Remittances

For a while there it seemed like "Remittances" were going to be the next big panacea in development economics. You know, you've all heard the stories about how Haiti's remittances are more than 100% of its GDP or how remittances trump the flow of private foreign aid in Uzbekistan, or how in Lilliputan nobody works anymore, they all live off remittances now.

And there's a lot of truth in that in the sense that it's definitely a phenomenon that is of a magnitude that begs for careful study. But honestly I've actually been a bit disappointed with a good bit of the relevant literature.

On one hand you've got the remittance cheerleaders who extol the great virtues of these cross border transfers. They're actually right to do so in fact but they tend to miss the point - I'll explain what I mean in a second, and in fact that is what this post is all about. On the other hand, it's almost too easy to say "hey, poor people are getting sent money now so they're better off". So people look for "counter intuitive" effects of remittance flows because "counter intuitive" effects are all the rage these days. As a result you get a somewhat sizable literature on the moral hazard effects of remittances. For example, this IMF working paper takes this position. The New Economist blog discussed similar results awhile back here (and btw that is a really good blog). The basic idea here is that when workers in destination countries send money back home to grandma in Azerbaijan, grandma doesn't work as much anymore... ha ha you foolish grandson, grandma got one over on you!

So let's dispose of the latter, "Remittances are bad" argument first since that's more straight forward. The basic problem here is that it doesn't pass the common sense test. Yeah, of course when folks send money to their grandma, she'll work less. That maybe the whole point. In fact, based on personal experience of a family which has sent much money back to the old world, this ain't "moral hazard". Quite simply, it's remittances doing what they're supposed to do. And while it's definitely possible to set up a model where it is moral hazard which leads to a decline in labor supply of remittance recipients, it is even more straightforward to set up a model where a fall in labor supply is the purpose that the remittance sender is trying to achieve. Since, empirically, all we observe is that (sometimes) labor supply falls when remittances go up there really isn't a way to distinguish between these two models and it certainly is no evidence for the "moral hazard" story.

Also, please note that the paper linked to above develops a model where an increase in the LEVEL of remittances is supposed to generate a decrease in the per capita growth rate (under some assumptions). Yet, the researchers find no evidence of that so they skip very quickly to a regression of the effect of the CHANGE in remittance flows on the level of growth. Which is a different thing all together. (pg 18 for model specification. I'm not sure what the offered explanation: "This specification better captures the dynamics of private transfers" actually means in this context. Table 4 shows the lack of relationship between level of remittances and growth. Table 5 shows the fudged model where there is a negative relationship between change in remittances and change in output (could it be that when output grows faster, wage differentials get smaller, so there's less of a need to send remittances?).

Ok. But what about the argument that remittances are all biscuits and gravy with tiny bits of sausage in it? Welllll, no. Sort of. I mean, yes, but, let's think about things more carefully here. (This is basically the gist of this WB report, which doesn't mean that agree with everything in it)

Bottom line is that most of the so called "gains from remittances" are straight up gains from IMMIGRATION. Or in other words, they are gains from the fact that some person from a poor household in a poor county has managed to make their way to a rich country and now has a richer income. Strictly speaking the gain from remittances is just the gain from INTER-HOUSEHOLD reallocation of income between the migrant and those who stay behind, not the overall increase in household income due to migration.

Let's illustrate this with some standard econ graphs. Take a household which is comprised of two individuals, say, brothers. And suppose that initially both brothers live in a poor country where they both earn the poor country wage of W(P). Now, we're going to take "household utility" as out metric here, and assuming that each brother's utility has diminishing returns to income and that each brother cares about the other we basically get that the two brothers should divide their total income (2*W(P)) equally between themselves (this is sufficient, not necessary. All we need is that there is some altruism between household members here). This is illustrated in a standard budget constraint/indifference curve below, where the utility of brother 1 is on the x-axis and the utility of brother 2 is on the y-axis;



Now suppose one of the brothers has the good luck to be able emigrate to a richer country where he earns the wage w(Rich). If there is no possibility of remittances here what is the highest utility level that the two brother household can attain here? Welp, it's represented by the indifference curve which crosses the new endowment point;



But we got that new blue budget constraint there - which illustrates the possible income/utility levels which are attainable IF there is a costless way to transfer resources from the lucky immigrant brother to the unlucky stay at home brother. Hence, if remittances are allowed the household will be able to reach a higher utility level as illustrated below;



Given all that we can actually decompose the benefit "from remittances" into that which is due to immigration of a particular household member and that which is due to, well, actual remittance flows:



All that basically means that the observed benefits from remittances that people rave so much about are mostly just straight up benefits from LABOR MIGRATION. Which are huge, but somehow that just isn't being said.

Now. I actually think the pure gains from remittances (moving from u2 to u3 in the graph above) are actually quite substantial as well. But it is important to keep two things in mind here:
1. These gains would not be possible without the migration of some household members in the first place. Hence, the ability to MIGRATE is a necessary condition for the REMITTANCE benefits to take place. The graphical analysis above misses this fact but it's there.
2. The size of the two effects are complementary. The bigger the gain from migration, the greater the disparity between those who migrate and those who stay behind. If there is diminishing returns to income, this means the gains from reallocation from the lucky migrants to those who stay behind are greater as well.

But all of this seems extremely simplified. I'm basically assuming that all these wages that people make are just consumption. But a strand of this literature emphasizes the fact that remittances can serve as basis for capital for households in poor countries. Something like; the lucky immigrant sends money to your grandma back in Lesotho and she invests that and starts her own business and boom, growth in Lesotho happens.

Again. There's some truth to that. But there's also problems with that kind of logic. First, we can take the above analysis and extent it to some kind of a dynamic setting where investment today pays of in growth in the future. But we're not missing much (I actually think there's all kinds of good reasons for economists to stay with static models - very often there's a simple way to reduce a dynamic model to a static one). So let's say that the sending of remittances is not just a pure transfer of resources but it also increases the income of the brother left behind. Maybe it provides funds for him to invest in a personal business etc. This is basically a shift/kink of the budged constraint above, and only a change in our labeling of our axis from "one period income" to "lifetime income":



So yeah, there's some additional benefits there to be had if the household members back home are more credit constrained (in very broad definition of that phrase) then the ... migrants in destination countries ... ? But wait a minute! Does that really make sense? After all, if anything, the return to investment, just like the return to labor tends to be higher in destination countries than in source countries. If the return in the destination country is higher then why shouldn't migrant invest in a business in his new found home, make more money, and then send it back? A hot dog stand in New York will make an immigrant more money than a similar business venture back in Nairobi. So why not invest in "capital" in the destination country for the household as a whole rather than using up resources in a relatively inefficient (compared to what you can get in US or EU) start up venture run back home? And then send the proceeds back so that all can enjoy it?

Again. There may be some truth to the view that remittances can facilitate investment back home. Usually a successful investment requires a good amount of local/tacit knowledge. Hence a newly arrived immigrant might not be able to take advantage of the investment opportunities in the host countries. You don't know how to speak English so you can't take advantage of the high rate of return to investment in US. But, if you send enough money back to Moldova, your relatives back home (who know the local language and economy well) will be able to turn that money into a productive business.

Except that the difference in rates of return is too huge to really make that story make sense. Again. Yeah, sometimes. For some people. Occasionally. But on average the brother who has been lucky enough to migrate is also likely to be the one lucky enough to have more and better investment opportunities.

And all that means is that most likely the majority of "remittances" flows that we observe are in fact meant to facilitate consumption. In other words, they're there for grandmas and brothers in poorer countries to be able to enjoy a standard of living which otherwise would be unattainable. And if you increase somebody's income they might work less (since there's no change in the wages they face this would be a pure income effect). But that's a good thing. In a similar way, the recipients may not spend their received remittances on investment (rationally, since the return to these investments in typical home countries is low) but instead buy themselves a cell phone or just some extra food. Is there anything wrong with that?

Finally, two caveats. First, you might actually see a spike in investment due to remittances if these are used to finance construction of new homes. I remember visiting a village in my own home country in the early 90's and it seemed like everyone there was building themselves a new house. The typical explanation offered by the relatives was "they got family abroad". But of course this is more of a consumption of a durable good rather than "investment" as that word is commonly used.

Second, there might actually be additional benefits from remittances (to consumption) which are not captured above. The graphs above all implicitly assume that both brothers face the same price levels in host and home countries. But of course the Balassa-Samuelson theorem (which is well supported empirically) tells us that price levels are lower in poor countries. Hence a dollar sent back to Bolivia, when converted to local currency, can go farther than if that dollar were to be spent in US. The graph below illustrates this:



(There's some caveats and details here - basically it matters how you label the axis (utility or income) and what is the exact shape of each individual's utility. I was too lazy to redraw the whole thing and basically it works out as illustrated above).

Oh and by the way, all the above generalizes easily to the case where the household welfare function assigns unequal weights to the two brothers, or where the household is comprised of more than two individuals, only few of whom are migrants, and other possible extensions.