The Great Stability is Over: The Poverty Trap Facing Low-Income Countries

Not so long ago, it was fashionable to think that the business cycle had been virtually abolished. Economists came to call this “the great stability” and for a decade or more, it looked as if realized growth outcomes could be taken as good proxies for long-term structural growth trends. The excitement for development economists was that this time many developing countries were growing significantly faster than rich countries. It seemed that the secrets of global convergence—which is what the Growth Report tries to tease out—had been discovered by a very large number of countries, including many African countries.

How quickly things change. The Great Stability has come to a shuddering halt. Growth forecasts for developing countries have come tumbling down. Even for Africa, which was thought to be one of the regions least integrated with the world economy, growth forecasts for 2009 have been cut in half (to 3.5%) with an even worse performance forecast for 2010.

The sad part is that low income countries have no resources with which to counter the cycle. Fiscal revenues depend on trade tariffs and natural resource taxes, both of which are collapsing. Monetary policy cannot easily be loosened in an environment where the exchange rate is headed south. Capital is leaving these countries and even official aid is being cut back.

Only strict followers of Hayek—who famously proposed that the Depression be allowed to run its course because it was the consequence of structural misallocations of capital and labor during the boom—think that the limited options for low income countries are a good thing. For others, it is unfortunate, but a consequence of circumstances.

That is perhaps too sanguine. It may be that the absence of any ability to counter cycles is one of the great poverty traps that low income countries face. The costs that are imposed are huge. There is evidence that volatility is very damaging to long-term growth. Ben Jones and Ben Olken show that almost all countries, including the poorest, have had decades when they grew faster than rich countries, but those same countries also have had decades of slower growth. Countries that have the highest growth rates over long periods of time are those that have the fewest episodes of slow growth, not those that have the most episodes of fast growth.

At the micro level, stopping or delaying investment projects once they are underway can significantly reduce their returns. And if volatility is expected, the composition of investment can change to avoid high-return, but long gestation projects. When kids are pulled out of school because they cannot afford to go any longer, or when preventive health is cut back, the costs are also huge and these are never really recovered even if the economy rebounds. There is a real asymmetry in the development cycle.

So maybe the lesson from this crisis is that much more attention should be paid to managing risk in low income countries and trying to develop countercyclical instruments in the international institutions that are supposed to be helping development.

It does seem strange that not a single low income country seems to have a stimulus package in place to counteract the current crisis, doesn’t it? That is, until you realize that they simply have no ability to fund it.

Originally submitted to the Growth Blog by Homi Kharas on February 16, 2009.