2 The Links Between Macroeconomic Policy and Poverty Reduction: Growth Matters

Alejandro Izquierdo, Ward Brown, Brian Ames, and Shatayanan Devarajan
Published Date:
August 2001
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Economic growth is the single most important factor influencing poverty. Numerous statistical studies have found a strong association between national per capita income and national poverty indicators, using both income and nonincome measures of poverty.5 One recent study consisting of 80 countries covering four decades found that, on average, the income of the bottom one-fifth of the population rose one-for-one with the overall growth of the economy as defined by per capita GDP (Dollar and Kraay, 2000). Moreover, the study found that the effect of growth on the income of the poor was on average no different in poor countries than in rich countries, that the poverty–growth relationship had not changed in recent years, and that policy-induced growth was as good for the poor as it was for the overall population. Another study that looked at 143 growth episodes also found that the “growth effect” dominated, with the “distribution effect” being important in only a minority of cases (White and Anderson, forthcoming). These studies, however, establish association, but not causation. In fact, the causality could well go the other way. In such cases, poverty reduction could in fact be necessary to implement stable macroeconomic policies or to achieve higher growth.

Studies show that capital accumulation by the private sector drives growth.6 Therefore, a key objective of a country’s poverty reduction strategy should be to establish conditions that facilitate private sector investment. No magic bullet can guarantee increased rates of private sector investment. Instead, in addition to a sustainable and stable set of macroeconomic policies, a country’s poverty reduction policy agenda should, in most cases, extend across a variety of policy areas, including privatization, trade liberalization, banking and financial sector reforms, labor markets, the regulatory environment, and the judicial system. The agenda will certainly include increased and more efficient public investment in a country’s health, education, and other priority social service sectors.7

Macroeconomic Stability Is Necessary for Growth

Macroeconomic stability is the cornerstone of any successful effort to increase private sector development and economic growth (see Box 2). Cross-country regressions using a large sample of countries suggest that growth, investment, and productivity are positively correlated with macroeconomic stability (Easterly and Kraay, 1999). Although it is difficult to prove the direction of causation, these results confirm that macroeconomic instability has generally been associated with poor growth performance. Without macroeconomic stability, domestic and foreign investors will stay away and resources will be diverted elsewhere. In fact, econometric evidence of investment behavior indicates that in addition to conventional factors (i.e., past growth of economic activity, real interest rates, and private sector credit), private investment is significantly and negatively influenced by uncertainty and macroeconomic instability (see, for example, Ramey and Ramey, 1995).

Box 2.Macroeconomic Stability

Macroeconomic stability exists when key economic relationships are in balance—for example, between domestic demand and output, the balance of payments, fiscal revenues and expenditure, and savings and investment. These relationships, however, need not necessarily be in exact balance. Imbalances such as fiscal and current account deficits or surpluses are perfectly compatible with economic stability provided that they can be financed in a sustainable manner.

There is no unique set of thresholds for each macroeconomic variable between stability and instability. Rather, there is a continuum of various combinations of levels of key macroeconomic variables (e.g., growth, inflation, fiscal deficit, current account deficit, international reserves) that could indicate macroeconomic instability. While it may be relatively easy to identify a country in a state of macroeconomic instability (e.g., large current account deficits financed by short-term borrowing, high and rising levels of public debt, double-digit inflation rates, and stagnant or declining GDP) or stability (e.g., current account and fiscal balances consistent with low and declining debt levels, inflation in the low single digits, and rising per capita GDP), there is a substantial “gray area” in between where countries enjoy a degree of stability, but where macroeconomic performance could clearly be improved.

Finally, macroeconomic stability depends not only on the macroeconomic management of an economy, but also on the structure of key markets and sectors. To enhance macroeconomic stability, countries need to support macroeconomic policy with structural reforms that strengthen and improve the functioning of these markets and sectors.

Macroeconomic Instability Hurts the Poor

In addition to low (and sometimes even negative) growth rates, other aspects of macroeconomic instability can place a heavy burden on the poor. Inflation, for example, is a regressive and arbitrary tax, the burden of which is typically borne disproportionately by those in lower income brackets. The reason is twofold. First, the poor tend to hold most of their financial assets in the form of cash rather than in interest-bearing assets. Second, they are generally less able than are the better off to protect the real value of their incomes and assets from inflation. In consequence, price jumps generally erode the real wages and assets of the poor more than those of the non-poor. Moreover, beyond certain thresholds, inflation also curbs output growth, an effect that will impact even those among the poor who infrequently use money for economic transactions.8 In addition, low output growth that is typically associated with instability can have a longer-term impact on poverty (a phenomenon known as “hysteresis”). This phenomenon typically operates through shocks to the human capital of the poor. In Africa, for instance, there is evidence that children from poor families drop out of school during crises. Similarly, studies for Latin American countries suggest that adverse terms-of-trade shocks explain part of the decline of schooling attainment (see, for example, Behrman, Duryea, and Szeleky, 1999).

Composition and Distribution of Growth Also Matter

Although economic growth is the engine of poverty reduction, it works more effectively in some situations than in others.9 Two key factors that appear to determine the impact of growth on poverty are the distributional patterns and the sectoral composition of growth.

If the benefits of growth are translated into poverty reduction through the existing distribution of income, then more equal societies will be more efficient transformers of growth into poverty reduction. A number of empirical studies have found that the responsiveness of income poverty to growth increases significantly as inequality is lowered.10 This is also supported by a recent cross-country study that found that the more equal the distribution of income in a country, the greater the impact of growth on the number of people in poverty (Ravallion, 1997). Others have suggested that greater equity comes at the expense of lower growth and that there is a trade-off between growth and equity when it comes to poverty reduction.11 A large number of recent empirical studies, however, have found that there is not necessarily such a trade-off12 and that equity in its various dimensions is growth enhancing.13

The sectoral composition of growth can determine the impact that growth will have on poverty. Conventional wisdom has been that growth in sectors of the economy where the poor are concentrated will have a greater impact on reducing poverty than growth in other sectors—indeed, this is almost a tautology. For example, it is often argued that in countries where most of the poor live in rural areas, agricultural growth reduces poverty because it generates income for poor farmers and increases the demand for goods and services that can easily be produced by the poor.14 Various country-specific and cross-country studies have shown that growth in the agricultural and tertiary sectors has had a major effect on reducing poverty, while growth in manufacturing has not.15 This reinforces the case for duty-free access to industrial country markets for agricultural exports from lowincome countries. The links may be more complex over the long run, however. While faster growth in agriculture may address rural poverty in the short-term, reliance on agricultural activity may also intensify output variability, which, in turn, would contribute to increasing rather than decreasing poverty. A more diversified economy with a vibrant manufacturing sector might offer the best chances for a sustainable improvement in living standards in the long run.

Implications for Macroeconomic Policy

What are the implications of these empirical findings for macroeconomic policy? First, in light of the importance of growth for poverty reduction, and of macroeconomic stability for growth, the broad objective of macroeconomic policy should be the establishment, or strengthening, of macroeconomic stability. Policymakers should therefore define a set of attainable macroeconomic targets (i.e., growth, inflation, external debt, and net international reserves) with the objective of maintaining macroeconomic stability, and pursue macroeconomic policies (fiscal, monetary, and exchange rate) consistent with those targets. In cases where macroeconomic imbalances are less severe, a range of possible targets may be consistent with the objective of stabilization. Precise targets can then be set within that range, in accordance with the goals and priorities in the country’s poverty reduction strategy (see the section on fiscal policy later in this pamphlet).

Second, most developing countries will likely have substantial scope for enhancing the quality of growth, that is, the degree to which the poor share in the fruits of such growth, through policies aimed at improving income distribution. These policies (e.g., land tenure reform, changes in marginal and average tax rates, increases in pro-poor social spending, etc.) often are politically charged, and usually require supporting structural and governance reforms that would empower the poor to demand resources and/or ensure that resources intended for them are not diverted to other groups of the population. As these topics pertain more broadly to political economy, rather than exclusively to macroeconomics, they are beyond the scope of this pamphlet. But they reinforce the point that economic growth alone is not sufficient for poverty reduction and that complementary redistributional policies may be needed to ensure that the poor benefit from growth.

Finally, while issues regarding the composition of growth also go beyond strict macroeconomics, several general policy observations can be made. There is a general consensus that policies that introduce distortions in order to influence growth in a particular sector can hamper overall growth. The industrial policies pursued by many African developing countries in the 1960s have long been discredited (World Bank, 1982). Instead, strategies for sector specific growth should focus on removing distortions that impede growth in a particular sector. In addition, policymakers should implement policies that will empower the poor and create the conditions that would permit them to move into new as well as existing areas of opportunity, thereby allowing them to better share in the fruits of economic growth. The objectives of such policies should include creating a stable environment and level playing field conducive to private sector investment and broad-based economic growth; removing the cultural, social, and economic constraints that prevent the poor from making full use of their existing asset base and accessing markets; and increasing the human capital base of the poor through the provision of basic health and education services. Using these policies, and the redistributive policies described above, policymakers can target “pro-poor” growth—that is, they can attempt to maximize the beneficial impact of sustained economic growth on poverty reduction.

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