12 If between 40 and 50 percent of the total welfare cost can be attributed to public expenditure volatility<sup>9</sup> , the resulting cost has to be contrasted with the potential benefits of public spending to determine the overall benefit to society of public spending. Even further, knowledge of how this welfare cost is distributed across members of society is necessary because the supposed beneficiaries of public spending could be disproportionately bearing the loss induced by volatility. If risk tolerance decreases with wealth, as evidence suggests (Ogaki, et. al. 2001), then the poor will bear most of the cost of volatility. Additionally, to compensate for risk, the poor will self-insure by choosing activities with low rates of return but smaller variance. They will change their production and savings decisions to compensate for increasing risk (Morduch, 1995; Jalan et.al, 2001), in ways that reduce their income and, hence, perpetuate poverty. More analysis of how societies do risk-sharing along the lines of Townsend (1994) for India and Ogaki et.al (2001) for Pakistan, would be beneficial. For the moment, these estimates indicate an extremely high aggregate cost of volatility, requiring high benefits of spending to compensate for that welfare loss.

Hence, gauging the growth impact of additional spending, as well as other impact on human capital formation and welfare, is important. The rest of the paper is devoted to these challenges.

# **B. Public expenditure, outcomes and growth at the macro level: Where is the chain’s weakest link?**

This section discusses the assessment of the relationship between public expenditure and growth, intermediated by the effectiveness of public spending in affecting outcomes such as educational attainment, the number of paved road kilometers, or the kilowatts of electricity delivered to users. Recent literature surveys by the IMF (2005) and the World Bank (2007) exemplify the high ambiguity about the relationship between public expenditure and growth at the macroeconomic level. On one hand, the IMF survey reports that “empirical evidence on the impact of public investment on growth remains mixed” and that “their [infrastructure projects] impact on GDP growth is more uncertain. Empirical studies that have tried to estimate such impact have yielded widely different results.... Empirical ambiguity over links between spending and growth has also been shown to exist for other types of expenditure...” (IMF 2005, pg. 13). On the other hand, the World Bank survey states that “...though some non-robustness remains in the evidence, this largely applies to studies before 2000. ... a number of recent papers reverse the earlier findings, and now find strong positive growth effects from public capital spending. [list of papers] show that sectors usually regarded as productive (transport and

> 9 Based on the percentage of the variance of household consumption volatility explained by public expenditure volatility (R<sup>2</sup> of the regressions presented in figures discussed in the text and footnote 5).  This assumes that policy volatility is exogenous with respect to consumption volatility, based on the instrumental variables estimation of Fatas-Mihov (2003) referring to output volatility.  This work is yet to be done for consumption volatility, but similarity of the country rankings by volatility between the FatasMihov papers and this paper’s, suggests results will not be radically different.