The Economics of Isolation and the Role of Aid

In the past month I have visited South Sudan, Sierra Leone and Rwanda. Although radically different in many important respects, these three low-income countries face the common problem that their economies are all small and isolated. The remarkable success of Rwanda in achieving the hat trick of rapid growth, rapid poverty reduction and increased equity demonstrates that at low levels of income much can be achieved by good economic policies even given isolation. However, the next stage – the transition to middle-income levels – would be frustrated by continued isolation.

Isolation is both an external and an internal phenomenon. South Sudan is an extreme in both respects: internationally it is landlocked and currently lacks rail, paved road or pipeline connections to a port; internally, the population is radically dispersed over a huge area without roads. Rwanda is also landlocked and lacking in a rail link. Being coastal Sierra Leone has the potential to be better connected, but its dramatic lack of all forms of infrastructure so raises transport costs that it too is isolated.

The existing economic activities in countries that are small and isolated are adapted to isolation. Each activity is free-standing, and can function despite a small scale of operation. The classic activity with these characteristics is subsistence agriculture, but even the export activities will have these features: in Sierra Leone and South Sudan the export activities are extractives, while in Rwanda they are smallholder coffee and tea. But such free-standing activities cannot raise the productivity of the labour force to middle-income levels.

The modern miracle of productivity depends upon the large-scale production of activities that are densely interconnected: each activity is dependent upon inputs from many other activities. The path to prosperity for these societies requires breaking into this web of interdependence, but for an isolated small economy the path to breaking in is tortuous. Quite possibly no modern activity is viable in such an economy because it depends upon inputs which cannot either be produced or imported at a viable cost. South Sudan comes disturbingly close to this corner solution. The unit costs of undertaking modern activities are so high that all modern products are either imported or unavailable: the main exception is beer, but even here the new brewery is currently loss-making.

More generally, the sequence of breaking into new activities for a small economy that remained isolated would quite possibly need to replicate the agonizingly slow path of industrialization in the original small, isolated industrializing economy, Britain. Industrial activities in eighteenth century Britain did not leap to the current range of modern products, but started with a much simpler range: for example, illumination proceeded from candles, to oil lamps, and to gas before arriving at electricity. This was not just because the more complex products had yet to be invented: there was no point in inventing products that the economy was incapable of producing because key inputs were lacking.

So far I have suggested two propositions. The first is that middle-income status depends upon breaking in to the modern web of interconnected activities. The second is that breaking in while remaining isolated would probably require stepping stones to modernity: the introduction of antiquated activities that would permit the gradual progression to more modern activities. Such a process, while feasible, would take a very long time. An implication is that it is vital for such economies to end their isolation.

While connectivity is vital it has high fixed costs: roads, railways, airports, fibre optics and pipelines. Not only is this expensive and risky, if transport services are efficiently priced at marginal cost, the investment will be loss-making. Small, poor, isolated economies cannot afford this investment, yet without it they are condemned to remain poor. Hence, they need international public risk capital (or its equivalent in the form of an oil well). Of course, even an investment in connectivity does not guarantee development. Although connectivity enables a range of modern activities to get established (initially relying upon imported inputs), each new activity requires pioneering investment. By demonstrating that these activities are viable, pioneers provide beneficial externalities for the economy: an implication is that pioneering is under-provided.

But for both government and donors, even though investment in connectivity may fail to trigger development to middle-income, it is risk-reducing. For both of them the key risk is that the country will stay stuck at low-income, and without connectivity this risk is very high indeed. Thus, the same investment can be unacceptably risky for private investors (whose objective is different) yet risk-reducing for donors. This is why small, poor, isolated economies cannot rely upon private investors to solve their development needs. Small, poor economies that are integrated into the global economy do not face these problems because modern inter-dependent activities can be introduced piecemeal, their inputs being supplied from the world market.

This article first appeared on Social Europe Journal