Leading Issues in Economic Development

By Gerald M. Meier; James E. Rauch | Go to book overview

CHAPTER V
Investment and Finance

Overview: Investment and Finance: The Engines of Growth?

EXHIBIT V.1. INVESTMENT AND FINANCIAL INDICATORS IN FAST AND
SLOW GROWTH ECONOMIES

Note V.1. The AK Model

SELECTION V.1. IS FIXED INVESTMENT THE KEY TO ECONOMIC GROWTH?

SELECTION V.2. FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

SELECTION V.3. TAMING INTERNATIONAL CAPITAL FLOWS

SELECTION V.4. CAN FOREIGN AID BUY GROWTH?

SELECTION V.5. THE MICROFINANCE PROMISE


Overview: Investment and Finance: The Engines of Growth?

Few doubt that investment in physical and human capital, financed primarily by domestic savings, is crucial to the process of economic development. Educational attainment is included in the Human Development Index discussed in Chapter I, making accumulation of human capital partially synonymous with development according to this measure. Achievement of high per capita incomes without accumulation of modern infrastructure, plant, and equipment seems a virtual impossibility, absent the kind of enormous mineral wealth that places a few oil-exporting countries among the high-income ranks. We are therefore not surprised to see the strong cross-country associations between rapid per capita income growth and high rates of fixed investment and school enrollment in Exhibit V.1. The importance of domestic savings follows from the well-known strong cross-country correlation between the savings and investment shares of GDP (Feldstein and Horioka 1980).

Whether or not savings and investment play a leading role in development, serving as “the engine of growth,” has on the other hand been a source of controversy since the early days of development economics. The controversy centered on the role of saving to finance investment in physical capital. W. Arthur Lewis (1954, p. 155) wrote, “The central problem in the theory of economic development is to understand the process by which a community which was previously saving and investing 4 or 5 per cent of its national income or less, converts itself into an economy where voluntary saving is running at about 12 to 15 per cent of national income or more.” Albert Hirschman (1958) took the opposite position, arguing that if opportunities for profitable projects were there, the requisite investable funds would be forthcoming. Saving could not create such opportunities, and would be wasted in their absence. For example, in an article entitled “The Vice of Thrift,” the Economist (1998, p. 85) states, “it has become clear that the surge in investment in East Asia in the 1990s was a sign of weakness, not strength. Much of the money was wasted on speculative property deals or unprofitable industrial projects."

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