14 _Policy, Planning, and Research Working Paper Series_ This paper presents empirical evidence pertaining to the 'adding up problem" and the 'fallacy of composition." It is shown that, rather than market constraintin the developed countries, export growth in the developing countries is largely determined by supply factors. Thus, the deceleration of economic growth in the developed countries after 1973 was accompanied by an acceleration of the growth ofthe exports ofthe developing countries.

It further appears that, under realistic assumptions, the future growth of manufactured trade between developing and developed countries would result in a net employment gain for the latter. This would happen as employment gains in technologically advanced industries employing technical and skilled labor would more than offset losses in industries using chiefly semi-skilled and unskilled labor. At the same time, these losses would occur over a ten-year period, thereby limiting the cost of adjustment.

The cost of adjustment in the developed countries would decrease further if outward-oriented policies gained wider acceptance in the developing countries as these policies ensure the upgrading and diversification of exports and permit increased intra-industry specialization that limits pressures on particular industries in the developed countries. Thus, the argument of the proponents of the fallacy of composition thesis is turned on its head: the difficulties of adjustment in the developed countries can be reduced if more developing countries adopt outward oriented policies, rather than persisting in exporting a limited number of simple manufactures.

This conclusion gains in force if one considers that the foreign exchange obtained through the exportation of manufactured goods is spent by the developing countries to purchase manufactured goods from the developed countries. Thus, the balance of trade does not change and, under outward orientation, the incrementin foreign exchange is often utilized in the same industries via intraindustry specialization.

Also, developingcountriescan export to other developing countries. With the industrialization of outward-oriented countries, they can increasingly exchange manufactured goods with countries at lower levels of development, thereby providing an impetus to their economic growth without encroaching on

# developed country markets.

The findings of this paper have important policy implications. They support the views of those who advocate the application of outward-oriented policies in developing countries. This conclusion is strengthened if consideration is given to the possibilities of increased trade among the developing countries themselves. Finally, outward orientation promotes efficient import substitution through the reform of the system of incentives.

This paper, a product of the Office of the Vice President, Development Economics, is a background paper for the 1988 World Development Report. Please contact Norma Campbell, room S9-047, extension 33769.

# 31. **Public** Finance **and** Economic **Development**

# Bela Balassa

_Budget deficits tend to lead to a deterioration of the balance of payments. Furthermore, increases in government consumption and the public investment have adverse effects on economic growth._ This paper reports on tests of alternative hypotheses as to the effects of a budget deficit, examines the influence of the size of the government on economic growth, and investigates the impact of public investment on private investment, total investment, and economic growth.

The econometric results provide evidence that a substantial part of the budget deficit of the developing countries is externally financed. Also, the budget deficit appears to adversely affect private investment. However, a correlation between the budget deficit, on the one hand, and the money supply, inflation rates, and economic growth, on the other hand, has not been observed.

At the same time, there is a negative correlation between the ratio of government consumption to GDP and economic growth. This relationship applies to all developing countries as well as to the regional subsamples of countries in Africa, Asia, and Latin America.

Finally, there is a negative correlation between public investment, on the one hand, and private investment, total investment, and economic growth, on the other. It further apppears that the negative effects of public investment on economic growth can be decomposed in two parts: their adverse impact on total investment and their unfavorable influence on the efficiency of investment.

Thesefindingshaveimportantimplications for the developing countries. They show that budget deficits have adverse effects on the balance of payments as well as on domestic investment. It further appears that increases in government consumption adversely affect economic growth. Finally, increases in public investment not only crowd out private investment but tend to lower the efficiency of investment, with adverse effects on economic growth.

The conclusions point to the need for reducing budget deficits in developing countries. They further favor lowering government consumption as well as public investment in these countries.

This paper, a product of the Office of the Vice President, Development Economics, is a background paper for the 1988 World Development Report. Please contact Norma Campbell, room S9-047, extension 33769.

# 32. **Municipal Development** Funds **and Intermediaries**

# Kenneth Davey

_Where rapid urbanization strains the capacity oflocalgovernments to provide necessary public services, municipal development funds can channel new investments to municipalities and strengthen local government._ Urban populations are growing at nearly double the rate of population growth in developing countries, putting considerable pressure on local governments to expand their physical and social infrastructure. Crowded cities are short of funds and unable to attract investments to expand the facilities, services, and enterprises needed to upgrade urban areas. To compound the problem, municipal governments, which bear most of the responsibility for urban areas, lack the financial and technical resources.

One way to route new investments to local municipalities is to establish municipal development funds. These funds lend money to municipal clients (or provide a mix of grants and loans) for longterm conventional investments in urban infrastructure, commercial plants, housing, and other important facilities.