Indirect effects of investment on poverty are not trickledown economics.
CDC is sometimes accused of practicing trickledown economics, because we talk about the indirect effects of investments and we want to help create economic growth in the expectation this will help eradicate poverty. Sometimes our investments have a direct impact on poverty, by improving the livelihoods or meeting the needs of low-income sections of society. At other times the direct impact may be felt by the relatively better-off and we are looking for an indirect impact on poverty. How does relying on indirect effects differ from trickledown economics?
[What exactly do I mean by direct or indirect impact and relatively better-off? See end of article].
Trickledown economics is the discredited idea that if you want to help the poor, your best bet is to increase the income of the rich –perhaps by cutting taxes on dividends — who will then invest and create wealth. The rich will also do things like buy yachts, and that will create jobs for everyone else.¹ It’s nonsense. If you have the power to affect the income of different groups and you want to help the poor, your best bet is to increase their incomes and then they will also buy things (just not yachts), which creates jobs and pushes up wages. Low income people can also be wealth creators, and raising their incomes puts resources into the hands of would-be entrepreneurs, whose potential is then more likely to be realised (including some “lost Einsteins” and “gung-ho entrepreneurs”).
The evidence that investments indirectly help people escape poverty, however, is overwhelming. We know it from historical examples of poverty eradication. As Yuen Yuen Ang, the author of How China Escaped the Poverty Trap, argues, China moved 850 million people out of extreme poverty in a matter of decades by encouraging all manner of private investment. China only recently started directing spending poverty alleviation — for decades the focus was on growth above all else. We also know it from looking at the data: as the economist Lant Pritchett puts it, the facts show that overall economic growth is empirically necessary for poverty eradication.
Evidence of indirect linkages and spillovers is all around us. Everyone understands that when a mill closes in a steel town, the impact extends beyond the steel workers. Careful research finds that for every new job created by foreign direct investment in Mozambique, for example, another 4.4 other jobs were created, that in Costa Rica the entry of multinational corporations that pay higher wages also pushes up wages in domestic firms. There are many more examples.² We should not be surprised by these findings. Markets are integrated, so one firm’s wages and prices affects others. Poverty falls when investment accumulates and drives up real wages across society.³
When CDC considers an investment, we look at the backward linkages (what’s involved in production — direct employees and workers in the supply chain) and forward linkages (what the goods and services produced are used for). We prioritise investments that we think will increase the affordability and availability of goods and services that low-income people buy; goods and services that are important inputs to production (such as electricity or fertiliser); and investments that will create better jobs for people who need them. That’s not everything we care about — there is the environment and climate change too — but it covers the economic side of it.
We might invest in a yacht builder if we thought it would create enough decent jobs for people that need them, perhaps also help workers acquire new skills that they can take elsewhere, and perhaps if would be an export industry that generates much-needed foreign exchange earnings. We would not be interested in the reducing the price of yachts for rich people. This is the difference between trickledown economics and the sort of indirect effects of investments that we target: the rich getting richer is on the ‘impact pathway’ of trickledown economics; for the indirect effects of investments that we look for, the rich getting richer is off the impact pathway. This is trickledown:
And here are indirect effects of an investment, with the rich getting richer happening on the side:
With trickledown, the rich getting richer is how impact happens. Whereas for non-trickledown indirect effects on poverty, investments may involve making the well-off better-off, but that’s not where the impact comes from.
Successful private businesses also usually enrich their owners. That’s true whether the business serves the wealthy or not. A successful business selling low cost clean cookstoves for low income households would create returns for investors too. When we assess the expected development impact of an investment, we never rely on the investment creating more income for the already well-off to trickledown to others.
The reality is that all businesses have some indirect impacts via goods and labour markets. That is not enough to make them a priority for CDC’s direct investments. When the ‘impact thesis’ for an investment is indirect, meaning that the impact we are targeting will arise through the actions of other firms than the one we have invested in, we are looking for something more powerful than simply adding some demand to the local labour market, for example. As I wrote here, the fact that higher rates of private investment are strongly associated with faster poverty reduction in Africa and South Asia does not imply that any investment is a good investment for CDC. We must be better than the average private investor. Sometimes, however, we invest to improve access to finance at the market level and that does entail supporting some businesses, via intermediaries, that are not particularly pro-poor, but which will contribute something towards the overall level of rate of investment, economic growth and poverty reduction. There is ample evidence that underdeveloped financial sectors in Africa and South Asia are a constraint on growth, and that many firms struggle to access the finance they need to grow. Firms may simply be credit constrained, but they may also struggle to raise more risk-bearing forms of capital, such as equity, which can be particularly important for high growth enterprises. Firms that can only access debt are likely to choose safer less ambitious business plans.⁴
That is why CDC has supported pioneering private equity investors to enter new markets, and why we support banks and other providers of finance to expand their lending to firms. In more mature markets we will take a more selective approach with intermediaries and direct our capital, through them, towards higher impact sectors, but in less-developed markets we would usually place fewer constraints on the types of business that intermediaries can invest in. We want them to succeed, and for others to follow them. When we support an African bank to expand lending to SMEs, for example, our capital will find its way into some businesses that primarily serve better-off sections of society. The same could be said when invest in an electricity generator, or a logistics and warehousing group, or an internet service supplier: the businesses that benefit from these things will also come in all shapes and sizes.
This is all is perfectly consistent with the mandate of the 2002 International Development Act, which requires foreign aid to be likely to contribute to a reduction in poverty. Investing in the local financial sector to promote broad-based economic growth is an important part of what DFIs like CDC should be doing, alongside direct investments in more obviously developmental businesses. The impact on poverty from some of the resulting investments may be indirect, but it’s not trickledown economics.
Direct or indirect impact, and “relatively better-off”
We use “direct impact” to describe the impact that an investment in a business has on its employees, suppliers and customers. If we invest in the electricity grid, however, impact is created by firms that use electricity. If we invest in a financial services provider, impact is created by the firms that borrow from it. We call those indirect impacts — they are at least one step removed from our investment. And those firms will themselves create second-round impacts beyond their employees and customers, through spillovers in markets, and so forth.
Many lower income countries have vast informal sectors and very few salaried workers. So although industrialisation is often the path to reducing extreme poverty that does not mean that when you invest in a formal manufacturing business that it will employ many people straight out of extreme poverty. Its workers will more often come from somewhat higher up the income distribution — perhaps people who were living on $5 or $10 per day. That’s what I mean by “relatively better-off” — poor, but not extremely poor. It’s because we believe those investments will also indirectly benefit people who are even less well off, we get accused of practicing “trickledown”. Creating a better job for someone who was living on $5 or $10 per day is a very different thing from cutting taxes for wealthy business owners, which is the sort of thing I think the term should preserved for.
There are various indirect mechanisms via which the growth of more productive formal sector firms can eradicate extreme poverty, despite those firms usually not reaching people in extreme poverty directly. One is by generating taxes to fund government anti-poverty programs. Another is that adding demand for labour in the formal sector helps others move onto lower rungs of the jobs ladder. Extreme poverty is primarily a rural phenomenon, and when people move out of agriculture and into jobs in cities, that also raises demand for food and incomes for those farmers who remain.
Note: this is a longer version of a blog published by my employer CDC Group. Additional material reflects my personal opinions.
Footnotes:
[1] The evidence from OECD countries suggests that tax cuts for the rich do not boost growth or reduce unemployment. It perhaps more plausible that raising the incomes of the better-off might lead to higher investment early in the development process. This paper presents theory and evidence for that argument.
[2] Some examples: who benefits from local productivity growth; electricity expansion and firm entry; Improved access to finance, productivity growth and price cuts; agricultural growth spilling over to manufacturing; cash transfers have a multiplier effect on the local economy.
[3] An emphasis on the importance of investment and economic growth for poverty reduction has become associated with the political right, but it was not always so. The famed left-wing economist Joan Robinson, for example, criticised Sri Lanka for attempting redistributive policies before it had sufficiently grown its economy — as recounted by Amartya Sen on page 7 of this interview. The existence of spillovers in production networks from investments to other areas of the economy is often the justification for policies traditionally associated with the political left, such as active industrial policy, which is often credited with the success of Asian economies. The UK Labour Party released a video to explain demand multipliers (in this case negative). The most recent evidence suggests that redistribution is good for growth, in which case pro-poor policies and the pursuit of economic growth can be seen as complementary.
[4] Here are a few papers about the importance of risk-bearing capital: Entrepreneurial risk under incomplete markets; Radical versus incremental innovation; raising capital under asymmetric information; micro-equity for microenterprises; macro development perspective on financial frictions ; venture debt ; synergising ventures.
