December 2007

Delhi School of Economics MA in Economics

Course 902: Issues in Economic Systems and Institutions

Teaching Notes1

Poverty measurement and policy: the Indonesian crisis Poverty reduction is one of the principal objectives of development, some would argue the objective of development, though, as we shall see, the latter formulation is more controversial than it may sound. If it’s a principal objective, we need to understand what it means, how to measure it, and how it relates to development patterns and policy choices. This case explores these issues. Since the whole of development influences poverty, we need to focus, and we look at two categories of question: concepts and measurement; and the policy choices raised by the economic crisis in Indonesia.

Analytical context

We outline here some of the analytical tools, looking first at links between poverty and choice-theoretic concepts, second, how to link this to measurement of welfare changes across the distribution, and third at questions of multiple “dimensions” of well-being and Sen’s capabilities approach.

Poverty and choice-theoretic concepts

Let’s start with an indirect utility function

v (p, w) = max u (x)

such that px ≤ w

This relates wealth (w), the choice of a vector of goods (x), a price vector (p) and utility (u). Utility is unobserved.

Now suppose society has some way of agreeing that utility below some level is “unacceptable”. Then, in terms of the expenditure function

1 These notes were prepared by Michael Walton and are solely for teaching purposes.

z = e ( p, u0)

Where u0 is the utility level at the poverty line. Note that prices are central to this definition. If unacceptable levels of utility are fixed over space and time, then this is absolute, expenditure poverty, and allows application of standard techniques of welfare evaluation. How might the unacceptable level of utility and expenditure be arrived at? The standard practical approach in contemporary poverty measurement is to start from a nutritional “minimum requirement”, calculated as the cost of this minimum, based on actual food consumption patterns of households who barely reach this minimum, with an added allowance for non-food consumption, based on the actual shares of food and non-food amongst the poor. This can be further adapted to allow for both different requirements for children, adults and the aged (know as “equivalence scales”), and for economies of scale in consumption as households grow in size. (If you note some potential for fuzziness in implementation here, you’re right.) Note also that most analysts prefer expenditure to income, both because expenditure is conceptually closer to a measure of permanent income, and because it is typically measured with less error.2

It is useful to show the poverty line in the overall distribution of incomes. This is done in Figure 1, that displays a typical stylized frequency distribution with respect to per capita household expenditures, with much greater densities around the middle of the distribution, and a long tail, owing to small numbers of households with high expenditure levels. The poor are those to the left of the poverty line.

Figure 1. Poverty and the overall frequency distribution of household per capita expenditures.

2 There is a lot more to say on poverty measurement: these notes are only intended to bring out a few points. See Deaton (1997) chapter 3 for a good survey.

Increases in expenditure, due to growth that affects the whole distribution, can be represented as a right-ward shift in the curve, leading to a reduction in those in poverty (Figure 2). Changes in poverty are only one part of overall distributional dynamics.

Figure 2 Growth in expenditures of the overall distribution and effects on poverty

This presents a picture on changes, but says nothing about how to add them up across households to give us an overall welfare measure. Just counting individuals below the poverty line, or “headcount” poverty, is by far the most commonly used. It happens to be a pretty dumb welfare measure. Think of the following: below the line, increments to expenditure, say from desperately poor to moderately poor, have zero impacts on the headcount measure. Marginal increases in income that happen to cross the poverty line do affect the measure. And increments to expenditure above the line, say from just not-poor to wealthy, have zero effects.

For calculating measures of poverty (below the line), a valuable, and much-used, set of indices was developed by Foster Greer and Thorbecke in their (FGT) class of measures, where the poverty index, Pα is given by

Pα = N-1∑((z – wi)/z)α for yi ≤ z (otherwise 0)

Where Pα is the poverty measure, α is a “poverty aversion factor”, that measures the extent to which society is averse to poverty levels below the poverty line, and N is the total population. This leads to the following commonly used poverty indices:

α = 0: poverty headcount

α = 1: poverty gap—the average shortfall from the poverty line expressed as a proportion of the poverty line

α = 2: squared poverty gap—with greater weights for larger individual shortfalls from the poverty line.

The relationship between individual welfare and social welfare of the various values for α are given in Figure 3.

Figure 3. The contribution to social welfare of changes in individual expenditure with alternative values of α in the FGT class of poverty measures

The P1 and P2 measures are a considerable improvement over the headcount, but still give precisely zero weight to welfare above the poverty line. This is still clearly inconsistent with how virtually all societies value income. It would be nuts for a rich country if the poverty line is that of a poor country. On the other hand, even people in the top parts of the distribution in poor countries are quite poor by global standards—for which standards in rich countries are surely the appropriate standards. What does this imply? A more sensible approach would aggregate across individuals using a general social welfare function with positive, but declining weights with respect to income across the whole distribution. A focus on absolute expenditure poverty is a politically useful way of

focusing government and donor attention on the most deprived, who should have the highest priority for policy, but is no substitute for a coherent overall approach.

Measuring welfare changes across the distribution

As noted, embedding poverty concepts in a choice-theoretic approach allows standard measures of welfare comparison to be used. The Friedman and Levinsohn (2002) study develops an empirically implementable application of the compensating variation concept to explore ex ante impacts of large price changes in Indonesia. This is briefly discussed here.

We want to know how much households would need to be compensated for price changes to restore the same utility. Take the expenditure function e(p,u). Then a first approximation of the compensation required is given by the first order Taylor expansion:

∆e ≈ x.∆p

But this only applies if the expenditure function is linear. If it is concave, the cost of restoring pre-crisis utility levels will be reduced to the extent households substitute away from goods whose prices rise disproportionately. This implies taking account of the full set of compensated derivatives of demand (s) from the Slutsky matrix. A second-order Taylor expansion provides a further approximation:

∆e ≈ x.∆p + ½ ∆p'.s.∆p

Now this can be applied across the whole distribution of households, with results organized for whatever partition of the data that we are interested in. Friedman and Levinsohn analyze these proxies for the compensating variation across the distribution of initial expenditures with a rural and urban partition. As just noted, it is useful to look at the whole distribution, that provides us the basis for applying whatever interpersonal ranking we wish, whether these are on some measure of social welfare or political salience. An exclusive focus on the poor (with your preferred value for α) is just one option.

Multi-dimensionality and Sen’s capabilities approach

When most analysts refer to poverty, they usually mean expenditure or income poverty. Yet income poverty is only one aspect of deprivation. Both poor and non-poor people refer to many features of deprivation, including lack of health, lack of skills, insecurity, lack of dignity, and lack of power (see Narayan et al, 2000, for a compendium of field-based research on the views of the poor). This has led to arguments that well-being in general, and poverty in particular, has to be analyzed in terms of multiple “dimensions”.

One way of analyzing this within a choice-theoretic framework is through a Lancaster-style approach that views demand for commodities as being a function of demand for their underlying characteristics, such as their contribution to nutrition.

An alternative way is in the conceptual work of Amartya Sen on “capabilities”, or the freedom that people have to lead the kind of lives they value—and have reason to value (see Sen, 1983). This starts from the view that what is of value are “functionings” or what people do, as opposed to the commodities they consume. Capabilities are then an ex ante “opportunity set” concept with respect to the potential individuals have to pursue such activities. These may range from quite basic considerations, such as “being adequately nourished or being free from avoidable disease” to more complex ones, such as “being able to take part in the life of the community” or “the ability to appear in public without shame”.3 These will be shaped both by opportunities for private consumption—determined by private wealth and prices of commodities—and the public provisioning and broader institutional context. In the World Bank’s World Development Report on Equity and Development, we also chose an ex ante concept of equity, in terms of equality of opportunity, drawing on Sen and related philosophical traditions. Note that an approach based on opportunities is robust to changes in preferences. Preferences change in the course of development, for economic and socio-cultural reasons. Yet the expansion of capabilities, or opportunity sets, is, at least in principle, measurable independent of preferences.

However, a difficulty with an ex ante concept is measurement, since we actually observe outcomes. Sen himself recommends using outcomes (for example of health and education status) as a way into to analyzing capabilities. We can see the Millennium Development Goals as an application of a perspective that well-being and deprivation has many dimensions, that can be viewed through the prism of Sen’s capabilities. They are, however, biased to the measurable, and do not include the more complex functionings related to participation and dignity.

Do you need to choose between a choice-theoretic and capabilities approach? Not necessarily. It depends on the question being asked.

The 1997-98 Indonesian crisis: welfare effects and policy responses

The East Asian crisis hit many of the previous East Asian “miracle” countries, that had previously grown at historically unprecedented rates for decades. Indonesia was hit particularly hard, and unlike most of the others (Korea, Malaysia, Thailand, the Philippines) the crisis precipitated broader political and economic transitions, and was unusually prolonged. That is a separate story. Here we are interested in the short-run impact of the crisis on poverty. First we provide some context in terms of Indonesia’s overall history and experience with poverty reduction over the long term.

3 This last comes directly from Adam Smith.

History

Indonesia is a country of over 200 million people, spread over an archipelago of thousands of islands. She became independent from the Dutch in 1949, and was then led by her first President Sukarno in an increasingly unstable alliance, that eventually spilled over into hyperinflation and a bloody civil war in 1965. Hundreds of thousands—perhaps millions—died. General Suharto came to power in 1996, leading a group of right-wing military officials, and became president in 1968. He banned the communist party, broke off relations with China and aligned the country with the West.

After the economy was stabilized, there followed almost three decades of growth, transforming the country from a very poor, largely rural society to a dynamic, industrializing one. While oil helped, central to this transformation were three factors: sound management of the overall economy, with Suharto delegating macroeconomic management to the Berkeley Mafia (so-named because of their Ford Foundation-financed training in Berkeley) led by the economist Widjojo; second, a political need and ideological commitment to support the peasantry, especially on Java; and third, an alliance between the military-dominated political elite and the Chinese business community, based on mutual dependence (and the credible threat of Chinese capital to fly out if conditions went bad.)

While this economic and political equilibrium was sustained for some thirty years—backed by the threat of repression—social pressures were rising in the 1990s, fueled by urbanization, a growing middle class, expanding university populations, and rising high-scale corruption amongst Suharto’s family and cronies.

Pre-crisis poverty changes and their influence on views on poverty reduction strategy

While the economy had been stabilized and was already growing in the 1970s, pessimism reigned on the prospects for poverty reduction, especially on the densely populated core province of Java. An influential concept was that of “agricultural involution”—that rural households applied more and more labor to paddy production to just sustain dismal per capita consumption levels. Yet at the same time the beginnings of a stunning improvement of welfare was underway, in terms of consumption poverty, health and educational indicators (Table 1)

Table 1 Welfare indicators for Indonesia, 1975 and 1995

1975 1995

Poverty (head count) 64.3% 11.4%

Life expectancy at birth (years)

48 64

Infant mortality (per 1000 births)

118 51

Primary school enrollment (net)

76% 95%

Secondary school enrollment (net)

13% 55%

Source: World Bank.

This transformation had a powerful influence on international thinking on poverty reduction strategy: the World Bank’s 1990 World Development Report on poverty was heavily influenced by the Indonesia experience in its formulation of a “two-part strategy” of labor-demanding growth and social service provisioning, with the labor demanding-growth driven by rural productivity increases and expansion of labor-intensive manufacturing, effected pro-agricultural policies, openness and infrastructure. Indeed, heavily influenced by the Indonesian and other East Asian record, this WDR placed less emphasis on safety nets, or, more broadly, the management of insecurity. This is now recognized to be a weakness in the framework. With the 1997-98 crisis, questions of insecurity were brought to center stage even in East Asia. The other major weakness of the 1990 WDR was the lack of attention to questions of institutions and power: these are actually central to the explanation of both successes and failures in reducing poverty in Indonesia.

The 1997-98 crisis and poverty impacts

The East Asian crisis started with the July 1997 devaluation of the Thai Baht. It soon spread to Indonesia with an August speculative attack on the Indonesian Rupiah. Indonesia swiftly moved into major crisis, with the Rupiah collapsing, inflation taking off, external long-term debt downgraded to junk bond status, disastrous balance sheet effects on much of the corporate sector (whose dollar liabilities far exceeded their dollar assets), and consequential problems for the financial sector. GDP fell almost 14 percent of GDP in 1998, and the Rupiah-Dollar rate went from 2000 to 18000. Food prices rose faster than general prices, and a social and economic crisis spilled over into a political crisis, with President Suharto eventually forced to resign by mid-1998.

For this case we’re not interested in explaining the crisis, but in the consequences for poverty and what this implied for policy choice.

How much did poverty and well-being change?

As it happened, there were huge differences in estimates of the size of the poverty impact early in the crisis, depending on the price deflator used. In July 1998, the government said that poverty had gone up by 40 percent because prices had risen 100 percent and nominal incomes were fixed. The World Bank (at that point) estimated real consumption expenditures had fallen by 3 percent and poverty had increased by only 4 percent, based on nominal changes in spending deflated by the consumer price index (CPI). Both of these were wrong: there were large changes in both the price level and relative prices, rendering both calculations incorrect, precisely for the reasons discussed in the analytical context. Let’s first look at the results from the ex ante analysis of Friedman and Levinsohn. They implement the formulae given above, based on actual price changes between January 1997 and October 1998, the initial consumption patterns of households, own-production of food and housing and (for the second formula) the estimated own- and cross-price elasticities of demand. The results for the first formula, with no substitution, are given in Table 2, in which the CV is expressed in terms of the ratio to initial expenditure levels—it is the amount needed to compensate households for the change in prices, that could then be compared with actual changes. Impact effects are larger for the urban poor, and least for the rural poor.

Table 2. Compensating variation for price effects by expenditure decile, rural/urban and poor/nonpoor status (as proportion of initial household expenditures).

Source: Friedman and Levinsohn, 2002

Figure 4 then shows the effect of allowing for substitution effects, using the approximation in the second formula (with a second-order Taylor expansion). This gives a substantially reduced estimate of CVs across the distribution, though the authors argue this is a lower bound, on the grounds that elasticities from large price changes will be lower than for the marginal changes estimated from the cross-section data.

Figure 4. Estimated compensating variation for rural and urban households with and without substitution effects

Source: Friedman and Levinsohn, 2002

Note that an important part of the relatively moderate effect for the rural poor flows from the value given to own-production, especially of food: absent this, the CV for the rural poor would be about twice as high.

Now let’s look at actual changes in poverty. Key to this is updating the poverty line in the wake of the large absolute and relative price changes. This involves applying the same concepts as in the overall analysis of welfare changes. In other words, we want a price deflator, П, such that, the household expenditure function (the expenditures required to reach the utility level at the poverty line) satisfy:

e (pt+n, u0) = e (pt, u0)*(1+П)

The typical approach (implemented by Suryahadi et al, 2003) is equivalent to the first approximation of Friedman and Levinsohn, based on actual budget shares of the poor. This is a huge improvement on the CPI when relative prices change, but will have biases (which way?) compared with an estimation allowing for substitution effects. The overall picture for overall poverty is summarized in Figure 5. By this method, the poverty rate more than doubled from pre-crisis levels to the peak, but then fell back to pre-crisis levels over about 18 months.

Figure 5 The evolution of poverty over the Indonesian crisis

Source: Suryahadi, Sumarto and Pritchett, 2003.

This presents the aggregate picture. Additional analysis of changes in the “poverty profile”—the pattern of poverty in relation to household characteristics—finds that the hardest hit were the urban lower income groups, while rural dwellers with export crops (especially in Sumatra and other “Outer Islands”) did relatively well.

Policy choices

So what were the policy options—especially in early 1998, when it was known that poverty was worsening sharply, but not that there would be a recovery? The stylized facts on impacts on poverty—drawing on the types of analyses just reviewed—were as follows:

n The hardest hit were in urban areas—who faced large adverse welfare effects owing to the combination of job losses and real wage declines, especially in relation to the price of food.

n There was some reverse migration to rural areas. n Rural areas suffered less severe losses, but higher initial poverty, with

heterogeneous effects depending on their net food consumption (how much they consumed relative to production) and whether or not they produced export crops.

n There was concern that households would pull kids out of school, or cut back on health care, owing to declining real incomes, with potential long-run effects on the human capital of the children.

This mix raises a number of questions for policy design. Here are three of the big choices:

1) Between spending on poverty and on other programs: revenues are falling and, while there is support for “safety net” spending, there are also large spending demands for other areas, especially for subsidies to kerosene (that is moderately regressive), and to the bailout of the banking system (that some argue is necessary to avert financial meltdown).

2) Between chronic and dynamic poverty: should spending give greatest priority to the poorest or those most hurt by the crisis?

3) Between choices over how to target, with a menu of options: a) subsidies to items important in the consumption basket of the poor, notably rice b) using self-selection through public works programs with a low wage c) channeling resources into reducing costs for school and health clinic attendance d) channeling resources to relatively poor communities.

We will discuss these choices in class and look at ex post empirical results for (b) and (c).

The policy question

You are a senior official with responsibility for poverty in BAPPENAS—Indonesia’s influential planning agency. It is early 1998. Prices are soaring, and the price of rice is rising faster than most other prices. The economy is in decline, urban factories are closing, and the depth of the crisis in the banking system is just becoming clear. In the years of growth the management of shocks was never on the agenda—for good or ill—with the government explicitly or implicitly relying on informal coping mechanisms as the primary safety net for the poor. Now both the government and donors are willing to put resources into programs to mitigate the effects of the crisis on households, for both welfare and political reasons. Discussions internally, and with the World Bank on international experience, suggest a menu of policy instruments that might be feasible to put in place in an emergency: food price subsidies, transfers to keep kids in schools and reduce costs of attending health centers, public works schemes and transfers to communities. At the same time you are aware of the broader context of expenditure choices, with kerosene subsidies rising, your financial sector colleagues looking at fiscal implications of a potential bank bailout, plus demands from the broader infrastructure investment program. How do you evaluate alternatives across program choice and allocations across location and households? What policy mix do you recommend? You need to prepare a policy brief for the Planning Minister for a Cabinet decision.

(Note you may wish to choose between focusing primarily choices within the safety net program, or between the safety net group of programs and other expenditure categories.)

Selected references

Deaton, Angus. 1997. The Analysis of Household Surveys. Baltimore and London: the Johns Hopkins Press.

Narayan, Deepa, Robert Chambers, Meera Naul Shah and Patti Petesch . 2000. Voices of

the Poor – Crying out for Change. New York: published for the World Bank, Oxford University Press.

Sen, Amartya. 1985. Commodities and Capabilities. Amsterdam: North-Holland. Suryahadi, Asep, Sudarno Sumarto and Lant Pritchett. 2003. “The Evoluation of Poverty

during the Crisis in Indonesia, 1996-99”. SMERU Working Paper, Jakarta, Indonesia.

Pritchett, Lant, Sudarno Sumarto and Asep Suryahadi. 2002. “Targeted Programs in an

Economic Crisis: Empirical Findings from the Experience of Indonesia.” SMERU Working Paper, Jakarta, Indonesia.

Friedman, Jed and James Levinsohn. 2002. “The Distributional Impacts of Indonesia’s

Financial Crisis on Household Welfare: A ‘Rapid Response’ Methodology.” The World Bank Economic Review, 16:3, 397-423.

Map of Indonesia