Author of Development Macroeconomics: Alternative Strategies for Growth, Basil Oberholzer, offers a comprehensive analysis of how macroeconomics can steer development and reduce poverty.

Which factors explain poverty? Development economists treat these questions in extensive debates and an impressive volume of literature. Explanations range from differences in countries’ endowments with natural resources to quality of economic and social institutions as well as cultural factors including traditions, religion, people’s entrepreneurial spirits, and so on.

Conclusions of these theories are often far from clear as regards, for example, the question whether richness in natural resources is an advantage or rather a disadvantage giving way to the so-called resource curse. Likewise, ideas of what good institutions are may largely differ as some economists stress the importance of unregulated markets while others’ consider state capacity to develop investment projects as essential. Cultural factors and people’s characteristics usually concern behavior at the microeconomic level without explaining how there can be systemic changes when responsibility is given to individuals.

While these explanations may give certain ideas of the reasons of poverty, they miss a systemic macroeconomic analysis of what the conditions for economic development are. This issue is simple and complicated at the same time. Irrespective of the historical, cultural and political circumstances as well as the economic structure of a country, two conditions have to be fulfilled if a capitalist economy is supposed to prosper: 1) production must be profitable and 2) demand must be sufficient meaning that firms can reasonably expect that they will be able to sell what they produce. The lower wages, the higher is the firms’ profit rate. However, the lower spending, the more demand is restricted. The bottleneck, which this contradiction implies, can only be relaxed when productivity increases such that the resource pool grows and allows for feeding rising wages as well as high profits.

Yet, productivity growth requires investment. But investment does not take place in poor countries because either it is not profitable or demand is not guaranteed (or both). Any measures such as trainings in entrepreneurial spirits or stronger protection of property rights are useless as long as the macroeconomic conditions for growth are not satisfied. Obviously, the market alone is not able to change anything about this. It is simply rational behavior to neither invest nor employ workers in such a situation. Consequently, poor countries remain stuck in a state of poverty and low investment. It is also difficult to build better institutions when resources are not available.

There is only one agent able to overcome this barrier: the government can make expenditures both for consumption and investment even if it will not gain a profit from it. Therefore, it can invest in agriculture, industrial plants and infrastructure and be competitive at it. Step by step, productivity increases. This crowds in the private sector because profitable investment opportunities become more. The economy enlarges its resource pool, which allows the gradual improvement of institutions. To enable and speed up this process, monetary policy and national development banks can be arranged in ways to support the government by targeting finance to priority sectors.

So far, so good. In this description, governments are potentially able to bring demand to very high levels that are only restricted by issues of institutional and organizational complexity of guiding a national economy. However, national economies are part of a global economy and exposed to international flows of goods and finance. This is where the so-called balance-of-payments constraint comes in. Trade deficits, external debt and erratic foreign investment flows are fundamental macroeconomic risks for any economy and particularly for developing countries. A negative current account tends to bring about exchange rate depreciation involving inflation spikes, increasing weight of foreign debt and accelerating capital flight. As soon as the exchange rate gets out of control, a currency crisis is in full blow and domestic production shrinks. To avoid this scenario, governments have to restrict growth such that external imbalances and accumulation of foreign debt can be avoided. Ambitious policy programs are often powerless.

A detailed analysis of the international monetary system shows the main problem of the balance-of-payments constraint but also provides the foundation for its solution. Let us give a short sketch of this: close consideration shows that countries with currencies that are not global reserve currencies and hence need foreign currency to pay for their imports have to pay twice for those imports. While the individual importer pays in domestic currency, the country’s central bank pays the foreign exporter in international currency. It can be shown that these two payments are not the same but add to one another. A country with a current account deficit not only gets indebted in foreign currency, it also loses a part of domestic output because a component of domestic demand goes lost due to the second payment in domestic currency.

Let us think about a reform of the international payment system in the tradition of John Maynard Keynes, Ernst Friedrich Schumacher and Bernard Schmitt. A country may set up an institution, which is responsible for all of the country’s international payments. An importer’s payment in domestic currency goes to that institution, which takes care of the international payment in foreign currency by managing liabilities via issuance of bonds. At the same time, the institution can make use of the domestic currency it received from the importer by reinvesting it in the domestic economy. Instead of depriving the economy of economic resources, a country with a reformed payment system now can strengthen its productive capacity despite an external deficit. A more detailed elaboration of the reform reveals that it allows developing countries to pursue ambitious economic policies again because they have significantly relaxed, if not removed, the balance-of-payments constraint.

*Cover image: Development Macroeconomics by Basil Oberholzer

**Group of Pump Room Operator Working at a Factory in Africa. Image credit: iStock, GCShutter

Development Macroeconomics: Alternative Strategies for Growth, by Basil Oberholzer, Economist, Swiss Federal Office for the Environment, Switzerland is available now.

Read Chapter 1 for free on Elgaronline.