What does that leave us with? It seems relatively clear there are things to avoid: hyperinflation; extremely overvalued fixed exchange rates; communism in its Soviet, Maoist, or North Korean varieties; or even the kind of total government chokehold on private enterprise India had in the 1970s with state-ownership of everything from ships to shoes. This does not help us with the kinds of questions most countries have today, given that no one, except perhaps the Venezuelan madmen, seem to be very keen on any of these extreme options. What Vietnam or Myanmar want to know, for example, is whether they should aim to emulate China’s economic model, given its stunning success, not whether to follow North Korea.
The problem is that while China is very much a market economy, as are Vietnam and Myanmar, China’s approach to capitalism is quite far from the classic Anglo-Saxon model and even its European variant. Seventy-five of the ninety-five Chinese firms on the 2014 Fortune Global 500 list were state owned, though organized like private corporations.82
Most banks in China are owned by the state. The government at both the local and the national level has played a central role in deciding how land and credit should be allocated. It also decides who gets to move where and with them the supply of labor to various industries. The exchange rate was kept undervalued for some twenty-five years, at the cost of lending billions of dollars to the United States at almost zero interest rates. In agriculture, the local governments decide who gets the right to use the land, since all land belongs to the state. If this is capitalism, it is surely with very Chinese colors.
Indeed, for all the excitement generated by the Chinese miracle these days, very few economists in 1980 or even 1990 predicted it. Often, at the end of one of our talks someone rises and asks why whatever country we are talking about doesn’t just emulate China. Except it is never clear what part of the Chinese experience we are supposed to emulate. Should we start with Deng’s China, a dirt-poor economy with comparatively excellent education and healthcare systems and a very flat income distribution? Or with the Cultural Revolution, a valiant attempt to wipe out all cultural advantages of the erstwhile elites and place everyone on an even playing field? Or with the Japanese invasion in the 1930s and its insult to Chinese pride? Or with five thousand years of Chinese history?
A similar puzzle arises in the cases of Japan and South Korea, where the governments initially pursued an active industrial policy (and to some extent still do), deciding what products to push for eventual export and more generally where investments should be made. And Singapore, where everyone had to put a large part of their earnings in a central provident fund, so the state could use their savings to build a housing infrastructure.
In all of these cases, the debate among economists has been whether growth happened because of particular unconventional policy choices, or in spite of them. And in each case, predictably, the discussion has been inconclusive. Did East Asian countries just luck out, or is there actually a lesson to be learned from their successes? Those countries were also devastated by war before they started growing fast, so a part of the fast growth might have been just the natural bounce-back. Those who herald the experience of the East Asian countries to prove the virtue of one approach or the other are dreaming; there is no way to prove any such thing.
The bottom line is that, much as in rich countries, we have no accepted recipe for how to make growth happen in poor countries. Even the experts seem to have accepted this. In 2006, the World Bank asked the Nobel laureate Michael Spence to lead the Commission on Growth and Development (informally known as the Growth Commission). Spence initially refused, but convinced by the enthusiasm of his would-be fellow panelists, a highly distinguished group that included Robert Solow, he finally agreed. But their report ultimately recognized that there are no general principles, and no two growth episodes seem alike. Bill Easterly, not very charitably perhaps, but quite accurately, described their conclusion: “After two years of work by the commission of 21 world leaders and experts, an 11-member working group, 300 academic experts, 12 workshops, 13 consultations, and a budget of $4m, the experts’ answer to the question of how to attain high growth was roughly: we do not know, but trust experts to figure it out.”83
ENGINEERING MIRACLES?
The young social entrepreneurs basking in Silicon Valley’s enthusiastic glow have probably not read the Spence report. According to them, we do know what will get the developing world to grow—they just need to adopt the latest technologies, chief among them the internet. Mark Zuckerberg, CEO of Facebook, is a strong proponent that internet connectivity will have a huge positive impact, a sentiment echoed in a hundred reports and position papers. One report from Dalberg (a consulting firm) tells us that “the internet is a tremendous, undisputed force for economic growth and social change [italics added]” in Africa.84
The fact is evidently so obvious that the report does not bother to cite much solid evidence, which is sensible since there is no such evidence to cite. After all, in developed countries there is no evidence that the advent of the internet ushered in a new era of growth. The World Bank’s flagship publication, the World Development Report, in its 2016 edition on digital dividends, after much hemming and hawing, concluded that on the impact of the internet, the jury was still very much out.85
The internet is just one of the technologies tech enthusiasts believe can be both a commercial success and an engine of growth for poor countries. The list of “bottom of the pyramid” innovations that are supposed to change the life of the poor and power growth from the bottom up is long: clean(er) cookstoves, telemedicine, crank-powered computers, and rapid testing kits for arsenic in water, to name a few.
One common feature a lot of these technologies (though not the internet) share is that they were developed by “frugal” engineers, such as the students at MIT’s D-Lab or the entrepreneurs funded by Acumen Fund, a prominent “social” venture capital fund. Behind this and other similar funds is the believable idea that one reason why developing countries are poor is that the technologies developed in the North are not appropriate for them. They use too much energy, too many educated workers, too expensive machines, etc. In addition, they are often developed by monopolies in the North, and the South has to pay a premium to get them. The South needs its own technologies, and for that it needs capital not available from the markets. This may be why growth does not happen on its own in many countries and it’s the gap that Acumen Fund tries to fill.
While the Acumen Fund sees itself as an entirely new type of organization, not an aid organization but a venture fund for the poor countries, in a sense its technology-oriented view of growth harks back to the 1960s, when engineers dominated the aid world and went bust trying to bridge the “infrastructure gap,” giving large loans to poor countries for building dams and train lines that would allow them to catch up with rich countries. Despite the lack of evidence that this has helped those countries to grow, the fascination for electricity as the source of growth and development has never really gone away. Ecuador is currently under severe financial strain thanks to a loan from China to build a massive dam that was never fully operational. Acumen loans are smaller and they are given to private actors rather than to governments, but the dream is still one where engineers will fix the world’s problems. One of Acumen Fund’s key sectors is electricity. The ideal source of energy has changed from large dams to power from grain husks, or the sun, and the latest “cool” idea is that it is possible to develop cheaper “off the grid” solutions to reach poor communities; but the focus on electricity goes back fifty years.
It turns out, however, that it is not easy to invent appropriate technologies that are also profitable in a poor country. A good part of what Acumen funds fails. A rule of thumb in the social investing world is that 10 percent of the ventures work out (the rest fold) and only 1 percent reach significant scale. The issue is more that it is difficult to identify those supposedly life-changing new products and services, and efforts to do so often meet a frustrating la
ck of interest from the people whose lives are supposed to be changed.
Electricity is a case in point. In a recent randomized controlled trial in Kenya, researchers partnered with Kenya Rural Electrification Authority to offer electricity connection at different prices in different communities. The demand fell very sharply as price rose, and villagers were not willing to pay anywhere near what would have been sufficient to cover the cost of connecting to the grid (not to mention building the grid).86
The frugal engineering world is littered with many similar disasters, from the $100 laptop to educate the world (which actually costs $200 and has been shown to have no impact on what children actually learn),87 to cleaner cookstoves that nobody wanted,88 to various water-filter technologies89 and innovative latrines.90 A lot of the problem seems to be that these innovations take place in a void, insufficiently connected to the lives they wish to change. The core ideas are often clever, and it remains possible that one day they will click, but it is hard to place a lot of faith in this prospect.
FISHING WITH CELL PHONES
A central tenet of all the growth theories we have discussed is that resources are smoothly delivered to their most productive use. This is a natural hypothesis as long as markets work perfectly. The best companies should attract the best workers. The most fertile plots of land should be farmed most intensively, while the least productive will be used for industry. People who have money to lend should lend to the best entrepreneurs. This assumption is what allows macroeconomists to speak of the stock of “capital” or “human capital” of an economy, despite the obvious reality that the economy is not one giant machine: as long as resources flow to their best use, each separate enterprise is like one cog in a smoothly operating machine, which spans the entire economy.
But this is often not true. In a given economy, productive and nonproductive firms coexist, and resources do not always flow to their best use.
Lack of adoption of available technologies is not just a problem for poor households; it seems to also be a problem in industrial settings in developing countries. In many cases, the best firms in an industry use the latest worldwide technology but other firms do not, even when it seems it would make sense economically.91 Often, this is because the scale of their production is too small. For example, until recently the typical clothing manufacturer in India was a tailor who made made-to-measure clothes in his one-man workshop, rather than a firm that mass produces. TFP is low not because the tailors are using the wrong technology, but because tailoring firms are too small to benefit from the best technology. In a sense, the puzzle is why these firms exist.
So the problem with technology in developing countries is not so much that profitable technologies are not available and accessible, but that the economy does not appear to make the best use of available resources. And this is true not only of technologies but also of land, capital, and talents. Some firms have more employees than they need while others are unable to hire. Some entrepreneurs with great ideas may not be able to finance them, while others who are not particularly good at what they are doing continue operating: this is what macroeconomists call misallocation.
A vivid instance of misallocation comes from the impact of the introduction of cell phones on fishing in the state of Kerala in India. Fishermen in Kerala would go out to fish early in the morning and return to shore midmorning to sell their catch. Before the cell phone, they would land at the nearest beach, where their customers would meet them. The market would run until there were no customers left or the fish ran out. Since the catch varied quite a bit from day to day, there were a lot of wasted fish at some beaches, while at the same time there were often disappointed customers at others. This is a stark example of misallocation. When cell phone connectivity became available, fishermen started to call ahead to decide where to land; they would go where there were lots of customers waiting and not a lot of boats. As a result, waste essentially vanished, prices stabilized, and both customers and sellers were better off.92
This first story spawned a second one. The main tool of trade for a fisherman is his boat, and good boats last much longer than bad boats. The technology of making a fishing boat is always the same, but some craftsmen are much better at it than others. Before cell phones, fishermen used to purchase their boats from the nearest boat makers. But when they started to travel to different beaches to sell their fish, they often discovered there were better boat makers elsewhere, and they started to ask them to build their new boats. The result was that the better boat makers got more work and the worst went out of business. The quality of the average boat improved and in addition, because the better boat makers got more work and therefore got to use their existing boat-making infrastructure more effectively, they could lower the price of the boats. Misallocation went down: the workers making boats, the equipment, the wood, the nails, and the ropes that went into a boat were all used more effectively.93
What is common to these two stories is that a communication barrier led to misallocation. When communication improved, the same resources were better used, resulting in higher TFP, since more was done with the same inputs.
Misallocation is pervasive in developing economies. Take the city of Tirupur in South India, the T-shirt capital of the country, which we have already encountered in chapter 3.94 There are two kinds of entrepreneurs in Tirupur: those who come from outside to start a T-shirt-making business, and those born and brought up in the area. The latter are almost uniformly the children of affluent local farming families, the Gounders, looking to do something different with their lives. Those who go there to make T-shirts are generally better at T-shirt making than the locals; many have family connections in the T-shirt business, and perhaps as a result firms run by outsiders make the same number of T-shirts with many fewer machines and their firms grow a lot faster.
But despite being more productive, Abhijit found in a study with Kaivan Munchi, the firms run by the immigrants were smaller in size and had less equipment than the firms run by the locals. The Gounders poured money into the firms run by their children instead of doing the “efficient” thing: lending money to migrants and passing the interest income so earned to their sons. As a result, efficient and inefficient firms could persist in the very same town.95
When Abhijit asked them why they preferred to sponsor their sons rather than lend money to the more talented outsiders and live off the proceeds, the Gounders explained they could not be sure of getting their money back. In the absence of a well-functioning financial market, they preferred to give money to their inept sons and get lower but relatively safe returns. It is also probably the case that they felt they had a duty to give their sons not only some hard cash, but also a means to earn a decent living.
Family firms are common all over the world (from small farms to large family groups), and they do not always fully adapt to “economic” incentives. Firms are passed on to sons even when daughters would be better at managing them,96 all the fertilizer in the family goes to one (male) person’s plot when it would make sense to use a little bit in all the fields.97 That is of course true not just of small farms in Burkina Faso or family concerns in India and Thailand, but of the United States as well. Out of 335 CEO successions at family firms a researcher investigated, 122 were “family successions” where the new CEO was a child or a spouse of the current CEO (often a founder or the child of a founder). On the day of the succession, the stock market returns of the companies that appointed an outside CEO went sharply up, while the returns of the companies that appointed an inside CEO did not. The market was rewarding the appointment of an outsider. And apparently the market was onto something. Firms that appointed family CEOs experienced large declines in performance in the subsequent three years, compared to firms that promoted unrelated CEOs: their return on assets fell by 14 percent.98
What all of this tells us is that we cannot take it for granted that resources will flow to their best use. If they do not within a single family, or within a town, we clearly
should not expect them to do so across an entire country. Misallocated resources will in turn lower overall productivity. Part of the reason poor countries are poor is they are less good at allocating resources. The flip side is that it is possible to grow just by allocating the existing resources to more appropriate uses. In the last few years, macroeconomists have spent a lot of effort trying to quantify just how much growth could come from better allocation. This is hard to do perfectly, but the results have been very encouraging. One very prominent estimate suggests that, in 1990, just the reallocation of factors within narrowly defined industries could have increased Indian TFP by 40 percent to 60 percent and Chinese TFP by 30 percent to 50 percent. If we allowed reallocations across broader categories, the estimates would surely be even larger.99
And then there is the misallocation we do not see, the great ideas that never see the light of day. Given that venture capital is so much more active in scouting out new ideas in the United States than in India, it is plausible that India is also missing more of these unsung geniuses.
BANKING ON BANKING?
Where does misallocation come from? Indian firms grow much more slowly than US firms, but are also much less likely to shut down.100 In other words, the United States is an “up or out” economy, where people try something new and either succeed and make it big or fail after a few years. By contrast, the Indian economy is exceedingly sticky: good firms do not grow and bad firms do not die.
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