"Is a rise in the saving and investment rate a precondition for successful development?"

It is also necessary that there is an increase in the volume of real savings so that there may be in an increase in the level of investment without the consequence of rising inflation and its associated costs. As point two above illustrates, however, the ‘channelling’ of savings is just as important in increasing their level.  It is for this reason, therefore, that development economists have stressed the need for the establishment of financial institutions, which can provide a convenient and safe method by which any savings that economic agents make can be allocated efficiently and effectively to the most productive uses. It is also stated that the need for such institutions is all the more important the poorer the country as the fund for investment projects must be attained from a larger population.

A common problem both empirically and relevant for current less developed countries has been that there has often been governmental opposition to such financial institutions and hence legal restrictions often hamper their operation. It is claimed that the success of Germany both today and during its process of industrialisation and development emanates from the German model of a financial system, but even this system faced initial opposition. Originally the German financial institutions were some of the most primitive in Western Europe and provided very little in the way of investment loans. These institutions underwent radical changes from the 1840’s as a result of the rapid expansion and success of the railroads.  There was much agitation during this period because “note-issuing banks which could provide capital raised by their operations to firms, particularly railway companies, which needed it was sternly opposed by the Prussian government. The government was fearful of the loss of revenue from any infringement of its own minting rights, and was afraid of the effect which financial speculation might have on state finances”. It was anxious that investment in railways might divert investment from the land driving down the value of estate mortgage bonds (Pfandbriefe). In 1846 the Royal Bank was converted into the Preussiche Bank which was a joint stock company with private capital and was also given the exclusive right of note issue, although this was under strict government supervision.

Despite these attempts to restrict the investment the railways were seen to be an obvious success and were very attractive to many investors, but the size of the funds required for the necessary investment provided a huge financial risk to banks and hence demanded insurance. Such insurance often came in the form of directorship of the railway companies, shares in the companies and a share in the voting rights. This was the beginning of the legendary relationship of the German banks and industry, which is still respected and admired today. Even with insurance and safeguards, however, the amount of money required and hence the risk involved exceeded the resources of most private German banks. This problem was overcome, however, through the creation of Joint Stock Banks, whereby groups of banks would get together pooling their funds and diversifying the risk involved allowing the investment projects to be financed.  

The success of Germany and its financial institutions, however, does not remove the fact that it is not just enough to create new financial institutions but the level of real savings must be increased to make such institutions viable. Indeed, when analysing the German industrialisation much attention is paid to the joint stock banks, but it would be an exaggeration to suggest these were the sole cause of economic development evidence illustrates that these tended to be the last source of capital. Mobilising savings is, therefore, seen as being one of the major problems and issues for developing countries., especially from the rural areas. In Germany rural savings played a very important role in its economic development and in areas such as the Ruhr coalfield local traders and merchants often provided credit where loans from financial institutions were hard to obtain. The importance of this is shown by the fact that by 1865 bank credits of this type were three times the value of the note circulation. 

Savings can be mobilised in a variety of ways from simply a voluntary reduction in the level of consumption, involuntarily from an increase in the level of taxation or compulsory lending to the government, through inflation or simply by the movement of unemployed labour into productive work. Savings may also be increased through external mechanisms through investment in foreign capital, restrictions of imports or through improvements in the Terms of Trade. Obviously the voluntary methods through which the level of savings can be increased will be less effective the lower the level of income and hence this is why it is often believed that government policies have a crucial role to play in the development of an economy.

India provides a very good illustration of where government policies have tried to be put into action. As a result of India’s colonial rule by the United Kingdom at the time of independence a Planning Commission was established in order to formulate 5-yearly plans for the economy. A socialist pattern of society was adopted by Parliament in 1954 and in 1956 the “Industrial Policy Resolution declared that public sector expansion was necessary to prevent the concentration of economic power”. In essence its aim was to try and ensure that the ownership and control of resources in the economy was distributed in order to benefit society as a whole. In the 1950’s India tried to emphasise production for the home market combined with a reduction in imports hoping to develop its own industries. These aims were to a large extent realised and this is illustrated by the fact that India now produces a wide range of manufactured goods.

India, however, provides a very good example of the fact that an increase in investment does not necessarily promote development. Over the past decades the annual growth rates in its industrial sector have fallen from 8% between the late 1950’s and mid 1960’s, to under 6% during the 1970’s and around 2% in the early 1980’s despite the fact that the investment-income ratio was becoming more and more respectable. Regardless of this, however, it was believed that the planning strategy of industrialisation that was developed by the five-yearly plans would promote economic development, easing the problems of poverty.

Many development economists would argue that India illustrates an example of where government has played an inadequate role in the development process and failed to regulate industry effectively so that its objectives were met. Although increasing the level of private investment and consumption is important, these only constitute a part of aggregate demand. Government expenditure and exports, which are subject to government policy, are highly significant and must not be overlooked. Part of the problem in the Indian case has been that during the late 1960’s there was a sharp fall in the level of public investment and only began to increase in absolute terms in the mid 1970’s. A fall in public investment is of course significant by itself but it may have far reaching effects, especially when the structure of public investment is considered.

From the mid-1970’s “public investment began to be increasingly used as an instrument to serve the political ends of the decision-makers and was not as effective as in the past”. The improper allocation of investment funds has knock-on effects leading to an insufficient level of demand in the economy as a result of the worsening income distribution. The importance of public investment in the form of the provision of public education, health services and social security is often ignored. Not only is there the issue that there is much more to economic development than increasing the level of national income per capita, but investing in ‘human capital’ in the form of health and education can also help to increase the productivity of the economy. Evidence from Anand and Ravallion (1993) suggests that increased national income per capita helps to increase life expectancy as a result of allowing increased public expenditure, especially on health care, and through reducing poverty. Surely, these are the aims of economic development and hence it is clear that government has a vital role to play and that many of the problems associated with India can be attributed to the ‘failure’ of the government.

This essay has shown, therefore, that although a rise in the saving and investment rate is a precondition for successful development, both the examples of Germany and India illustrate that the framework by which this is achieved is inherently important. Issues such as promoting rural savings, regulation of financial institutions, financial repression and government policy are all relevant and hold the key to whether development is successful or not.