Thursday, January 15, 2009

WHY ARE SOME COUNTRIES RICH --- MORE THAN, SAY, $25,000 PER CAPITA INCOME --- AND MOST AREN'T?

PART ONE: INTRODUCTORY COMMENTS

The long buggy article that follows was originally published as the 3rd installment in a long strung-out 8-article series on economic development that began in early April 2004 and ended in July of the same year. It's reprinted here on January 14, 2009 with some minor changes.

The chief reason for the reprint? Quite simply, to bring down to earth with lots of concrete examples some of the high-flying comments found in a buggy post published at the buggy site earlier this month --- to be specific, January 3rd, 2008 --- on the standard neo-classical theory of economic growth.

The Solow Model Rehearsed

You might look at prof bug's January 3rd, 2009 article on the subject.

It delves into the Solow theory and model from one angle. Here we'll confine ourselves to some introductory comments.

Introduced in the mid-1950s by Robert Solow of MIT. Solow eventually won a Nobel prize for this theory, which has been modified in a variety of ways that "augment" his original modeling of his theory. It has also spun off at least one major alternative theory.

Solow's model, you see, did lead to the conclusion that long-term economic development depended on constant technological progress, but it did not incorporate technology as a causal variable within his model's framework. Instead, technology acted as an "exogenous" variable that --- like manna from heaven --- would work its influence to save a country with abundant cumulative capital from an inevitable "steady-state of growth". This state would be caused by ever greater diminishing returns on cumulative capital, which --- interacting with a growing labor force (the only "endogenized" explanatory variable in the model) --- would mean that the rate of economic growth couldn't be increased in the future . . . unless --- well, unless technological innovations occurred to offset the steady-state.

The Challenge of the Romer Variant

The alternative model --- usually called endogenized economic growth --- was developed in the 1980s by Paul Romer. It directly incorporated technological progress as a key explanatory variable, alongside Solow's two variables of capital accumulation and the growth of the labor force. The exact differences --- including how Romer and his followers sought to find proxy measures of technology (such as R&D expenditures) --- don't need to bother us in the buggy argument that follows.

The same is true of the rejoinders offered by Solow and his followers: most notably, "augmenting" the original Solow model by adding qualitative improvements in the educational levels and workplace skills of the labor force. It's a change called human capital. And the claim of the Solow-inspired economists is that once it's instrumentally proxied --- say, by average years of education of the labor force (or the percentage of the total labor force with post high-school education) --- there's no need to "endogenize" techology itself as an explanatory variable, though somehow it still manages to save the economy from a descent into a state of steady-growth.

The Buggy View

For our purposes right now (January 15th, 2008), observe that the buggy analysis that unfolds here is something of a summary statement of what he argued in the first two bugged-out articles --- published back in 2004 --- about economic development. It seeks to distill the necessary changes that any country's policymakers need to undertake --- institutional, cultural, and policy-oriented --- if they hope to launch their country onto a growth-path of out of poverty and sustain it over the long-term, for decades or even generations, narrowing the gap with the rich countries in the process.

The summary will uncoil in a set of simple, straightforward theoretical propositions --- exactly four in all, each then clarified and illustrated with concrete examples. Grasp those four theoretical propositions and their implications, and you'll be well situated to make sense of why the world is divided into rich and poor countries, with fortunately several others rapidly growing and converging toward the levels of productivity and per capita income in the rich countries.

PART TWO: LONG-TERM SUSTAINED GROWTH REFINED THEORETICALLY: FOUR SUMMARY PROPOSITIONS

What Explains Why Rich Countries Are Rich and Others Aren't?

And now, with these clarifying remarks under your belt, shift your attention to the four major propositions that are the heart of our explanatory endeavor here.

1. Rich countries are rich, first off, because they have invested high rates of their GDP in both physical and human capital over several decades or even centuries, and they have done so efficiently (productively). In the upshot, they benefit from cumulatively impressive sums of skills and physical capital --- plants, machines, office buildings, laboratories, infra-structure, and schools and universities, not to forget the high levels of systematic spending on R&D.

Several countries, note quickly, have mobilized high levels of capital investment for decades, but without much to show for it. Their investments weren't made efficiently; the money was largely wasted or diverted to unproductive ends. The Soviet Union is the classic example here; Maoist China down to 1978 is another; the same is true of every other Communist country. Nor is that all. State-directed capitalism in India until the 1980s had roughly the same outcome; so too did the import-substitution developmental strategy of Brazil, Mexico, and the rest of Latin America until then, their economies hobbled by inefficient nationalized industries, runaway regulations, and extravagantly high tariff levels and exchange rates, not to forget excessive money creation and hence galloping inflationary trends.

What happened in the end was fully predictable.

In particular, over several decades, all these countries had relied mainly on quantitative growth, subject to ever greater diminishing returns in their investments. They couldn't switch to qualitative economic growth, driven by ever greater levels of productivity and technological progress. In the upshot, their rates of GDP growth tapered off over time, then plunged toward zero and a stationary state, overwhelmed by self-inflicted burdens of diminishing returns and Himalaya-high market inefficiencies.

  A question immediately prompts itself: what will determine whether investment in physical and human capital any one country are used efficiently or productively --- raising the levels of labor, capital, and total factor productivity (a technical concept, shorthand for technology broadly viewed in interacting with labor and capital)?

2. The answer: essentially a combination of good institutions and good policies. For the time being, think only of good institutions that operate in a clearly beneficial manner. In particular, when countries have successfully grown over the long haul, then you will likely find that to a large degree (with of course variations here across these countries) . . .

• Business institutions in them ---corporate governance, start-up firms and other entrepreneurial enterprises --- have been encouraged by formal and informal rules to operate with transparency and accountability. Poor performances is therefore easy for share-holders or banks or other outside investors to monitor and try to correct. If the corrections aren't timely, then market competition should sooner or later bring about either faster reforms or lead to bankruptcy.

• Financial institutions --- banks, brokerage houses, stock and bond markets, insurance companies, and venture capital --- have themselves been carefully monitored in order to encourage transparency and accountability too. If they have operated this way and there is competition present in the financial sectors, then these institutions will likely perform their key function effectively: to allocate capital in productive ways by bringing savers and investors together.

If, oppositely, they aren't monitored and quickly punished for transgressions, then scandals galore will likely mark the financial sector in any country's economy. Just recently, we Americans have learnt this lesson anew for the upteenth time in our history.

• Legal institutions have been created that operate with widespread public approval and enforce statutes and regulations that are generally followed spontaneously by most people in the country. Honest and impartial judges, good prosecutors, and a police force that is respected are essential here.

The upshot if these conditions hold? Corruption in both the public and private sectors is likely to be quickly discovered and punished. Nepotism in the corporate, financial, and administrative worlds has been limited or non-existent. Advancement up their hierarchies has been increasingly determined by performance, not by crony clientele-contacts.

• If cultural beliefs and social norms turn out to be dysfunctional and hold back sustained economic growth, then they have been vigorously encouraged over time in the rich countries to change in more socially desirable ways --- by the educational system, churches, the media, political dialogue, voluntary associations, and the like. Meanwhile, to enforce socially desirable behavior, it will usually be necessary to toughen formal rules in any society --- legal or otherwise.

Note though: formal rules and enforcement mechanisms --- including statutues, courts, prosecutors, and the police --- can only do so much here if prevalent culture-based beliefs and social norms collide with them. The legal system itself may be shot through with corruption, nepotism, and the use of double-standards in applying law to the rich and powerful. Even if it isn't, the courts and the police will likely be overburdened. Meanwhile, lawless behavior of various sorts will continue to flourish.

Nor is that all. Even if political or religious or educational authorities push for cultural change, hoping to alter dysfunctional beliefs and social norms, such change will almost always occur slowly. That's true of all countries. If "cultures" could change rapidly --- deeply ingrained beliefs and values, transmitted from one generation to another --- they wouldn't likely be what we mean by culture.

• Political institutions have been created that remain flexible while encouraging overall stability and oblige politicians to operate in ways that are accountable and transparent to the electorate and the media. When this condition prevails, then poorly performing leaders can be removed in the next election.

One of Japan's problems, to cite just them, in adapting its economy since the late 1980s lies precisely here: for a half century, except for a few months in the early 1990s, the country has been ruled by the same political party, the Liberal Democrats. A disillusioned Japanese public hasn't had the choice of a unified Opposition party to elect in the LDP's place and ensure that newer, bolder policies would be implemented. The status quo keeps marching along, powerful vested interests the only beneficiaries.

• A merit civil service has emerged in the rich countries, not one that operates according to patronage and crony connections. Something else too. All bureaucracies are prone to certain kinds of predictable pathologies: expanding budgets, mushrooming missions, and ever more personnel irrespective of performance . . . not to forget endless red tape. In successfully developed coutries, various corrective mechanisms have been created that limit the impact of such pathological behavior.

In most developing countries, oppositely, the civil service is little more than a milk-cow for patronage on the part of dictators or demagogic democratic leaders. More generally, advancement up organizational ladders in any institutional domain that counts --- the legal system, the military, education, the financial system, big business, whatever --- will usually take place by means of clientele networks, not performance.

• Good educational institutions at all levels have been fostered. So too has solid on-the-job training by business firms and public agencies. Both are essential to economic vigor over the long haul. So too, don't forget, is advancement to positifons in both the private and public sectors by means of achievement, not crony clientelism and mutual backscratching services.

3. Over time, the policies a government implements for the economy should approach the Washington consensus on integration into the global economy and the creation of sound money, fiscal solvency, enhanced market competition, effective tax revenues, and an effective social security network.

No country has even grown rich --- say, a per capita income of over $18,000 (the EU and Japanese average is about $26,000, the US around $38,000) --- without implementing such policies against a background of effective institutions.

Even here, though, there is clearly room for different cultural and political contexts: the Anglo-American free-market model, EU welfare-state capitalism (effectively adapted in Scandinavia and to an extent in Holland to the new global context, but not in Germany, France, Belgium, Spain, Portugal, or Greece), and a Japanese-like model that --- pruned of excessive governmental subsidies and regulations --- does emphasis social order and solidarity.

About all one can say is that there are trade-offs: the EU countries and Japan that have excessively interfered with free-markets have experienced a marked slow-down in growth since 1990 --- essentially when the new advanced technologies in information, communications, and bio-tech were paying off in growth here in the US (and elsewhere). Still, Sweden, Finland, Holland, and Denmark have adapted pretty well as small, cohesive countries --- their cohesion being challenged by large numbers of immigrants these days (hence a populist government in Copenhagen on the conservative side, and for a while in Holland) --- have done generally well. Possibly so will Germany, France, Italy, and Spain --- even if the changes needed risk setting off social conflicts and strife.

4. If a country is able to enjoy decent institutions and leaders (political, business, financial, bureaucratic, legal, and educational), then long-term development will be sustained by TECHNOLOGICAL PROGRESS:

More concretely, technological progress means a combination of:

Innovations that create new products or improve on the ways existing products (goods, services) are produced. Such innovations can be generated by home-based R&D, or – as Singapore and the other East Asians have done so well --- through swift importation (technological transfer) that diffuses the innovations created abroad quickly through its own industries.

The most radical technologies create whole new industries of a revolutionary sort that change the ways people work and spend their leisure time: computers, telecommunication satellites and wireless connections, air travel, automobiles, entirely new forms of credit (credit cards), and so on. Ever since the industrial revolution of the late 18th century, they come in clusters every few decades and have these dramatic effects.

As a twist here, when you hear about technological progress, think of ....
advances in knowledge that can be embedded in newer, better machines or lead to new and better management, marketing, and work within enterprises and bureaucracies. And remember: as the previous buggy article in this mini-series showed, the most dramatic advances are those that entail radically restructuring changes for entire societies and then --- through globalizing processes --- are diffused elsewhere to other countries.
By spawing entirely new industries in clustered waves of innovation every few decades, these revolutionary technologies dramatically alter the way we work and spend our leisure time. As we'll now see, they have another dramatic impact. They immediately influence the global distribution of power, military, diplomatic, and economic.

Oh oh! What with the length of this buggy analysis, it seems wise to divide it into two different postings. The rest of the argument will follow tomorrow (it's all done.)