Development Cooperation - Evaluation and New Approaches

Ahrens, Heinz (Ed.) Book Development Cooperation - Evaluation and New Approaches Schriften des Vereins für Socialpolitik, No. 308 Provided in Cooperation with: Verein für Socialpolitik / German Economic Association Suggested Citation: Ahrens, Heinz (Ed.) (2005) : Development Cooperation - Evaluation and New Approaches, Schriften des Vereins für Socialpolitik, No. 308, ISBN 978-3-428-51867-8, Duncker & Humblot, Berlin, https://doi.org/10.3790/978-3-428-51867-8 This Version is available at: https://hdl.handle.net/10419/285779 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/legalcode.de Schriften des Vereins für Socialpolitik Band 308 Development Cooperation – Evaluation and New Approaches By Tilman Altenburg, Jörn Altmann, Rainer Durth, Oskar Gans, Philipp Harms, Heiko Körner, Matthias Lutz, Rainer Marggraf, Rainer Thiele Edited by Heinz Ahrens asdfghjk Duncker & Humblot · Berlin OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Schriften des Vereins für Socialpolitik Gesellschaft für Wirtschaftsund Sozialwissenschaften Neue Folge Band 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 SCHRIFTEN DES VEREINS FÜR SOCIALPOLITIK Gesellschaft für Wirtschaftsund Sozialwissenschaften Neue Folge Band 308 Development Cooperation – Evaluation and New Approaches asdfghjk Duncker & Humblot · Berlin OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Development Cooperation – Evaluation and New Approaches By Tilman Altenburg, Jörn Altmann, Rainer Durth, Oskar Gans, Philipp Harms, Heiko Körner, Matthias Lutz, Rainer Marggraf, Rainer Thiele Edited by Heinz Ahrens asdfghjk Duncker & Humblot · Berlin OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Bibliografische Information Der Deutschen Bibliothek Die Deutsche Bibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über <http://dnb.ddb.de>abrufbar. Alle Rechte, auch die des auszugsweisen Nachdrucks, der fotomechanischen Wiedergabe und der Übersetzung, für sämtliche Beiträge vorbehalten #2005 Duncker & Humblot GmbH, Berlin Fremddatenübernahme und Druck: Berliner Buchdruckerei Union GmbH, Berlin Printed in Germany ISSN 0505-2777 ISBN 3-428-11867-7 Gedruckt auf alterungsbeständigem (säurefreiem) Papier entsprechend ISO 9706 ∞ * Internet: http://www.duncker-humblot.de OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Preface This volume represents some of the Proceedings of the Annual Meeting of the Research Committee on Development Economics (Ausschuss für Entwicklungsländer) of the German Economic Association (Verein für Socialpolitik) held in Cologne, Germany, in July 2004. The meeting focused on the effectiveness of, and new approaches in, development cooperation. Both issues have become increasingly important in recent years in view of the declining volume of budget funds allocated to development cooperation. The first two papers deal with the effectiveness of development cooperation. Philipp Harms and Matthias Lutz discuss the macroeconomic effects of foreign aid. At a crucial moment of the aid effectiveness debate where economists have begun to question the recent consensus that the macro-economic productivity of aid mainly depends on the recipient country’s policy environment, the authors shed new light on the issue. After a discussion of the main theoretical arguments justifying the assumption of positive growth effects of foreign aid, Harms and Lutz examine the more recent econometric studies on the growth effects of aid, particularly those that focus on the role of policies and institutions in recipient countries. They interpret the (in many ways contradictory) results, question the above-mentioned consensus, and draw their conclusions with regard to the orientation of future, hopefully more conclusive research on the macroeconomic effects of foreign aid. The paper by Rainer Thiele is devoted to the closely related issue of the “optimal” allocation of aid among recipient countries, aimed to ensure maximum efficiency with respect to poverty reduction. Giving an overview of the relevant literature, he shows that the application of different allocation criteria can lead to dramatic variations in the poverty-efficient allocation of aid. Against the background of his lucid assessment on the robustness of the empirical results underlying the specification of the allocation rules, Thiele stresses the high payoff of additional research aimed at providing donors with more robust guidance and also makes suggestions concerning the direction of such research. The following four papers are centred on new approaches towards a closer integration of the private sector into development cooperation. Tilman Altenburg discusses the perspectives of joint action with so-called lead firms in production networks. He shows to what extent these firms and local stakeholders pursue both complementary and conflicting aims, and identifies areas that are most suitable for cooperation. Finally, the author draws some practical conclusions concerning the OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 creation of strategic alliances with lead firms and makes suggestions concerning critical aspects relevant for implementation, such as how to deal with the risks of corruption, abuse and windfall gains at the expense of the public purse, or how to minimize transaction costs. Jörn Altmann discusses the paper by Altenburg and other ways of integrating the private sector into development cooperation. He highlights the impact of WTO agreements (GATS, TRIPS, TRIMS) on the future development of the private sector, both domestic and foreign, in low-income countries. Among the policies aimed to integrate the private sector into development cooperation, the author analyses the promotion of investment, co-financing, build-operate-models, capacity building via training, private capital funds, and micro-financing. The paper by Rainer Durth focuses on the opportunities provided by tapping financial markets for bilateral development cooperation. In view of the ambitious and far reaching new approaches in development cooperation, as reflected in the Millennium Development Goals (MDG) or the Poverty Reduction Strategy Papers (PRSPs), the author emphasises that bilateral development cooperation should be reoriented with a view to consistently follow the criterion of complementarity to the activities of multilateral donors and private investors. In this context, he suggests that a particularly promising approach for bilateral development cooperation is to supplement the scarce concessionary funds by financial resources from the steadily growing international capital markets. Durth shows in some detail that the German government has already started on this path, with its new FC financing instruments that make it possible to provide the necessary financial basis, and at the same time to make the use of funds more individual and thus more effective. Heiko Körner, in a comment on Durth’s paper, expresses his doubts as to the basic philosophy underlying today’s conception of poverty reduction programmes. He argues that the classical instruments of development policy are scarcely able to improve the situation of the poor in a sustained way unless the social processes are prevented which, in a kind of vicious circle, cause self-feeding and consequently persistent poverty in low income countries. The last two papers deal with economic aspects of low and middle income countries’ pension schemes from a human capital perspective. On the basis of theoretical models that make allowance for the fact that pension systems have an additional effect on the human capital of a society, Oskar Gans identifies economically viable pension systems and discusses potential ways of constructing efficient paths for adjustment. Against this background, he evaluates the real-world reforms of two emerging market economies, namely Chile and Malaysia, and deals with the need for human capital-based reform that may be derived from such an evaluation. In his analysis, he also takes into account German efforts at reform whenever this seems appropriate. Rainer Marggraf discusses Gans’ implicit microeconomic hypotheses regarding human capital formation. In his analysis of family decisions, he concentrates on 6 Preface OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 the fact that individuals invest in human capital through children. He presents a family decision model that makes due allowance for this fact, and discusses implications for positive analyses of pension schemes. Halle (Saale), January 2005 Heinz Ahrens Preface 7 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 (RMSM) of the World Bank. Another example are the projections, formulated for the World Bank in Devarajan et al. (2002), of the future aid requirements to reach the Millennium goals. 4 The basic two-gap model has two components. 5 The first concerns the link between investment and growth and determines the supply side. 6 In the Harrod-Domar tradition, gap models assume a linear relationship between output (Y) and capital (K), YK v;1 where vdenotes the capital-output ratio or ICOR (incremental capital-output ratio). This implies that output growth will be a function of the investment rate (I), _ Y Y_ K vY I vY ;2 where a dot over a variable denotes the change over time (e.g. _ YdY=dt is the change in output between now and the next period) and the depreciation rate. Note that current output is predetermined by past investments. As a planning framework, (2) allows policy makers to determine the minimum level of investment (I * ) required to achieve the desired rate of output growth (g * ): I Yvg;3 The second component of the two-gap model deals with the determination of investment. From basic national income accounting we know that SpIGTXM;4 14 Philipp Harms and Matthias Lutz 4In their paper, Devarajan et al.(2002) acknowledge the criticisms the two-gap model has received, but nevertheless base their projections on it, arguing that it “. .. is a transparent and flexible framework for examining, for a large number of countries, the aid requirements of achieving the poverty goal” (p. 17, footnote 9). 5This subsection presents what amounts to the simplified textbook version rather than the more sophisticated versions in the original and subsequent two-gap papers. See, for instance, Tarp (1993, Ch. 4), Gillis et al.(1996, Ch. 6), Basu (1997, Ch. 5), Nafziger (1997, Ch. 16) and Agenor and Montiel (1999, Ch. 13). A further extension, the so-called ‘three-gap model’ which also includes a public investment constraint, was developed by Bacha (1990). The key results remain unchanged, however, and it is the simplified version presented here that has been used for policy purposes. 6The view that investment is the key to growth is characteristic to thinking about development during the post-WWII period. It is epitomised by the following well-known dictum of W.A. Lewis (1954, p. 155): “.. . the central problem in the theory of economic development is to understand the process by which a community which has previously been saving and investing 4 or 5 per cent of its national income or less converts itself to an economy where voluntary savings are much higher” (quoted in Tarp 1993, p. 82). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 with S p = private savings, G= government (current and capital) expenditure, T= taxes, X= exports and M= imports. This can be rewritten as ISpTG |{z} domestic savings MX |{z} foreign savings SF:5 In equation (5), private savings and the budget surplus have been aggregated into ‘domestic savings’ (S). The last term is referred to as ‘foreign savings’ (F), since the trade deficit (on goods and services) has to equal the sum of net current transfers (including foreign aid), net capital inflows (capital account plus financial account) and net factor payments. For the remainder of this paper, it is best to think of Fas foreign aid, as we will abstract from private capital flows. In the two-gap literature it is assumed that all the terms on the right-hand side of (5) are determined exogenously. The feasible levels of investment are thus given by ISG SF:6 If the resulting investment level happens to be below the desired level I * , the economy would be facing a savings gap. To derive the foreign-exchange gap, assume further that imports consist of capital imports (M K ) and other imports (M O ): MMOMK:7 A fixed share mof all capital goods needs to be imported from abroad, I1 mMK1 mMMO:8 Substituting MXFinto this equation gives I1 mXMOF:9 Again, the two-gap model assumes that the variables on the right-hand side are either exogenous or predetermined. The investment constraint due to this foreignexchange restriction is given by IFG 1 mXMOF:10 There is a ‘foreign exchange gap’ (or ‘trade gap’), if this investment level is below I * , i.e. below the level required to achieve the desired level of output growth g * . The Macroeconomic Effects of Foreign Aid 15 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Depending on the various exogenous and predetermined variables, either the savings constraint (6) or the foreign-exchange constraint (10) can be binding for a country. Note that neither implies that the economy is in a disequilibrium. Rather, there is a difference between the ex-ante desired and the ex-post actual investment rate. The two constraints on investment are plotted as a function of foreign aid Fin Figure 2. The savings constraint (6) is represented by the SG-curve, the foreignexchange constraint by the FG-curve. 7 Investment Iis bounded by either of the two curves. The feasible regions are depicted by the bold shading. To the left of F’ investment is limited by the foreign exchange constraint FG, to the right of F’itis limited by the domestic savings constraint SG. From (2), it follows that these limits on investment translate directly to the feasible growth rates that can be obtained in an economy characterised by these features. Figure 2: The savings and foreign-exchange gaps An increase in foreign aid moves the economy to the right. This raises the feasible level of investment. Thus, independent of which of the two gaps applies, more aid increases the feasible growth rate of the economy. By how much it can rise, however, depends on which of the two constraints is binding. The effect will be smaller when the economy faces a savings gap. 16 Philipp Harms and Matthias Lutz 0F IFG F' I' SG SG FG 7FG is steeper than SG since 1 / m>1. The vertical positions of the two curves depend on (X–M O )/mand S. For both constraints to be relevant for positive values of Fand I, the two curves have to intersect in the right quadrant, as in Figure 2. This requires (X–M O )<mS. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 II. Assessment Gap models can be criticised on various grounds. First, and foremost, the twogap approach is unsatisfactory methodologically, with prices fixed, no role for expectations, and static behaviour of agents and governments. Another major criticism relates to the link between investment and growth, specifically the assumption of a constant capital-output ratio. The Harrod-Domar model no longer features as a serious contender in growth theory, having been superseded not only by the neo-classical growth model but also by endogenous growth theory. 8 In these more recent frameworks, the role of physical capital investment is rather modest, as the focus shifts towards education and research & development as the ultimate determinants of growth. The second major criticism addresses the relationship between foreign aid and investment. In a model with optimising agents, it is not obvious that all of aid should go into investment. From the point of view of private and public agents in the recipient country, an inflow of aid constitutes additional income. If agents behave rationally and prefer a smooth consumption flow, part of any additional income will be consumed and only part of it invested. The share to be saved depends on how transitory the additional income is. The longer the aid inflow is expected to last, the more of it will be allocated to current consumption. Typically it is the government or part of the public sector that is the domestic recipient of aid. In this case it is possible that it alters its general expenditure pattern as a result of the aid inflow. For instance, resources previously earmarked for investment may get re-allocated to current expenditure. In any case, whether it is the private or the public sector that responds by raising current consumption / expenditure, the fungibility of aid makes it unlikely that all aid resources are devoted to investment. Empirically, it implies that as aid inflows rise, there will be a reduction in domestic financing of private and /or public investment. The negative correlation between aid and the aggregate savings rate implied by this does not mean that aid has a negative effect – just that there is unlikely to be a one-for-one rise in investment. Finally, the two-gap approach appears rather naive in ignoring the disincentive effects of aid. For instance, countries that perceive donors to disburse aid according to financing needs have an incentive to artificially raise this need, e.g. by lowering their domestic investment efforts. In addition, there are a number of reasons why part of the aid disbursed by donors may ‘be lost’ in the aid delivery process. Most obviously there are the standard transaction costs. The resource costs of aid negotiations, delivery and administration may be high. Accordingly, Kanbur The Macroeconomic Effects of Foreign Aid 17 8While it is possible to derive a similar aggregate relationship between capital and output in some endogenous growth models, the latter either require very specific assumptions on the production function, such as in the Jones-Manuelli (1990) model, or they rely on a broader definition of capital including human capital (Lucas 1988). 2 Schriften d. Vereins f. Socialpolitik 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 (2000, p. 419) argues: “In my view, the real cost to Africa of the current aid system is thus the fact that it wastes much national energy and political capital in interacting with donor agencies.” In addition resources may get wasted directly by corrupt government officials and indirectly via rent-seeking activities. 9 C. Using aid to overcome ‘poverty traps’ I. Theory The ‘gap models’ described in the previous section identified foreign aid as a way to raise investment and to move developing countries’ growth rates closer to a desired level. An important implication of this framework is that investment and growth return to their initial levels if the inflow of aid dries up. In other words: the long-run growth effects of aid are only realised if the volume of aid disbursements is raised persistently. Proposing aid as a means to achieve higher growth in developing countries therefore requires quite heroic assumptions about donor countries’ generosity. This changes once we move to a theoretical framework in which growth is hampered by the presence of poverty traps. A poverty trap may have different sources, which can be traced back to population dynamics, agents’ savings behaviour, the existence of complementarities, or properties of the production function. Regardless of the exact causes, the consequence is the existence of multiple steady states and the possibility that countries which start out with a low per-capita income find themselves in a vicious circle with poverty and low-growth reinforcing each other. Conversely, a temporary injection of foreign capital could help the economy to take off and to permanently reach a higher level of per-capita income. The mechanics involved in such a setup can be illustrated with a simple example: suppose that all the assumptions of the Solow model are satisfied – that is, agents have access to a constant-returns to scale technology FK;Lwith physical capital Kand labour Las inputs, and there are no private international capital flows, so that domestic investment Ihas to be financed out of domestic savings S: YFK;L;11 _ KIK;12 IS;13 where denotes the exogenous rate of depreciation. For simplicity, we assume that there is no exogenous technological progress. 18 Philipp Harms and Matthias Lutz 9If aid inflows are large, they may also generate Dutch disease type effects which will adversely affect the foreign-exchange constraint through a real appreciation. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 We depart from the Solow model by assuming that there are basic (‘subsistence’) consumption needs that agents have to satisfy, and that savings are zero as long as per-capita income does not exceed this level of subsistence consumption. Hence, the savings function is described by SsY~ CLif Y >~ CL 0if Y ~ CL ; ( 14 with 0<s<1and ~ Crepresenting (per-capita) subsistence consumption needs. Combining equations (11)– (14) yields a modified ‘Solow equation’: _ ksfk~ C  nk;15 where kis the capital stock in per-capita terms and nis the exogenous population growth rate. In Figure 3, the evolution of the capital stock (in per capita terms) _ kis depicted as the distance between the bold line and the dashed line. Apparently, the system has two steady states: one stable, Solow-type steady state k ** , to which the percapita capital stock converges from below and above. And a second, unstable steady state k * that determines the boundary of the poverty trap: if a country’s initial capital stock (per capita) is lower than k * , the dynamic forces of the model will drive it to an ever lower level. Figure 3: Poverty traps in a Solow model with subsistence consumption The Macroeconomic Effects of Foreign Aid 19 2* k*k** k OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 The intuition behind this result is straightforward: when agents have a very low income, subsistence consumption needs prevent them from investing in the maintenance (let alone the expansion) of the capital stock. As a consequence, depreciation reduces the capital stock even further, reinforcing the process of poverty and decay in future periods. While our model focused on a particular source of the poverty trap – the presence of subsistence consumption needs which reduce agents’savings behaviour at low levels of income – alternative models that concentrate on non-convexities in production yield quite similar results. 10 Against this background there is an obvious role for aid: since a one-time increase of the capital stock can propel a country out of the poverty trap, one does not need permanent inflows of aid in order to lift developing countries to higher levels of income and growth. Instead, a one-time injection could do the trick. In fact, this is precisely one of the remedies that Nelson (1956) proposed in his early contribution on growth in the presence of poverty traps: “Increases in income and capital achieved through funds obtained from abroad [ .. . ] can help to free an economy from the low-level equilibrium trap.” (p. 904). II. Assessment The idea to use aid as an instrument to initiate the ‘big push’ seems so compelling and attractive that we rush to highlight the numerous caveats that need to be taken into account: first, and most importantly, the model above suggests that poverty is due to unfavourable initial conditions. While this may be part of the truth, over-selling the argument risks downplaying the role of current institutions and policies. In fact, the exaggerated reliance of developing country policymakers on the big-push idea and their neglect of the current policy environment may be one reason for the failure of this idea in many cases. Second, while aid seemed to be the only way to alleviate a shortage of capital in the 1960s, this notion seems somewhat dated in times of massive private foreign investment in developing countries. There may still be a case for regarding aid as a substitute or catalyst for private capital flows – especially since many of the poorest developing countries are apparently shunned by foreign investors. However, unless one comes up with a compelling argument why private capital markets do not provide these countries with the volume of foreign investment that they ‘deserve’, aid is likely to provide a brief cure of symptoms rather than a contribution to sustained development. 20 Philipp Harms and Matthias Lutz 10 In Murphy, Shleifer and Vishny (1989) and Acemoglu and Zilibotti (1997), the adoption of a more productive technology is prevented if current income is too low. In Azariadis and Drazen (1990) as well as Galor and Zeira (1993), fixed costs combined with financial market imperfections hamper human-capital investment at low income levels. Surveys of this literature are provided by Benhabib and Gali (1995), Azariadis (1996), Galor (1996), Basu (1997) and Ray (1998). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 D. Evidence on aid, investment and growth I. Hypotheses The positive view on the role of aid based on the models presented above rests on two testable relationships – that between aid and investment and that between investment and growth. In what follows we assume for expositional simplicity that these two relationships take a linear form and that the variables in question only vary along the time dimension. The two key relationships thus take the form of the following two simple regression equations: It Yt01Ft Ytut;16 _ Yt Yt01It Ytet;17 The last term in each regression, u t and e t , may either be thought of as the stochastic error terms in a simple bivariate regression, or as a composite measure of any other variables that may influence the left-hand side variables plus stochastic error. If aid works as presumed in the two-gap framework, the null hypotheses of i) no effect of aid on investment (i.e. 1= 0) and ii) no effect of investment on growth (i.e. 1= 0) should be rejected in favour of the alternative that α 1 >0 and 1>0. Instead of proceeding in two steps, the two predictions may also be tested jointly in form of: _ Yt Yt01Ft Ytvt;18 where 0010,111and vtet1utis now a composite error term (or measure of all other influences). A rejection of H0:10against H1: 1> 0 implies that aid (via its effect on investment) has a statistically significant, positive effect on growth. While this provides a direct test of the effect of aid on growth, it has the disadvantage over the two-step approach that, in case there is no significant aid effect, we do not know which (or both) of the two relationships in (16) and (17) is not supported by the data. The remainder of this section is largely based on three previous studies: –Hansen and Tarp (2000) summarise the results of 29 papers, published between 1968 and 1998, that estimate at least one of the above relationships. Their metaanalysis thus provides a summary statement of earlier research findings on the aggregate impact of foreign aid. The Macroeconomic Effects of Foreign Aid 21 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 –Boone (1996) examines the effect of aid on a variety of macroeconomic variables and several development indicators. His study has been widely cited as final proof that there is no significant, positive influence of aid inflows on investment and growth in recipient countries. –Easterly (1999) takes issue with the still widespread use of the ‘gap model’ in international policy circles and re-examines the evidence on the basic two-gap relationships for a large sample of developing countries. II. The effect of aid on investment Table 1 summarises the effects of aid on investment identified by the three studies listed above and some own estimates. The studies surveyed by Hansen and Tarp provide overwhelming support for the hypothesis that aid raises the level of investment in recipient countries, with 15 out of 16 regressions providing a positive and significant estimate. However, due to the limitations of the period in which they were undertaken, not all of them feature particularly large data sets or the more sophisticated econometric methods available today. The newer estimates in Boone (1996) and Easterly (1999) paint a much bleaker picture. The majority of the individual country estimates in Easterly are either insignificant or significantly negative. Boone (1996) only finds a positive and significant effect in one specification 11 . Our own estimates feature a re-estimation of the country regressions in Easterly (1999) based on the simple bivariate relationship posited in (16). The data are taken from the World Bank’s World Development Indicators 2003 on CD-Rom. 12 There are two differences to Easterly’s work. First, we base our estimates on longer time-series (1960– 2001) and include a slightly larger set of developing countries. For a country to be included, there had to be at least twenty years of consecutive observations available. Second, we use aid lagged by one period rather than the contemporaneous value as explanatory variable in an attempt to deal at least with some of the potential endogeneity of aid. Nevertheless, these estimates are purely meant as a crude summary of the basic correlation between foreign aid and investment. The bottom row of Table 1 summarises the results from running individual country regressions and from using all observations in a fixed-effects panel regression. The individual country results are more favourable of the gap approach than Easterly’s, but the positive and significant estimates are still in a minority. However, the panel estimate – included as a summary of the basic relationship across all countries – is positive and highly significant. The estimated coefficient is 0.25, 22 Philipp Harms and Matthias Lutz 11 Based on ten-year averages of the data and estimation with instrumental variables. 12 The series used are ‘Gross capital formation (% of GDP)’, ‘GDP (current US$)’ and ‘Official development assistance and official aid (current US$)’. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 suggesting that, on average, a quarter of aid inflows translate into investment. This is not a large effect, and significantly below one (as suggested for the savings gap constraint by the very simple version of the two-gap model presented in section 2). However, at least in terms of this simple bivariate regression, there is support for the assertion that there is a positive relationship between aid and investment at the aggregate level. The summary evidence in Table 1, though providing a benchmark, is not satisfactory in all respects. Many of the papers surveyed in Hansen and Tarp (2000) are outdated, and the simple regressions in Easterly (1999) as well as our own can at best inform on the basic correlation between aid and investment. Two papers that have recently looked at the effect of aid on investment using newer data, and more sophisticated econometric models and methods, are Feyzioglu et al. (1998) and Hansen and Tarp (2001). Table 1 The effect of aid on investment (both relative to GDP) Number of estimates Total Negative significant Not significant Positive, significant Hansen & Tarp (2000) (taken from 7 studies published between 1972 and 1998) 16 0 1 15 Boone (1996) (panel data, 10-year averages, 96 countries, 1971 –90) 8071 Easterly (1999) (by country 88 countries, annual data, 1965–95) 88 36 35 17 Own estimates (94 countries, annual data, 1960–2001, aid lagged by one period) By country 94 22 41 31 Coefficient t-ratio Panel (FE, n= 3321) 0.25 10.48 Notes: The results are taken from: Hansen and Tarp (2000), Table 1; Easterly (1999), Table 1; Boone (1996), Table 4. Feyzioglu et al. (1998) estimated the effect of aid on both public and total investment in fixed effects regressions with annual data for up to 38 countries during 1971– 90. Hansen and Tarp (2001) base their estimates on a sample of 56 countries, using 4-year averages during 1974 –93. Although the two studies differ with respect to the additional explanatory variables included, both Feyzioglu et al. (1998) and Hansen and Tarp (2001) reach the same conclusion: aid has a significant positive effect on investment. The Macroeconomic Effects of Foreign Aid 23 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 able – but they share a general result: the BD finding is much too shaky to serve as a basis for policy prescriptions. In what follows, we will sketch the empirical strategies and results that support this conclusion. Specification Hansen and Tarp (2001, henceforth HT) mounted an early attack on BD by arguing that their result merely captured diminishing returns to aid. Referring to the Solow model as well as Dutch disease phenomena as possible reasons for a concave aid-growth relationship, they showed that the policy-interaction term is no longer significant once additional polynomials of aid – in particular, aid squared – are used as regressors (see column 4 of Table 3). 19 There are two conclusions to be drawn from HT: first, there is an optimal level of aid, beyond which additional aid flows are counterproductive – i.e. an abundance of aid may be too much of a good thing. Second, while this optimum may depend on country-specific characteristics, it does not depend on economic policies as captured by the BD index. BD claim to capture cross-country differences by using a set of control variables as well as regional dummies. As Jensen and Paldam (2003) argue, this makes their results extremely vulnerable to omitted-variable bias. Jensen and Paldam therefore verify the robustness of the ‘good policy model’ (BD) and the ‘medicine model’ (HT) by using country-specific fixed effects instead of regional dummies (and other time-invariant control variables). Showing that the BD result breaks down while the coefficient on the quadratic aid term is still significantly negative if this alternative specification is used, they conclude that “. . . the medicine model is far superior to the good policy model when it comes to robustness in the within sample replications” (p. 12). Finally, there is no clear reason for using four-year averages in a growth regression. 20 So an obvious robustness check is to test whether the BD result holds at lower frequencies. This is done by Easterly (2003) who reports that “. .. the coefficient on the interaction term between aid and policy no longer enters significantly for periods of 12 years and for the pure cross-section of 24 years” (p. 30). 30 Philipp Harms and Matthias Lutz 19 This is surprising, given the BD finding that aid squared is no longer significant (while the policy-interaction term is) once five influential observations are removed from the sample. The explanation may be that – in contrast to BD – HT use both aid squared and policy squared as regressors. The HT model gets powerful support from Roodman (2003) who subjects it to a battery of robustness tests and states that “.. .the most robust and far-reaching conclusion to emerge from the testing is that of Hansen and Tarp, the sole proponents in the work examined here of the straightforward view that aid works on average, albeit with diminishing returns” (p. 35). 20 The standard explanation for not using annual data is that averaging helps to “eliminate business cycle factors and measurement error” (Boone 1996, p. 304). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Sample size Our belief in the validity of econometric results is based on the notion that they reflect a structural relationship which does not depend on the inclusion or omission of a few data points. However, exactly this presumption turned out to be wrong in the BD case: thus, Roodman (2003), Easterly et al. (2003), Easterly (2003), as well as Jensen and Paldam (2003) show that the policy interaction term is no longer significant when an additional four-year period (1994 – 97) is added to the original BD data set, and when some ‘newly found’ observations enter the sample (see column 5 of Table 3). Moreover, the BD result breaks down if official development assistance (ODA) instead of ‘effective development assistance’ (EDA) is used as a regressor. 21 Finally, as Jensen and Paldam emphasise, the result heavily relies on the inclusion of a large number of control variables and the sample reduction that results from limited data availability. 22 In fact, neither the ‘good policy model’ nor the ‘medicine model’ nor any other non-linear model with aid as a determinant of growth gets empirical support if one makes use of the maximum number of data points. The policy variable A third line of critique focuses on the policy variable used by BD. An obvious objection is that this proxy is extremely ad-hoc: why should good policies be reflected by a combination of low inflation, a low budget deficit, and trade openness and not, say, a low black market premium? Why is the Sachs-Warner index used instead of some alternative measure of trade openness like the sum of imports and exports over GDP? These points are raised by Easterly (2003) who reports that interacting aid with alternative policy variables, such as the black-market premium, does not yield a significant coefficient. A related argument is brought forward by Brumm (2003) who emphasises that the BD policy variables are, at most, proxies for the quality of a country’s economic policy, and that one needs to account for measurement error when using such proxies. Adopting an econometric approach that is more robust to measurement error and that treats economic policy as a latent variable, he comes up with the The Macroeconomic Effects of Foreign Aid 31 21 “Effective development assistance” (EDA) as defined by Chang et al.(1998) is computed by isolating the grant component of concessional loans and adding it to the volume of outright grants. While EDA may give a more accurate impression of the sacrifices made by donor countries, the original ODA series covers a larger number of countries and time periods. 22 A carefully assembled table in the appendix of Jensen and Paldam (2003) singles out the countries that did not make it into the BD sample because either EDA data or some control variable were not available. It is quite disheartening that, to a large extent, these are countries with very low incomes to which the BD message was supposed to apply in the first place. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 surprising finding that the coefficient of the interactive term is significantly negative – which suggests that aid is more effective in countries where it meets a bad policy environment. 23 Quite related are the results of Guillaumont and Chauvet (2001) who find that the BD interactive term is insignificant in a regression focusing on twelve-year intervals, but that aid is more effective in countries which are characterized by an unstable economic environment. 24 Finally, Harms and Lutz (2005) test whether aid has an effect on the volume of private foreign investment, i.e. the sum of foreign direct investment and portfolio equity investment. Instead of the BD policy index, they use a set of governance indicators developed by Kaufmann et al.(1999). The first advantage of these data is that they carefully isolate different aspects of the ‘political and institutional environment’, distinguishing variables that refer to the political system (‘voice’ and ‘political stability’) from measures that reflect the quality of official government activity (‘government effectiveness’, ‘regulatory burden’) and from indicators that reflect the population’s respect for laws and institutions (‘graft’, ‘rule of law’). The second advantage is that the Kaufmann et al. (1998) data are based on a systematic aggregation of measures from different sources and thus represent a consensus view on countries’ institutional and political situation. Regressing private foreign investment (in per capita terms) on aid per capita and an interactive term, Harms and Lutz (2005) find that, for countries with an ‘average’ institutional environment, aid has no impact. However, it becomes significantly positive in countries where investors meet a heavy regulatory burden. The explanation they offer for this puzzling finding is that the impact of (aidfinanced) public infrastructure services on the marginal productivity of capital may be larger in countries where an oppressive regulatory environment prevents the private sector from providing these services. IV. Endogenous institutions and conditionality A further reason for criticising the BD policy variable is that it represents a set of policy outcomes which are very likely to be a function of both aid and growth. Of course, BD are aware of this problem, and they discuss it explicitly in their paper. However, despite their reassurances, the reader is left with the nagging feeling that the BD result reflects a combination of various causal effects. If one wants to isolate the direct effects of aid on growth, one is left with the question whether there are any ‘deeper’ structural variables that capture the policy environment and that are less likely to be a function of other endogenous variables. Dalgaard et al. 32 Philipp Harms and Matthias Lutz 23 Brumm’s (2003) analysis differs from BD both by using an alternative econometric method and by considering a pure cross section of 24-year averages. 24 Guillaumont and Chauvet (2001) use the stability of agricultural added value, the stability of the real value of exports, the trend of the terms of trade and the log of initial population as proxies for economic vulnerability. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 (2004) offer the fraction of land in tropical areas as a candidate, arguing that climatic differences are correlated with slow-moving variables that affect the business environment. 25 They show that an interactive term of aid with this ‘institutional variable’ has a significantly positive effect on growth, suggesting that “over the last thirty years, aid seems to have been far less effective in tropical areas” (p. 36). Apart from forcing researchers to interpret their empirical results with caution, the discussion of the potential endogeneity of policy variables highlights another channel through which aid may affect investment and growth in developing countries: if massive aid inflows raise the extent of rent-seeking and corruption in recipient countries, the detrimental consequences on factor allocation and productivity may dominate the beneficial effects of a better infrastructure and rising education. This is exactly the point emphasised by Bauer (1991) in his fierce critique of the standard practice of aid allocation. Again, it is an empirical question whether the perverse consequences of aid observed in some countries are systematic or exceptional. And, not surprisingly, the literature offers a wide range of – sometimes contradictory – results on this question: Svensson (2000) considers the International Country Risk Guide’s index of corruption and finds that aid raises graft in ethnically fractionalized countries. He interprets this as empirical support for a model in which windfall gains exacerbate the distributional struggle between competing interest groups. Knack (2001) uses the change of a composite measure of governance – comprising the ICRG’s indicators of corruption, bureaucratic quality and rule of law. As in Svensson (2000), Knack’s results suggest that aid dependency worsens governance. However the effect of ethnic diversity is dampening rather than exacerbating. While the results of Svensson (2000) and Knack (2001) indicate that any beneficial economic effects of aid may be superseded by its negative impact on governance, Tavares (2003) defends the opposite point of view: his empirical findings suggest that aid reduces corruption. How can we explain these differences? And who is right? Closer scrutiny of the contributions by Svensson and Tavares reveals that they are strikingly similar with respect to their samples and empirical approaches. However, they differ in their choice of instrumental variables: while Svensson uses income, the terms of trade and population size as instruments for aid, Tavares focuses on variables that capture geographic and cultural proximity. Confronted with a choice between the two approaches, we believe that Tavares’set of instruments is better suited to address the endogeneity problem. The possibility that aid affects the quality of governance and policies finally leads to the question why donor countries do not target these variables by making aid conditional on recipients’ efforts in reform and their policy performance. UnThe Macroeconomic Effects of Foreign Aid 33 25 This line of argument goes back to Hall and Jones (1999) as well as Acemoglu et al. (2001). 3 Schriften d. Vereins f. Socialpolitik 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 fortunately, as Dollar and Svensson (1998) document, this approach seems to have failed in many cases: apparently, the threat to withhold future resources in case of poor reform performance has rarely been credible – either because of overruling strategic and economic interests (see Alesina and Dollar 2000 as well as Alesina and Weder 2001) or because of the mechanics of aid allocation within donor agencies (Svensson 2003). F. Conclusions Almost ten years after Boone (1996) first investigated the hypothesis that the effectiveness of aid depends on the policy environment in recipient countries, we seem to have gone full circle: for some time, Boone’s result that aid is ineffective – even if one controls for the political system – seemed to be replaced by a new consensus that (aid) money matters in a good policy environment (Burnside and Dollar 2000). However, this consensus has started to unravel in recent years: some authors (Hansen and Tarp 2001, Roodman 2003, Dalgaard et al. 2004) argue that aid has a significantly positive and non-linear effect on growth, but that the nonlinear relationship rather reflects diminishing returns or deep structural differences than the importance of “good policies” as defined by Burnside and Dollar (2000). Others (Brumm 2003; Harms and Lutz 2003) find that policy and institutions matter, but in a way that turns Burnside and Dollar (2000) on its head. A third set of papers (Easterly et al.2003; Jensen and Paldam 2003) claims that one cannot find a robust effect of aid on growth unless one uses an artificially restricted sample. Does this mean that we are back to square one, and that the past ten years leave us with nothing but a stack of empirical investigations that differ in their choice of data, specifications, and results without delivering any reliable policy recommendation? We believe that such a frustrating conclusion would ignore the important insights that can be gained from a more nuanced look at the recent research output. In particular, it is surprising how little care and time has been devoted to a discussion of the question which component of a country’s political, institutional and economic fabric one actually wants to capture by controlling for the policy environment. Is it the government’s ability to control the budget deficit and the central bank’s willingness to fight inflation? Is it the extent of red tape and corruption that hampers business activity? Or is it political stability, the transparency of the political process and the reliability of the legal framework? While these aspects of the ‘political and institutional environment’ are likely to be correlated – with a politically unstable country possibly favouring corrupt administrations who use seignorage for lack of a sound tax base – they are not the same. For some reason, these differences have been lost amidst the recent critiques of Burnside and Dollar (2000), and we argue that it would be wrong to conclude from the findings of, e.g., Easterly et al.(2003) that, in general, we can neglect the political, institutional, and economic framework in recipient countries when assessing the effec34 Philipp Harms and Matthias Lutz OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 tiveness of aid. In fact, the BD policy variable may just fail to capture the aspects that matter most. Or the functional relationship between aid, macroeconomic variables, and policies may be more complex than suggested so far – involving, e.g., threshold effects or other forms of nonlinearities. Moreover, we think that it is misleading to explore the effects of aid without accounting for the supply side of aid, i.e. without considering the criteria that are used to allocate aid or the composition of aid flows. It is hardly surprising that huge sums of mainly military support that were unleashed for strategic rather than humanitarian purposes during the cold war did not have much of a growth effect. 26 It is also not surprising that a variable as aggregate as official development assistance does not have a robust effect on growth. In fact, given that ODA comprises such diverse components as emergency food aid, the building of village wells, the construction of airports and the salaries of teachers, it is surprising that some researchers obtained any results at all. Hence, we believe that the unravelling of the BD consensus is a starting point rather than an end of the aid-growth debate, and we emphasise the desirability of taking a more disaggregate view – both with respect to the various aspects of policies /institutions and with respect to the different components of aid. We are sure that, once these subtle but important differences are accounted for, future research will come up with important and robust results on the macroeconomic effects of aid. References Acemoglu, D. / Zilibotti, F. (1997): Was Prometheus unbound by chance? Risk, diversification and growth, Journal of Political Economy, Vol. 105, pp. 709 – 751. Acemoglu, D. / Johnson, S. / Robinson, J. (2001): The colonial origins of comparative development: an empirical investigation, American Economic Review, Vol. 91, pp. 1369 –1401. Agenor, P. / Montiel, P. (1999): Development Macroeconomics, 2 nd Edition, Princeton, Princeton University Press. Alesina, A. / Weder, B. (2002): Do corrupt governments receive less foreign aid? American Economic Review, Vol. 92, pp. 1126 –1137. Alesina, A. / Dollar, D. (2000): Who gives foreign aid to whom and why? Journal of Economic Growth, Vol. 5, pp. 33– 63. Azariadis, C. (1996): The economics of poverty traps. Part one: complete markets, Journal of Economic Growth, Vol. 1, pp. 449 – 486. Azariadis, C./Drazen, A. (1990): Threshold externalities in economic development, Quarterly Journal of Economics, Vol. 105, pp. 501 –526. The Macroeconomic Effects of Foreign Aid 35 26 See Burnside and Dollar (2000), Alesina and Dollar (2000) as well as Alesina and Weder (2003) for an empirical exploration of the determinants of donor countries’ aid allocation. 3* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Bacha, E. 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Washington DC, The World Bank. 38 Philipp Harms and Matthias Lutz OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Aid Allocation and Aid Effectiveness By Rainer Thiele, Kiel A. Introduction Philipp Harms and Matthias Lutz provide a comprehensive and very useful survey of the literature on the macroeconomic effects of foreign aid. They conclude their analysis with a fairly agnostic statement, arguing convincingly that robust empirical evidence on aid effectiveness has not yet been established, but that it may be forthcoming if aid is considered in a more disaggregated way than has been in the past. This paper deals with the related issue of how empirical findings such as those discussed by Harms and Lutz might affect the allocation of aid among recipient countries and thereby help improve international development cooperation. It first discusses an allocation rule for aggregate aid developed by World Bank researchers, which has become very influential in the policy arena, and some possible extensions of this rule. Then the focus shifts to two specific areas of development cooperation, namely the role of pro-poor expenditures and of measures aimed at overcoming the geographical disadvantages of the tropics. The paper closes with some concluding remarks. B. The Collier / Dollar allocation rule Up to now, the most notable attempt to base recommendations concerning the reform of foreign aid allocations on existing empirical evidence has been made by Collier and Dollar (2001, 2002). Collier and Dollar first perform growth regressions along the lines of Burnside and Dollar (2000), with aid and various control variables entering as left-hand-side variables. Based on the estimated regression coefficients, they then simulate the poverty-efficient aid allocation, which maximizes the number of people pulled out of poverty worldwide. Under this allocation rule, the initial poverty headcount and the quality of governance are key determinants of aid flows to individual countries, where the latter is approximated by the World Bank Country Policy and Institutional Assessment (CPIA), which consists of 20 different components covering various aspects of macroeconomic management, structural policies, social policies and institutions. Changes in the poverty OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 confuses climate-related problems with poor governance. Since there is a very high probability that countries having a low CPIA rating are located in the tropics, an aid regime aimed at mitigating adverse initial conditions would lead to an allocation of funds that differs fundamentally from the one suggested by the Collier / Dollar rule. Among the possible geographical disadvantages of tropical countries, a high susceptibility to diseases such as malaria and low agricultural productivity figure most prominently. Confronting these disadvantages would mainly involve additional efforts in international agricultural and health research. Since any breakthrough in these research areas, such as the development of drought-resistant grain varieties, finally has to be implemented at the country level, governance considerations are likely to come into play again. High-yielding grain varieties, for example, will arguably lead to substantial increases in farmers’ incomes only if they are complemented by efficient input and output markets. In the same vein, healthier people will need access to efficient labor markets in order to capitalize on their appreciated human capital. F. Concluding remarks The overview provided in this paper has shown that the application of different allocation criteria can lead to dramatic variations in the poverty-efficient allocation of aid among recipient countries. A lack of robustness of the empirical results underlying the specification of the allocation rules renders it impossible to rank them properly so that the literature is currently of little help for practical development policy. The only general conclusion that can be drawn is that all allocation rules considered in the paper suggest that aid effectiveness is likely to depend on the quality of governance, albeit in very different ways. The large impact that different allocation rules would potentially have on aid flows and aid effectiveness suggests a high pay-off of additional research aimed at providing donors with more robust guidance. As for the future research direction, it is necessary to analyze aid allocations in a more disaggregated way than most previous studies have done. This is particularly obvious with respect to the aid variable itself, which comprises a heterogeneous set of items ranging from military goods to basic social services, but it is equally true for governance, where an aggregate indicator such as the CPIA faces the problem that at least some of its elements may have a differential impact on aid, growth and poverty. In this context, the analyses conducted by Mosley et al. (2004) and Dalgaard et al. (2004) constitute useful first steps. 46 Rainer Thiele OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 References Acemoglu, D. / Johnson, S./Robinson, J. A. (2001): The Colonial Origins of Comparative Development: An Empirical Investigation, American Economic Review, Vol. 91, pp. 1369 – 1401. Burnside, C. / Dollar, D. (2000): Aid, Policies, and Growth, American Economic Review, Vol. 90, pp. 847 –868. Clemens, M. / Radelet, S. (2003): The Millennium Challenge Account: How Much is Too Much, How Long is Long Enough? Center for Global Development Working Paper 23, Washington, D.C. Collier, P. / Dehn, J. (2001): Aid, Shocks, and Growth, World Bank Policy Research Working Paper 2688, Washington, D.C. Collier, P. / Dollar, D. (2001): Can the World Cut Poverty in Half? How Policy Reform and Effective Aid Can Meet The International Development Goals, World Development, Vol. 29, pp. 1787 –1802. – (2002): Aid Allocation and Poverty Reduction, European Economic Review, Vol. 46, pp. 1475 – 1500. – (2004): Development Effectiveness: What Have We Learnt? Economic Journal, Vol. 114, pp. 244– 271. Collier, P. / Hoeffler, A. (2004): Aid, Policy, and Growth in Post-Conflict Societies, European Economic Review, Vol. 48, pp. 1125 –1146. Dalgaard, C. J. / Hansen, H./Tarp, F. (2004), On the Empirics of Foreign Aid and Growth, Ecomomic Journal, Vol. 114, pp. 191 – 216. Devarajan, S. /Dollar, D. / Holmgren, T. (2001): Aid and Reform in Africa: Lessons from Ten Case Studies, Washington, D.C., The World Bank. Dollar, D. / Svensson, J.(2000): What Explains Success and Failure of Structural Adjustment Programmes, Economic Journal, Vol. 110, pp. 894 – 917. Easterly, W. / Levine, R. (2003): Tropics, Germs, and Crops: How Endowments Influence Economic Development, Journal of Monetary Economics, Vol. 50, pp. 3– 39. Guillaumont, P. / Chauvet, L. (2001): Aid and Performance: A Reassessment, Journal of Development Studies, Vol. 37, pp. 66 – 92. Gundlach, E. (2004): The Primacy of Institutions Reconsidered: The Effects of Malaria Prevalence in the Empirics of Development, Kiel Working Paper 1210, Kiel Institute for World Economics, Kiel. Langhammer, R. J. (2004): Halving Poverty by Doubling Aid: Is There Reason For Optimism? World Economy, Vol. 27, pp. 81 – 98. Mosley, P. / Hudson, J. / Verschoor, A. (2004): Aid, Poverty Reduction, and The “New Conditionality”, Economic Journal, Vol.114, pp. 217 –243. Nunnenkamp, P. (2002): Shooting the Messenger of the Good News: A Critical Look at the World Bank’s Success Story of Effective Aid, Kiel Working Paper 1103, Kiel Institute for World Economics, Kiel. Aid Allocation and Aid Effectiveness 47 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Ravallion, M. (2001), Growth, Inequality, and Poverty: Looking Beyond Averages, World Bank Policy Research Working Paper 2558, Washington, D.C. Sachs, J. (2003): Institutions Don’t Rule: Direct Effects of Geography on Per Capita Income, NBERWorking Paper 9490, Cambridge, MA. Wößmann, L. (2001), Why Students in Some Countries Do Better: International Evidence on the Importance of Education Policy, Education Matters, Vol. 1, pp. 67– 74. 48 Rainer Thiele OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Cooperating With the Private Sector in Development Cooperation: Strategic Alliances with Lead Firms in Production Networks By Tilman Altenburg, Bonn A. Introduction International cooperation in the field of private-sector development has recently experienced two important changes. The first relates to a shift from supply-side to demand-side interventions. Traditional development aid focused on equipping individual firms or local small and medium enterprise (SME) clusters with the competencies which donors perceived to be essential for them to serve international markets. Given the increasing diversification of demand, changing fashion trends and rising product standards, this approach was not very successful. Today, policymakers increasingly acknowledge the need for close cooperation with strategic actors on the demand side, e.g. private retail or brand-name companies which hold the key to market access. To make the most of such cooperation it is important to gain a thorough understanding of the way firms are participating in (international) value chains and production systems, for example to identify sources of strategic knowledge, to recognize barriers to entry and figure out what determines the appropriation of gains. The second change is about modes of service delivery. While traditionally aid was delivered almost exclusively through public agencies, in the last 10 – 15 years development agencies have increasingly been looking for private-sector participation in the delivery of development services. Besides commissioning private companies to implement projects by order and for the account of public agencies, an increasing number of companies are getting involved in a variety of strategic alliances with development agencies. Strategic alliances differ from awards of contracts to private contractors in that partners in alliances share a common interest in achieving certain outcomes and are willing to share risks for this purpose. 1 Hence the private partners’ interests go beyond earning a service fee, and the firms can be expected to have much more of the ownership needed to make the joint project successful. Strategic alliances allow development agencies to draw on complemen1The term “strategic alliance” covers a variety of different cooperative arrangements including e.g. franchise contracts and joint ventures. This paper focuses on temporary, nonequity alliances (public-private partnerships, PPPs). 4 Schriften d. Vereins f. Socialpolitik 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 tary expertise, benefit from the often superior efficiency of private partners, and leverage additional capital for the purpose of development (Demtschück 2004, pp. 14 f.). The present paper argues that strategic alliances in development cooperation should focus on lead firms in order to maximize their impact and outreach. Lead firms are companies which provide strategic and organizational leadership beyond the resources that are directly under their management control and therefore determine the development opportunities of subordinate participants in their network. As production and trade are increasingly taking place in tightly coordinated forms, lead firms have become more important as innovators, coordinators and “governors” (Humphrey and Schmitz 2001, pp. 19 ff.) of production networks. They are the ones who hold control of key technologies and patents, who introduce brand names, who are capable of integrating product and service inputs efficiently, who determine the logistics parameters in the supply chain, or who set and enforce different kinds of product and process standards. Such standards are becoming increasingly relevant and diversified, ranging from quality issues to social and environmental characteristics of the production process down to procedures to assure traceability of products or to decide on issues of certification and auditing. As a result, lead firms have considerable influence on the barriers to entry for Third World producers, their opportunities for technological learning, and their share of gains in the value-adding process. If development cooperation aims to integrate poor producer groups in modern production processes and to improve environmental or social standards, partnering with lead firms is just about indispensable. Given this relevance of lead firms and a growing number of partnering experiences with them, the present paper discusses opportunities and limitations for development cooperation with these firms. Section B describes the trends towards increasing integration of production networks and identifies the most relevant factors driving this process. Section C then elaborates on the increasing importance of lead firms, distinguishing their different roles as innovators, coordinators and governors of production networks. Section D discusses, from the perspective of developing countries, the risks and opportunities inherent in the increasing integration of international production systems. Section E deals with the topic of interests, highlighting the fact that lead firms and local stakeholders in developing countries pursue both complementary and conflicting aims and seeks to identify which areas are most suitable and promising for joint action. Finally, Section F draws some practical conclusions for strategic alliances in development cooperation, comparing places where the interests of lead firms and development agencies coincide and pointing to some additional aspects that are relevant for implementation, such as how to deal with risks of corruption, abuse and private windfall gains at the expense of the public purse, or how to minimize transaction costs. 50 Tilman Altenburg OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 B. Increasing integration of production networks International trade is increasingly taking place in tightly coordinated forms, either as intra-firm trade or as trade between legally independent firms in quasiintegrated value chains and production networks. UNCTAD estimates that transnational corporations (TNCs) account for about two-thirds of world trade: One third is intra-firm trade, the other third is directly affected by TNC locational and sourcing strategies (UNCTAD 2001, p. 56). Pure spot market transactions, where independent producers manufacture without knowing in advance who their customers will be and which product and process standards they expect them to comply with, are no longer the prevalent way of doing business. Different concepts are being used to describe the trend towards increasing integration and coordination of production processes. There is a long history of analyzing the interactive process of production in terms of linear processes, whereby different actors consecutively transform a raw material into a final good, involving different manufacturing stages as well as services (e.g. design, delivery). Following the seminal work by Hirschman (1958), a great number of terms have been coined to describe this linear process, including “value chains,” “production chains,” “commodity chains,” “supply chains,” and “filières.” 2 In real life, however, production processes are usually not neatly arranged in one straight line of successive stages but ramify into a large number of different supply chains and overlap with processes in many related branches (Kaplinsky and Morris 2001, p. 4). Furthermore, production processes involve a number of relationships at the same stage of the value-adding process, e.g. joint ventures, strategic alliances and other forms of collective action among firms, with some such firms participating in other chains. And finally, value-chain participants receive complementary inputs from consulting firms, business associations, training and R&D institutions and the like, which are not part of the value-adding process. Thus the “chain” metaphor does not adequately mirror the complexity of the coordination processes involved here. Several more recent studies therefore propose replacements for the linear “chain” concept. For example, Henderson et al. (2001) suggest the term “global production network.” 3 In this study we use the term “value chain” when we refer to the value-adding process in the narrow sense, e.g. when we discuss the distribution of gains between assemblers and their suppliers, while “production network” is used to refer to the broader perspective of systemic, network-like production processes involving difCooperating With the Private Sector 51 2See Stamm (2004) for a critical discussion of these concepts. 3In fact, already earlier versions of the chain approach have a more comprehensive understanding of chains in the sense of networks, emphasizing the role of firms that are horizontally linked to the chains. Hopkins and Wallerstein (1986, p. 159), for instance, use the following definition: “The concept commodity chain refers to a network of labor and production processes whose end result is a finished commodity. In building this chain we start with the final production operation and move sequentially backward. . .”. 4* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 ferent kinds of “horizontal” inter-firm relations as well as complementary supporting firms and institutions that do not directly participate in the process of value addition. For example, a multi-stakeholder dialogue dedicated to enforcing social standards in the garment industry would usually involve many actors beyond those of the value chain. The motivation behind make-or-buy decisions, i.e. whether a company prefers to integrate vertically (e.g. acquisition of intermediate producers), to establish contractual arrangements with its suppliers or to procure inputs on the spot market has long been a matter of debate in industrial economics. While traditional industrial economics explained vertical integration mainly as a strategy to erect entry barriers for competitors and build up monopolies or monopsonies (e.g. Bain 1956), Williamson (1985) showed that vertical integration may increase efficiency (improving the situation for both consumers and producers) if it saves transaction costs (more exactly: if the reduction of costs involved in market transactions exceeds a possible increase of organization costs related to in-house production) (see also Grossman and Hart 1986). The empirical global trend towards more tightly coordinated production networks is mainly driven by the pursuit of efficiency gains and thus supports Williamson’s emphasis on transaction costs. Two major market trends are decisive: –First, mounting competitive pressure obliges companies to increase efficiency and meet more sophisticated technological demands. This in turn requires closer interaction with partners upstream and downstream in the value-adding process; –and second, demand is growing for compliance with social, ecological, hygiene and other standards as well as for greater transparency of input-output relations, forcing firms to take tight control of the whole production process. I. Increasing efficiency and meeting technological demands Increased global competition is forcing firms to enhance the quality of their products, to improve customer orientation and to accelerate the pace of innovation while at the same time cutting costs. This makes competition more complex. “No individual firm, not even a dominant market leader, can generate all the different capabilities internally that are necessary to cope with the requirements of global competition. Competitive success thus critically depends on a capacity to selectively source specialized capabilities outside the firm that can range from simple contract assembly to quite sophisticated design capabilities.” (Ernst 2001, p. 9). Taking their embeddedness in networks of complementary firms and institutions into account, companies have basically four options to improve their performance: 1. To improve their internal organization, e.g. developing better products, streamlining work flows, introducing performance-based incentives, and improving quality management; 52 Tilman Altenburg OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 2. to optimize make-or-buy decisions, i.e. getting rid of low-margin activities and possibly developing or acquiring new capabilities which complement the existing core competencies; 3. to exert influence on partners upstream and downstream in the value chain, with the aim of boosting their performance. This pays off for a firm whenever these improvements lead to greater sales or lower input prices. Influence may be gained either by exerting pressure on or supporting network partners, or by a combination of both. To increase performance pressure, customer firms often place orders with several competing suppliers or present timetables for an incremental reduction of purchase prices. On the other hand, technicians are sometimes seconded to improve quality management and other aspects within supplier firms; 4. to lower transaction costs in the production network within which the firm is embedded. Adequate measures range from building trust to standardizing logistics tools at the interfaces where companies interact. In most industries, competitive pressure has generated substantial organizational improvements at the firm level. For several decades, management tools have continuously been improved, and this has contributed significantly to increasing productivity. As a result of intense management consulting and benchmarking, transparency among firms has increased, average practice has been brought closer to best practice, and relatively homogeneous business models have evolved. Consequently, the scope for further productivity growth within companies is limited, and it is difficult to stand out from competitors on the basis of purely internal process improvements. On the other hand, numerous sector studies reveal that considerable potentials for increasing productivity remain untapped within supply chains. The large car manufacturers were among the first to focus their attention on streamlining their supplier and distribution networks. In some cases car manufacturers force their suppliers to carry out value analyses together with experts seconded by the carmakers themselves. In complying, suppliers are obliged to disclose their cost structure to the customer. If the value analyses reveal possibilities to reduce costs, these savings are immediately converted into price reductions to the advantage of the car manufacturers (Altenburg et al. 1998, p. 41). In other branches value-chain integration is much less advanced, or at least has not been established as a common practice across the whole sector. In food retailing and in the garment industry, for example, international sourcing is often still far from being systematically organized, and some large corporations exert astonishingly little influence on what happens upstream in their value chain. 4 Cooperating With the Private Sector 53 4See Weitz and Altenburg (2001) for the food retailing industry and Botzenhardt and Altenburg (2001) for the garment industry. Interviews with purchasing departments revealed that – despite the possibilities afforded by the Internet – sourcing decisions for tropical fruits are still largely based on coincidental personal contacts with supplier firms; in the garment OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 These differences reflect sector-specific patterns of industrial organization. 5 On the whole, however, the most substantial productivity gains can be expected from improving relationships with supply chain partners and complementary service providers within the firm’s production network (options two, three and four). This requires coordinated production planning, compatible logistic standards, and other agreements which go far beyond spot market transactions. II. Compliance with standards Stakeholders, especially critical consumers, are increasingly demanding compliance with social, ecological, hygiene and other standards and transparent procedures within the chain. Some consumers are willing to pay a price premium for goods with certain product or process characteristics, for instance food products which are free of pesticides or not genetically modified; meat and poultry products from farms that respect certain principles of animal welfare; assembled consumer goods from factories which do not employ child labor or which guarantee certain working conditions; wood products from sustainably managed forests; kosher and halal products, etc. While the main pressure comes from consumers, recently some ethical investors have started demanding compliance with certain social or ecological standards (see Bartolomeo and Wilhelm 2003). Most of the attributes demanded by consumers and investors are not evident in the product itself. Goods therefore carry two types of information: the natural appearance of the product (which the consumer may easily verify at the point of purchase) and the symbolic information attached to it. In order to meet the increasing consumer demands for symbolic product properties (including image factors as well as characteristics of the production process), companies have to hold control of all upstream activities and sometimes introduce significant changes. In addition, this control has to be proven to the customer, because “symbolic information is detached from the thing to which it refers and its veracity may be corrupted either during production or transmission. Under such circumstances assuring the integrity of the product information chain becomes much more important than optimizing the efficiency of the physical product supply chain.” (Müller 2001, p. 8). Consumers are not willing to pay a surcharge unless the information on product and process characteristics provided with the respective good is reliable. Standards and certification procedures designed to control, document and verify attributes of the 54 Tilman Altenburg industry, different stages of the value chain do not have enterprise resource planning systems, or these systems are not compatible. As a result, multiple communication problems occur. For example, retailers place huge orders with their suppliers in Turkey transmitting Polaroid photos of the required samples rather than codified information on cuts, coloring etc. 5For instance, the strong influence car-makers have over their suppliers may be due to a high degree of market concentration and the relevance of specific investments that make suppliers highly dependent on certain customers (Monteverde and Teece 1982). In the food and garment industries supplier relations are often less captive. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 production process are required, and sophisticated logistics concepts are being developed for tracing products back to the primary producers. Certification and auditing have become large industries worldwide. (Reardon et al. (1999) use the concept of “credence goods” for products with a high content of symbolic information.) In many product markets new price segments have been introduced that are based on properties which are not directly verifiable by the consumer. Coffee sells at different prices depending on attributes such as “organically grown,” “grown by smallholders” or “traded fairly”; prices of eggs differ according to the conditions under which the poultry has been kept, the type of feed used, etc. The ability to provide reliable information about production processes to the customer is thus an innovative way of adding value to products. The variety of product attributes to be certified and the number of standards is continuing to increase. Some of the standards are set by actors outside the production network, such as governmental and intergovernmental agencies or NGOs, while others are set by business associations or even individual firms (Nadvi and Wältring 2002). C. The increasing importance of lead firms The increasing integration of value chains and production networks enhances the importance of lead firms. According to Rugman and D’Cruz (2000, p. 84), the “flagship company” (lead firm) provides strategic and organizational leadership beyond the resources that lie directly under its management control. The strategy of the lead firm affects the strategic direction and development opportunities of subordinate participants in its network, while the latter do not have the same amount of influence over the lead firm Lead firms set the parameters for products, processes, and logistics to which other firms of the chain conform, thereby determining the conditions for lesser firms to participate in the chain, and they influence the distribution of gains along the chain (Humphrey and Schmitz 2002, see also Messner 2002, p. 21 f.). Lead firms derive their strength from three main capabilities: –the capability to generate innovations; –the capability to coordinate networks; –the capability to set and enforce standards. Today, the core competencies of many lead firms are in intangibles – ideas, information, and relationships – rather than manufacturing. All these are highly knowledge-intensive and often require considerable capital investment, e.g. advertising campaigns for the introduction of a new brand. In contrast, subordinate firms in global production networks, and especially those in developing countries, tend to be restricted to the tangible and knowledgeCooperating With the Private Sector 55 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Many transnational corporations have set up specialized organizational units and procedures to deal with suppliers. “A survey of TNCs in the automobile and electronics industries found that 16 out of 18 automotive TNCs had adopted a strategy for global supplier development, while the corresponding data for electronics TNCs was 8 out of 15 . .. For instance, in Malaysia four of eleven electronics affiliates surveyed had such programmes . ..; a survey of Northern Ireland found 38 per cent of foreign affiliates with similar programmes . ..” (UNCTAD 2001, p. 140, based on different sources). As a result, as Dunning (1992, p. 456) states “the findings of a large number of studies over the past 30 years are virtually unanimous that the presence of foreign-owned firms has helped raise the standards and productivity of many domestic suppliers, and that this has often had beneficial effects on the rest of their operations.” (See also Altenburg 2000 for an overview.) All in all, the enhanced role of lead firms has far-reaching consequences for developing countries, involving both risks and opportunities. Whether and on what technological bases developing countries achieve integration in global production networks, and whether they manage to exploit their potential benefits, depends on many factors: Technological characteristics of the respective branch, the corporate strategy of lead firms, the absorptive capacity of local firms and, last but not least, the wisdom of local policy-makers. As we shall discuss in the following section, lead firms and policy-makers from locations where these firms make investments (or where they source inputs) pursue largely congruent aims. This opens up interesting perspectives for strategic alliances. However, some conflicting interests remain. E. Interests of lead firms versus interests of locations in developing countries We may assume that there is a great deal of congruency of interests because both parties are interested in upgrading the local institutional and business environment. As noted above, gaining competitive advantages is increasingly a matter of coordinating and governing a corporation’s upstream and downstream relationships more efficiently than one’s competitors do. Consequently, the competitiveness of firms depends on factors lying beyond the boundary of the company and include the production system in which the firm is embedded. If lead firms “can procure inputs locally, particularly in host economies in which labour costs are low, they can lower production costs (some service inputs, for example, may be very expensive to import). If they can subcontract directly to local suppliers, they can increase their specialization and flexibility, and adapt technologies and products better and faster to local conditions. Technologically advanced suppliers can provide affiliates with access to a pool of external technological and skill re62 Tilman Altenburg 13 Rasiah’s (1994) study of Penang’s electronics industry describes one of the most convincing cases. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 sources, feeding into their own innovative efforts.” (UNCTAD 2001, p. 129). In short, having efficient complementary firms close by helps lead firms to sustain their competitiveness. At this point a caveat is necessary: Although firms become increasingly reliant on linkages with value-chain partners and providers of complementary services, these linkages may not involve local firms. Instead, lead firms may import the overwhelming share of their supplies, and even if they source locally, their partners may be other foreign affiliates which may constrain technological spillovers into the region and hamper local accumulation of capital (ibid., p. 133). By and large, nevertheless, the level of development of the local business community and institutions is an important factor for the locational choices of firms. Firms will prefer those locations where relevant input factors are available at a low cost, where transaction costs are low and the general business environment is supportive. As we have seen above, lead firms are, to a certain extent, willing to invest in the quality of local clusters. All this is in line with the public interest of the host country (or region) in enhancing locational spillovers and upgrading local competitiveness. Local policymakers and most stakeholders welcome spillovers from lead firms, especially the generation of employment and technological skills. Moreover, local stakeholders have an interest in local linkages because they help to embed investment in local business networks and make them less footloose. However, even if lead firms, guided by their “enlightened self-interest”, contribute to the upgrading of their local business environment, this is not likely to lead to the most efficient outcome in terms of public welfare. Additional public support may be required where companies underinvest in local capabilities because they are unable to privately appropriate the returns, and in some cases public interests even conflict with the lead firm’s interests. Two kinds of market failure are likely to occur: 1. Public goods and externalities: As we have already argued, a diversified and competitive local network of supporting firms and institutions benefits both the large investors that build on these networks and the local population. However, for any individual corporation, building and upgrading all the complementary structures required – e.g. research facilities, human capital, specialized suppliers – would usually be too costly. Moreover, unless supplier relations are captive, it is often not feasible to exclude other (nonpaying) firms from using the relevant structures. This creates an incentive for free-riders and leads to situations where the public good “supportive enterprise structure” is likely to be undersupplied. Finally, firms may refrain from investing in complementary firms in order to avoid boosting their own competitors. Modern supplier relations or joint ventures increasingly involve sharing of relevant tacit knowledge about technologies and customers. This may imply leakage of strategic information and ultimately enable some of the supported firms to copy products that are Cooperating With the Private Sector 63 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 core competencies of the lead firm. Hence private-sector technology providers, while interested in enhancing the efficiency of their value-chain partners, will seek to keep their own strategic assets secret and limit knowledge transfer or even suppress learning processes that might endanger their own knowledge edge in the area of their core competencies. Where business partners have access to critical knowledge, lead firms will try to prevent them from cooperating with competitors. In the same vein, companies often try to externalize risks and costs. For example, they may take advantage of information asymmetries to shift the risks of fluctuating markets to their suppliers, or they may externalize environmental costs. 2. Noncompetitive markets: Firms have an interest in establishing monopolies in order to obtain rents. Lead firms are defined by their ability to set and enforce standards, to coordinate and control large production networks, and to advance product innovations. All this raises barriers to entry and hence lowers the degree of competition. If lead firms gain too much control of the market, they may prevent competitors from serving the market and completely subordinate and exploit their supply-chain partners. Wherever firms seek to suppress technology transfer, to externalize social costs or to restrict competition, this creates a conflict of interests with governments and other local stakeholders. Further conflicts may arise with regard to the distribution of gains along the chain. Lead firms often try to diversify their supply base in order to weaken the bargaining power of suppliers and to be able to appropriate a larger share of value added. If they succeed in doing so, they restrict capital formation in local firms and may even drive local firms into bankruptcy. If local suppliers anticipate this opportunistic behavior, they may refrain from making technologically desirable specific investments. Both cases lead to underinvestment in the development of local clusters. The public sector in a given location should aim at increasing allocative efficiency of resources. The allocation of resources is efficient when it is not possible to improve the situation of any economic agent without penalizing another one. Policy-makers must therefore try to find an adequate balance between supporting lead firms in their efforts to upgrade the local business environment and pursuing public interests that are not fully congruent with those of the lead firm, e.g. to capture larger rents for local producers and consumers. As we shall see further on, this a constant source of tension in public-private partnerships. Finding the right balance becomes even more difficult when we consider that production networks compete against each other. Countries or industrial locations have an interest in increasing the competitiveness of those production networks which concentrate a considerable portion of value added within their boundaries. Take the example of a lead firm cutting costs at the expense of the margins of its local subsidiary or suppliers. While this obviously curtails local incomes in the short run, it may increase the competitiveness of the lead firm’s production net64 Tilman Altenburg OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 work, increase its market share and spur future investments. Local industrialists hence have to consider whether to support such cost-cutting measures or not. If local stakeholders strongly advocate their interests, lead firms may consider moving (or at least threaten to move) to another location (although in practice high sunk costs often prevent firms from doing so). All this presupposes a large measure of both strategic competence and willingness to cooperate on the part of key representatives of an industrial location. These are quite heroic assumptions. With regard to strategic competence, we have seen that competitive success is increasingly dependent on systemic conditions, and this implies that it is impossible to have all the relevant information. Contemporary concepts of industrial policy seek to reduce this problem by involving a large number of informed stakeholders in the planning process, as well as by designing planning procedures based on regular performance measurement and feedback loops to readapt targets and policy instruments. Even so, it is by no means clear whether the cost of collecting and processing all the relevant information and of implementing policies to increase locational spillovers will be lower than the benefits of such correction of assumed market failures (Chang 1996, p. 25). Even if policy-makers or other key representatives of the location have the informational means needed to take the right decisions, there can be no presumption that they will always be willing to serve only the public interest. Local stakeholder interests are heterogeneous, and local policy-makers obtain their legitimacy from representing different interest groups. The following points illustrate the diversity of specific stakeholder interests: 1. Lead firms may put pressure on the host country government to cut taxes and exempt them from certain requirements (e.g. mandatory national equity shares, compulsory contributions to skills development funds); if they fear competition they may lobby against the deregulation of markets; 2. Even within the local business community we may assume that interests diverge considerably. For example, some firms (especially less efficient competitors) may be threatened by new business models, while others (complementary specialist firms) may expect new business opportunities. Although these interest groups are usually less powerful than lead firms, they sometimes “have sufficient autonomy to develop and exercise their own strategies for upgrading, and they have the possibility of combining with other lesser firms to improve their collective situation within the network.” (Henderson et al. 2002, p. 21). 3. Civil society organizations advocate a broad range of interests, e.g. environmental concerns, labor issues, and business interests. Some of them are conflicting, e.g. the interests of trade unions and business associations. Governments represent these and other interests. The outcome of the policy process depends on patterns of how legitimacy is created in a specific government, Cooperating With the Private Sector 65 5 Schriften d. Vereins f. Socialpolitik 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 and this again may differ between local, provincial, and national governments (which in turn are superposed by regional and global institutions). It would be naive to assume that government institutions always take unselfish decisions in the optimally balanced public interest (as standard welfare economics is inclined to assume). First, government institutions provide an arena in which interest groups with different degrees of power vie to influence policy. As certain interest groups are better organized and more powerful than others, the outcome of this struggle will usually be biased towards them (Chang 1996, pp. 19 f.). It is likely that lead firms will be among the powerful actors, unless they are foreign and see themselves up against strongly nationalist governments. Therefore the possibility that individual interest groups will use their political connections to garner special favors, i.e. to pocket rents at the expense of consumers or taxpayers, is a real one. In some cases “regulation is acquired by the industry and is designed and operated primarily for its benefit.” (Stigler 1975, p. 114). Second, bureaucrats may pursue their personal interests, e.g. in increasing their salaries or the budgets under their control rather than seeking to optimize public welfare. Summing up, the optimal development of production networks may require some public action to maximize spillovers and embed lead firms in the local business environment, to improve the distribution of gains in favor of the host country and to avoid competition-distorting behavior and rent-seeking. This, however, requires considerable strategic competence and development orientation on the part of local decision-makers – neither of which can be taken for granted. F. Opportunities for development cooperation For about 10 –15 years now, development cooperation has been undertaking efforts to involve private-sector companies in the delivery of services that are critical for Third World development. New initiatives range from compensating firms for delivering development services that go beyond their core business – as in the German PPP program (Altenburg and Chahoud 2002) – to “Build-operate-own” (BOO) and “Build-operate-transfer” (BOT) arrangements in the provision of infrastructure and multi-stakeholder initiatives designed to define and enforce social and ecological standards in supply chains. Most major donors, including the World Bank, Regional Development Banks, UNIDO, USAID and DFID, have recently initiated specific programs to support strategic alliances with private-sector companies (see Demtschück 2004 for an overview). Private-sector participation is most extensive in infrastructure projects, where it increased considerably during the 1980s and 1990s, but suffered a major decline in the wake of the Asian financial crisis (World Bank 2001, p. 152; for a discussion of the reasons behind this decline see Wolff 2004; Krause 2002, pp. 4 ff.). 66 Tilman Altenburg OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 What are the main arguments for entrusting private companies with the task of delivering development services? 1. The internal production efficiency of private-sector companies is usually higher than that of public enterprises. This can both be explained theoretically and confirmed empirically. In private firms incentives for cost reduction are stronger, since private shareholders are subject to hard budget constraints and, given their own risk, willing to control more thoroughly the parameters relevant for efficiency (Shirley and Walsh 2000 discuss this in detail and provide empirical support). Public service providers often lack customer orientation as well as incentives to improve performance, especially if they are fully publicly financed and not subject to competition (unless hierarchical governance succeeds in creating sufficient pressure to perform). 2. Involvement of private-sector companies leverages additional capital for financing development. Private-sector capital may substitute for official development aid in countries and sectors with access to international capital markets, hence freeing up scarce public resources that may be targeted towards poor countries where markets are in many cases threatened with failure. 3. Synergies and complementarities between public and private actors may create productivity gains. On the one hand, development agencies may build on existing private initiatives, e.g. supporting spillovers from private investment projects; 14 on the other hand, public action may be indispensable, or at least helpful, to render private investment possible, e.g. by insuring political risks, facilitating dialogue with governments and civil society, supporting improvement of the legal framework, or fostering organizational development of public and semi-public institutions. 4. Cooperation between development agencies and the private sector may contribute to mutual appreciation and learning. It may raise awareness for development issues within the private sector, while development administrations may gain knowledge about certain management aspects in which the private sector is generally believed to be more efficient. Moreover, by showing that large firms in fact cooperate with development agencies, the latter hope to overcome their sometimes negative reputation of being bureaucratic, in this way becoming more generally accepted within the business sector. 15 The concept of lead firms is helpful to identify corporations with a specifically broad impact and outreach. As we have argued above, lead firms are the ones that are in command of technologies or brand names, control access to important markets, set sector-wide (or at least chain-wide) standards and influence other barriers Cooperating With the Private Sector 67 14 This is the focus of the “PPP facility” in German development cooperation. 15 This one of the main arguments for PPPs emphasized by the German Ministry for Economic Cooperation and Development: http: / / www.bmz.de / themen / Handlungsfelder / ppp/ ppp10.html #eins 5* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 to entry, and that select and sometimes support partner firms. Public programs to promote the economy, and especially SME policy, have to take this into account. If such programs involve lead firms in the program design and establish partnerships with them, public support services may become better adjusted to the needs of the SME customers (because lead firms know best what is needed to achieve and sustain competitiveness) as well as more widely accepted and implemented (because lead firms have the market power to enforce certain changes). Partnering with lead firm may help to resolve a broad range of development issues, e.g. to develop new markets for local products, to establish sector-wide labor and environmental standards, to develop local suppliers, to introduce new management techniques, to provide infrastructure services for the poor and to raise awareness of HIV / AIDS prevention, to name just a few examples. 16 Supply-driven government programs for local economic development, in contrast, where government institutions provide the technologies or training courses they consider to be relevant, and where bureaucrats choose the candidates to take part in support programs, often have a poor record, especially when their aim is to develop a national supplier base for international firms (cf. Altenburg et al. 1998, pp. 84 ff. for the case of supplier development policies in Mexico. See also Battat et al. 1996). Cooperation with lead firms will only succeed if these firms are willing to cooperate with the public sector on development issues. This raises the question why these firms should take any interest in strategic alliances. In fact, many companies are not willing to engage in cooperative arrangements with government institutions, pointing in particular to the high transaction costs involved. Those companies that do cooperate advance three main arguments (Altenburg and Chahoud 2002, p. 27): 1. Cost sharing: Public co-financing may cut the costs of necessary improvements in the value chain. 2. Legitimacy: The private sector (and especially transnational corporations) is often heavily criticized for exploiting Third World countries, for paying unfair prices, repatriating profits, evading taxes, bribing politicians, crowding out local competitors, etc. Criticism is especially pronounced in potentially polluting (mining, chemical, pharmaceutical) and labor-intensive industries (garment, footwear, toys, coffee). It is no coincidence that these industries are particularly engaged in corporate social responsibility, especially if they are associated with brand names. Working together with public development cooperation is seen as a mark of confidence and increases the legitimacy of the respective companies. 3. Complementary specialization: Among the specific competencies attributed to development agencies are their experience in dealing with governments and certain stakeholders (e.g. farmers or trade unions) and in supporting organizational development in different cultural settings. 68 Tilman Altenburg 16 For more practical examples visit the websites of the German PPP program (http: / / www.bmz.de / themen / Handlungsfelder / ppp / ) or USAID’s Global Development Alliance http: / / www.usaid.gov / our_work / global_partnerships / gda / ) OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Consequently, there appears to be considerable scope for win-win-situations: Public-private partnerships are a promising way of combining the financial resources and expertise of both parties, and both may increase their legitimacy by gaining the support of a broader constituency. Development agencies should therefore consider such partnerships wherever the private sector is willing to take part. However, three limitations need to be kept in mind: 1. The lead firm’s interest may not be in line with the public interest in the host country, especially where a lead firm may try to abuse of its market power to prevent local firms from upgrading into strategic business fields or to crowd out local competitors. 2. If obligations, cost sharing arrangements etc. are not well-defined, public-private alliances imply risks of abuse or waste of public resources, especially if considerable amounts of public subsidy are involved. The World Bank, for example, admits that “both in private infrastructure and contracting out of public services in general, there is a danger that the shift from public to private provision is associated with a breakdown of discipline and corruption”, and goes on to note that as long as new rules of public-private coordination are ill-defined, “opportunities for abuse increase. Many private schemes have, indeed, been associated with corruption in a number of countries.” (Klein and Hadjimichael 2003, p. 101.) Even if corruption can be excluded, there is always a considerable risk of creating windfall gains for the private sector, i.e. if the private partners receive public support for activities which they would have performed in any case. 3. Public-private agreements require additional processes involving transaction costs, e.g. for awarding projects, negotiating tariffs and monitoring performance. These costs may in some instances exceed the benefits of public-private cooperation. While the first restriction relates to an essential conflict of interests (and has therefore been discussed in the previous section), the other two may apply even if public and private partners pursue complementary goals, and they reflect, rather, inefficiencies in managing the partnership. The following paragraphs deal with the question of how to keep these costs low. To limit the risk of corruption, abuse and private windfall gains at the expense of the public purse, responsibilities among alliance partners need to be clarified and proper risk-sharing systems defined. Agreements should specify performance or outputs for which each partner can be held responsible, while partners from the private sector should be largely autonomous in choosing the best method for achieving the agreed goals (ibid.). From the point of view of development agencies, partnerships with the private sector make sense only if the public contribution triggers an additional development impact that goes beyond the impact that the private partner – in pursuance of his own interests – would have had anyhow, or that he is legally obliged to comply Cooperating With the Private Sector 69 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 with. If a firm receives public financial support for activities that are not additional in this sense, this represents a windfall profit for the firm and a waste of public resources, taking into account the fact that the subsidy has not been necessary to catalyze the achieved outcome – irrespective of the size and quality of this impact. The criterion of additionality is especially relevant, because many public private partnerships are being criticized for supposed violation of this principle. Even though no public program that aims at supporting the private sector can fully rule out unnecessary transfers, it is essential to clarify prior to every support program where the border runs between what, under the given market-based framework conditions, can be expected of the companies involved in terms of their own profitability calculations and where, accordingly, it would make sense to set additional incentives to induce the private sector to assume additional development-related commitments. The criterion of “additionality” is, however, difficult to define, because the transitions are fluid between the enlightened long-term, possibly even philanthropically motivated, interest of companies and the core areas of public goods, in which markets tend to fail. Furthermore, information is distributed asymmetrically, i.e. only the private partner knows what investments he would have made even without flanking support, and he may seek to gain as much support as possible for activities that lie in his own economic interest. In addition, publicprivate partnerships often give rise to interactive learning processes, the concrete results, costs, and risks of which are difficult to assess ex ante. Here there is no choice but to work with assumptions of plausibility. This, though, should not mean that the public partner is released from his obligation to weigh the cost-benefit relation as thoroughly as possible and to justify his decisions in this light. Finally, the aspect of transaction costs needs to be considered. As we have discussed earlier, there are some good reasons for governments and development agencies to contract out public services or enter into strategic alliances with firms. Yet we have also seen that this implies a series of principal-agent problems, because public and private actors may pursue partly different interests, and the private partners (the “agents”) have an incentive to maintain information asymmetries in order to negotiate favorable contract conditions, e.g. to maximize public support, to leave the expected outcomes relatively unspecific and to externalize risks. This again underscores the need to clearly define the contractual relationship, with the services, prices and the distribution of risks, etc. which it may entail as well as to reach agreements on targets and to monitor the extent to which such targets have been met. This causes costs – precisely under the conditions normally given bounded rationality and asymmetrical information. Summing up, production and trade increasingly take place in tightly coordinated production networks, and some firms – the so-called “lead firms” – increasingly dominate the rules of the game. Whether and under what conditions a network integrates producers from developing countries, whether it establishes barriers to entry that are too high for small producers, and to what extent it supports technolo70 Tilman Altenburg OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 gical learning increasingly depends on the lead firms. These firms may therefore be important partners for development cooperation. Using public funds to involve the private sector as a contractor or strategic partner in the delivery of services in development policy makes sense on condition that 1. it creates a positive development impact that goes beyond the effects the respective corporate investment would have had anyway; 2. this additional impact exceeds the additional transaction costs of the publicprivate arrangement as well as potential windfall gains accruing to the private partner at the expense of the public budget; and 3. the net benefits of the public-private partnership (after discounting the abovementioned costs) must be higher than the net benefits from an alternative public-sector intervention, i.e. opportunity costs have to be considered. “Value-formoney tests” should therefore be conducted to determine the price at which the public sector would be able to supply the service in question. In public tenders this would make it possible to define an upper price limit for which private suppliers would be permitted to offer the service (Klein and Hadjimichael 2002, p. 101). All in all, public-private partnerships make high demands on development agencies. In order to achieve win-win situations, the latter have to be able to communicate with unfamiliar partners from the business world, understand their rationality and estimate the adequate degree of public incentives to stimulate additional private sector engagement and minimize the abuse or waste of public resources. If development agencies learn to cope with these challenges and professionalize alliances with the private sector, these may make substantial contributions to development cooperation. References Aggarwal, R. (ed., 2000): Multinationals from Emerging Economies, Theory and Practice, Greenwich, CN. Altenburg, T. (2000): Linkages and Spillovers between Transnational Corporations and Small and Medium-sized Enterprises in Developing Countries. Opportunities and Policies, in: UNCTAD (ed.): TNC-SME Linkages for Development, New York and Geneva, pp. 3–61. Altenburg, T. / Bosse, D. / Brunzema, T. / Eckhart, J. / Unger, B. / Zeeb, S. (1998): Förderung und Entwicklung von Zulieferindustrien in Mexiko, Berlin (Deutsches Institut für Entwicklungspolitik). Altenburg, T. / Chahoud, T. (2002): Synthesebericht über die Evaluierung Public-Private-Partnership in der deutschen Entwicklungszusammenarbeit, Bonn (BMZ). Cooperating With the Private Sector 71 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 II. Dedication and commitment I consider the following aspect as crucial. In order to explain what I mean let me refer to the BMZ’s Concept for Development Cooperation with Latin American Countries (Bonn 2003), as a proxy for a variety of policy and position papers of the Ministry (BMZ = Federal Ministry for Economic Cooperation and Development). The Concept names as target dimensions the economic, social, ecological and political dimensions. Later, the same paper calls for mobilizing contributions of the private sector to social, economic and ecological development (p. 12). The political dimension mentioned above does not appear here, apparently leaving it to the state agents. Factually this can be considered realistic but in terms of development policy it is probably not meant since the comment of the European Economic and Social Committee on “The Role of Civil Society in the European Development Policy” states: “The political dimension of development is recognized within which the contributions of the public and private sectors, of civil society and the economic and social actors are equally indispensable. Only a close cooperation between all those social areas (what is meant is probably the different social actors, J.A.) can guarantee a coherent development policy and improve the efficiency of assistance” (EESC 2003, par. 3.2). I am not going to discuss this rather palish statement but would like to underline the following: obstacles to development are predominantly not of an economic but of a political nature. Much more important than efficiency or capacity problems – which can in general be solved – is the political determination of a government to develop its own country, including the utilization of all own resources. Dedication and commitment are the customary terms that name the hubs very strikingly. In this context let me quote a statement of Claudia Radeke. She is head of department of the Kreditanstalt für Wiederaufbau (KfW) and points out (Radeke 2003, p. 141) that – when she started working in development cooperation 20 years ago – the development level of Ghana was very similar to that of Thailand, South Korea or Malaysia. Today, the three Asian countries partly are donors themselves. During the 30 years of my own involvement in development cooperation while I have worked in some 75 non-European countries I often looked in vain for convincing evidence of the dedication and commitment of the partner governments to really develop their country. Instead, I have come across a large variety of not really serious declarations of intent. One aspect is the necessity of decentralization which is crucial for the private sector. Private investment is of course – and usually in large projects – also negotiated and influenced on the national level. But one strength of the private sector consists in the operations of small and medium enterprises (SMEs). I shall not expand on the well-known effects relating to employment, income, tax revenue, infrastructure, know-how transfer etc. My point is that private activities take place on the local level, and require local decisions. The basic environment for private 78 Jörn Altmann OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 investments is usually very much improvable since also in this context the political dedication and commitment to implement decentralization is often not sufficient. Of course there are positive examples such as Mali. 2 An increased integration of the private sector should, hence, not be burdened by unrealistic expectations. An efficient management of expectations implies considering the perception that private engagement cannot substitute the crucial and indispensable political engagement – in the sense of dedication and commitment of the government. Thus, concerning development policy, the contribution of the private sector can only yield lower ranking effects. This holds good even more so as the investment volume of public and private development cooperation taken as a whole is not apt to solve the serious development problems of the world. There are many external restrictions to development but I consider the internal restrictions usually to be much more important. The following sections analyse some issues relating to the impact of international agreements on the integration of the private sector into development cooperation and summarize some of the approaches applied in practice. III. WTO regulations and the private sector The WTO rejects all attempts to credit it with mandate in the field of development policy. But it does link trade in goods with ‘new’ issues – GATS (General Agreement on Trade in Services), TRIPS (Agreement on Trade-Related Aspects of Intellectual Property Rights), TRIMs (Agreement on Trade-Related Investment Measures), public procurements –, and this of course has significant effects on development policy in general and the role of the private sector in particular. In the course of the implementation of those agreements a massive strengthening of the private sector takes place worldwide, also – and in particular – in developing countries. As a tendency, enterprises in countries which are strong in exports or imports, will be able to enter sectors which where barred to them hitherto. In the course of realizing the WTO agreements the private sector will take over tasks which so far were the domain of public agents. But also this coin has of course two sides: positive effects for export-oriented enterprises are off-set by predictable crowding-out effects in developing countries, together with apprehensions relating to a deterioration of the supply situation of poor population strata (Altmann 2004). 1. General Agreement on Trade in Services (GATS) So far, in many countries the service sectors – among others water and power supply, education, or health care – were not open to foreign private suppliers beIntegrating the Private Sector 79 2See more extensive analyses of decentralisation policies in Altmann (2002) and (2000). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 cause, for example, governments sought to ensure certain quality standards, or favoured local employment. The objectives of the GATS are market liberalization, (implicitly:) privatisation, creation and safeguarding of competition, and domestic treatment of enterprises and investors in all domains of services. 3 This would rule out, for example, to give preferences to enterprises with local personnel. Existing entry restrictions would have to be abolished, including monopolies in postal services; restrictions for foreign equity participation in local enterprises as well as subsidizing local competitors would have to be abrogated. The GATS radiates also onto negotiations on freedom of establishment of enterprises and the free movement of the working force. The GATS excludes public services (which is a non-defined notion in the agreement) as well as air transport rights and directly related activities (except for maintenance and repair services). According to the GATS’ philosophy also traditionally public sectors should be opened to private enterprises, such as railways, postal services, telecommunication, energy and water supply (not the water itself, but the related services such as pipe nets or water treatment), education (kindergartens, primary and secondary schools, adult education, universities, distant learning), health care (foster homes, homes for the aged) or the audiovisual part of culture. Also excluded are emergency provisions and public procurements. According to the GATS, each state should decide on its own – by means of socalled commitments – which service sectors should be privatised and opened for international competition, and which ones should not. The latter may theoretically apply to all services, but above all to those areas which the country in question considers as core public competences. The WTO argues therefore that there was no coercion to privatise public services; the term ‘privatisation’ was not even included in the agreement’s text; even public or private monopolies were tolerable. Hence, governments could continue to organize certain services via public agents. This position stands on shaky grounds since the exemption clause is tied to two cumulative criteria (Sander 2003, p. 261 ff.): The service in question is neither offered commercially nor delivered in a competitive context. Should one of the two criteria not apply, the service is governed by the GATS, which implies to respect the MFN principle (and domestic treatment), a transparency liability 4 as well as an obligation of progressive liberalization (“in-built commitment”). Hence, the state has a covenant to facilitate market access in following negotiation rounds. 80 Jörn Altmann 3The service sectors also include tourism, leisure activities, transportation, communication of all sorts (incl. radio and television), commercial services (e.g. marketing and other consultancies), legal advice, trade, distribution, traffic, road construction, financial services (incl. electronic banking), insurances, construction, environment (waste and waste water disposal and treatment, audits), security, computer services, IT, and cardiac surgery. 4Transparency is understood by the GATS as the obligation to publish all relevant regulations and to establish information centres where foreign governments and enterprises can seek advice. In addition, the WTO has to be informed pro-actively on legal amendments in the domain of services. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 In consequence, the GATS will foster a vast inclusion of the private sector – above all from industrialized countries – into service sectors relevant to development policy. A central point of criticism is that private suppliers cannot be bound to offer their services all-embracingly so that above all the supply of social services would probably be thinner and more expensive. Should a country identify unfavourable developments in the course of time this could not be corrected: a revision of once liberalized sectors is de facto not possible as it requires a consensus of all affected countries and enterprises – which might include compensations. Consequently, many sectors might lose their political flexibility, and the decision structures of national, regional and local governments could be bypassed. 5 The history of origins of the GATS is marked by some not really democratic peculiarities on which I shall not comment here (Altmann 2004). 2. Agreement on Trade-Related Investment Measures (TRIMs) A multilateral investment agreement – which would be relevant for private activities – does not (yet) exist. The original initiatives of the EU and the USA concerning a comprehensive investment and investment guarantee agreement within the OECD – the Multilateral Agreement on Investment (MAI) – could not be realized and were abandoned above all due to the resistance of the French government following massive public protests in 1997 and 1998. (The USA had incorporated rather similar regulations already in Chapter 11 of the NAFTA treaty.) The ‘diluted’ remains of TRIMs – as part of GATT ’94 – comprehend merely five pages and do not introduce new rules or obligations, as opposed to GATS or TRIPS, but simply apply the existing GATT rules – however, only to goods and not to services. It goes without saying that this has far-reaching consequences as thus domestic treatment applies to investments in every economic sector. Herein lies the explosiveness of TRIMs. Given this, special regulations for foreign investors are not acceptable, notwithstanding the fact that several industrialized countries have exactly done this in the course of their own development, e.g. in form of capital controls (CCPA 2003, p. 6). The TRIMs agreement does not define what is meant by trade-related investment measures but confines itself to an annexed list of examples including e.g. minimum investment sums, entry restrictions for certain sectors, compulsory employment of local personnel or enterprises, compulsory transfer of technology, local content regulations, import restrictions, restrictions on transfers of capital or profits, or stipulating binding export targets. According to the agreement, such regulations are not allowed (Nunnenkamp and Pant 2003, Brooks 2003). They would have had to be Integrating the Private Sector 81 5“GATS is designed to facilitate international business by constraining democratic governance” (Sinclair 2003, p. 68) and “In reality, the GATS is more of a governance agreement than a trade agreement” (Lambert 2002, p. 1). 6 Schriften d. Vereins f. Socialpolitik 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 abolished by 2000 already, but numerous countries have made use of the possibility to extend the time limit while the question has remained open as to which evaluation processes and criteria are to be applied (CCPA 2003, p. 8). Factually the EU, USA, Canada and Japan – as complainants against such extensions – have insisted that the countries in question negotiate bilaterally with them and seek a case-by-case consensus, drawing on the existing WTO threat-potential for breach of agreement. Most of the TRIMs-related complaints submitted to date to the WTO related to the automotive and the food processing industry. The present discussion focuses above all on the question whether the TRIMs Agreement prohibits regulations concerning foreign investments (which is denied by the WTO) or whether it merely prohibits a discriminating treatment of goods in the context of foreign and local investments (which is maintained by the WTO). Opponents to an investment agreement defy the possibility that an investor might sue a country – by reference to a TRIMs or MAI agreement – for compliance with the investment regulations, and claim compensation for breach of agreement (investor-state lawsuit), as it is anchored in the NAFTA treaty. Given the absence of a multilateral investment agreement one observes the conclusion of bilateral agreements. Germany has done so with more than 130 partner countries, worldwide there may be more than 2100 bilateral investment agreements (FUE 2003, p. 4). The investment issue will remain on the WTO as well as of the Doha agenda. Many developing countries want to treat foreign investors differently than local ones in order to influence local development processes and protect weak local industries against strong competition from abroad. Industrialized countries maintain that such discrimination and the lack of investment guarantees virtually render the investments required (and desired) impossible. It is well possible that the industrialized countries will prefer a system as in GATS, which offers the host countries a choice which sectors they would subordinate to an investment agreement. Since WTO agreements are de facto irreversible the governments then would have no possibility to revise taken decisions. Opponents of the TRIMs call less for a WTO investment agreement than for the establishment of binding international rules for transnational enterprises, e.g. a UN convention stipulating both the rights and obligations of investors: corporate accountability including liability (FoEI 2002). C. Approaches to integrating the private sector into development cooperation I. Investment promotion in the investing and in the host country On the national level of investing countries flanking measures are necessary in order to promote the intended integration of the private sector into development 82 Jörn Altmann OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 cooperation. I shall not expand on well-known instruments such as tax incentives, investment protection or investment guarantees by the investor’s country, or institutions such as the the Multilateral Investment Guarantee Agency (MIGA; it is part of the World Bank group). Analogous measures in the host country and capital (re-) transfer agreements between the investor’s and the host country increase the incentives for private investors. Also, an improved transparency of privatisation measures and tendering of international donors add to a positive investment climate. Many observers deplore the intransparency in advertising public tenders. 6 It should be added that private investments, which are expedient in terms of development policy, may have a downside with regard to a dislocation of jobs from industrializing countries. Often there is a clear conflict of objectives. And also in this context there is a problem of delimitating incentives for new investments against windfall effects when investments would have been made anyway. The World Bank, the IMF, and regional development banks propagate a privatisation of public enterprises, above all of municipal utilities. Such investments can also be co-financed. Quite often public institutions are cut down to their profitable components (Klaus Gihr of KfW has called this the “decoration of the bride” (Hoering 2003)), staff is reduced, liabilities are transferred off-balance or re-scheduled, and subsidized financing made available. As a tendency, this results in a reduction of employment, and in turn in rising prices of goods and services. This is the ‘classical’ conflict between pure market efficiency and income redistribution, which I shall not discuss further. According to the existing regulations of WTO – to be more precise: of GATS – it is practically impossible to call off privatisation measures, that do not live up to expectations. II. Co-financing and build-operate-models On several levels specific investment facilities are offered, e.g. by the European Investment Bank (EIB), the World Bank, the German KfW-DEG Group, the Agence francaise de Developpement (AfD), USAID etc. They are based on longterm loans, guarantees and equity, and are increasingly handled by the private banking sector. 7 This is meant to reduce the risk that external financial assistance will flow – via state banks – to politically suitable debtors. A corresponding structuring of the allocation criteria may foster sectoral or regional accents. But financial assistance is a monetary instrument. As pointed out above, however, the central and crucial problems are predominantly of a political nature (similarly Radeke 2003, p. 142). It is primarily in industrializing economies that private enterprises have given impulses to economic development. As also Altenburg states in his paper, the activIntegrating the Private Sector 83 6See e.g. Sow 2002, p. 23 f. and Hope 2002, p. 29. 7http: / / www.eib.org / news/ press / press.asp?press=2597 (21. 6. 2004). 6* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 ities of the private sector in developing countries lead to barely surveyable positive development effects. This suggests bringing public and private actors together. Usually this takes place as a co-financing where the public partner partly, and often entirely, shoulders the investment. The concept of such PPPs is part of multinational, European, and since the mid-90s also of the German development cooperation – first called “development partnerships” and now “strategic partnerships for sustainable development”. Both within the Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ) (on behalf of the BMZ), and on the level of the German Lander, PPP councils were established, above all for the infrastructure sector. 8 The starting point is not the promotion of German enterprises but the mobilization of a private contribution to social, economic and ecological development, which would not materialize without public participation. Co-financing and PPP are instruments which can be used in different sectors, e.g. in environmental protection or social infrastructure, or give targeted support to medical, pharmaceutical or technical research. 9 Non-economically oriented co-financing, though, is much less frequent. As to investments in infrastructure, a variety of models of operation have been developed, e.g. the BOT (Build-Operate-Transfer) or the BOO (BuildOwn-Operate) concepts, including leasing systems, while the delimitation between contracting-out and outsourcing is blurred. The cost-benefit ratio of PPP is not always favourable in terms of development policy. The list of counter-arguments is long: 10 –Critics maintain (e.g. Hoering 2003, p. 12, Altenburg and Chahoud 2003) that, given a scarcity of public funds, more and more tasks are transferred to private enterprises, but the benefit in terms of development policy is often non-existent, above all not for LDCs and for poor population strata. –PPP projects concentrate in industrializing countries (threshold countries) (China, Brazil, South Africa) which are attractive for the participating enterprises in any case. PPP is above all successful where it is not that much needed: in economically appealing countries or sectors. On the other hand, PPPs are much less successful with regard to the ultimate task of development cooperation, namely poverty reduction. –In some infrastructure sectors dualism develops: profitable sectors (“fillet steaks” such as water, electricity, education) are privatised, other sectors – on which the vast majority of the population has to rely – depend on public institutions, the financing of which becomes even more difficult as public funds are partly absorbed by PPP. 84 Jörn Altmann 8http: / / www.uni-weimar.de / Bauing / bwlbau / seiten / position / pos12200.htm (13. 5. 04). 9In 2003, the BMZ has supported an aids research project by DaimlerChrysler, also including infectious diseases and the development of antibiotics. 10 Altenburg has named some of them in his paper. See more extensively Altenburg and Chahoud 2002 and 2003. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 –Often the focus is on pure investment or economic promotion which results in the fact that the participating enterprises – not seldom large enterprises – can reduce their costs while transferring their risks to the public partner. In most projects the private share is small, and in German PPP projects the share of public funds is often 100 per cent (Hoering 2003, p. 4). –Public funds “follow” private funds instead of being targeted on sectors where they would be required in terms of development policy. –Many such measures would have been executed anyway – the well known free rider phenomenon. –Few projects are oriented towards the requirements of poverty reduction; expensive high-tech approaches are dominant as opposed to low-tech /low cost approaches. –Although in principle it would be appropriate to strengthen the political, economic and regulatory frameworks, PPP predominantly enhances the micro level. This is why one should prefer a grouping of activities, and PPP should focus more on large-scale cooperation with the private sector (Altenburg and Chahoud 2002) at the meso level of institution building in the host country, e.g. on chambers of commerce or crafts or governmental institutions. Because of the cited methodological constraints and the relatively small absolute volume, the benefit of PPP in terms of development policy is in total considered to be of little relevance (Altenburg and Chahoud 2003). 11 III. Capacity building by enterprises from industrialized countries Very many staff from developing countries is trained and gains experiences when working in and for enterprises from industrialized countries. This holds good both for employments in enterprises residing e.g. in Germany and those operating in host countries. The extent of such capacity building and its impact on the development of the home countries of such staff is not obvious but cannot be valued highly enough. This entails a vast profile of qualifications, ranging from professional competences in the strict sense over transfer of technology and soft skills to intercultural competences. And those effects are to be considered win-win scenarios since both the home and the host countries (and enterprises) benefit largely; Altenburg, too, elaborates this aspect in his paper. Staff placements themselves cannot be integrated into development policies since this is the sole responsibility of the enterprises. What is possible, though, is the integration of the preceding education and training in German universities. Integrating the Private Sector 85 11 Blank (2003) is of a different opinion. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Although the latter is predominantly borne by the state, the ensuing professional training on the job takes place within the private sector and is a private contribution to development policies. IV. Private capital funds In capital funds of the type referred to here the investor buys a liability from the financial market. He excuses the debtor from the obligation to repay in hard currency. Instead, the debtor has to pay the equivalent of the title in local currency into a counter-value fund while the exchange rate is subject to negotiation. The fund’s capital is utilized for the objectives defined by the creditor. This may relate to a commercial investment project, a development or environment project (debt-for-development or debt-for-nature swaps) or others. In practice commercial swaps are by far the most important. Independently from a development enhancing investment of the funds, the major advantage of such a system lies in the reduction of the indebtedness and the corresponding debt service. The attractiveness for the private investor lies in a favourable exchange rate, besides other potential benefits in the context of his investment (e.g. tax incentives). Also in cases where the capital investor is a public agent, a private component may derive from the capital management being contracted to private enterprises. Their efficiency advantage, though, is retrenched by the disadvantage that local capacity building is restricted accordingly. V. Micro-financing by “people’s banks” An instrument which is known since long and applied successfully, is microfinancing. The Grameen Bank in Bangladesh is considered originator of this concept. It was founded in 1983 by Professor Muhammad Yunus who was nominated twice – but in vain – for the Nobel Prize. There is no need to expand on this wellknown concept again, but it is a classical example of a private initiative. From the original ‘gamete’ several successful spin-offs have developed worldwide, both in industrialized and developing countries, and in many different sectors. 12 VI. Integration of altruistic agents Altruistic foundations and funds In many countries we can find impressive examples of private institutions which are successfully engaged in development cooperation. This includes the colourful 86 Jörn Altmann 12 See a comprehensive and innovative analysis in Schmidt and von Pischke (2004). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 bouquet of NGOs and private foundations which are to be ranked – as opposed to the political foundations – among the private development agents. I shall not elaborate on the engagement of NGOs, only one sentence: the scene is not at all homogeneous as to the objectives pursued; NGOs are not always altruistically oriented, some are well influenced by large commercial enterprises or a government (also Walk and Brunnengräber 2001, p. 13 ff., Brand 2000, p. 16 ff.). Private foundations come in Germany less to the fore, contrary to the USA, but there are many more than is vastly known. They usually pursue long-term programmes, quite often up to 10 or 15 years or more, which enhances the development of mutual understanding and respect (Scott 2003, p. 117). Their concept is not marked by social engineering but is based on own engagement and participation of the participating parties. 13 Such concepts can be promoted by –tax privileges (Scott 2003, p. 118), e.g. with regard to donations, or inheritance tax regulations fostering foundations; –tax exemptions for interest from foundations’ investments; –issuing of ethically motivated soft loans, that is the investor subsidizes the raising of funds (Lichtblau 1999, p. 88 f.); such loans, however, exhibit only very small volumes. Sponsoring A promising field is the sponsoring of development-relevant activities or projects – hospitals, kindergartens, sport clubs, orphanages, etc. As a rule, the objectives of the participating enterprises lie not so much in the issue in question rather than the sponsor-pursuing image or media effects. Such expenses reduce his income and profit taxes so that – theoretically – investment incentives could be enhanced by offering more tax incentives. “Fair trade” Nobody knows exactly how many third world shops, action groups and initiatives exist in Germany alone. Generally they aim at guaranteeing higher prices to the producers than the emotionless commercial market would allow. The share of such initiatives in world trade – although well meant – is in total very small. VII. Cooperations between the private sector and NGOs In some respect the dividing line between altruistic and commercial concepts becomes blurred. NGOs (Greenpeace, Amnesty International, WWF, FoE, etc.) put Integrating the Private Sector 87 13 I must say that I am very much surprised that one should attempt to depict something as qualitative as an altruistic motivation in a quantitative model (see e.g. Calmette and Kilkenny 2001). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 mixture of three alternative allocation mechanisms – democracy, bureaucracy and groups of economic interests. Whether bypassing market mechanisms will actually lead to an efficient use of resources, however, remains to be seen. Given the rather mixed past experience with mostly public development assistance, there is ample reason to be sceptical. II. Scarce financial resources The MDG are mostly directed at improving social indicators. Their implementation falls mainly under the purview of state protagonists – in line with the forum in which they have been negotiated and adopted. So it is proper to ask what public resources are available for the task. According to the OECD, development assistance funds disbursed by official donors in 2003 amounted to USD 59.1 billion, slightly more than the mean ODA figure for the past years (OECD, 2004a, p. 134). The ratio of ODA to Gross National Income has fallen significantly since the 80ies, and it is stagnating at a rather low level (see Figure 1). Source: OECD 2004a Figure 1: Official Development Assistance (ODA) The World Bank estimates that additional funds of around USD 50 billion would have to be made available each year to meet the MDG on schedule by 2015 (see also Reisen 2004, p. 5). The financial gap for the last four years thus only amounts to around USD 200 billion. Given the obvious financing gaps the donors undertook explicitly at the March 2002 Monterrey Summit to adhere to the MDG and increase their financial contri94 Rainer Durth 0,00 0,05 0,10 0,15 0,20 0,25 0,30 0,35 ODA/GNI 1986-87 average 19911992 average 1998 1999 2000 2001 2002 ODA ratio of donor countries over time OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 butions. Thus, the Federal Republic of Germany, like the other EU states, has pledged to raise the share of German ODA in GDP to 0.33%. A look at the historical development of German ODA (Figure 2) shows that aspiring to this goal in only two years is very ambitious in the present and expected budget situation. For the next two years this would require an annual increase of roughly USD 1 billion, which is in contrast to the fact since the early 1980s the German ODA ratio has actually shrunk by around 0.01% per year! Source: KfW Figure 2: German Official Development Assistance (ODA), as a share of GDP In other words, both at the national and the international level only a fraction of the funds regarded by experts as necessary to achieve the MDG will be available by 2015. At the same time the share of ODA in the capital flows to developing countries has declined continuously. In spite of all this, however, it must not be forgotten that around six times as much capital is being provided for investments from domestic savings in developing countries. Considering this decline in the relative importance, it will become more and more urgent to define how ODA should be designed in the future to achieve the greatest possible developmental impact with the available scarce resources. III. Relationship between bilateral and multilateral development cooperation The new development policy approach is based on an ongoing local dialogue involving the local government, the local civil society and the other donors. Participation in the dialogue presupposes local presence, which typically can hardly be Tapping Financial Markets for Bilateral Development Cooperation 95 0,25 0,27 0,29 0,31 0,33 0,35 0,37 0,39 0,41 0,43 0,45 0,47 0,49 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 managed by most bilateral donors. Multilateral donors that have developed new instruments like PRSP, in turn, benefit from scale effects in many developing countries. As a consequence, the relative importance of bilateral donors decreases while that of multilateral donors increases. What under the catchword “donor coordination” presents itself as a welcome process may have negative consequences as well: –Donor coordination enhances the above trend towards grants and a development cooperation that is unrelated to the market but oriented towards state institutions and political processes. –Development projects are less “visible” in the donor countries, and in the medium term this is also likely to influence the willingness of their populations and politicians to make payments. As a result of donor coordination, less ODA will then be available worldwide in the medium term. 3 –The development cooperation landscape loses diversity, and an international development bureaucracy may arise that dominates national debates and players who inevitably lack critical mass. In the medium term this development bureaucracy could turn into a sort of supply monopoly on the implementation of development cooperation, and competition (among donors) as a discovery procedure could be eliminated, not least at the expense of many poor people and countries. C. Complementarity as a criterion for designing bilateral German development cooperation The new development policy approaches associated with the MDG obviously change the practice of development cooperation. In particular, they cause multilateral development cooperation to focus more on cooperation with public agencies and through the use of grants. Bilateral development cooperation is then forced to decide whether it wants to pursue the same goals on the same path with fewer funds – for instance through closer donor coordination. Under the (bold) assumption that the path taken will make the greatest possible development impact and donor coordination will at minimal effort lead to a success that is comparable to that of multilateral development cooperation, there are good statistical reasons for taking this path. From a dynamic, long-term point of view, however, this decision causes problems: After all, the bilateral donors can, at best, be just as good as the multilateral ones, but at the same time they cannot achieve the formers’scale effects because of their smaller size; so the bilateral resources could then be utilised more effectively for development investments through multilateral channels if these have the necessary ex96 Rainer Durth 3This reflects the experience that has been gathered under the OECD Consensus, for example; see for instance OECD 2004b. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 pertise. The result would be the multilateral development bureaucracy mentioned above which would have the character of a monopoly or, at best, an oligopoly. To avoid such a developmentally obstructive monopoly, bilateral development cooperation could be deliberately positioned to complement multilateral development cooperation. This would mean stepping up the support for project executing agencies and projects that are no longer at the centre of attention or can no longer be supported under multilateral development cooperation. At first glance, this would particularly affect private sector and, in some cases, municipal executing agencies as well as infrastructure projects. But bilateral development cooperation could not only attempt to reach out to different types of executing agencies and implement projects that are necessary though of lower rank as measured against the MDG. It could also systematically seek to increase the resources for development investments by making it possible to tap not only the tight state budgets of the donor countries but also the steadily growing international capital markets. To achieve this, the classical financing instruments of bilateral development cooperation need to be expanded. In this connection the complementarity of bilateral development cooperation acquires a double meaning. For one, it should complement the contributions of other donors and, for another; it should not distort the market and substitute purely commercial financings. In short, it must also be complementary or subsidiary to commercial financings. This means there must be a genuine demand for the financing that would exceed the capacities of the private players in such a way that they are incapable of achieving the necessary degree of goal implementation in the foreseeable future. The interventions made by bilateral development cooperation should then be aligned with the market as closely as possible, they should not weaken the initiative and responsibility taken by individuals, and they should strengthen the ability of individuals to solve their problems themselves as help towards self-help (see section D.V). The influence of bilateral development cooperation on private economic activitites shows a second and more current direction: Whereas in the past the idea was to help German enterprises tap the markets of large developing countries, today it is possible to help developing countries and selected project-executing agencies access the international markets. This enables them to tap a new, large source of funding which cannot be left unutilised for the realisation of the Millennium Goals given the enormous financing gaps. Used intelligently, bilateral development cooperation funds can have a strong catalyst effect, making possible maximum development impacts at a comparably low financial cost. Tapping Financial Markets for Bilateral Development Cooperation 97 7 Schriften d. Vereins f. Socialpolitik 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 D. The instruments of German bilateral financial cooperation At the UN conference “Financing for Development” held in Monterrey in 2002 Germany promised to contribute towards realising the MDG by durably raising its ODA ratio. With budget funds for development cooperation declining and the year 2015 approaching ever faster, a significant increase of Germany’s ODA contribution is currently feasible only if the scarce budget funds can be increasingly complemented by market funds. As discussed above, this approach is appropriate also in viewof the international division of tasks in development matters, and it is a developmentally welcome approach because it permits “harder” infrastructure investments to be realised with private-sector actors. In particular, it opens up new possibilities for innovative approaches in the area of Public Private Partnership (PPP). To be able to take this approach, the financing instruments of German Financial Cooperation were thoroughly expanded in the last few years. 4 They range from traditional grants to loans with largely flexible terms that almost match those of commercial banks. This way the partner countries for the first time are offered a complete set of financing instruments under bilateral development cooperation. The “value added” for the recipients thus tends to shift from favourable financing terms to the offer of financing and implementing expertise for developmentally sound projects. I. FC grants and FC loans: pure budget funds Grants and loans are the classical instruments of German Financial Cooperation (FC) (see Figure 3). They employ federal budget funds only. Accordingly, the approval of specific projects lies exclusively with the German Ministry for Economic Cooperation and Development (BMZ). –Grants. Grants are extended to the Least Developed Countries (LDC). Countries that do not belong to the LDC may receive grants as well if projects are to be supported in specific sectors, for instance self-help oriented measures for poverty reduction or social infrastructure. –Loans at IDA terms. These loans have a maturity of 40 years with 10 grace years and an annual interest rate of 0.75%. The grant element of these loans is over 80% (untied loans). IDA terms are generally available to all countries that obtain funding from the World Bank subsidiary, the International Development Association (IDA) at these terms. –Loans at standard terms. Loans at standard terms run for a term of 30 years with 10 grace years, at an annual interest rate of 2%. They are available to all countries that are listed in Section 1 of the DAC list and do not have access to more favourable terms. 98 Rainer Durth 4In addition, innovative financing instruments for the realisation of the MDG are also being discussed at the multilateral level. A current overview is offered by Reisen 2004. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Source: KfW 2004 Figure 3: Financing Instruments in German Financial Cooperation 2003 II. FC development loans: mixture of budget and market funds German FC has known the possibility of mixing budget funds with market funds since as far back as the 1960s. The basic idea that applies to all mixing instruments is to augment the scarce but very favourable budget funds by adding commercial market funds. The result is a bigger loan with less favourable terms. In what way the funds are augmented depends on the project to be supported. However, since the Federal Republic bears only a portion of the loan-loss risk at best – unlike in pure budget funds – some of the risk remains with the implementing organisation for FC, Kreditanstalt für Wiederaufbau (KfW), which thus needs to give its conTapping Financial Markets for Bilateral Development Cooperation 99 Financial Cooperation (FC) •Grants •Loans - IDA terms - Standard terms Development Loans: •Mixed Financings •Composite Financings •Loans at Subsidised Interest Rates FC Promotional Loans DEG Funds ·Participations Budget Funds (2003: EUR 1,085 million) Market Funds (2003: EUR 932 million) Mezzanine Financings Loans Guarantees 7* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 sent to a financing operation in each individual case. Overall, the harder loan terms and the commercial handling of loan-loss risks exact greater selectivity when it comes to choosing projects and borrowers. –Mixed financing. Mixed financing combines budget funds earmarked for a specific country with market funds, with the economic and political risks of the market funds covered by an export credit insurance agency – such as Hermes – against a fee. Market funds are employed at market interest rates at full cost coverage. They usually run for a term of 10 years with five grace years. Mixed financing has been around since 1963; it is the classical market-mixing instrument. To what degree the loans must be tied to supplies usually depends on what export credit insurance company is providing the coverage. –Composite Finance. Composite finance combines budget funds at IDA terms with commercial funds into a single loan (a “tranche”). The loan has a maturity of 25 years with 10 to 12 grace years. The risks for the market funds are not covered by an export credit insurance but by the Federal Republic, which created a coverage instrument specifically for this purpose in 1994, the Guarantee Limit for Composite Financings (volume in 2004: EUR 2 billion) administered by the Federal Ministry of Finance. Accordingly, there are no limiting country ceilings. This financing instrument, however, is available only for countries with a low to medium risk (currently up to Hermes category 5). Composite financings mobilised an investment volume totalling EUR 211 million in 2003. –Loans at subsidised interest rates. Under the loans granted at subsidised interest rates, which were employed in 2001 for the first time, a purely commercial loan is given at an interest rate reduced to such an extent by subsidies from the federal budget that the loan acquires the quality of development assistance. The risks are borne 100% by KfW which, however, is able to insure itself by other means. The loan term is typically 10 to 12 years with 2 or 3 grace years. At present only Hermes category 2– 3 countries qualify. Loans at subsidised interest rates were granted in a total of EUR 76 million in the year 2003. All FC development loans can be granted untied to supplies and qualify as ODA without restriction so long as they achieve the grant element required. Adapting the blend of the loan funds and terms accordingly makes it possible to take accurate account of the profitability and eligibility of specific projects. This should make them interesting particularly for infrastructure projects that generate a positive cash flow. Besides, adding capital market funds significantly increases the possible volume of investment. In comparison with a simple grant, a loan extended at a subsidised interest rate, for instance, can provide an amount that is 10 times as high for development aid investments, with the same cost to the federal budget. In terms of development policy, there is a big, only partly developed potential for the combined utilisation of budget and market funds. The latter currently account for around 12% of German FC; the use of FC development loans is limited by the 100 Rainer Durth OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 availability of budget funds and the willingness of the federal government to assume more of the risks associated with market funds. The natural area of operation of FC development loans is in developing countries which hitherto have no access to the capital market. Here they can be used to finance economic and social infrastructure projects. However, this requires the Federal Republic to assume the corresponding risks and, in some cases, the willingness to mix budget and market funds in a proportion that is more favourable for the recipient countries. But FC development loans are also an option in countries that already have access to capital markets. Particularly the various financial crises of the 1990s have shown that development setbacks still pose a threat to many industrialising countries. Here FC development loans offer a possibility for continuing development cooperation that is easy on the budget. A demandbased selection of cooperation priorities, however, is a precondition in these countries. This implies not only that loans at near market-level terms exact a greater sense of ownership of the partner but also that there must be a deliberate search for priorities where there may be win-win situations for the donors as well as the recipients. German expertise is in relatively high demand in the energy or environment sectors, for instance, suggesting that they may be focal areas in industrialising countries. III. FC promotional loans: market funds for official development investments Finally, since 2002 development investments may also be financed under FC with funds raised by KfW in the capital market and in which the Federal Republic neither assumes the risks nor provides a grant. Interest rates, maturities and grace years can be agreed freely; simple direct loans and structured financings are possible, but also complex project financing and even equity investments (for instance in micro banks). To be eligible for financing, however, a project must be regarded by KfW and the BMZ as deserving of support against development policy criteria and as an acceptable risk. FC promotional loans are not mixed with any budget funds so they do not qualify as ODA but merely as “other official flows” (OOF). In return, however, they are not subject to the establishment of priorities and the requirements of the BMZ on country limitations. They are nevertheless acknowledged to contribute to BMZ sector objectives, for instance in the promotion of renewable energies. Borrowers may be governments but also private entities; unlike for other FC instruments, a government guarantee is not necessary. In 2003 FC promotional loans were already granted in a volume of EUR 246 million. The developmental advantages of the FC promotional loans are that they can mobilise additional capital for development investments. Presupposing that the projects have a corresponding innate effect, this makes an additional contribution to the realisation of the MDG. Besides, they give Financial Cooperation greater latitude. Tapping Financial Markets for Bilateral Development Cooperation 101 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 In particular, existing executing agencies can be supported in the transition from concessionary to commercial financings, and new target groups can be included, for instance for the promotion of the private sector in developing countries. Although budget funds are not available for FC promotional loans and the Federal Republic assumes none of the risk involved, meaning they are granted on KfW’s own responsibility, there is an agreed procedure for this financing instrument that gives the BMZ the necessary political competence for intervening. It is based on the official mandate which the BMZ gave KfW in 2002. On this basis KfW identifies concrete projects in developing countries and involves the BMZ in the development rating and financial planning as early as possible. If both procedures are successful, a passage is introduced into the agreed minutes of the intergovernmental negotiations that secure the debt service towards KfW and demands KfW to be treated on a par with international financing institutions. Finally, KfW reports briefly to the BMZ once a year on all new FC promotional loans. Adding FC promotional loans to the financing instruments of German FC is designed to close the gap between concessionary and commercial financings. However, FC promotional loans not only constitute a natural addition to the existing FC instruments; in return, they can also be strengthened by embedding them into the expertise and concessionary development cooperation instruments. Moreover, the diversification of the financing tools will help German bilateral cooperation better meet the criterion of complementarity to multilateral donors on the one hand and private-sector creditors on the other. In this discussion, two problem complexes always become apparent: subsidiarity and risks. IV. DEG funds: market funds for development investment of the private sector As part of KfW Bankengruppe (KfW banking group), DEG – Deutsche Investitionsund Entwicklungsgesellschaft mbH – is committed to promoting the private sector in developing countries. Its financing activities are specially tuned to the needs of private enterprises. DEG offers capital to companies for investments in developing and newly industrialising countries. This capital can take the form of private equity participations, mezzanine financing, loans, and guarantees at market-oriented conditions. It is used to finance sustainable, profitable, developmentally effective, and ecologically as well as socially viable projects in sectors such as manufacturing, agriculture, infrastructure and services. DEG invests in local financial markets to enable reliable access to investment capital in the partner countries. To date DEG has cooperated with more than 1,100 companies. Financings were given in a total of EUR 5.6 billion, enabling an overall investment volume of EUR 37 billion. DEG pursues the objective of strengthening and expanding private-sector structures in developing and industrialising countries. This is intended to form 102 Rainer Durth OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 a basis for sustainable economic growth and a lasting improvement of people’s living conditions. In the year 2003 alone DEG financed new investments totalling EUR 500 million. V. What does subsidiarity mean for financial cooperation? Bilateral development cooperation based on the criterion of complementarity must be defined against other donors as well as against possible private-sector players. While the more recent development policy approaches described above are rather designed to mend the failure of state mechanisms, bilateral cooperation that is also based on commercial resources should concentrate on identifying and palliating market failure. In the context of developing countries, this classical line of reasoning for economic policy action means an attempt at supporting projects that either produce sufficient positive external effects or public goods, or at mitigating information or adjustment deficits in existing markets. The leverage of official development assistance is likely to be particularly strong in the financial sector, which typically is susceptible to considerable distortions. Worldwide ODA is only less than 3% of total development investment channelled through this sector. But the development of a suitable financial sector infrastructure can raise the allocation efficiency substantially and far beyond the ODAvolume in many countries. The principle of subsidiarity is applied to FC promotional loans with the idea of consistently pursuing the goal of efficiency: FC may not intervene unless there is a need and unless this need demands too much of private players or unless their solutions are less helpful (Collin 2001, p. 47 ff.). The task demands too much of private players if their ability to solve it is inadequate from a general economic viewpoint. The latter could also mean that the private sector can be regarded as not being up to the job if it develops suitable activities yet is incapable of attaining the economically necessary degree of goal achievement over a measurable period of time. Consequently, promotional activities can also be carried out additionally to private-sector activities (“When”). Once a need has been established, and if public action is suitable for remedying the situation, the question arises by what means the assistance should best be provided. Intervention is subsidiary if it conforms to market mechanisms as much as possible, does as little as possible to weaken people’s own initiative and increases as much as possible people’s abilities to solve their problems themselves as help towards self-help (“How”). For bilateral development cooperation the insistence on market conformity means that development projects as well should be financed at market terms wherever their commercial profitability so permits. Funds at concessionary terms are necessary particularly when the market as a system fails because of external effects or public goods. Nevertheless, the financing instrument should always be chosen in accordance with the limitations of the individual case at hand. The creation of competition – for instance in the financial sector – directly Tapping Financial Markets for Bilateral Development Cooperation 103 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Economic Assessment of Pension Systems Based on the Human Capital Approach: The Outlook for Reform in Chile and Malaysia By Oskar Gans, Heidelberg We will begin by asking to what extent economically viable pension systems can be identified and then discuss potential ways of constructing efficient paths for adjustment. Following this, we will consider how the real-world reform of government pension systems in Chile and Malaysia should be evaluated against this background, and deal with the need for reform that may be derived from such an evaluation. Where appropriate, German efforts at reform will also be taken into account (see also: Sachverständigenrat 2003, p. 216 ff.). A. On the efficiency of alternative pension systems The discussion will center around the two fundamental pension procedures, namely the pay-as-you-go (PAYG) system and the fully funded (FF) system. In order to describe how each system functions, the recommended approach is to start with an exogenous macroeconomic development. However, we can dispense with this approach in this paper (see e.g. Homburg 1988, pp. 13 – 29). Our primary interest lies in the macroeconomic effects of alternative methods, including those of the specific shape of each respective procedure. The chosen economic model has a decisive impact on these effects. This may seem self-evident but in political debates its meaning appears to get lost time and again. I. Traditional lines of argument The only adequate way to analyze the economic impact of pension systems is by using multi-period models. In actual fact, central theorems have been derived from traditional neoclassical growth models – either in rudimentary or in fully completed form – which fundamentally assume identical descriptions of supply conditions but differ considerably by the imputed intertemporal preference function. 1 1The Solow model contains a “non-system” element – from a neoclassical perspective – by assuming an exogenously given savings ratio. By introducing an intertemporal preference function, the saving ratio is endogenized. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Despite these differences, they all have one thing in common: they endogenize the savings ratio and thus, with regard to inputs, exclusively endogenize the formation of physical capital. It is therefore not surprising that the economic effects of alternative pension systems can be defined precisely in terms of the formation of savings. With regard to the intertemporal preference function, two extremes may be distinguished (for a clear explanation, see Romer 1996, p. 38 ff.). In the first case, households optimize their consumption decisions across a finite number of periods (for example: Period 1 as the working period and Period 2 as the period of retirement), and each generation is interested only in its own consumption (Diamond overlapping generations model). In the second case, there is a given number of identical households with an infinite life-span; 2 i.e., in contrast to the Diamond model, a household does not disappear after (e.g.) two periods; it therefore optimizes its decisions based on an infinite time horizon. What is decisive is that there are no intergenerational conflicts of interest in this model (Ramsey-Cass-Koopmans model, in the following: “RCK model”). 3 1. Efficient procedures (1) Let us briefly explain the impact of the introduction of an FF or PAYG system in the Diamond model (see e.g. Homburg 1988, pp. 49 – 60). If an FF system is introduced, then private saving falls by exactly the amount of the unearned premium reserve, i.e. macroeconomic capital formation remains unchanged. This is because households regard private saving and saving credited to their FF system as perfect substitutes. Under certain conditions, 4 the PAYG has exactly the same effect on private saving because pension claims obtained in this system are also regarded as saving. The key difference between the two procedures lies in the fact that in the PAYG aggregate saving falls, as, in contrast to the FF system, the contributions paid to the pension fund do not represent a sacrifice in macroeconomic consumption; instead, they are disbursed to, and consumed by, the generation in retirement. (2) The further-reaching question of the efficiency of the two procedures is of interest to us, although we must note that the amount of capital accumulated does not per se allow us to draw conclusions on the efficiency of an economic development path. In the context of the ideal model world which we have conceived here, 112 Oskar Gans 2In such a model, pensions do not exist in the form of an intergenerational exchange of benefits between the working population and the retired population. Nonetheless, one can still analyse the extent to which the mandatory introduction of a PAYG or FF system impacts on the intertemporal allocation process. 3One implication of this model is the validity of the Ricardian equivalency theorem. 4The growth rate of wages must be equal to the interest rate. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 however, the answer is clear: since a (Pareto) efficient state is being assumed for the initial situation and the FF system does not change this economy to any major extent, the FF system is then also efficient. 5 By contrast, the PAYG is inefficient because it creates incentives to accumulate less capital than in the initial situation. Given these results, however, one is tempted to ask whether it may be assumed without any further ado that in the case of exclusively private pension provisions the path of growth is always efficient. In fact, for a Diamond economy, the possibility of an “excessively high” saving ratio and thus dynamic inefficiency can be demonstrated – and this despite the assumption of a completely competitive system (see e.g. Romer 1996, p. 81 ff.). This outcome does not violate the fundamental welfare theorems because the latter are based on a finite number of agents while the possibility of dynamic inefficiency is based on the assumption of an infinite number of generations. In such a scenario, an adequately funded PAYG is efficient because it reduces the saving ratio to a level that corresponds to the Golden Rule and thereby benefits the present generation and all future generations despite less being saved (Aaron’s Paradox). Numerous convincing arguments have been brought forth against this efficiency theorem (for more on this, see Gans 1996, pp. 55 –60). It must also be noted that not even the establishment of a PAYG is necessary to reduce the saving ratio. (3) In the RCK model there is no selection problem concerning the FF and PAYG systems because neither procedure, on balance, changes the intertemporal allocation process. In the case of the FF system, the same line of argument as in paragraph (2) may be applied. With regard to the introduction of a PAYG system, it behooves us to remember that such a procedure is equivalent to substituting government debt for taxes. If the Ricardian equivalency theorem holds (see footnote 6), the latter is, as is well known, ineffective. In the following, the RCK model is credited with having a reference function. In the following we will assume a model of overlapping generations; however, we do not want to rule out the possibility that, borrowing from the RCK model, a generation might also be interested in other generations’ well-being, which could be specifically taken into account by, for instance, introducing a hereditary motive. 2. Efficient adjustment paths (1) For reform discussions which can revolve not only around parametric changes within existing systems but precisely also around a transition to an alterEconomic Assessment of Pension Systems 113 5The analysis is based on the simplifying assumption that a private and voluntary FF system is efficient. In addition, we will assume that, with the FF system imposed by the government, savings are generated which are not larger than those generated in the private and voluntary FF system. These assumptions do not fundamentally alter our line of argument. 8 Schriften d. Vereins f. Socialpolitik 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 native method, it is not enough to identify efficient procedures using a comparative dynamic approach. Rather, it must also be asked whether it is possible to construct (Pareto) efficient adjustment paths. Welfare economics suggests such a possibility because the criterion of the potential Pareto improvement, assuming no-cost redistribution in the post-reform stage, posits the primacy of efficient conditions before inefficient conditions (see Gans und Marggraf 1997, p. 56). Within the existing model framework, which allowed only intertemporal allocative distortions, such an efficient transformation path, however, cannot be derived (see Breyer 1989). Homburg (1988, p. 87 ff.) presents a contrary view. He begins by showing that the losers of an introduction of a PAYG (= all future generations) are able to compensate the winners (= “introductory generation”) for the PAYG not being introduced. According to Homburg’s line of argument, the collective Equivalent Variation (EV) of the introduction of a PAYG is negative ((i) EV (1 !2) = EV (FF system !PAYG) <0) (see Gans und Marggraf 1997, p. 135) for a sufficiently large number of participating generations. From this undoubtedly accurate statement, Homburg concludes that, if an PAYG has already been introduced, the abolition of the PAYG would then be worth it. Accordingly, the (collective) Compensating Variation (CV) of this measure ((ii) CV (2 !1) = CV (PAYG !FF system)) would be positive, which comes as no surprise because of (iii) EV (1 !2) = – CV (2!1) (Gans und Marggraf, p. 136). However, in that case it would not be permissible to conclude from EV (FF system !PAYG) <0 that CV (PAYG !FF system) >0 if, in the second case, the negative effects emanating from PAYG on macro-economic capital formation have already cropped up. For now, EV (1 !2) in equation (iii) refers to another economy than – CV (2 !1), i.e. the latter has relatively little capital at its disposal. At best, the implicit debt inherent in the PAYG can be converted into an explicit government debt to be paid off by future generations, though that would not change anything about aggregate capital formation because the PAYG and the explicit government debt represent intergenerational transfer mechanisms that have the same impact; i.e. the PAYG is actually not surrendered at all by this transformation. An argument against this “pessimistic view” is that the abolition of the PAYG and the introduction of the FF system create an efficiency potential which would, in principle, enable the Pareto efficient transfer from the PAYG to the FF system. It is argued, for instance, that the PAYG distorts households’ labor supply decisions (Breyer 1989) something that the introduction of an FF system can help to avoid. It is also stated that, by taxing capital gains, the intertemporal consumption decisions are distorted in favour of present consumption, and that the FF system works against this distortion. The flaw in this and similar arguments is that the changeover from the PAYG to the FF system is generally neither necessary nor the firstbest solution for eliminating distortions outside the pension system (for more see Sinn 2000, p. 398 ff.). For this reason, they are also not suitable as evidence of the existence of a Pareto optimal adjustment path. 114 Oskar Gans OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 II. The Human Capital foundation of pensions Since the debate about the economic effects of pension systems is being conducted in the framework of conceptions of theoretical growth models, arguments for or against certain procedures have changed in line with advances in growth theory, as one could expect. Merely the explicit inclusion of human capital in the macro-economic production function invites one to conclude that the capital foundation of pension, in a departure from the traditional PAYG/ FF system discussion, should not depend solely on physical capital. Furthermore, especially for the problem of dynamic inefficiency, one may suppose that it can be nearly ruled out if physical capital formation is accompanied by human capital formation, the latter therefore counteracting the potential decline in the marginal productivity of physical capital. And finally, one may simply be surprised at how the one-sided focus on physical capital could have prevailed for as long as it did. Atrulyrigorous continuation of the debate on the efficiency of pension system is not possible without a link to a (new) growth model. Endogenous growth theory offers two basic versions: (for more, see the clear description given in Frenkel und Hemmer 1999, p. 173 ff.): A first version explicitly models the R&D sector, while a second, using the Uzawa-Lucas variant, includes not only physical capital formation but also explicitly the production and accumulation of human capital. Since we want to adhere to the concept of capital foundation, it seems appropriate to assume a human capital model. 1. Lucas’ overlapping generations model (1) The centerpiece of the human capital model developed by Lucas is the production function of the educational sector, in which human capital is produced: _ hB1uththt:1 In this model, htdenotes the prevailing stock of human capital (per capita of the working-age population) and _ his growth over time. utis the percentage of disposable working time deployed in the tangible goods sector, with the percentage 1utaccordingly being accounted for by the education sector. Brepresents a technology parameter, a rate of depreciation. For a given utoutput _ his a linear function of the extant human capital. To take account of overlapping generations in this model, discrete time intervals are introduced: htht1B1ut1ht1ht1:2 If the human capital stock of the previous period is completely written off in each time interval (1, this gives us: Economic Assessment of Pension Systems 115 8* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 htB1ut1ht1:3 (For this and the following, see Wigger und v. Weizsäcker 2003, pp. 437 – 459.) Although the human capital stock available to the working population of the period t1(= retirees of period t) is completely written off, the human capital endowments of the overlapping generations are coupled to one another. Generation thas an increased amount of human capital at its disposal as the deployment of human capital of the generation t–1 in the education sector rises. Let us ask, further, how high the wages of a worker of period t1 w t1to be derived from the production of tangible goods is if a human capital unit is paid a wage of wt1. Let w t1ut1ht1wt1:4 ut1ht1gives us that human capital which the workforce offers to the tangible goods sector on the labor market in period t+1; the rest is, as we know, used for human capital formation. To create a relationship between workers’ wages in the period t+1and workers’ human capital decisions of the period t+1, we use the human capital recursion described in equation (3). This gives us: w t1ut11ut11utB2ht1wt1:5 The wages of workers in period t1 w t1accordingly rise with increasing working time spent on human capital formation (measured as 1ut) by persons who are retired during the period t1. Apparently the marginal product of investment in education 6 in period tequals: @w t1 @1utut11ut1B2ht1wt1:6 If one assumes that, in an overlapping generations model, each generation is interested only in its own income (its own consumption), then equation (6) describes a marginal return which does not accrue to those who created it (or to whom the creator would allow this return to be given). It is therefore an externality which is indicative of suboptimal human capital formation and therefore of inefficiency in competitive equilibrium. 116 Oskar Gans 6This marginal return falls as investment in education increases although human capital production itself shows constant marginal returns, for the change in w t1is derived from the production of tangible goods, into which human capital goes, with the production function of the tangible goods sector displaying the usual neoclassical features. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 This must be separated from the question of whether this inefficiency can be eliminated in a Pareto improving manner. The elimination of inefficiency alone requires the payment of wages up to the marginal return on investment in education to the working population of period t(“Pigou subsidy”). Since in a neoclassical setting the yield of the human capital formed in period tthat occurs in period t1exceeds the subsidy to be paid in period t, every generation may be made better off through intergenerational transfers. It would be possible to finance the subsidy, for example, via government debt in period twhich would have to be paid off by the working population of period t1. By establishing a PAYG system in which the workers of period t1pay a pension equivalent to the subsidy amount (plus interest) from their increased wages – owing to human capital – to the pensioners of the same period, the same effect is achieved. 7 Apparently a PAYG system of this type is efficient. (2) With regard to the reform debate in Germany it must be noted that a PAYG system already exists in this country, within which workers actually pay old-age pensions to retirees from their wages. The key criterion for evaluating this measure, however, is that, at the households’decision-making level, there is hardly any link between today’s human capital formation and tomorrow’s old-age pension. 8 It must, in addition, be explicitly noted that the (imputed) efficiency of a PAYG modified in line with the human capital approach must not be misinterpreted as a sign of inefficiency of an FF system! Rather, it follows from the human capital model that households, in their pension decisions, should include, alongside physical capital, also the formation of human capital, which seems attainable by eliminating the distortion discriminating against human capital. Just as was often indicated formerly that the FF system, too, is ultimately a PAYG system because the workforce always has to provide for retirees, now one could argue alternatively that the combination of a “classical” FF system and a modified PAYG is not different from an FF system with a tangible assets and a human capital foundation. 9 (3) Finally, it is of special interest to discuss the extent to which the inclusion of the human capital approach into an overall reform in Germany increases the chances of constructing a Pareto efficient transition path. In a departure from the Economic Assessment of Pension Systems 117 7It is by no means necessary to impose the burden of financing a subsidy entirely on the working population in period t1because the retirees of the same period benefit from higher interest income which is attributable to increased human capital formation (Wigger und von Weizsäcker 2003, p. 449 f.). To that extent, the intergenerational transfer that is associated with the PAYG is just one of many options. 8Wigger and von Weizsäcker regard the inclusion of vocational training periods in the calculation as an element of such a chain. 9From the vantage point of endogenous growth theory, however, it is not possible to speak of “symmetry” of the two types of capital because the only way to sustainably increase the growth rate of per-capita income is through an increased accumulation of human capital. This matter is not without significance for the long-term income securing function of capital as – conversely – the destruction of human capital is much more difficult to repair than the destruction of tangible assets. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 examples given in Section A.I.2, the unused efficiency potential lies in the pension system itself. It is, therefore, possible in principle, too, to identify Pareto efficient adjustment paths which lead from the current system (traditional PAYG in pure form) to a comprehensively reformed system (an FF system in combination with a modified PAYG). The question of whether this can be used to actually justify the theory that substituting an FF system for the traditional PAYG actually enables a Pareto improvement will be discussed below. 2. The Becker / Murphy / Tamura model (1) Additional information about how to design a pension system that is (also) human capital-based can be obtained by breaking down in greater detail the process of human capital production. It makes sense to take account of children as the carriers of human capital which becomes productive when the children have grown up. Becker, Murphy and Tamura (1990, pp. 512– 537) describe a model with (identical) individuals who live for two periods. In the first period, namely childhood, individuals accumulate human capital, and in the second period, adulthood, they work in the tangible goods sector, devote part of their time to rearing children, and the rest of the time to forming human capital; at the end of this second period they die. From this model, which explains fertility and thus the number of children endogenously, multiple steady states can be derived, two of which are stable: one with economic underdevelopment and one with sustained growth of per-capita income. (2) For our purposes, this model cannot be applied without modification, either. Although it contains overlapping generations, with each working parental generation providing for its children, it has no retirees, who likewise have to be supported from the incomes generated by the working-age population. For conceptual purposes and therefore without any additional explicit formalization, let us add a third (retiree) generation to this model and see what additional knowledge this gives us. The central issue here is how the working age population’s decision-making parameters, i.e. the number of children and thus the time needed to raise children 10 as well as the time invested in forming human capital (with working time spent in the tangible goods sector as a residual) can be applied for overall optimization, including the retirement period, if externalities are ruled out. Apart from minor modifications, this approach and the Lucas overlapping generations model share the production function of the human capital sector. The key difference, however, lies in the role that the number of children plays in the decision-making process, which means that we will largely confine ourselves to this factor. 118 Oskar Gans 10 The time spent on educating each child is an exogenously given constant in the model. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 In such a model the consequences for the selection of an efficient pension system are trivial if externalities are ruled out, because the various amounts of retirement paid to each retiree are the result of the optimization process. The only interesting thing is how to calculate, in such a model, those externalities that are not the result of internalized returns on the formation of human capital. And if one decides to go without a formal presentation of the mechanics of the model, what remains is the plain finding that, if a PAYG modified toward the human capital approach is introduced, pensions can also be defined in terms of the number of children because they play a key role in the amount of human capital formed. In the interest of giving concrete shape to the PAYG, this makes it necessary to abandon the previous assumption of homogeneous generations because it is precisely the number of children that sets families apart. In order to compensate for external returns on human capital formation in a manner in line with the causes, it is additionally necessary to differentiate these compensation amounts according to the respective contributions of the number of children and the per-child spending on education toward the development of human capital. (3) Before roughly outlining the concept of human capital-based pensions, let us conclude our theoretical explanations by asking how significant it is for the extent of externalities if the utility function of a generation talso contains, as arguments, the utility of future generations. The RCK model, into which human capital decisions are easily integrated, provides us with a helpful reference point. The intergenerational externalities disappear in such a model because the utility items of all generations are entered into the one intertemporal utility function without any differentiation. However, any attempts to influence individuals’ decisions regarding the intertemporal and intergenerational allocation of resources are bound to fail because government intervention inevitably provokes compensatory counter-reactions by the private sector. Although retirees do not occur in the model set forth by Becker, Murphy and Tamura, in this model an approach is used with the help of which the extent of the externality may be explained. The model distinguishes between an egotistical and an altruistic motive for child-rearing and human capital formation. According to this, it is clear that strong (weak) externalities may be expected when the egotistical (altruistic) motive predominates, i.e. child rearing and the associated human capital formation are primarily construed as investment (consumption) activity. 3. Questions regarding the concrete shape of an efficient overall system (1) A number of different shapes of pension procedures can be derived from the concept of human capital foundation. Box 1 outlines such a possibility. Economic Assessment of Pension Systems 119 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 In Germany, the debate surrounding reform (on this see, e.g., Fehr 1999, pp. 175– 214) points both towards strengthening the fully funded pension as well as taking into account the number of children within the existing PAYG system. Such a strategy is unlikely to be transferable to the Chilean case, especially as the possibility of “revitalizing” the old PAYG system through restructuring is likely to be a non-starter. It might be possible to sell a reform strategy in which the progress already made in dismantling the old PAYG system is, in principle, continued in unchanged fashion, with the human capital-oriented reform measures being launched in the new FF system. It might help to view an FF system as an overall system which is funded by both tangible assets and human capital (see Section A.II.1). If one assumes given benefits and autonomous financing of such an institution, then the contribution rates need to be differentiated by number of children and / or other human capital-related features. 21 What this means for childless contribution payers, for instance, is that the return on their capital would be relatively low. C. Pension system in Malaysia As in the case study for Chile, we begin by describing the starting situation followed by a brief outline of the extant government pension system, including its performance. Then, on this basis, we will study options for a human capital-based reform in a third part of this section. I. Starting situation The formal pension system in Malaysia is based primarily on a type of (statutory) pension insurance composed of the Employees Provident Fund (EPF), the Pensions Trust Fund, the Armed Forces Fund, the Malaysian Estates Staff Provident Fund and the Teachers Provident Fund (Fuentes Iriarte 2003, p. 106). Of these, the EPF is by far the most important element; and it is for that reason that we will discuss only this element in further detail. The second pillar of the pension system is based on an informal intra-family system in which the old are provided for by younger members of the family. It can be called an intra-family PAYG. This type of social security is considered more significant than the statutory pension insurance scheme (Peng and Chang 1994, p. 217 f.; Jones 1993, pp. 282– 286). 126 Oskar Gans 21 Particular significance is to be attached to the latter in developing countries and emerging market economies with relatively high fertility rates in order to avoid misincentives. In addition, the intensity of parents’ reactions, or ability to react, to such signals depends on government educational policy. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 II. The “Employees Provident Fund” 1. Characteristic features In Box 3 we have compiled some key features of the EPF. 22 Box 3 Features of the Malaysian EPF What the EPF has in common with Chile’s new pension system is that it also works according to the funding principle. However, the insurance elements are so insignificant that one can more closely describe it as a compulsory saving system than a pension insurance system (Gans 1996, p. 53). The insurance against the income and longevity risk is additionally impaired by the fact that a considerable percentage of the saved amounts may be withdrawn from the fund for certain purposes (e.g. house building, children’s university education) before the contribution payer enters into retirement. 23 Economic Assessment of Pension Systems 127 22 Information based for the most part on Fuentes Iriarte 2003, pp. 107 –111. 23 This contrasts, however, with the use of these funds for purposes that also include pension. Procedure: FF system More of a compulsory saving system than a pension insurance system Participants: All non-self-employed persons compulsorily insured Financing (Contribution rates): 2000: 21% of labor income (Employees’ share: 9%, employer’s contribution: 12%) Voluntary contributions possible Benefits: Disbursements: Mainly as lump sums upon retirement, invalidity, death Pre-retirement withdrawals are significant Different disbursement modalities Government regulations: Government organization Government payments to AFP only as loans OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 The interesting element from a fundamental policy standpoint is that, unlike in Chile, private institutions are not competing to manage money in funds; instead, the EPF is a governmental organization. However, the rules for government payments to the AFP are a reflection of skepticism of the “western-style” welfare state arrangements. Although the government assumes the task of paying benefits if the fund is unable to, these payments are made only as a credit. II. Microeconomic and macroeconomic performance 24 Comparisons for the 1980 – 1999 period show that the yield on fund money was at least as high as that on investments having a similar level of risk. The fund, however, is unable to sufficiently insure against income and longevity risk if one takes as a basis the actual amount of average EPF savings at the time that the insuree person insured enters into retirement, as, among other things, it is necessary to factor in the pre-retirement withdrawals that have often been made. Since benefits are usually disbursed as lump sums, a notional pension has to be calculated for comparative purposes. In 1990 this pension was far below the poverty line. Regarding the impact of the EPF on aggregate capital formation, 25 there are some signs of a violation of the so-called law of neutrality, according to which savings with the fund only substitute for private savings. Potential positive effects of the EPF may, among other things, be attributable to the fact that for some groups of persons the compulsory saving with the fund exceeds saving that would otherwise have been voluntary. III. Possibility of a Human Capital – oriented reform (1) The aim of the debate on reform in Malaysia (Fuentes Iriarte 2003, pp. 122 – 123; Tan Sri Lee Siow Mong 1986, pp. 35–49) is – not surprising considering the starting situation – a change in the current system that goes much further than in Chile. The centerpiece is the transformation of the compulsory payment system towards a “real” pension insurance system with insurance against income and longevity risk. (2) The starting situation in Malaysia appears to be extremely favorable regarding potential starting points for a human capital-based reform. For one thing, since there was never a statutory, collective PAYG system, there is no past “mortgage” in the form of an implied government debt that needs to be paid off. Moreover, as 128 Oskar Gans 24 Information based on Fuentes Iriarte 2003, pp. 111 – 119. 25 In a departure from the Chilean case, a comparison with a PAYG system is not possible as such a system never existed in Malaysia. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Asian societies have private intra-family “pay-as-you-go” procedures, precisely the idea of human capital-based pension is not foreign. In addition, the following arguments in favor of a collective system can be derived from the disadvantages of such individual solutions: high risks through death, disease or lack of professional progress of the children; loosening of family ties and the gaps in the system they produce and the increasing perception of financial dependency of the elderly. However, resistance to reform is to be expected. The fact that, if one assumes the idea of an overall FF system covered by tangible assets and human capital, the equivalency principle is simply more difficult to operationalize for human capital than for financial / physical capital, is likely to be significant here. Moreover, one cannot dismiss the political argument that collective systems are vulnerable to redistribution policies that can put the equivalency principle in grave danger. D. Summary (1) Using a traditional analysis of pension systems, i.e. based entirely on tangible assets, it may be shown that an FF system is efficient whereas a PAYG system is inefficient. What does not follow, however, is that, if a PAYG system already exists, a (Pareto)efficient transition to an FF system is possible. Attempts to construct efficient transformation paths that would counteract distortions on other markets with the introduction of an FF system (“opening up of efficiency potential”) have been unconvincing. (2) In economies with endogenous human capital production, the latter is associated with externalities and thus suboptimal. The resulting inefficiency of competitive equilibrium may be eliminated by a PAYG system that complements the FF system if it is designed as a system for remunerating investment that has been made in education. Models with endogenous fertility, modified adequately, provide further indications of ways to design the system. The assumption of homogeneous generations has to be sacrificed because families differ from one another in the number of children, which in turn has a key impact on the individual contribution to human capital formation. In addition, the Becker / Murphy / Tamura model uses an approach with the help of which the extent of the externality can be explained. (3) Even if one decides to adopt a total system in which a traditional FF system is combined with a PAYG system that internalizes externalities, there is further scope for concrete design features. Moreover, coordination with other policymaking areas is necessary. Economic Assessment of Pension Systems 129 9 Schriften d. Vereins f. Socialpolitik 308 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 If one, on the basis of the German situation, assumes that a PAYG system exists, then an overall reform can be divided into two separable partial reforms (PAYG system !FF system and establishment of a modified PAYG system respectively). Since efficiency gains only occur in the second partial reform, it is impossible to construct a (Pareto) efficient adjustment path from the PAYG to the FF system here either. If, in actual fact, one confines oneself only to the second reform, this amounts to a “revamping” of the traditional PAYG system. For acceptability of a reform to society, group-specific patterns of burdens are significant; these, too, are dependent on the extent and the speed of reform. If one chooses, for instance, an overall reform in the above sense, this subjects certain groups of persons to multiple burdens. (4) In Chile the changeover in government pension insurance from a PAYG system to an FF system was launched in 1980. According to estimates, the PAYG system will be extinct by the year 2050, i.e. up until then two different schemes will exist side by side. The implicit deficit of the old PAYG system still existing when the system is changed will be paid off out of the government budget. In the new pension system, all non-self-employed persons are compulsorily insured. The capital stocks are managed by private institutions (“Administradores de Fonds de Pensiones”) that compete against one another; the “Superintendencia de Administradores de Fonds de Pensiones” acts as a supervisory authority. The system contains welfare state elements: there are (conditioned) government guarantees for a minimum pension and for a minimum yield on fund capital. Compared with Germany, the outlook for the success of a human capital-based system reform appears to be favorable because the dismantling of the old PAYG system has already made major progress. In the light of the thorough reform launched in Chile in 1980, the given reason for which was precisely the superiority of an FF system against an PAYG, the acceptability of additional reform is likely to be very low. Unlike Germany, the old PAYG system as a basis for a reform (“revitalization”) would not come into question anyway, i.e. the (new) FF system would have to be designed as an overall system in which a human capital foundation exists alongside a tangible capital foundation. (5) Malaysia’s statutory pension insurance is dominated by the “Employees Provident Fund”. Although the procedure on which this system is based can be called an FF system, it is more of a mandatory saving system than a classical pension insurance scheme. The fundamental policy characteristics differ from those of the new FF system in Chile, too: the capital is managed by a single government organization, whereas the welfare state elements of the Chilean system are not present, either. The conditions in Malaysia appear exceptionally favorable for a human capitalbased reform. For one thing, there is no statutory PAYG system, which means that, in a total reform, it is not necessary to pay off a “mortgage” in the form of an implicit government debt. In addition, the Malaysian society is supported in great 130 Oskar Gans OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 measure by intra-family transfers between generations. In this so-called second (and most significant) pillar of old-age insurance, which may be termed a voluntary private PAYG, the human capital foundation plays a key role, i.e. thinking in such categories is not foreign to this society. Based on the disadvantages of such a system (risks through death, disease or lack of professional progress of children; loosening of family ties), it is only one step toward a collective PAYG system organized by the government. Resistance to reform, however, is still to be expected, especially if many are afraid that the equivalency principle will be severely impinged upon. References Becker, G. S./ Murphy, K. M. / Tamura, R. (1990): Human Capital, Fertility, and Economic Growth, Journal of Political Economy, Vol. 98, pp. 12 – 37. Blankart, C. B. (2003): Zur politischen Ökonomie von Rentenentscheiden, in: Rose, M. (Hrsg.): Integriertes Steuerund Sozialsystem, Heidelberg, Physica, S. 385–396. Breyer, F. (1989): On the Intergenerational PARETO Efficiency of Pay-As-You-Go Financed Pension Systems, Journal of Institutional and Theoretical Economics, Vol. 145, pp. 643 – 658. Fehr, H. (1999): Welfare Effects of Dynamic Tax Reforms, Tübingen, Mohr Siebeck. Frenkel, M. /Hemmer, H.-R. (1999): Grundlagen der Wachstumstheorie, Munich, Vahlen. Fuentes Iriarte, R. (2003): Der Humankapitalansatz zur Gestaltung staatlicher Rentensysteme. Theoretische Konzeption und potentielle Umsetzung in Deutschland, Chile und Malaysia, Lohmar, Eul. Gans, O. (1996): The Economics of Social Security in Developing Countries: Positive and Normative Considerations, Economics, Vol. 54, pp. 44 – 67. Gans, O. / Marggraf, R. (1997): Kosten-Nutzen-Analyse und ökonomische Politikbewertung 1, Berlin, Heidelberg, New York, Springer. Homburg, S. (1988): Theorie der Alterssicherung, Berlin, Heidelberg, New York, Springer. Jones, G. W. (1993): Consequences of Rapid Fertility Decline for Old-Age Security, in: Leete, R., Alam, I. (eds.): The Revolution in Asian Fertility: Dimensions, Causes and Implications, Oxford, Clarendon Press, pp. 275–295. Peng, T. N. / Chang, T. P. (1998): The Changing Age Structure and its Implications for Malaysian Society, in: Soon, L.Y., Shyamala, N. (eds.): The Seventh Malaysia Plan: Productivity for Sustainable Development, Kuala Lumpur, University of Malaya Press, pp. 203 – 221. Queisser, M. (1993): Vom Umlagezum Kapitaldeckungsverfahren: Die chilenische Rentenreform als Modell für Entwicklungsländer?, Munich, Cologne, London, Weltforum. Romer, D. (1996): Advanced Macroeconomics, New York et al., McGraw-Hill, pp. 494 –522. Economic Assessment of Pension Systems 131 9* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Rose, M. (1998): Konsumorientierung des Steuersystems – theoretische Konzepte im Lichte empirischer Erfahrungen, in: Krause-Junk, G. (ed.): Steuersystem der Zukunft, Berlin, Duncker & Humblot), pp. 247 – 278. – (2003): Vom Steuerchaos zur Einfachsteuer, Stuttgart, Schäffer Poeschel. Sachverständigenrat (2003): Staatsfinanzen konsolidieren – Steuersystem reformieren (Jahresgutachten 2003 / 2004), Stuttgart, Metzler-Poeschel. Sinn, H.-W. (2000): Why a Funded Pension is Useful and Why it is not Useful, International Tax and Finance, Vol. 7, pp. 389– 410) Tan Sri Lee Siow Mong (1986): Social Security – A Practitioner’s Point of View, ASEAN Economic Bulletin, Vol. 3 / 1, pp. 35 – 49. Werding, M. (1999): Umlagefinanzierung als Humankapitaldeckung: Grundrisse eines erneuerten Generationenvertrages. Pay-as-you-go Public Pension Schemes Revisited: A Draft, Jahrbücher für Nationalökonomie und Statistik, Vol. 218, pp. 491 –511. Wigger, B. U. / Weizsäcker, R. K. von (2003): Rentenfinanzierung und inter-generationelle Gerechtigkeit: Eine wachstumstheoretische Perspektive, in: Rose, M. (ed.): Integriertes Steuerund Sozialsystem, Heidelberg, Physica, pp. 437 –459. 132 Oskar Gans OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 Family Decisions Affecting the Formation of Human Capital By Rainer Marggraf, Göttingen In his article Oskar Gans assesses pension systems making due allowance for the fact that such systems have an additional effect on the human capital of a society. His analysis is conducted with respect to the macroeconomic perspective. Since the formation of human capital is based upon decisions made by members of the society every macroeconomic analysis is based on how individuals would react to the implementation or a change in a pension system. Therefore, in order to understand and evaluate the results of the macroeconomic analyses, one must examine the microeconomic hypotheses upon which the results are based. Oskar Gans’ article is based on microeconomic ideas regarding human capital formation developed by the Chicago School, which is presented and discussed below. Individuals invest in human capital through their own and their children’s education and continuing education. The effects of pension systems are especially important with respect to investing in human capital through children. Therefore, I will concentrate on this aspect in the following discussion. In Section A, a family decision model in the Chicago School tradition is presented, which includes the number of children and the human capital formation of each child as endogenous variables. Implications for a positive analysis of pension systems are discussed in Section B. Section C examines the question of how normative analyses can be conducted if human capital, and thus also the population, are endogenous variables. A. A rational choice model of family economics The systematic economic analysis of the family in the Chicago tradition began in the late 1950’s with articles by Harvey Leibenstein (1957) and Gary Becker (1960). Particularly, Gary Becker has written numerous articles (e. g. Becker 1991, 1992) that have contributed to further development of the economics of families. The core of family economics is formed by a one-period comparative static framework in which a couple has agreed upon a mutual utility function. This utiOPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 lity function is defined by a vector of non-marketable commodities produced in the home Z0such as good health, nutrition and entertainment. UZ01 Z0z0 jj1;...;m The parents act as if they want to maximize (1) given their limited capacity to produce the household commodities. These commodities are produced with inputs of a vector of market goods and services (x j ) and a vector of time inputs (t j ) of the family members. z0 jfjtj;xjj1;...;m2xjxk j tjtk jk1;...;r The input of purchased goods is limited by the lifetime monetary income of the family which, in turn, is equal to the lifetime market earnings of the family (the product of market wage (w) and labour time) and of non-labour income (V). The amount of the family’s time available for household productivity is equal to the life span of the family members (T) minus labour time. Both restrictions can be combined to the following restriction: pZZ0wTVI3 pZpzjj1;...;m In equation (3) p Z represents the vector for the marginal costs of the household commodities. The sum of the total value of the life span of the family members and of non-labour income is usually called full income (I). Parents take care of their children. Their utility depends positively on the wellbeing of the latter. Therefore, the well-being of the children is included in the household commodities. Parents can influence the welfare of their children by investing in the children’s human capital as well as by legacy (l). It is generally assumed that parents do not discriminate between their children. The amount of planned human capital hper child is the same for all children. Assuming that parents are able to compare the utility of their children, we get the altruistic parental utility function UZ;Uin;h;l;d:4 In (4) Zrepresents all of the household commodities not related to children, n the number of planned children and U i the aggregated level of utility of all children. Even though the parents do not know the exact preferences of their children, 134 Rainer Marggraf OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31 they do know how current social and political decisions will affect the well-being of their children. In (4) drepresents these factors. If the parential decision variables h, l and nare also to be explicitly considered in the full income restriction, one must take into account that some of the costs (c n ) and revenues (r n ) are based only on the number of children (e.g. maternity costs, child allowance), that costs (c h ) and revenue (r h ) exist which are only dependent on the children’s human capital (e.g. magazine subscriptions, the quality of family discussions), and that there are costs (c) and revenues (r) which depend both on nand h(e.g. tuition fees, scholarships). pzZcnnchhcnqpllI0rnnrhhrnh5 In (5) I0represents the non-child related portion of the full income and p l the costs of inheritance (e.g. attourney expenses). If we combine (gross) costs and revenues to net costs (p n ,p h p), we get pzZpnnphhpnhpllI:6 Decisions made by parents are the result of maximizing (4) given restriction (6). Parents determine the optimal values (according to their view) for the number of children and the transfer of human and real capital to their children. However, they do consider the net costs of raising the children and the dependence of their own utility on their children’s utility. B. Implications In this model children influence the parents’ level of utility directly as well as indirectly. Directly because the well-being of the children is included in the bundle of home produced commodities. The indirect effect of children on the utility level of the parents is due to the fact that children have an effect on the supply of the remaining household commodities. These effects can be negative or positive. Raising children costs time and money, but children can help with housework, support their parents as they become older, etc.. Thus, children have a ‘consumption value’ and a ‘production value’. The effect of social security systems on p, p n or p h depends on their arrangement and on whether they represent a substitute for the support of the children. If the children are called upon to finance the social security systems, then there is a change in the value of d. The decision-making model does not predetermine how the parents’ reaction to a change in the above mentioned exogenous variables will affect the decision variables n, h and l. Just as in the traditional household model, only the sign of some income-compensated reactions is determined. Family Decisions Affecting the Formation of Human Capital 135 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/978-3-428-51867-8 | Generated on 2023-01-16 12:27:31