How can we end poverty?

How can we end poverty? Perhaps the most important question there is. The problem is that there isn't a clear answer to it. Each and every year, billions of dollars of both government and private development aid are spent on food aid, transportation infrastructure, insecticide-treated bed nets, and vaccine development for tropical diseases. An obvious question, not often enough asked, being Is this money well spent?

As Raphael Auer points out there are two general views on this question:

Jeffery Sachs (2005) claims that these measures will help poor nations getting their first step on the "ladder of development" and ignite self-sustaining growth. William Easterly (2006) asserts that already several trillion dollars have been spent on inefficient aid that increased corruption and that, to a large extent, failed to reach those in need.

Auer has a new column at VoxEU.org where he asks How can we end poverty? The determinants of development. Auer opend his column by asking Why do economies prosper? He points out there are two rival theories on this.

What explains the huge international differences in GDP per capita? Surprisingly, the economics profession disagrees on the answer to this fundamental question. At the risk of simplifying a diverse discussion, one can group the existing literature into two rival schools of thought emphasising either:

• geographic endowments, or
• institutions

as the main determinant of economic development.

Auer goes on to explain

The first school of thought argues that the prevalence of disease, climate, the quality of soil, the abundance of natural resources, terrain ruggedness, and other geographic endowments directly impact income. Peasants in tropical areas are likely to be bed-ridden with malaria during harvest and have to spend much of their savings on the treatment of the disease. Agricultural yields are low in arid areas with nutrition-poor soil. While roads and railways have to be built everywhere, the cost of doing so varies greatly with the surrounding terrain. Following this line of reasoning, the "endowments" school of thought argues that most Sub-Saharan countries are among the poorest of the world due to their adverse climate, rugged terrain, and rampant disease.

The second school of thought disagrees, arguing that institutions are the basic force of development. Countries with rampant corruption and high risk of expropriation do not prosper because private effort and investment are not rewarded and, therefore, do not materialise. If checks and balances on politicians are absent, public goods are not provided efficiently or not at all. Where private contracts are not enforceable, valuable business partnerships are not formed in the first place.

While it is true that the two rival groups have been able to provide ample empirical evidence for views, the discussion is still far from being settled. Auer explains that the main issue is that the two literatures often interpret very similar correlations as evidence for very different theories.

For example, malaria has a large effect on income today, but it also had an impact on settler mortality during colonialism. Should we attribute the high correlation between the prevalence of malaria and income to the direct effect of the disease or, rather, is it an artefact of malaria's impact on settler mortality rates and colonial institutions?

Important policy implications hinge on the answer to this question.

• If most of the effect is direct, one should distribute bed nets, mass-produce Artemisia-based medication, and develop new vaccines.
• If, on the contrary, this correlation is a by-product of the institutions brought forward by colonisation, policy should be focused on fixing past mistakes and restoring good governance.

Since the instrumental variables used in the existing institutions literature are either geographic variables themselves or are highly correlated with geography, they cannot distinguish the partial effects of geography and institutions on income. Based on similar considerations, Avinash Dixit (2007) concludes that

"the notion that geographic and historical variables are merely instruments for institutional determinants of economic success is supported more by the intuitive appeal of the stories told than by the statistical significance of the tests performed. The value of rhetoric should not be ignored, but I wish the econometric evidence were more compelling."

Auer goes on to argue that the interaction of history and geography can distinguish between theories of development. He writes

To address this concern, in a recent study (Auer 2008), I show how the effects of institutions and geographic endowments can be distinguished.

The key insight is that one can distinguish between the determinants of development by utilising the fact that geographic endowments had a differential effect on institutional development in former colonies and in the rest of the world. For example, in a former colony, high prevalence of malaria has reduced income because of both the direct effect of the disease on income and the indirect effect of the disease on settler mortality and thus colonisation policies. In contrast, in a country that has never been colonised, only the first of these two effects is present.

While the indirect impact of endowments on colonisation policies and thus institutions is present only in former colonies, the direct impact of endowments on income is present in all countries. Therefore, one can identify the relation between income and institutions by utilising the difference in how endowments have shaped institutional development in former colonies and in the rest of the world.

In contrast to the existing literature, this way of identifying the relation between institutions and income does not restrict the direct effect of endowments on income to be absent, thus allowing me to estimate the partial effects of the two channels.

Put simply the result of Auer's research is, institutions dominate. That is institutions are the main, but not the only, determinant of development. Endowments do have a statistically significant and economically relevant impact on income.

For example, in a typical specification, I find that a one standard-deviation difference in the included measures of geographic endowments is associated with a direct effect on income per capita equivalent to a seven-fold difference in GDP per capita. For a former colony, the same one standard-deviation difference is associated with an effect on colonisation policies, institutional outcomes, and thus income equivalent to an additional 18-fold difference in GDP per capita. Thus, while institutions are substantially more important that endowments, the direct effect of economic endowments can hardly be neglected.3 Together, both channels can explain around 40% of the variation in international income levels.

What then are the implications of these results for what is needed to end poverty? Auer explains

In my view, two conclusions can be drawn.

• First, geographic endowments do matter for prosperity and we do have policy recipes at hand to address the most pressing problems of the world's poorest countries such as high prevalence of disease, lack of access to clean water, and poor agricultural yields.

Therefore, the current development efforts seem to be the only appropriate course of action and can put an end to extreme poverty. However, it is not certain that the current efforts can end poverty.

• Second, we need to be aware of the limits of the current policy recipes and need to focus much more on developing appropriate institutional reforms that can convert development aid into sustained economic growth.

While it is obvious that sick and malnourished peasants cannot easily escape poverty on their own, it is far from certain that a country with healthy and well-nourished inhabitants will automatically grow.

To ignite development, the presence of private incentives to work and invest is as fundamental as is the physical capability to do so.

So one thing we do understand is that aligning social and private incentives is a prerequisite for growth. The important thing we don't fully understand is how this can be achieved.

• Raphael Auer (2008), "The Colonial and Geographic Origins of Comparative Development," Swiss National Bank, Working Paper No. 2008-08.
• Avinash Dixit (2007), "Evaluating Recipes for Development Success," The World Bank Research Observer, 22(2), pp. 131-158.
• William Easterly (2006), The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good. Oxford University Press: New York
• Jeffrey Sachs (2005), The End of Poverty. Economic Possibilities for Our Time. The Penguin Press: New York.