Pioneers of the static interest rate

When an author describes his work in the abstract or the introduction, it is common to highlight what is "new," "novel," "unique," an "improvement," or "better." But you do not write that your paper is "pioneering" or "seminal," as this can only be established by others in hindsight.

That does not stop Sarbajit Chaudhuri and Manash Ranjan Gupta, who start their abstract with "This paper makes a pioneering attempt to provide a theory of determination of interest rate in the informal credit market in a less developed economy in terms of a three-sector static deterministic general equilibrium model." OK. So we have a static model to determine the interest rate. That is pioneering. I always thought the interest rate was tied to the relative price of commodities in different periods. I guess the genius here is that with a static model, one needs not to worry about future shocks and even current shocks are instantaneously resolved so the model is also deterministic! This allows to simplify everything to a great extend, but apparently still provides a major improvement of Gupta (1997), that was, however, already pioneering the static determination of the interest rate. So the pioneership of this paper must lie elsewhere. I think the pioneering aspect is rather in the assumption that there is no flow across regional informal markets and moneylenders have a local monopoly. Imagine the pioneering strides we are now making towards a closed-form solution of the model!

Avoiding the Lewis path

In the best of all worlds, improvements in agriculture productivity leads to surpluses that allow capital accumulation and the development of industry, which then provides better inputs for agriculture. This is a virtuous circles that eventually leads to agriculture using only a tiny fraction of the workforce and representing a minuscule portion of GDP. This so-called Lewis path to growth has happened in many western economies, but does not seem to take off in Africa, in particular.

Bruno Dorin, Jean-Charles Hourcade and Michel Benoit-Cattin show that the Lewis path is not the unique equilibrium path in a growth model. A particular concern is the so-called Lewis trap that would result from a lack of additional agricultural land, where agriculture keeps growing in the labor force for little gain in output. But why insist on farming where land is no good? We have a global economy now and can produce goods where the comparative advantage is highest. Many areas of Africa are simply no good for agriculture, so we should stop insisting that they should go through all the motions of the Lewis path. Go straight to manufacturing and import food (my previous rant on this). This would also imply that other areas would specialize in agriculture, which is good even though the authors complain that this would lead to urban poverty there. People will move where the jobs are, for example to charter cities.

Child labor and fertility

Child labor has often been described as a vicious circle. Parents have too little income to feed their family and require their children to work. Children do not get educated and end up earning too little to sustain their own family. One may then question why they decide to have children in the first place.

Simone D’Alessandro and Tamara Fioroni build a model of human capital and fertility with child labor. At least in theory, they highlight that destitute parents find it relatively advantageous to have children: they are less costly as they can work. If their net contribution is positive, they want to have many children. And this mechanism can be self-reinforcing if the gap between skilled and unskilled wages is large. This is an amplified quantity/quality trade-off that increases child labor and leads to more wage inequality. The only way out is to make it more attractive for unskilled parents to have fewer children and not have them work. Legislating child labor away will not help, as already demonstrated many times. One example was discussed here, and some was to get one of the vicious circle as well: 1, 2, 3.

Industrial Revolution in Britain: it was thanks to human capital

Despite the fact that it happened about 200 years ago, we are still puzzling why the Industrial Revolution happened, why it started in Britain and it happened at that moment. A sample of previous work relevant to this has been discussed on this blog: 1, 2, 3, 4. While all this is old history, it is still kind of relevant, as we are also trying to understand how to get the least developed economies to get through a similar revolution. The circumstances are different, but lessons from two centuries ago may be useful.

Morgan Kelly, Cormac Ó Gráda and Joel Mokyr add another piece to the puzzle. British men were significantly better fed and taller than their continental counterparts. They likely had better cognitive skills, too, as we know today that they correlate positively with physical health. And, the distribution of these positive traits was such that a significant share of the population had the right characteristics to participate in the Industrial Revolution. That was not the case elsewhere. Thus, good human capital and a good distribution of it are necessary for the Industrial Revolution, but likely not sufficient.

Give girls a bicycle

It is well known that girls from developing countries face hurdles in their schooling experience. This goes from subtle issues during their periods, curricula geared towards boys, and household work to plain denial of access to schools. While some of this has to do with cultural issues that are difficult to overcome with (economic) policy, some help could be surprisingly easy. It happened before in public health, my favorite example being telling kids to wear shoes eradicated hookworm from many parts of the world.

Karthik Muralidharan and Nishith Prakash have a recommendation, and that is to give girls a bicycle. They base this on an experiment they ran in India, where girls were offered a bicycle if they continued into secondary education. This helped overcome traditions that would not let girls out of the village and increased enrollments by 30% and closed the boy-girl gap by 40%. The authors also claim this is more cost-effective that the traditional cash transfers because bicycles have positive externalities, such as the safety of girls during commutes and more generally empowering them. As with any such experiment, one can question whether the result can be generalized, but it is interesting nonetheless.

PS: As several readers noted by email (but could have commented), this is not a randomized experiment. Rather, the authors used an initiative conducted by the government of Bihar. I apologize for the confusion.

Why invest in cows if their return is negative?

In some developing economies, cattle are used as store of value. This is because there is no other good asset available as financial markets are not developed. Cattle has its drawbacks though, as it can die from disease or hunger, usually at the worst moment, can walk away or be stolen, and thus needs constant guard. This implies that their return could actually be negative.

Santosh Anagol, Alvin Etang and Dean Karlan find that cows and buffaloes in rural India have a negative return of a whooping 64% respectively 39%. If you take the extreme assumption that labor has no return, then their returns are minus 6% respectively plus 13%. How is that possible? The authors offer several potential explanations: measurement error, preference for home-made milk, the lack of other saving vehicles, in particular those that allow commitment to keeping those savings, improvement in social and religious standing, and preference for lotteries (small probability of striking it rich with female cattle). The one I like the most is that marginal return of labor is actually zero. Indeed, farms do not operate like firms. As they are typically family-operated, everyone "works" even if that means being idle most of the day. This idle person may have a productivity close to zero, and may thus be used to guard cattle.

Are weak governments going to make Arab labor markets better?

I find Arab economies depressing because the amount of mismanagement is staggering and because institutions are very ill-conceived. Part of it comes from the influence of religion, and part form the legacy of the Ottoman empire. It is unclear how corrupt and incompetent governments fit into this history, but they are certainly to blame, too.

Ragui Assaad shows that the labor markets in Arab countries are seriously messed up and finds the governments as the main culprits. Government employment is particularly important and is used as a political tool. The result is a lot of nepotism and cronyism, bloated administrations doing nothing, and large sectors of the economy depending on the government's largesse. Few businesses thrive without these handouts, there is thus very little healthy competition that tries to innovate. The competition is only in getting favors from agencies. As a consequence, there is little accumulation of human capital. While there is a boom in education, not much useful is concretely learned: the education sector is just as corrupt and diplomas do not mean much. I may add that the fields of study are also driven by the corrupt environment, as rent-seeking is everyone's goal.

Is this a hopeless situation? Assaad thinks Arab economies are stuck in this equilibrium. But I think there may be a way out. Indeed, the Arab Spring has considerably weakened governments. This is usually a bad outcome, but in this case this is an opportunity. While this may lead to some chaos, this may be better than counter-productive order. We'll see.

What's up with the labor income share?

The labor income share in national income has been generally decreasing across industrialized countries for about three decades now. The consequences of this can be large, as this means a major reallocation of economic surpluses towards capital income (and the fact that Cobb-Douglas production functions become less appropriate). This trend has been exacerbated with the last recession, much to the dismay of many who see the rich capitalists screwing the labor force.

According to Loukas Karabarbounis and Brent Neiman that is at least not the entire story. Rather they emphasize that this drop in the labor income share is due to an increase in capital accumulation as a consequence of the decline in the price of investment goods. The drop cannot be attributed to changes in industrial composition, as it is also happening within industries. Note that this decline in investment good prices is often taken a symptom of technological progress, which means that for the first time since the industrial revolution, technological progress is leading to a decrease in the share of the production surplus that workers can capture. It just so happens that technology nowadays is labor-decreasing, or at least less labor-augmenting that it is capital-augmenting, and I do not think there is much that we should do about it at the technology level. At the fiscal level, that may be another question, though.

Income divergence in the face of faster technology adoption

We live in an increasingly global world. As production moves to where capital and labor are the cheapest, we should be expecting a convergence of incomes across the world. Know-how and technology also flow more rapidly from leaders to followers, which should reinforce this convergence. Thus, unless something is really messed up with other factors of production (institutions, climate, ...), we should observe convergence. Yet it has not happened as much as one would have expected, quite to the contrary. What is wrong with my reasoning above?

Diego Comin and Martí Mestieri focus on the diffusion of 25 technologies across 132 countries over two centuries. They conclude that the adoption speed of new technologies has indeed increased faster in poor countries, but not the penetration rates (once diffusion is completed). That means that while countries first use new technology earlier than before, especially developing ones, the later use the technology relatively less throughout the economy. This has an ambiguous impact on convergence, but with a simple model Comin and Mestieri show that the latter effect is predominant, and how. With their numbers they can justify a multiplication by 3.2 of the income gap between rich and poor countries over the last two centuries, that is, almost all of the fourfold increase in that gap observed in the data. One more reason to wean the poorest countries off the illusion that they must grow a healthy agricultural sector, which uses little technology on land that is not well suited for agriculture in the first place (more). They need to jump to stronger manufacturing and adopt more technology throughout the economy.

How much do firms want to stay informal?

In developing economies, a substantial fraction of the economy stays informal, that is, unregulated, untaxed and unprotected. Why so? One could argue that they want to avoid red tape and corruption. Or they may find the the benefits of formality, like better access to credit or payment systems, courts and insurance, do not outweigh the costs being visible to the state, like workplace regulation, taxes and competition with untaxed businesses.

Suresh de Mel, David McKenzie and Christopher Woodruff perform an experiment in Sri Lanka wherein firms are offered various incentives to formalize, from simple administrative help to lump-sum payments corresponding to two months of profits. Helping with the red tape does not change much, however payments got up to half of the firms to formalize. The threshold to formalization seems rather low in monetary terms, and may also include some path-dependence. From post-experiment interviews with participating firms, the authors learned that the formal firms not change their profits much, but owners felt more legitimacy and they report more confidence in the state. Thus, they are unlikely to return to informality. And if this were to happen at a greater scale, I surmise this would have importance scale effects in formalization, as formal businesses would fear less informal competition. Formalizing an economy may thus be relatively cheap to achieve.

Reducing child labor with micro-insurance

Micro-insurance is insurance for the poorest against what sometimes seem trivial risks to us. Yet, for the poorest of this world small shocks can be devastating. It is also believed that such shocks are often the reason why parents have to send their children to work even though they know it is bad for their future. It is thus natural to study whether the introduction of micro-insurance reduces the incidence of child labor.

Andreas Landmann and Markus Frölich benefit from a randomized experiment in rural Pakistan, where a micro-credit enterprise is also offering micro-insurance to members that can be voluntarily extended to additional family members. We are talking about microscopic insurance here, like health insurance for a dollar a year. It turns out that in villages where the extension is offered the incidence of child labor is lower by up to a fourth, when combined with help filling claims. The authors interpret their results not to come from the mitigation of adverse shocks, but rather from the feeling of security.

As with all randomized experiments, the question on whether these results can generalize is open. One would need many more (costly) experiments to find assurance that micro-insurance is effective in reducing child labor. In addition, this kind of study cannot measure the aggregate impact of interventions. Imagine micro-insurance were available to everyone and child labor incidence is reduced. This is bound to increase adult wages, which may reinforce the decrease in child labor as even fewer parents need to send their kids to work. But for this to happen, we need more than a few villages.

Is better rewarding experience the solution to Third World development?

We all know that developing countries lag far behind developed ones, and that the usual factors of production are not sufficient to explain this difference. Hence the emphasis in policy circles on "institutions" and other vaporous concepts. Incentives for the accumulation of capital mysteriously do not seem to work either, as first highlighted by Lucas. What about incentives for accumulation of human capital?

David Lagakos, Benjamin Moll, Tommaso Porzio and Nancy Qian do not quite address human capital as in education, but rather experience. They document with micro-data from 36 countries that returns to experience are high in developed economies, but essentially flat in developing ones. With a growth accounting exercise, they then show that this difference accounts for a third of the remaining gap after having factored in human and physical capital differences. The question is then, why is experience not rewarded in developing economies? The classical explanation of why seniority pays revolves around job-worker match quality that improves over time, job-specific human capital accumulation, and the nature of dynamic job contracts. Why would this not apply? The authors this this is because total factor productivity and experience accumulation are complements. Some literature points out this may be true: Andrés Erosa, Tatyana Koreshkova and Diego Restuccia and Rodolfo Manuelli and Anand Sheshadri.

Misallocation of human capital in developing countries

It is now well established and documented that capital and labor are very poorly distributed across and within sectors in developing economies. The impact of this misallocation is large enough to explain a non-negligible part of the gap between rich and poor countries. This analysis has, however, only pertained to worker counts and physical capital. What about human capital?

Dietrich Vollrath looks at the sectoral allocation of human capital in 14 developing economies, analyzing the marginal return by using wage data. He comes to the conclusion that the misallocation has an impact on GDP of at most 5%, more than in the US but clearly negligible to explain cross-country differences. I find this hard to believe from my casual observation. For example, in many developing economies, the brightest minds go into government administration because this is where they can extract the most rents (some call this corruption). They expand a bureaucratic machine at the expense of the productive sector. That cannot be good for GDP. Using wage data here can be misleading, as the marginal product of corrupt bureaucrats, at least in social terms, is certainly not reflected in their wage. Add to this important informal sectors where wages may be substantially mismeasured, even in household surveys, and I am not quite as confident in the data as Vollrath seems to be.

Cannibalism in Ireland

Cannibalism within most animal species arises only in extreme circumstances. It is not clear to me why this is less prevalent than intra-species killing, as the latter has a clear negative impact on the survival of the species, whereas eating already dead fellows has no impact. In any case, there is a huge taboo on cannibalism, and humans are no different. But it happens in extreme situations, and famine may be one.

Cormac Ó Gráda studies the incidence of cannibalism during famines and focuses on Ireland. Unlike for other great famines elsewhere or before, conclusive evidence for cannibalism and especially murder-cannibalism seems difficult to find for 19th century Ireland. The famine was certainly severe enough for some hearsay about it to emerge, perhaps figuratively. Does the lack of a record imply that the Irish are more humane and principled? Or that the taboo is so strong that cannibalism is unmentionable? While the paper provides an interesting analysis of the historical record, answers to these questions would also be interesting.

Natural disasters and economic growth

Recently, I discussed how being in a disaster-prone area may have consequences for economic growth and the ensuing costs from calamities. This discussion was largely theoretical, but there are some empirical papers out there that can provide some good insights.

Pelle Ahlerup is the author of the latest one, and he finds that natural disasters have a positive impact on growth, and this result is largely driven by humanitarian aid. Does this mean we should wish for more disasters? Of course not, because just looking at economic growth is the wrong welfare measure. After all, a disaster leads to the destruction of life or goods, and the ensuing economic effort is replacing this loss. That effort could have been used for better purposes without the disaster. What is more interesting in the paper is that the impact on growth lasts well into the long run, beyond repairing the damage. This is where humanitarian aid comes in, as it may have helped give the economy the spark it needed to get back on rails. One can imagine that this could be associated with some foreign direct investment, or positive experience for foreign investors, or some long-term development project to prevent the consequences of such disasters in the future. Haiti comes to mind here. The fact that disaster have no impact on growth in developed economies reinforces my hpothesis.

Imagine Chinese growth rates without misallocations

China has been growing at a very rapid pace, and many have studied how this has happened and why. Yet, when you look at the economy now, it is still remarkably inefficient, especially with a financial sector that is very far from potential. In particular, the state-controlled banks do not provide loans for the best investment opportunities, but rather disproportionately to state-owned enterprises, which obviously are not as productive as the private sector.

Robert Cull, Wei Li, Bo Sun and Lixin Colin Xu use a survey of manufacturing firms that the World Bank conducted in China in 2005 to document what determines the firm;s financial constraints. To no one's surprise, state-owned enterprises have a big advantage. But among them, those who have CEOs that are well connected with the government or the Party have is even markedly easier. This points of course to the massive misallocations within China that people are still complaining about. Imagine how much richer China could be with a better allocation of its financial resources.

But of course, one can argue that China is growing like crazy because it is transitioning from even worse misallocations, where there weren't even private savings to sustain a more productive manufacturing sector. This argument has been made, among others, by Zheng Song, Kjetil Storesletten and Fabrizio Zilibotti. Not only is China growing through rapid investment in more productive technologies, it is doing so while getting more efficient in distributing financing. And seeing how inefficient it is, there is a lot of potential growth for many more years.

About growth miracles and lost decades

What makes countries grow? That is probably the most important question in economics, especially when you think about the huge differences in economic well-being across the world's economies. Yet, we do not have good answers to date, except for explaining obvious growth disasters (North Korea and Zimbabwe come to mind). Empirical work may have identified some regularities ("institutions", "distance from equator"), but these factors are either vague, not that robust, or difficult to explain. In particular, why is it that some countries suddenly grow fast while similar ones go into prolonged stagnation?

Recent research by Nancy Stokey shows that the distance between growth miracles and "lost decades" can be surprisingly small in theory. Add to this more complexities of real economies, and I surmise they could even overlap according to observables. Her point is the following. Using a rather bare bones model with technology (which flows from abroad) and human capital (which needs to be accumulated domestically), she shows that there are multiple equilibria depending on initial conditions and policies. The key is that there are positive reinforcements in both directions between technology and human capital. More technology makes human capital more productive (and worthwhile), while more human capital makes adoption of new technology easier. Start with little human capital, and you'll never notice all the technology that is available and your economy is trapped in poverty. With a lot of human capital, you never miss a beat on what is new out there, and your economy grows.

Policy in here is represented by barriers to technology inflow and subsidies to human capital accumulation. Changing such policies can have a dramatic impact. A stagnating economy can tip over to a growing one with little change in policy, and as this economy is now catching up to the others, grow rates are impressive. Or small changes the other way can get an economy to suddenly stall. In Stokey's calibration, lowering barriers is more effective, because human capital accumulation takes away resources, but I am not convinced there is that much of a difference as human capital will end being accumulated anyway.

Why pay interest on deposits if depositors do not ask for interest?

In developing economies, savings decisions are characterized by an important lack of commitment. People are aware of this and try to overcome this with institutions that seem strange to us, like ROSCAs where you pay regularly into a club and you get your investment back without return at a random date. What seems foolish to us makes sense to someone who cannot resist spending (often out of necessity) but need to make a capital purchase. But then, why would banks pay interest on savings deposits, as they appear to do in these countries? People should be willing to save into illiquid savings vehicles for free, right?

Carolina Laureti and Ariane Szafarz show this is no that simple. Indeed, banks need the additional incentive of interest on illiquid savings to meet regulatory requirements for reserves. Also, the banks cannot differentiate well between rich and poor savers. The rich ones do not have this time consistency problem and require a return. Of course, one could have the interest rate increasing with the level of deposits, but that does not seem to be an option. In fact, I notice that, at least in rich countries, it is often the opposite, as if banks do not want large amounts in savings accounts. I wonder why.

Insure better against natural disasters

When Hurricane Sandy hit the East coast of the US, relatively few people died, there was considerable damage, but no long term consequences of significance are expected. The story is different with Hurricane Katrina, which inflicted damage of a similar order of magnitude but New Orleans and its surroundings are still feeling the hit. Look at similar weather events in developing countries and the recovery takes even longer, if ever. This should not have to do with the number of victims, as there is some evidence that sudden population drops actually improve conditions for the survivors.

Goetz von Peter, Sebastian von Dahlen and Sweta Saxena use data on natural catastrophes from a large reinsurance company and find that what matters for subsequent macroeconomic performance is not the cost of the damage, but the cost of the uninsured damage. It just so happens that the proportion of insured property increases with development. Yet another argument to encourage adoption of insurance policies in developing economies (I, II III, IV).

Is Africa doing much better than we thought?

When economic historians will look back at the global economy of last decade or two, they will likely summarize them as marked by a big recession in western economies, tremendous growth and convergence in Asia and South America, and stubborn lack of growth in Africa. As usual, one would say for Africa, which is a really frustrating continent.

Alwyn Young writes that this last assessment may be all wrong because the official statistics are biased downward. Looking at the consumption of durable like cell phones, cars, housing and health, as well as the use of time on the market by women (all reported by the Demographic and Health Survey), he finds that growth rates are more than triple what is indicated in the official statistics. How could they (or him) be so wrong? For one, price data is almost non-existent, which makes deflating nominal statistics rather hazardous. Second, it looks like the informal sector is being vastly underestimated. Mozambique and very recently Ghana have seen their GDP multiplied after the analysis of detailed surveys of their economies. If Young is right, Africa may not be quite catching up, but at least it is not losing ground.