. You go up in the short term and then you go up even more in the long term. That’s Norway, the richest country in Europe, it’s Australia, and it’s Canada. The resource curse is entirely confined to countries below a threshold of governance. They still go up in the short run, that’s what we see across in the bottom billion at the moment; the best growth rates they’ve had ever. The question is whether the short run will persist. We’ve got governments historically over the last forty years; it hasn’t. There’s countries like Nigeria, which are worse off than if they’d never had oil. There’s a threshold level above which you go up in the long term, below which you go down, just a benchmark of that threshold. It’s about the governance level of Portugal in the mid-1980s.

The question is, is the bottom billion above or below that threshold? Now there’s one big change since the commodity booms of the 1970s, and that is the spread of democracy. I thought maybe that is the thing which has transformed governance in the bottom billion. Maybe we can be more optimistic because of the spread of democracy. So I looked. Democracy does have significant effects, and unfortunately, they’re adverse. Democracies make even more of a mess of these resource booms than autocracies. At that stage I just wanted to abandon the research, but it turns out that democracy is a little bit more complicated than that, because there are two distinct aspects of democracy. There’s electoral competition, which determines how you acquire power, and there’s checks and balances, which determine how you use power. It turns out that electoral competition is the thing that’s doing the damage with democracy, whereas strong checks and balances makes resource booms good. And so what the countries of the bottom billion need is very strong checks and balances. They haven’t got them; they got instant democracy in the 1990s, elections without checks and balances.

How can we help improve governments and introduce checks and balances? In all of the societies of the bottom billion, there are intense struggles to do just that. The simple proposal is that we should have some international standards, which will be voluntary, that we should spell out the key decision points that need to be taken in order for it to harness these resource revenues. We know these international standards work because we’ve already got one. It’s called the Extractive Industries Transparency Initiative. That is the very simple idea that governments should report to their citizens what revenues they have. No sooner was it proposed than reformers in Nigeria adopted it, pushed it, and published the revenues in the paper. Nigerian newspaper circulation spiked, people wanted to know what their government was getting in terms of revenue.

We know it works. What would the content be of these international standards? I can’t go through all of them, but I’ll give you an example. The first is how to take the resources out of the ground. The economic process is taking the resources out of the ground and putting assets on top of the ground. The first step in that is selling the rights to resource extraction. You know how rights to resource extraction are being sold at the moment, how they’ve been sold over the last forty years? A company flies in, does a deal with the minister, and that’s great for the company and it’s quite often great for the minister, and it’s not great for the country. There’s a very simple institutional technology which can transform that, and it’s called verified auctions. The public agency with the greatest expertise on earth is, of course, the treasury, that is the British Treasury, and the British Treasury decided that it would sell the rights to third generation mobile phones by working out what those rights were worth. It worked out they were worth 2 billion pounds. Just in time, a set of economists got there and said, “Why not try an auction? It’ll reveal the value.” It went for 20 billion pounds through auction. If the British Treasury can be out by a factor of ten, think what the ministry of finance in Sierra Leone is going to be like. When I put that out to the president of Sierra Leone, the next day he asked the World Bank to send him a team to give expertise on how to conduct auctions.

There are five such decision points; each one needs an international standard. If we could do it, we would change the world. We would be helping the reformers in these societies who are struggling for change. That’s our modest role. We cannot change these societies, but we can help the people in these societies, who are struggling and usually failing because the odds are so stacked against them. Yet, we’ve not got these rules. If you think about it, the cost of promulgating international rules is zilch, nothing. Why on earth are they not there? I realized that the reason they’re not there is that until we have a critical mass of informed citizens in our own societies, politicians will get away with gestures; that unless we have an informed society what politicians do, especially in relation to Africa, is gestures, things that look good but don’t work. So I realized we had to go through the business of building an informed citizenry. That’s why I broke all the professional rules of conduct for an economist and I wrote an economics book that you could read on a beach. However, I have to say, the process of communication does not come naturally to me, this is why I’m on this stage, but it’s alarming. I grew up in a culture of self-effacement. My wife showed me a blog comment on one of my last talks, and the blog comment said, “Collier is not charismatic, but his arguments are compelling.” If you agree with that sentiment and if you agree that we need a critical mass of informed citizenry, you will realize that I need you. Please become ambassadors. Thank you.

Jim Alexander: Professor Rae will be back on Wednesday and we’ll see you then.

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