The Neo Classical Theory

A radical shift away from the international dependence theory began to emerge in the 1980s. The neo classical theory essentially argued for unobstructed free markets as the best conduit for rapid and successful development. Unfettered markets, it came to be believed, would not only foster competition, they would also ensure the efficient allocation of resources that, in turn, would push a developing economy on to a stable growth path. Surprisingly, the theory evolved almost alongside the rise of conservative governments in the western economies.

Three differing strands of this theory gradually began to take shape. These are:
(i) the free market approach;

(ii) the public choice theory; and

(iii) the marketfriendly approach.

Of these, the first two contended that markets should be totally free, and that any  government intervention is necessarily bad. The public choice theory, associated with  libertarianism, is perhaps more radical in arguing that governments themselves are rarely good, and therefore, their intervention should be minimal. The market-friendly approach has gained currency in more recent years. While continuing to advocate free markets, the theory recognises several market imperfections, especially in the developing economies. It, thus, argues in favour of government intervention to fix several such imperfections. The three approaches essentially differ on the nature and extent of market regulation.

Robert Solow was one of the pioneers of the neo classical theory of development. In the Solow model, workers produce output by using tools and machines in factories (collectively referred as capital). Income per worker increases with an increase in output per worker. Workers can produce more output when they work with more tools. Thus, in Solow’s model, growth (in income) requires capital accumulation. Firms should, therefore, be willing and able to invest in equipment that makes workers more productive. Solow also recognised that there are only so many machines that any given worker could use. Thus, at some point increasing capital becomes less and less helpful in raising workers’ productivity. Growth (in income) in such a situation can be sustained only if accompanied by technological progress, or innovations, to make resources (labour and capital) more productive over time.

Romer, a renowned development economist, argued that government fiscal and monetary policies alone are unlikely to promote economic growth. Fiscal policies, such as greater government spending, or cuts in taxes (that may translate to higher consumption expenditure) could, at best, provide a short run stimulus to the economy. When government or people consume more, firms also produce more to satisfy this demand. However, more consumption expenditure implies less saving, and less saving leads to less deposit in banks for firms to borrow.

This makes it harder for firms to expand through capital accumulation. Thus, the boost to economic activity from an increase in spending is only temporary. Similarly, monetary policy measures that are designed to increase money supply may also induce a temporary surge in spending. But, in the long run they do little to raise an economy’s stock of capital, or advanced technology.

Like Solow, Romer emphasises production method improvements for long run economic growth, and further elaborates how this could be achieved. Specifically, he highlights the role of knowledge accumulation from investment in education, and in research and development. Romer also suggested that governments could consider subsidising research that facilitates innovation, and resist extending support to dying industries that fail to innovate.