Of Development and Debt

note: I originally wrote this for the Dani Rodrik seminar. As it grew, though, it became apparent that it didn’t really have much to do with “One Economics, Many Recipes” and that it was thus a bit unfair to ask Dani to comment on it. On the other hand, I liked it too much to kill it altogether – dd

“One Economics, Many Recipes” makes a lot of useful and constructive suggestions about how to attack the central problems of economic development. However I don’t think it gives enough emphasis (fundamentally because I don’t think it’s possible to give enough emphasis) to international debt as a constraint on development. Nearly all of the success stories in the book relate to countries which started their periods of development without a large debt burden, and the presence or absence of large net external debt is certainly one characteristic which matches up well to the motivating stylised fact in the book – the distinction between those countries like Argentina which followed all the standard policy recommendations but didn’t develop and those like China which ignored them and did. In this essay, I’ll try and flesh out a few provocative views on the financial aspects of development policy, which in my view are just as important real-world constraints as the institutional real-economy factors that are the main subject matter of the book.

Actually, just as I don’t think it’s sensible to carry out international comparisons of crime rates without taking demographics and urbanisation into account, I don’t think that any kind of comparative analysis of developing economies can be carried out at all without conditioning on the debt burden. It’s that important. When you have a situation in which a country’s capital account is dominated by contractual flows payable in foreign exchange, that is far and away the most important fact about that country’s economy. This is because as long as the debt service constraint is binding (and I discuss what happens when it isn’t, below), then unless the country is receiving massive net transfers from abroad, the entire economic development program is going to end up being twisted toward a capital account constraint which almost certainly has nothing to do with a sensible locally-based development plan of the kind that Dani advocates.

And when you do base your analysis on debt as the “first fact”, all sorts of other problems start appearing in a new light. In Manzano & Rigobon’s analysis, for example (carried out using cross-sectional regressions, so appropriate caveats apply as I still don’t really like cross-sectional regressions when they agree with me), “Natural Resources Curse” disappears when you condition on the amount of debt outstanding. I’ve also argued elsewhere that there’s good reason to believe that a lot of the governance problems in developing countries have their roots in the debt burden – when a balance of payments crisis at least once every ten years is more or less written into the numbers, it is much more difficult to develop a stable government, and the incentive is much greater for incumbent rulers to get while the getting’s good.

And, sticking to the analysis of “One Economics, Many Recipes”, debt makes everything more difficult. Seen as a piece of economic cybernetics, Dani’s point is that the conditions for development are those that you would expect to hold for a planning system – a predictable basis upon which to make plans (law and order), predictable feedback from plan to planner (a price mechanism), and compatibility of goals for the planner (appropriability of profits) . It isn’t difficult to see how a debt burden interferes with this. A debt burden immediately creates a wedge between returns on investment and appropriable returns to the decision makers. It distorts price signals, not least by creating a special demand for foreign exchange which needs to be satisfied by the production of export commodities.

And finally, it’s in the nature of debt gearing that it increases the riskiness of any financial system. Not only does this undermine the basis for planning, it also interferes with a fourth precondition for development – the reinvestment of the proceeds of successful investments into new projects. In general, Latin America’s growth underperformance of the last hundred years hasn’t been due to a slow rate of growth during normal conditions – it’s been the result of periodic crisis which have meant that Latin American economies haven’t enjoyed the benefit of compounding.

So debt is bad stuff. I’d also argue that debt makes a good “first fact” because, and this is the controversial bit, it’s one of the aspects of a developing economy which it is more sensible to regard as exogenous than many others. In general, whatever choices are available to the new government of a third world country, the choice of an outstanding stock of foreign debt isn’t one of them. As you install yourself in the Presidential palace, the outstanding debt figure is waiting for you on your desk, as is the general assumption that it’s your job to pay it. Thanks to the miracle of compound interest, it isn’t even usually true to say that most developing countries even have all that much control of their debt path over time. For the sake of being provocative, I would even say that overseas debt plays an important part in the kernel of truth at the centre of the vast nut of nuttiness which is the “bastard-Chomskyite”[1] theory of development – the surprisingly widespread belief that underdevelopment in the third world occurs as the result of an intentional policy on the part of OECD countries, and that rich countries’ economic growth occurs at the expense of poor countries.

What do I mean? Well, as I type, it does not currently say on Amazon that “People Who Bought ‘One Economics, Many Recipes‘ Also Bought ‘Confessions Of An Economic Hit Man‘ “, but maybe it should. John Perkins’ book was flawed – I can sort of see the commercial idea behind the decision to intersperse an interesting account of Big Development in the 1970s with a psychosexual memoir, but I think it was terribly unwise – but in all the chucklemouthed dismissals of it as “conspiracy nonsense” that came out in the reviews, I didn’t see one single person who was prepared to deny that the firm Chas T Main did exist, that it did offer consulting services to developing world governments bidding for large debt-financed projects and that Perkins did work for it in the role he said he had, and therefore was at least as well-placed to comment on the ethical standards it observed as, say, Michael Lewis was to tell us about the bond department of Salomon Brothers in “Liar’s Poker“.

And his central case (stripped of a lot of unsupported and probably intrinsically unsupportable assertions about intelligence agencies) is that a substantial proportion, perhaps even the greater part of the debt of many poor countries to multilateral organisations is the result of high-pressure salesmanship, often with bribery being an integral part of the process, and often with high-level political support from rich country governments promoting domestic business interests. This is a fact – it’s actually so well-substantiated a fact that it was quite an achievement on Perkins’ part to make it look like a wild self-aggrandising piece of conspiracy theory.

Furthermore, a lot of those domestic business interests were in the resources sector, so it can certainly be argued that this is a big cause of the ganglion of problems described as “natural resources curse”. And this explanation of “natural resources curse” can even make a testable prediction – it would predict that Honduras, Guatemala and the Dominican Republic, none of which has significant natural resources, but all of which have been the subject of the same kind of treatment as the resource states from developed world business interests, would each of them have a big debt burden and a set of governance and development problems pretty similar to natural resource curse. And guess what, the prediction works; the banana republics are about as bad as you’d expect them to be[2].

To put it plainly, a lot of the problem of development which needs to be solved has to do with a specific problem called debt which has been inflicted on the developing world from outside by people who wanted to expropriate a lot of wealth from them – it isn’t an intrinsic problem of those economies, any more than a bond trader whose Porsche just got keyed has been made a victim of “nice car curse”. But the good thing about this problem is that it has a really easy solution.

I honestly think that Mohammed Yunus’s Nobel Peace Prize ought to have been given to Nestor Kirchner of Argentina, for doing something much more radical which will potentially have a lot more impact on the development of the poor world. Before the Second World War it was not unknown for debt obligations of poor countries to be enforced by gunboat. After the war, this was unfeasible, and so the obligation was enforced with the threat that any defaulters would be starved of overseas capital forever. This was never a credible threat in the game theory sense, and Kirchner was the guy who definitively called the markets’ bluff. He defaulted on Argentina’s debt, and nothing very bad happened – I don’t think anyone will seriously argue that Argentina’s future access to capital markets is going to be any different from that of, say, Thailand, which has never defaulted.

Which means that my second bite of the cherry in this seminar is rather tangential to the book. I do think that it’s more or less impossible to get a full understanding of development issues without recognising the central importance of debt, but on the other hand, it’s a problem with a single solution and an easy one – if you don’t like it, don’t pay it.

[1] “Bastard Chomskyite” in an analogous sense to Joan Robinson’s use of “Bastard Keynesian” to refer to people who used a misunderstanding of Keynesian economics to advocate for inflationary fiscal policy in the 1970s.

[2] In other words, “natural resource curse” is just a special case of the tendency of developing countries in the twentieth century to attract predatory overseas capitalists like dogs attract fleas. The Seven Sisters were the masters of playing the political-industrial game, but there were others; lots of otherwise inexplicable collapsing development paths can be explained just by noticing that the economy in question caught a nasty case of ITT, Dole Fruit or the Vestey family.