Chapter 2: Institutions, Governance and Growth
To establish how aid can make an effective contribution to development, it is first necessary to get some understanding of what the determinants of growth are. By the 1980s, it was evident that old development theory, with its emphasis on physical capital, and the presumed equivalence between foreign savings in the form of aid and investment, provided an inadequate explanation for the poor economic performance of developing countries. Early neo-classical models were also facing difficulties because their key prediction of a convergence between the per capita incomes of developing and developed countries, based on the crucial assumption of diminishing returns, did not seem to be occurring. Statistically, it had been observed that there was a lack of any inverse correlation between growth rates and the initial level of per capita GDP. Nevertheless, the growth-accounting exercises based on the aggregate production-function approach had by now yielded significant insights into the sources of growth. The findings of several important production-function studies, such as Maddison (1970), Robinson (1971), Nadiri (1972) and others, have been summarized in Thirlwall (1999). These studies found that, while the major sources of growth were factor inputs in the form of labour and capital, the gains to growth from improved health, nutrition and education were also considerable. Such gains in factor productivity accrued either through improvements in the quality of labour or through various other channels of increased efficiency. These empirical insights spurred the formulation of new theories of endogenous growth, starting with Romer (1986, 1989) and Lucas (1988)...
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