The Law And Economics Of Development Economics Essay

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Ragnar Nurkse (1907 -1959) was one of the most important pioneers of development economics, and although his writings have been neglected in recent decades, leading development economists and international organizations like the United Nations are now turning to Nurkse in search for new inspiration, due to the failure of neoclassical economics to adequately explain the experience of poor and developing countries. Until now, however, all Nurkse's published works were out of print, and the most recent editions stem from the early 1960s.

Ragnar Nurkse, Trade and Development reprints Nukse's most important works, making them widely available for an audience of economists, policy makers, researchers and students. The works reprinted here, include two essays never printed before in this format 'Growth in Underdeveloped Countries', (1952) and 'International Trade Theory and Development Policy' (1957), as well as the collected essays from Equilibrium and Growth in the World Economy (1961), and the monograph Problems of Capital Formation in Underdeveloped Countries (1953).

The ancient urge to make two ears of wheat grow where one (or none) grew before has in our days been powerfully reinforced by the impact upon the poorer countries of the example held out by the better-off ones. It is to this "demonstration effect" that we are indebted for so much of the unrest now stirring in the West's agricultural back yard, and perhaps the historian of our epoch will eventually judge that the United Nations Organization has been important chiefly for having focused world attention on this problem. Indeed, the very fact that there is now an official world organization, and consequently a forum for complaints brought by Abel the farmer against Cain the industrialist, has something to do with the power of the "demonstration effect." Backward countries no longer live in isolation; the Japanese accomplishment in industrializing a whole society while holding living standards down and shutting it off from the cultural impact of the West has become difficult to emulate this side of the Iron Curtain. We still have a long way to go before One World becomes a political reality, but meanwhile the movies and the radio are seeing to it that Western-and especially American-consumption habits exert their pull in the remotest villages of Asia. And overshadowing all there is the East-West split, itself in part a consequence of the unequal distribution of the world's goods among the world's inhabitants.

Towards the Law & Economics of development: Ragnar Nurkse (1907-1959)

Problems of capital formation in underdeveloped countries

The meaning of 'capital formation' is that society does not

apply the whole of its current productive activity to the needs and

desires of immediate consumption, but directs a part of it to the

making of capital goods: tools and instruments, machines and

transport facilities, plant and equipment -- all the various forms of

real capital that can so greatly increase the efficacy of productive

effort. The term is sometimes used to cover human as well as

material capital: it can be made to include investment in skills,

education and health -- a very important form of investment. I

would prefer, however, not to take up matters relating to cultural,

social and demographic conditions, partly because of the great

diversity of those conditions, but mainly because of my lack of

knowledge in these fields. I would rather limit the discussion, on

the whole, to the accumulation of material capital.

The essence of the process, then, is the diversion of a part of

society's currently available resources to the purpose of increasing

the stock of capital goods so as to make possible an expansion of

consumable output in the future. It is on this basic feature of

capital accumulation that our attention will be centred. Certain

aspects of the process will be treated as subsidiary. Thus the

technological side of capital formation will be almost entirely

neglected. When the stock of capital increases, naturally the

technical form of it changes. Imagine a group of workmen

building a road, each of them equipped with a dollar's worth of

capital, namely, with a shovel. Now if capital per head were

increased to, say, one thousand dollars, so that each could have a

thousand dollars' worth of equipment to work with, it would be

senseless to give each worker a thousand shovels. Some of them

at least would now get, say, a tractor or a small truck to work with.

Capital changes its concrete shape with the capital-intensity of

production. This change in the technical appearance of equip-

ment is what usually strikes the layman most. It is no doubt

an interesting and important phenomenon, but for us it is merely

an engineering aspect of the increase in the stock of real capital.

We shall generally take it for granted without further discussion.

We should only remember that there may be important technical

discontinuities in the physical shape which capital may assume

as and when production becomes more capitalistic.

What is commonly known as 'technical progress' can mean

two things. First, and quite frequently, it refers to the con-

struction of more and better instruments of production and to

the utilization, for this purpose, of a greater share of the existing

store of technical knowledge. The store of knowledge may

remain unchanged, and yet we may have 'technical progress' in

the sense of a greater application and embodiment of it in material

objects. The other sense of the term is that in which technical

knowledge increases without any change in the form or quantity

of capital goods. An advance in technical knowledge in the

abstract may be of no economic relevance if there is no capital in

which to incorporate it and with which to take advantage of it in

the process of production. Leaving aside the engineering aspect

of capital formation, we shall proceed on the assumption -- a quite

realistic assumption for the less developed countries -- that there

is a great fund of technical knowledge in the world which could

be applied advantageously to the productive process if only the

economic resources were available to make use of it.

There will be more to say on financial than on technological

matters, but the financial aspect too is one that will be pushed

into the background by our concern with the 'real,' or non-

monetary, problems of accumulation. A detailed discussion of

financial mechanics would involve us in questions of financial

organization and institutions, which show considerable -- and

sometimes only accidental -- differences from country to country,

and are not always of basic importance.

So much for what is not on our agenda. Now we must see

what is.


In discussions of the problem of economic development, a

phrase that crops up frequently is 'the vicious circle of poverty.'

It is generally treated as something obvious, too obvious to be

worth examining. I hope I may be forgiven if I begin by taking

a look at this obvious concept.

It implies a circular constellation of forces tending to act and

react upon one another in such a way as to keep a poor country

in a state of poverty. Particular instances of such circular con-

stellations are not difficult to imagine. For example, a poor man

may not have enough to eat; being under-fed, his health may be

weak; being physically weak, his working capacity is low, which

means that he is poor, which in turn means that he will not have

enough to eat; and so on. A situation of this sort, relating to a

country as a whole, can be summed up in the trite proposition:

a country is poor because it is poor.'

ability and willingness to save; the demand for capital is governed

by the incentives to invest. A circular relationship exists on both

sides of the problem of capital formation in the poverty-ridden

areas of the world.

On the supply side, there is the small capacity to save, resulting

from the low level of real income. The low real income is a

reflection of low productivity, which in its turn is due largely to

the lack of capital. The lack of capital is a result of the small

capacity to save, and so the circle is complete.

On the demand side, the inducement to invest may be low

because of the small buying power of the people, which is due to

their small real income, which again is due to low productivity.

The low level of productivity, however, is a result of the small

amount of capital used in production, which in its turn may be

caused at least partly by the small inducement to invest.

The low level of real income, reflecting low productivity, is a

point that is common to both circles. Usually the trouble on the

supply side receives all the emphasis. The trouble there is cer-

tainly obvious and serious, and some aspects of it will be thoroughly

gone into later. But the possible block on the demand side, once

one becomes aware of it, is also fairly obvious, though it may not

be so serious, or so difficult to remove, as the supply deficiency.

Besides, let us remember that capital is not everything. In

addition to the circular relationships that plague the capital

problem, there are, of course, matters of unilateral causation that

can keep a country poor; for instance, lack of mineral resources,

insufficient water or barren soil. Some of the poorer countries

in the world to-day are poor partly for such reasons. But in all

of them their poverty is also attributable to some extent to the

lack of adequate capital equipment, which can be due to the small

inducement to invest as well as to the small capacity to save.

The inducement to invest is limited by the size of the market.

This proposition is, in effect, a modern variant of Adam Smith's

famous thesis that 'the division of labour is limited by the extent

of the market.' 1 The point is simple and has long been familiar

to the business world. It is a matter of common observation that

in the poorer countries the use of capital equipment in the

production of goods and services for the domestic market is

inhibited by the small size of that market, by the lack of domestic

purchasing power, not in monetary but in real terms, in a sense

to be presently defined. If it were merely a deficiency of monetary

demand, it could easily be remedied through monetary expansion;

but the trouble lies deeper. Monetary expansion alone does not

remove it, but produces merely an inflation of prices.



"The Schematic Representation of the Structure of Production", 1934, RES

Conditions of International Monetary Equilibrium, 1945.

Problems of Capital-Formation in Underdeveloped Countries, 1953.

Patterns of Trade and Development, 1959.

Equilibrium and Growth in the World Economy, 1961.

Towards the Law & Economics of development: Ragnar Nurkse (1907-1959)

"Contrasting Trends in the Nineteenth and Twentieth Century World Trade." He noted that, in the nineteenth century (1815-1914), trade was an engine of growth transmission as well as a means of improved allocation of existing resources. This was a period in which Great Britain was the focal center of economic expansion that resulted in a very substantial increase in the demand for primary commodities from the so-called Regions of Recent Settlement (RRS) located in the temperate zones of North and South America, Australia, and New Zealand. Great Britain was also the source of the very large movements of financial capital that was instrumental especially in building the railway infrastructure in the RRS that facilitated the movement of their exports to Great Britain. This period in time was truly the first great movement of globalization that served to integrate what are now many of the world's high-income, industrialized countries.

From WWI to the end years of the 1950s, once the postwar recovery took hold, the production and trade of the major industrialized countries rose significantly. But in contrast to the nineteenth century experience, Nurkse noted there was a marked


slowdown in the rate of expansion in the primary exports, excluding oil, of the poorer countries. He attributed this slowdown to a number of factors: (1) the shift in the industrial countries from industries with a high raw material content to industries with a low material content; (2) the rising shares of services that did not depend on significant material inputs; (3) the low income elasticity of demand for many agricultural products; (4) increased agricultural protectionism; (5) substantial economies in industrial uses of natural materials; and (6) development of synthetic and other man-made substitutes for many staple commodities.

The question that Nurkse then raised was what are the less developed countries to do? Given the pessimistic outlook for expanding production of agricultural products and other raw materials, the issue was whether and how industrialization could be pursued. The choices appeared to be production for export and production mainly for the domestic markets. Nurkse was inclined to favor industrialization for export especially in developing countries that were relatively labor abundant. But he expressed some concern about supply-side difficulties arising from the comparative lack of social and physical infrastructure in many poor countries, and, on the demand side, the possible protectionist reactions in the industrialized countries if their high-cost suppliers especially of labor-intensive manufactures were to be injured and displaced by imports. Nurkse considered at some length the difficulties that might arise in promoting industrialization to serve the home market. The concerns here related to the interactions of agricultural and industrial development in relation to the patterns of expansion of domestic demand and the pitfalls of following policies of import substitution. Nurkse described three strategies of trade and growth, distinguished by the portions of the economy in which that growth was to be concentrated. The first strategy - what we will here call Strategy I - is to grow by producing and exporting primary products. This is the mechanism he described in his first lecture as having successfully achieved the growth of the RRS during the 19th century. At that time, countries such as the United States provided primary inputs to the rapidly expanding industrial complexes of Europe, especially the UK.

The RRS themselves therefore remained relatively unindustrialized under Strategy I. This worked well during the 19th century, but for reasons we will mention below, was inadequate during the 20th. Therefore his other two strategies were directed toward industrialization.

Strategy II is also export based, but instead of exporting raw materials, this exploits another comparative advantage of many developing countries: their relative abundance of unskilled labor. Thus this strategy rests on the exports of labor intensive consumer goods, such as textiles and apparel.

Strategy III, introduced for reasons to be discussed in a moment, is not based on exports at all, but rather on producing for the domestic market of the developing country itself, or perhaps for itself and other developing countries in its region. Because the domestic market for any good is rather small, and because without substantial exports demands for other consumer goods could not be satisfied through imports, Strategy III requires production not just in a few sectors, but in just about all, including both a broad range of consumer manufactures and also food. Nurkse did allow this strategy to include


imports of capital goods, which he regarded the developing countries as the least capable of producing themselves. Thus there had to be a certain amount of exports of something, perhaps again primary products but in smaller volume than in Strategy I.

Nurkse saw substantial limitations to each of these strategies, and it was the limitations on Strategies I and II that led him to consider the third in spite of its obvious economic inefficiency. The limitation on Strategy I, exporting primary products, was the now familiar expectation that world prices of primary products tend to fall over time. This evidently was either not true or not a problem during the 19th century, but Nurkse was in good company during the 1950s in perceiving it to be a problem then, and in expecting the problem to continue. Therefore he dismissed Strategy I as inadequate for the developing countries of his day.

The limitation that he saw for the Strategy II was not nearly as commonly perceived in the 1950s, and indeed one can marvel at his prescience. This was that, as developing countries expand their exports of labor intensive goods, they would encounter increasing trade barriers for these products in their developed country markets. He well understood that labor intensive sectors in the developed world would have to contract for this strategy to succeed, and that political forces in those countries would resist that contraction. Thus the access into these markets by developing countries would be limited by tariffs or other trade barriers, as a direct result of any success that they began to achieve. Thus, the strategy of growth through manufactured exports would be undermined.

It was the limitations on the first two strategies that led him to consider the third, for which he also saw limitations - several of them, in fact - but also at least one positive


effect that bears mentioning. The most obvious limitation, of course, is that countries would be denying themselves most of the benefits of pursuing their comparative advantage. By allowing them, under this strategy, to continue importing capital goods, he did not deny them that benefit completely. But by having them produce a full range of consumer manufactured goods, he more or less assured that consumers in developing countries, to the extent that their incomes rose enough to afford these goods, would be poorly served. It seems clear that he was well aware of that, but as already noted he found the alternatives nonviable.

The more severe limitation of Strategy III, and one he stressed, was that it depended on countries being able to feed themselves. Without exports to pay for imported food, countries would have no choice but to be essentially self sufficient, and yet it was not obvious to him that they could do it. Resources would have to continue to be devoted to agriculture and to improving productivity there, or there would be no surplus labor available to produce other goods for the domestic market. He saw this as the most binding constraint on economic development, given his pessimism about the other two strategies, and he seemed rather pessimistic about this as well.

He also discussed one other important limitation on this strategy of producing for the domestic market: that the domestic market would be very small in many countries, often too small to support efficient production. Thus he acknowledged the existence of scale economies in manufacturing production, and thus that producing for only a small domestic market would be very costly, with or without comparative advantage. His solution to this, mentioned only in passing, was that developing countries should not eschew exports entirely, but that they should export to each other, and that they


presumably should specialize within their developing-country regions to the extent needed to support minimally efficient plants.

This essentially completes the description of Strategy III, although it includes one additional implication, if successful, that bears mentioning. To the extent that a developing country succeeds in growing its productive capacity in a broad range of manufactures, not just labor intensive ones, it will eventually be able to export some non-labor-intensive goods to the rich world. The advantage of this is that, by steering clear of the overstressed labor-intensive industries of the developed world, it will avoid the protectionist backlash that he forecast to be stimulated by labor-intensive exports. Instead, developing-country exports of more capital-intensive goods would feed into the nexus of trade within more advanced industries that already goes on among developed countries, and the new additions from the developed counties would be accepted without complaint.

Nurkse's Growth Model

It may be noticed that these strategies do not really address how to make economic growth happen in the first place. Rather, they simply assume such growth, and they are concerned instead with how to accommodate that growth within the world economy. Nurkse did not, at least in these Wicksell Lectures, pretend to have anything new to say about the causes of growth or how to achieve it.

Instead, he simply accepted that growth requires saving. He did not discuss how this saving was to be achieved, although he seemed to see it as coming from within the developing economies rather than from abroad. And he did not discuss the mechanisms

by which savings is to be transformed into investment of one sort or another, and the associated difficulties with that transformation.

In particular, he did not really address how each of his three strategies for trade and growth might be implemented. He simply spoke of countries as choosing one or another. We can infer that his Strategy III would have to be implemented with trade barriers of some sort, to prevent imports of manufactured goods, but there is no implication here that such trade policies would themselves cause growth to occur. His lectures were about accommodating a country's growth within or outside of world markets, given that the growth occurs. They were not about how to achieve growth. His first lecture seems to be explaining the growth that occurred in the 19th century as being a result of the exports of primary products, but it seems unlikely that Nurkse believed that such exports, in and of themselves, would have produced growth. Rather, when these exports took place in a growing world market, they added nicely to the incomes of the countries, and thus provided a source from which savings and investment could be extracted. But presumably he would have agreed that additional ingredients are needed to prompt that savings, even out of a higher income, and that some countries undoubtedly participated in the 19th century export boom without translating it into savings and growth. Indeed, it is to some extent those countries who remained underdeveloped and were the subject of his strategies when he wrote.

As for implementing the strategies, aside from using trade barriers for Strategy III, it is not clear what Nurkse had in mind for directing an exporting economy into either raw materials or manufactures. He tends to speak of these choices as though policy


makers might control them directly, which of course may have been true in some developing countries of his day.

Alternatively, one could argue that the world market would determine this specialization. If a developing country does have an abundance of raw materials, then absent any policy to prevent it happening, exports of these will occur, with implications for income that depend on their price. However, if prices decline as Nurkse expected, and if in addition the country's labor force is expanding beyond the capacity of the resource sector to employ it, then again in the absence of policy to prevent it, labor-intensive production and exports will occur.

In other words, unless a country deliberately implements Strategy III by restricting trade, the choice between Strategies I and II will be made for it by world markets. In each case, whether these will lead to growth will depend both on the returns that a country is able to derive from its specialization, which Nurkse discusses, and on whether it is able to turn income into savings and investment, which Nurkse leaves aside.

Nurkse's Trade Model

In order to accommodate many of Nurkse's ideas within an economic model, that model must include at a minimum more than one manufacturing sector as well as a primary product or agricultural sector. These sectors must employ labor, of course, some sort of capital, and presumably land and/or natural resources for the primary product sector. In addition, to capture the role of scale economies that play a small role in his discussion, it would be desirable to have increasing returns to scale in at least some manufacturing. Finally, the model may treat a small country for which prices in trade are given, except

that it must also include the feedback from exports to rest-of-world protection that Nurkse expected in labor-intensive manufactures.

To capture these elements, the model would have to be a hybrid of other models, and one might fear that it would be too cumbersome to be of use. That is not the case, however, as we will suggest.

Start with the model that Anne Krueger (1977) presented of trade and development in her Graham Lecture thirty years ago. This was itself a hybrid of a 2-factor (labor and capital), many-sector Heckscher-Ohlin (HO) model combined with a three-factor (labor, capital, and land) specific-factors model. Her model had a single agricultural sector employing labor and land, plus an arbitrary number of manufacturing sub-sectors employing labor and capital. As discussed further in Deardorff (1984), labor in this model is distributed between agriculture and manufacturing largely based on the stocks of land and capital that are specific, respectively, to agriculture and to manufacturing as a whole. Within manufacturing, however, because both labor and capital are mobile among the multiple sub-sectors, that part of the model behaves like the HO Model. Nurkse's Track Record

How accurate did Nurkse's model of trade and growth turn out to be, as we look back now with fifty years of hindsight? Some of his predictions have been borne out, but not all.

International monetary policy

In Section II we consider Nurkse's elaboration of governments' attempts to 'sterilize'

the monetary impact of external payments shocks in a context devoid of international rules. A

study of the foundations of Nurksian stabilization rules for the principal dimensions of

macroeconomic policy follows in Section III. Section IV outlines Nurkse's doctrine on the international coordination of macroeconomic policy against the background of an emerging

Bretton Woods system; and it also demonstrates continuities between this doctrine, the

immediate postwar Chicago, and late twentieth century treatments of this subject. We reflect on

the enduring elements of Nurkse's classic contribution in the final section.


First, his prediction about a declining terms of trade in primary products has had a mixed record, and at the current moment looks particularly wide of the mark. Prices of primary products have moved both down and up over the last fifty years, in rather large swings. There certainly were times, especially in the first decade or two after he wrote, that primary product prices indeed fell. But in the later period they rose, and today many primary product exporters are doing quite well, at least with that part of their economies. Not all, however, have so clearly benefited from exports of primary products, even when their prices rose. Many such countries have failed to translate their incomes from exports into savings and investment, suggesting to some that there exists a "resource curse." Even some oil exporters have failed to make good use of their oil windfall.

However, as this formalization of Nurkse's model perhaps makes clearer than his own discussion, a country's ability to sustain itself from primary product exports alone depends not just on their price but on the abundance of the natural resource itself (land, in the model) relative to labor. As populations have grown, the shift to labor-intensive production has become more necessary. Thus Strategy I has often been inadequate for success.

Nurkse foresaw quite correctly that Strategy II would lead to trade barriers being erected to limit the labor-intensive exports of developing countries. This actually began with restrictions on exports of clothing from Japan, when it was in effect a developing country during its recovery from the devastation of World War II. But these restrictions expanded, both in their coverage of textile and apparel products and in their coverage of developing country exporters, as various countries other than Japan attempted to pursue Strategy II. The barriers ultimately took the form of the Multi-Fibre Arrangement


(MFA), which was only terminated in 1995 with the creation of the World Trade Organization, which then phased out the barriers over the subsequent ten years.

What Nurkse did not foresee was that these barriers would not be large enough to prevent quite a number of countries from pursuing the strategy successfully, albeit less successfully than they might have in the absence of the MFA. One reason for this may have been the fact that the barriers of the MFA took the form of quotas, as well as tariffs, and the rents from the quotas accrued to the exporting countries themselves. Thus while they could not export as large a quantity as they might have if unrestricted, the price they got for their exports did not suffer. Indeed, because these quotas were allocated country by country, some countries were able to earn more from exports of textiles and clothing than they would have without the MFA.

This advantage should not be overstated. In addition to the MFA, tariffs on textiles and apparel remain some of the highest charged by developed countries. And overall, as noted by Schavey (2001) of the U.S., tariffs on the exports of developing countries are quite a bit higher than the average tariff on all imports into developed countries. The latter was reduced tremendously by the eight successful rounds of multilateral trade liberalization under the General Agreement on Tariffs and Trade, but in part because developing countries were exempted from reducing their own tariffs during these negotiations, they got little in return. And it is no doubt true that resistance to lowering tariffs on their exports was motivated in large part by the disruption to developed country industries that Nurkse predicted.

Nurkse therefore expected Strategy III to be, by default, the one chosen by most developing countries. For several decades after he wrote this was the case, under the

label of Import Substitution. As he foresaw, this strategy depended on countries being able to feed themselves, since without exporting they could not count on substantial imports of agricultural goods. Nurkse therefore saw the need for increased productivity in agriculture, although he did not see how this would occur. In fact, agricultural productivity did increase substantially as a result of the Green Revolution, thus forestalling in many (but hardly all) countries the famines that would otherwise have accompanied their rapid population growth.

On the other hand, while many countries pursuing this strategy did manage to grow, they grew only slowly, which would be no surprise to Nurkse. The surprise would have been that countries using Strategy II were able to grow so much more rapidly than the import-substitution countries, in spite of the protection they confronted in the developed world. And it was this example, first by Japan and then by the Asian Tigers, that has gradually led more and more developing countries to shift from Strategy III to Strategy II.

Nurkse might note that the Asian Tigers were small economies, so that their exports never rose to the level that might have prompted a more extreme protectionist response. Indeed, he might also observe that today, as ever more countries pursue Strategy II, including now the very large economies of China and India, the protectionist backlash may be growing. This could account, for example, for the fact that the latest round of multilateral trade liberalization, the Doha Development Agenda, seems headed for failure.

On the other hand, we might also observe that the successful pursuit of Strategy II by an increasing number of countries has led over time to the near disappearance of many

of the most labor-intensive industries from the developed world, in spite of efforts to protect them. As a result, the constituent interests for protecting these industries have themselves declined. This is an outcome that Nurkse did not anticipate, but it is one that he would have well understood. Ragnar Nurkse_s contributions in the 1940s provide rules for international policy coordination complementing the contemporary position outlined by the Chicago economist Henry Simons. Nurkse_s scheme was significantly different from Bretton Woods. Interwar currency and inflation experience underscored the ineffectiveness of sterilized intervention when proceeding with inconsistent monetary and fiscal policies and vague exchange rate commitments. Credible exchange rate rules are possible only with international coordination harmonized by inflation discipline. Nurkse uses an accelerationist, natural rate argument, thereby severely circumscribing attempts to subordinate monetary and fiscal policies to the growth of employment. Ultimately, countries participating in policy coordination must use macroeconomic policies to control the rate and variability of inflation. Nurkse_s scheme depends on the antiinflation and imported credibility messages embodied in his policy rules; insistence that rules be founded on publicly recognizable criteria; recognition of the NAIRU and negative view of trade restrictions and exchange controls. His analysis of policy coordination and scepticism regarding global schemes for international financial relations accord with received wisdom in the late twentieth century.

International cooperation to establish a contingent exchange rate rule was feasible.

Exchange rates should be fixed but adjustable in an orderly manner; 'absolute rigidity of

exchange rates' is rejected (ICE: 211). Exchange rate policy is best assigned to the balance of

payments. An exchange rate should be set initially by using a centre country currency as

numéraire - a currency which may not necessarily be tied to gold. Short term cyclical

movements in the current account would use central bank reserves, supplemented as the case