Top down versus bottom up in International Development Assistance

Comparing different approaches to effectively promote growth in the least developed countries

Bachelor Thesis 2010 38 Pages

Business economics - Business Management, Corporate Governance


Table of Contents

1. Introduction

2.. Top-down approach
2.1 Structural Adjustment Program and its demise
2.2 The Paris Declaration and the rise ofPoverty Reduction Strategy Papers

3.. Bottom-up approach
3.1 Participation in development assistance
3.2 One Dollar a week - discussing the income transfer

4. Top-down vs. bottom-up - fusing the findings

5. Outlook




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1. Introduction

In the course of history, Great Britain happened to become the world's first country to industrialize. Western Europe and the United States followed soon after, each region showing different characteristics of economic development. That development was not matched by all countries. Entire continents, South America, Africa, to some part Asia, had not experienced a comparable economic boost. Many sub-Saharan countries, for example, struggle till this day to reach a level of sustainable and constant economic growth that would close, or at least diminish, the income and life-quality gap between them and what is generally called the North.

This Thesis is not to examine the reasons why some countries flourished and increased the wealth of their citizens manifold, while others failed to do so. Rather this paper analyzes selected macro- and microeconomic models that have been applied and still are applied to finally allow the least developed countries to leap-frog. Nearly infamous is the Structural Adjustment Program that bears the negative connotation of forcing the underdeveloped countries to open their countries to serve the interest of the West, which reflects an extreme top-down approach of development assistance. This Thesis examines to what extent this inflated statement is true, how the International Monetary Fund changed its course, and how bottom-up measures fare instead. So, two approaches lie at the heart of this Thesis: Top-down and bottom-up.

International development assistance is marked by these two opposing strategies. Historically, the distinction stems from the 18th century. Top-down aimed to create and install a perfect set of (political) institutions - an approach that views incumbent evolving systems as inferior.1 On the other hand, bottom-up described the evolution of institutions, a democratic process from the base of the people.

In matter of economics, the former theory demands enormous insights from the economist to establish a functioning system that foresees the interrelations of many variables. Shortcomings in bottom-up environments cannot be assigned to one certain designer.2 Instead, the outcomes (positive and negative) are the sum of many factors and people working together and influencing each other intentionally or unintentionally.

These two opposing theories describe a fundamental dispute in international development assistance over the efficient promotion of economic growth in less developed countries. Here, following the historical definition, top-down is described as extrinsic aid. Standard models are designed to bring relief. Whereas, bottom-up focuses on the individual needs and prevalent conditions. Bottom-up aid projects intend to provide the necessary measures for the people in need to help themselves, to initiate their own development.3

The Bachelor Thesis examines which approach impacts the overall economic welfare of a targeted country or group of people to what extent. Building on the theoretical advantages and disadvantage, as well as past records, this Thesis sheds light on the question which of the two approaches is preferable for future development assistance.

The second section takes a closer look at the macroeconomic measures and their influence to spur economic growth. It examines the characteristics of the Structural Adjustment Program and what led the International Monetary Fund to abstain from this program. The shift towards untied aid and the rise of the Poverty Reduction Strategy Papers that followed is subject of the second subsection of part 2. The third section moves to the bottom-up approach by discussing the effects of participation. Subsequently, the focus is set on cash transfers to the poor to exemplify the most extreme concept of bottom-up aid. Experiences from different countries' programs is taken to evaluate the concepts. The findings will be fused to compare the effectiveness of top-down and bottom-up in Chapter 4. An outlook with the attempt to formulate an advice for future development assistance concludes the Thesis.

2. Top-down approach

Economists have produced multiple models to describe different factors' influence on output. These stylized images of reality are supposed to allow drawing conclusions about what parameters have to be changed to spur economic growth. This section will first take a closer look at the neoclassical growth model and the new growth theory, as well as the general relations between the factors capital, human and natural resources, and innovation on output. Afterwards, it will be explained on which of these principles the Structural Adjustment Program (SAP), employed by the International Monetary Fund (IMF), were based, why the SAP was dismissed and instead Poverty Reduction Strategy Papers (PRSP) turned to.

To determine why the Least Developed Countries (LDC) lack behind in economic terms, it has to be clarified what the growth rate depends on. Output growth is the most important signal for an increase in overall welfare. Measured as gross domestic product (GDP), output is the sum of all incomes - wages, and gains on capital like rents, interest, and profits.4 Alternatively, GDP can be stated as:

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The relations shown in equation (1) are straight forward: The gross domestic product is positively related to consumption (C), investment (I), government spending (G), and exports, for X (net exports) describes the difference between exports and imports.

It becomes obvious how growth can be stimulated. Seen from the government's perspective, G is the only factor which it has direct influence on. Yet, it possesses tools to determine the other summands via fiscal and monetary policy. The central bank controls the interest rate by expanding and contracting the money supply. Widening the money supply decreases the interest rate, which leads to higher investment (I) and more consumption (C).5 This boosts output. Fiscal policy refers to the capability of raising taxes and spending money on goods and services.6 Depending on the marginal propensity to consume (MPC) additional government spending will yield through the multiplier effect, ceterisparibus, an increase in the GDP level of:7

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The effect of aid inflow is - in theory - similar to equation (2). The multiplier suggests an outward shift of the production possibility frontier where consumption and saving rise proportionally to the marginal propensity to consume, and to save, respectively.8

Four elements are imperative for economic growth. Those are human resources, capital, innovation and natural resources.9 Human resources describe the skills and abilities the labor force possesses. Development is not constant, but fluctuates with new ground-breaking innovations. Education and health are the most central traits that have to be publicly or privately provided to lay grounds not just for an innovative environment, but also to increase the productivity of labor in general. Capital includes infrastructure such as railways, power grid, and other tangibles. It has to be accumulated via saving which is the portion of income not consumed. The role of natural resources is ambiguous. In theory, a country with many resources would be expected to have cost and trade advantages due to economies of scale and comparative advantages. In practice however, a significant portion of the underdeveloped countries own oil fields, valuable minerals, or vast farm land. It seems to be rather a bane than a boon. Not atypically, the non-traded sector in these countries experience a decline - a situation known as the Dutch disease.10

In many cases, LDCs - a list of which is provided in the annex - are poorly equipped with at least three of these elements. As they are strongly interrelated and self­reinforcing, underdeveloped countries are doomed to be trapped in a vicious circle: Saving is little when income is little. But saving is essential for the capital growth, hence insufficient savings hamper the productivity growth which in turn result in low incomes.11 Analogously, poverty is associated with poor education. Without proper education innovations are rare, the implementation of advanced technology difficult. The deficit in growth will be matched by population growth instead, which decreases productivity gains in food production and output in general.12 To achieve sustainable growth, this circle has to be interrupted. Two common models describe the problem and suggest what is needed to foster growth.

The neoclassical model of economic growth (also known as the Solow growth model) predicts how to raise wages through so-called “capital deepening”.13 Given labor, additional supply with capital will lead to a higher marginal productivity of each worker. Capital is marked though by diminishing returns, for not all investments are lucrative to the same extent. Finally, stagnation results from the lack of new output enhancing investments. Technological development becomes a necessity for further growth. For developing countries with a low capital-labor ratio,14 the neoclassical growth model implies that with the same amount of capital injected less developed countries will enjoy higher growth rates than advanced countries.

Related to the neoclassical, the new growth theory was developed. It describes how technological changes are occurring endogenously.15 The progress depends on human inventions and abilities. This allows ongoing growth without reaching the steady state, as it is the case with capital deepening under the neoclassical model. Schooling is an important feature to trigger future innovations. This theory is supported by the fact that the bulk of inventions are made by innovators that spent time with formal schooling well above average.16 Hence, LDCs' governments are supplied with significant power to take part in this process. A clever design of taxes and subsidies promotes human capital accumulation to lead to long-term positive effects on growth.17

The shortage of capital is seen as the major deficiency less developed countries suffer from.18 The models mentioned above underline the importance of capital. Empirical data support this fact: Advanced levels of investment financed predominantly by domestic savings are agreed to have been the decisive feature for Hong Kong, South Korea,

Singapore and Taiwan to reach the status of the Newly Industrialized Countries.19 Helping to surpass the bottleneck, the IMF provides highly indebted and the Least Developed Countries with different types of loans. Especially during the 80s and early 90s,20 it was popular to connect the loans with certain obligations. These included external and internal conditionalities. While the internal parts of the Program requested microeconomic changes, e.g., privatizations of state-owned industries and enterprises and deregulation,21 the external measures aimed at the macroeconomic policies of the recipients, incorporating neoclassical beliefs of economic theory. In the first decade of the new millennium, the IMF abstained from the use of SAP and turned to Poverty Reduction Strategy Papers instead. Why this was the case and what this shift reveals about the top-down approaches introduced in the first part of this chapter will be analyzed in the subsequent sections.

2.1 Structural Adjustment Program and its demise

In the early 80s, the Least Developed Countries experienced serious balance of payment deficits.22 This was an outcome of the energy crisis of 1979/1980. The sky-rocketing oil prices in the aftermath of the Iranian revolution had the western central banks adopt a policy of tight money, i.e. high interest rates, to prevent inflation. Higher interest had also to be paid by the LDCs on their debts. The economic downturn that followed was accompanied by deflation and austerity in the developed countries undermining their import demand and deteriorating the terms of trade for the LDCs.23 Lending became increasingly difficult. The International Monetary Fund stepped in and offered loans to the countries in need. To tackle the prevalent fundamental problems, e.g. an overvaluation of the currency,24 the IMF thought the LDCs to suffer from, it attached obligations to the financial support - the Structural Adjustment Program.

The Fund offered mainly two types of loans which differed in duration and target group. Stand-by agreements were loans at commercial rate to help finance the macroeconomic adjustments and was granted for one to two years. For especially committed partners these were extended to three years.25 Acknowledging their special burden, low income countries could apply for special loans, charging an annual interest rate of 0.5% and with semiannual repayments starting five and a half years after the loan had been received.26

The IMF was, at least at that point in time, dominated by the neoclassical theory.27 The SAP reflected three pillars of this belief: liberalization, deregulation and privatization.28 Liberalization was mainly coined on trade. Inspired by the Ricardian model of comparative advantage, free trade was hailed a safe way to enhance growth. With a functioning price mechanism, trade allows each country to produce and exchange the goods and services it enjoys a comparative advantage at.29 Trade barriers like tariffs and import quotas distort this mechanism and cause welfare losses. This is especially true for LDCs. Marked by small GDP compared with developed countries, they have little influence on world prices. (With the exception of some scarce resources that some underdeveloped countries are well equipped with.) Tariffs they introduce have no large enough effect on world prices to generate a welfare surplus.30 Whatever domestic producers and government gain, it is more than offset by the loss in consumer surplus.31

Uncompetitive prices and excess demand are underlying the balance of payment problem many LDCs unsuccessfully coped with.32 The solution approached by the International Monetary Fund relied on free trade and was threefold: A devaluation of the currency makes exports relatively cheaper for the foreign customer while, secondly, imports (seen from the LDC's perspective) become more expensive. The increase in foreign demand spurs economic growth. Domestic substitutes for the imports, which prices have risen, will be sought and cause a shift to home country products. To achieve this positive effect, the sum of export and import demand elasticity must be greater than one, taking the Marshall-Lerner condition into account.33 Thirdly, a depreciation of the currency decreases the real interest rate, assuming the nominal interest rates do not match the hike.34

Liberalization was not limited to trade policy. The SAP focused also on the domestic economy of the recipient countries. Labor had to be freed from government restrictions. It was argued that fixed wages and minimum wages cause unemployment, as with a lower capital/labor-ratio more capital-intensive production methods become attractive, and the gap between labor demand and supply is artificially widened.35 The promotion of competition was demanded by removing entry barriers. Too little competition creates too high prices. The firms are not forced to produce where marginal cost equals average cost. Rather monopolistic conditions are observable when entry barriers exist. Here, businesses produced only the quantity where marginal cost is equal to marginal revenue, and charging a higher price than under perfect competition.36

Closely connected to liberalization and boosting competition is privatization. State- owned companies distort the market and are responsible for failure of the same. State and parastatal entities usually possess substantial market share. Therefore, denationalization and privatization disaggregate the supply side which is necessary to move closer to perfect competition.37 This IMF obligation encompassed railroad companies, electricity facilities, etc., but also encouraged competition in sectors as health and education.38 Moreover, the Fund pressed against price ceilings and floors, and instead have the market determine the prices by balancing demand and supply. State expenditure must be reduced, a minimum budget is desired.39

The IMF and its SAP have been subject to broad criticism. It starts with the assumptions. For the neoclassical models to function, markets cannot fail. And that is exactly the point: As explained in the previous paragraphs, the IMF sees the problems causing the deficient development of the poor countries in distortions caused by market interference. That burdens their Program to guarantee failure-free market conditions.


1 See Easterly (2008), p. 95.

2 See Easterly (2008), p. 95.

3 See Easterly (2008), p. 96.

4 See Samuelson/Nordhaus (2005), p. 426.

5 SeeBlanchard(1997), p.115.

6 See Samuelson/Nordhaus (2005), p. 412.

7 See Samuelson/Nordhaus (2005), p. 493.

8 See White (1992), p. 224.

9 See Samuelson/Nordhaus (2005), p. 558.

10 See White (1992), p. 227.

11 See Samuelson/Nordhaus (2005), p. 583.

12 See Samuelson/Nordhaus (2005), p. 583.

13 See Samuelson/Nordhaus (2005), p. 565.

14 See Ghatak (2003), p. 9.

15 See Samuelson/Nordhaus (2005), p. 566.

16 See Ghatak (2003), p. 62.

17 See Ghatak (2003), p. 56.

18 See Ghatak (2003), p. 146.

19 See Ghatak (2003), p. 64.

20 See IMF (2004).

21 See Summers/Pritchett (1993), p. 383.

22 See OECD (2009a), p. 28.

23 See Milward (2000a), p. 26.

24 See Ghatak (2003), p. 351.

25 See Milward (2000a), pp. 27, 28.

26 See IMF (2004).

27 See Milward (2000a), p. 27.

28 See Summers/Pritchett (1993), p. 383.

29 See Ghatak (2003), p. 354.

30 SeeKrugman/Obstfeld(2003), p.191.

31 The infant industry case is an exception, the discussion of which is not a subject of this Thesis.

32 See Ghatak (2003), p. 351.

33 See Ghatak (2003), p. 358.

34 See Krugman/Obstfeld (2003), p. 355.

35 See Milward (2000b), p. 54.

36 See Samuelson/Nordhaus (2005), p. 178.

37 See Milward (2000a), p.31.

38 See Milward (2000a), p. 34.

39 See Milward (2000a), p. 33.


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Otto-von-Guericke-University Magdeburg
ODA Development Assitance aid top-down bottom-up UCT CCT PRSP SAP structural adjustment policies imf cash transfers



Title: Top down versus bottom up in International Development Assistance