in growth between countries (confusing). In other words, investment has a
significant and positive relationship with economic growth but the causal rela-
tionship is weaker than other proximate causes of growth. One economist calls
this ‘an elusive quest for growth’. This section reviews these findings and
argues that the small impact of investment is wrong for developing countries.
Robust empirical results
Many early models of economic growth dating from the 1940s and 1950s,
developed by economists such as Roy Harrod, Evsey Domar and Arthur Lewis,
placed investment at the centre of their analysis. As countries shook off colonial
rule from the mid-1950s onwards, newly formed independent governments
turned to such theories in their efforts to boost growth rates. These theories had
clear, if simplistic, policy implications. Increasing growth required more invest-
ment which in turn required some combination of higher domestic savings and
more foreign exchange (the latter if imported machinery was necessary).
Government intervention was often seen as necessary to mobilize those extra
savings,and to ensure that scarce foreign exchange was not frittered away on
imported consumer goods. This thinking also influenced the international aid
industry that grew up after the 1950s. Economists could calculate the GDP
growth rate required in a developing country to promote industrialization and
reduce poverty at a reasonable rate. The investment rate required for this growth
could be compared with existing and future resources available from domestic
savings,government tax revenue and foreign exchange (export revenue).
Donors could then plug the gap with a mixture of loans and grants. William
Easterly notes that between 1950 and 1995 Western countries gave $1trillion
(measured in 1985 dollars) in aid mostly using this method or what he calls the
‘financing gap approach’. This was, he suggests, ‘one of the largest policy
experiments based on a single economic theory’ (Easterly, 2001b:33).
Both cross-country growth regressions and growth accounting (see Chapter
2) have found a positive relationship between investment and economic growth.
Numerous cross-country growth regressions find investment to be positively
linked with economic gro wth. Thus Islam (1995) finds that physical (and
human capital) leads to more rapid economic growth, and Ojo and Oshikoya
(1995) find that investment has a positive impact on growth among 17 African
countries between 1970 and 1991. There are inevitable problems in demonstrat-
ing a causal link between investment and economic growth. The theory
discussed above proposes that investment can drive economic growth through
augmenting capacity. The inverse is also possible; economic growth can drive
investment. According to the British economist John Maynard Keynes a grow-
ing economy with expanding markets and rising profits may motivate the
‘animal spirits’ of entrepreneurs to invest (see Box 3.2 on p. 72). So investment
can be both a cause and effect of economic growth. One study using a sample of
101 countries between 1965 and 1988 confirms this point, finding that past
growth has a significant effect on current investment (Blomstrom et al.,1996).
Domestic and Foreign Direct Investment 65