This is the second of a two-article mini-series on the alleged dangers that hover over the US economy in the rest of this decade, and two in particular: the rising Federal deficit and the rising US current account . . . trade in goods and services (plus some unilateral transfers). The mini-series was prompted by some worried concerns that were voiced by a visitor, John, set out in the previous article. That article tried to show that the two biggest worries associated with these two deficits in the US economy, the Federal budget and the US current account, reflect fears of "crowding out": 1) either of US private investment as the US Treasury sells more and more securities to finance the growing US Federal deficit --- this year alone, around 4.0% of GDP --- 2) or of US exports, making the trade deficit even worse.

PART ONE:
SUMMARY OF THE PREVIOUS ARGUMENT

(i.) Crowding-Out Version One: Federal Deficits Harm Private Investment

The first crowding-out fear --- that private investment in the US economy will be cumulatively hurt --- turns on the concern that there is a given pool of national savings . . . at any rate from domestic sources: thus, as the US Treasury competes with private investors seeking to borrow those savings for their own purposes --- particularly US firms wanting to buy new or more machines or offices or plants --- interest rates will have to rise and choke off much of the private investment. Over time, the outcome will be a lower level of investment and hence GDP growth. Some of those who espouse this theory see crowding out of private investment as 100% effective --- a total wash-out: each dollar the US Treasury accumulates from selling new securities to finance the US Federal deficit will, it's argued, be one dollar less that's available for private investment.

In that case, even in a recession, deficit spending won't have any impact on raising short-term GDP growth. All it does is hurt long-term investment and economic growth.

Other economists tend to take a more qualified view, maintaining that at least some crowding out of private investment will occur. Even so, over time, the pace of US economic growth will still suffer until the Federal deficit ends and a surplus is initiated. (A Federal surplus, by way, adds to overall national savings: by firms, by households, and in the government sector. The individual states are generally prohibited from running deficits; and if they do, they won't be allowed to do so for long.)

Are these fears of crowding out sound?

Despite some theoretical debate here among economists, this much can be said with certainty: those fears are exaggerated. The evidence of the late 1980s and again of the early years of this decade is graphic here. As the trends in both periods indicate, Federal deficits can rise rapidly, yet interest rates themselves --- especially long-term ones that count for private firms' investments (and consumers' acquisition of houses) --- not only aren't hurt, they can, as the experience since the end of 2001 recession demonstrates, fall to record low-levels.

 

(ii.) The Second Version of Crowding Out: US Exports Are Hurt and Create or Worsen
Trade Deficits

Enter the alternative view of crowding out, which links the rising Federal deficit to the rising trade deficit in goods and services. If --- so this twist in the argument goes ---interest rates don't always rise in the US economy as the US Treasury sells bills and bonds to cover the Federal deficit, it's only because foreign capital has streamed into the US economy to supplement insufficient levels of US savings and hence to keep those rates low. And it's true: lots of foreign investors are particularly interested in buying the US Treasury securities: they're safe and liquid and hence easily sold the next day if the investor wants to pull out of them. Nor is there any danger that the US Treasury will ever default on them.

How then does crowding out occur in this second scenario?

The answer: through the impact of the dollar's exchange rate, its price in terms of other currencies. As bursting inflows of foreign capital stream into the US economy from abroad, foreign investors have to sell Yen, Yuan, pesos, euros, or pounds in order to acquire dollars for their investments; in turn, the climbing exchange rate of the dollar hurts American exports abroad and facilitates the sale of foreign exports to American firms and consumers. In this way, US exports are crowded out in foreign markets, import sales boom here, and the excessively fast growing US trade deficit --- current account --- is the result.

That deficit, moreover --- now around 5.0% of GDP --- won't be sustainable. That's the key in this new crowding out version.

Sooner or later, it's argued, a big dislocating adjustment of the American economy will be necessary as worried foreign investors start selling off their dollar investments: the dollar will fall, and there might even be a panic sell-off of their US investments by foreigners. In turn, as the dollar falls rapidly, inflationary pressures will be introduced into the US economy, interest rates will rise fast, and a recession will be needed to squeeze out the inflationary pressures. Otherwise, inflation will continue to rise as the dollar falls, a problem that will be clarified here in a moment or two.

The following brief comment was left by John, a lawyer who has spent long stints working in West Europe, including a year's internship with the German government. He returns to Europe frequently for professional reasons as well as for vacations, and so he has followed our series on development --- just about ready to be extended to a 6th article --- and especially how Anglo-American capitalism differs from the EU welfare-state sort, with particular interest.

Note that the buggy reply to John unfolds with lots of twists and turns; and though they shouldn't be hard to follow, they added up to a fairly hefty commentary . . . so much so that the reply has been divided into two articles. What follows is the 1st of the two. The second will immediately ensue, a direct continuation of the overall argument.

From John

Prof Bug:

In this wonderful ongoing series of yours on the performance of the US economy --- especially compared to its rivals abroad in the last decade or so --- would you be willing to discuss what many of us worry about more and more: whether, to put it bluntly, the US economy isn't heading into troubled waters as the Federal government's deficits rise and rise and the US current account, our trade in goods and services with the rest of the world, does the same? Aren't these big problems lying ahead for us?

I have to come clean here. What particularly worries me is that these problems would be compounded by one political party coming to dominate the Federal government after the elections this year. If that happened, might not the President and Congress --- unable to agree on the need to cut back on federal spending --- panic and sooner or later institute big jumps in federal taxes to offset the federal deficits?

If that should happen, note the irony, buggy prof.

The American economy would be stuck with both growing levels of governmental spending and ever higher taxes --- a sure-fire recipe, it seems, for hobbling economic competitiveness and dynamism in the future, as it has done, apparently, in West Europe for two decades now. All this, moreover, might be occurring as the EU countries moved in the opposite direction. Faced with structural problems galore and near stagnant economic growth, their welfare-oriented, regulation-obsessed governments might have no choice but to launch more and more market-oriented reforms: in particular, cut government spending, cut taxes, de-regulate, and in these ways reinvigorate their economies. If they did, then --- as we were moving toward an EU level of spending and taxation --- they would be moving toward our system of free-market Anglo-American capitalism that you've discussed. Wouldn't that be a joke! Above all on us Americans.

Now take the irony a step further. If all this did happen on both sides of the Atlantic, wouldn't the huge existing lead of the US in per capita income and dynamism --- roughly 30-35% higher now than the EU average as you note --- be gradually overcome, vindicating the theory of convergence catch-up growth as the gap narrowed? Are we shooting ourselves in our economic foot, so to speak, prof bug?

 

The Buggy Reply

John: Many thanks for your comment. It allows for some extended replies that deal with contemporary worries about the course of US finances and the growing trade deficit. As for the the last part of your comment --- the EU moving toward a Anglo-American free-market form of capitalism even as the US moves toward more spending and taxation --- I'll be much briefer here, taking up the two related points in the next article or two in this series.

PART ONE:
WILL TAXES RISE HERE AGAIN? SHOULD WE EVEN WORRY ABOUT
THE FEDERAL AND TRADE DEFICITS?

Will Taxes Rise Rapidly in the US?

Most likely not, even though a future Congress and the next President might decide to raise them back to the 2002 levels before the third round of Bush tax cuts last year (2003). To explain, consider this quintet of points:

1) Presumably, by a single party federal government, you are referring to . . . well, possibly a Republican majority for several years in Congress along with a Republican president. If so, I'm not sure that will happen even this fall; but if it did, it wouldn't last long. Back in 1964, when Johnson pasted Goldwater, there was talk about a dominant Democratic majority for decades. It lasted exactly four years as far as the presidency went. Then, in the 1980s, the balance shifted toward Reagan and the Republicans, but Clinton was able to get elected twice in the 1990s.

If, oppositely, you're thinking about a Democratic sweep in both the Congressional and Presidential elections this fall, then yes . . . Democrats would probably be more reluctant to reduce government spending while raising taxes slightly. Or, more likely --- a scenario that will appear at the end of this article --- they would shift the tax burden more toward the affluent, while agreeing with Republicans to cut back on some expenditures. Raising taxes on the broad middle class, by contrast, would be politically unpopular, something Democrats and Republicans both are aware of.

2) As for any tax rises, to go on with this latter point, the likeliest outcome would be that the next president and Congress do exactly what the tax reductions of 2003 intended (unlike those in 2001 and 2002): phase out many of them as the economy, thanks to the big fiscal boost those tax reductions caused (plus very low short-term interest rates), continues to grow at a high pace the next few years.

3) If the president and Congress do let the reductions phase out, then the CBO -- Congressional Budget Office --- projects that the federal deficit will fall from around 4.0% of GDP this year to around 1.5% (or lower) in 2009. We should also start to see a noticeable decline by 2006 under way toward that goal. Remember, if GDP rises faster than the annual federal deficit, the total of US government debt as a % of our annual GDP will continue to fall --- a desirable outcome. As for government surpluses, they may or may not be desirable. It all depends on the growth rates of GDP and job-creation.

4) If, by contrast, a Republican Congress and president decide to make the tax cuts permanent, then one of two things will happen: either they will also agree on major reductions in government spending --- alas, with little chance that most of the pork barrel will be cut out --- or then we will be back in the Reagan era of the 1980s and structural fiscal deficits (as opposed to cyclical ones in a recession and coming out of it ) will then mount rapidly. In that case, the CBO projects mounting deficits after 2009 that, like the Reagan deficits, couldn't be sustained too long, absorbing far too much of our national savings.

5) All that said, some figures, John, might help allay much of your worry. First, here's a table that sets out the data on Federal government spending, receipts, the size of the deficit, and so on across the administrations of all presidents since 1946, with particular breakdowns for the Reagan, George Bush Sr., and Clinton years, compared with the estimated figures for 2004 in the George Bush Jr. year.

This, the 5th article in the mini-series on economic development, resumes the argument where it was left dangling at the end of previous article. Its theme: why convergence theory --- which postulates that follower countries with good human skills, good institutions, and good economic policies should eventually close the gap in per capita income and productivity with the lead countries --- is generally sound except in one instance: where the gap relates to the US. This is a big problem that has to be explained. The various convergence mechanisms entail, after all, a prediction of such catch-up growth; and yet the US has remained the lead country for over 120 years now . . . something that shouldn't occur if convergence theory is sound.

As things now are shaping up, please note, there will probably be a need for 3 or 4 more articles in this series on development. In the meantime, shift your attention now to the current argument. Its first two parts will unfold here in this 5th article; the next two parts will figure in the 6th article of the series. Why two articles. Dividing the argument this way seems to be a good simplifying device, a way to keep your attention jogging along at a comfortable pace; nothing more profound anyway.

PART ONE:
INTRODUCTORY COMMENTS: THE US FORGES AHEAD AGAIN

In more concrete terms, the need for an explanation of the ongoing US lead, now 120 years old, is all the greater because Germany and Japan --- the two other major capitalist countries in the world --- had closed the gap with the US in per capita income to around 90% by the end of the 1980s . . . exactly as convergence catch-up growth had predicted. The closer they came to that 90% level, the more droves of observers --- European, Japanese, even American --- talked about US decline, relative or even in some instances absolute. Absolute decline: was that possible? Yes, to judge by the rhetoric of the day anyway. Recall the presidential campaign of 1992 here. The present generation of Americans, it was repeatedly said in that campaign, might be the last to enjoy a living standard better than that of their parents.

The Reality?

Even in 1992, such rhetoric was thoroughly misguided. Since then, we know that even talk about relative US decline has turned out to be wrongheaded, a topsy-turvy form of hot air.

Consider the evidence in the following table and diagram. The table is the buggy prof's: note that per capita income is estimated through 2004 (based on OECD projections for the last six months of the year); all other figures are for the start of 2004. The diagram is from IMD, a prominent Swiss Business School that, for years now, has annually ranked dozens of countries in terms of their overall competitiveness, and on four composite sets of quantitative measures: economic performance, government effectiveness, business effectiveness (including labor markets), and infrastructure quality. Generally, it and the World Economic Forum --- another Swiss-based institute (with links to Harvard) --- put out the best overall rankings of comparative economic performance . . . including prospects for the future.

	Population in Millions	GDP PPP$ $Billions	% of World GDP	GDP per capita PPP 2004 Est.	Defense Spending $Billions	Defense Spending % of GDP
World	6300	$50,000	-------	$7, 900	$900	1.8%
USA	280	11,200	22.0%	$39, 400	$390	3.8%
EU-15	380	9,900	19.0%	26, 300	140	1.4%
Germany	80	2,300	4.5%	27, 200	38	1.4%
France	60	1, 800	4.0%	27, 900	45	2.5%
Britain	60	1, 900	4.0%	28, 100	32	1.7%
Russia	140	1,400	2.5%	9,400	55	4.5%
Japan	129	3, 700	7.0%	28, 700	45	1.2%
China	1200	7100	14,.0%	6,000	100	1.4%

Sources: OECD, EU, The Economist, CIA WorldFactbook

Here's the IMD rankings: to save space, only the first half of the 60 countries evaluated are found in the diagram. Note how large the US lead is over the 2nd, 3rd, and 4th countries. Note too that Germany --- ranked 20th last year --- is now in 21st place; the UK is ranked just behind it, 22nd place; and Japan is ranked 23rd.

PART TWO:
WHY DID THE RHETORIC OF DECLINE TAKE SUCH A HUMPTY-DUMPTY DIVE IN THE 1990s?

There are two answers, both arriving at the same conclusion. A fairly simple, straightforward explanation will figure in this section. The deeper explanatory endeavor will unfold later in Parts Three and Four of the argument (found in the next article in this series): it will look at and analyze the prevalent forms of capitalism in the industrial world --- the Anglo-American, the EU welfare-state, and the East Asian (Japanese-inspired) --- in a key comparative respect: their ability to innovate bold, radically restructuring technologies of the kind that alter the basic techo-economic structure and institutions of a country when they materialize. Tersely put, each one of these distinguishable capitalist models entails a specific kind of national-innovation system --- with of course variations across specific countries in each model --- and for 120 years now, the US has been by far the most dynamic and innovative here.

This is the 4th of a 8-article mini-series on economic development, the mini-series itself part of longer series --- which seems to stretch back in time all the way to the Battle of Gettysburg, but more likely to the end of April this year --- on the democratic prospects of the Arab Middle East. It takes up where the 3rd article left off: at the point where it explained that convergence theory predicts how the gap between the US as the lead country and rich follower countries like Japan or Germany or even smaller ones like Sweden or Taiwan should, in principle, be closed sometime in the future.

As the article concluded, the prediction has not been borne out.

The US has been the richest country in the world in per capita income since the 1880s, roughly half the time that has expired since the industrial revolution of the late 18th century erupted. Far from the gap in per capita income and productivity being closed, the EU average is now back to where it was in the early 1960s --- about 63% of the US level. Germany and Japan, two countries that had closed the gap to around 90% by the end of the 1980s --- widely touted as late as 1993 to match the US level by the end of the decade, then to go on and surpass it in the next decade --- are themselves not doing much better, comparatively speaking.

Why has convergence theory not worked out, at any rate for the US lead? The previous article didn't delve much into the reasons for catch-up growth not to work in its case. The current article seeks to repair the omission. There are two possible explanations: either convergence theory is wrong, or the US enjoys a superior form of capitalism --- a system of national innovation, plus an unusually mobile and flexible population, that surpasses that of the EU or Pacific Asian countries.

Not surprisingly, the latter explanation is what will be stressed here. In particular, we will try to show that the US has an unusually effective system of national innovation . . . at any rate, compared to its rivals in Europe or Pacific Asia.

 

PART ONE
CONVERGENCE THEORY CLARIFIED

Convergence Theory

Convergence theory itself is sound enough . . . at any rate, for developing countries with good institutions, good economic policies, a rule of law, and sufficient human talents to work with modern technologies, all matters set out at length in the first three articles of this buggy mini-series. Even if they start out with only partially effective institutions and a dictatorship, those countries that can sustain long-term development over several generations have managed to reform their institutions, encourage a rule-of-law, and move in almost every instance to solid democratic politics.

• Similarly --- to clarify some key points set out in the previous two articles --- whatever the initial policies that ignited short-term economic bursts in effectively developed countries, the improved political process led, eventually, to policy-changes that approximated the Washington Consensus of the early 1990s about long-term development: sound money and finances, government spending over the long haul that doesn't endlessly run up national debt, an effective protection of private property that limits bribes, corruption, and defaults on contracts. The protection of intellectual property rights is no less important. So too is a decent social security network. And finally, no country has ever become rich without full integration into the global economy.

• One other thing too: In shaping their policies, the policymakers in successfully developed countries have to pay increasing attention to how the incentives of various economic agents --- investors, managers, would-be entrepreneurs, workers seeking new training, and tax-payers in general --- are affected by those policies. It's no secret what the best policies would do as far as incentives go. They would encourage entrepreneurship, technological innovation, an efficient allocation of capital investment to the most promising firms and industries, and proper education and work habits that, taken together, cause a shift away from quantitative, investment-led development and toward a more qualitative, technology-driven form of dynamic economic growth.

• But note right off: even as countries adapt their institutions and policies in these ways, there is still leeway for different institutional outcomes. In particular, as you'll see in Part Three of this article, Anglo-American capitalism is only one successful model. East Asian capitalism and EU Continental welfare-state capitalism are two other successful models. Whether they lead to similar flexibility in adapting to change is, however, another matter --- a point also stressed and clarified in Part Three.

Thanks to these national assets, such countries can launch themselves onto a path of sustained long-term economic growth over generations. In the process, countries like Taiwan, South Korea, Hong Kong, Israel, or Singapore --- all affluent countries now --- have tended in the last generation to converge on the levels of per capita income and productivity enjoyed by the rich industrial countries like Japan, the US, and West Europe. For that matter, though it's to early to judge the outcome, China and India --- both pursuing more market-oriented policies and integration into the global economy --- have been growing the last 15 years or so at rates of GDP three times that of the EU and Japan, and way ahead of the US too . . . all in line, as we'll see in a moment, with what convergence theory predicts.

 

Nor is that all. The theory's prediction that catch-up growth will also work for the follower countries that are themselves highly developed --- growing faster than the very rich lead country --- has also been sound for about half the time-period, about 240 years, since the industrial revolution was ignited in the late 18th century.

The exception, which the argument in this article tries to account for, is the US . . . the leader country since the 1880s. Time and again, the American lead in productivity and per capita income has been narrowed by faster growing follower countries --- most notably, from 1950 until 1990 or so, by Japan, Germany, and France. Yet time and again, American economic dynamism was eventually reignited and the country pulled ahead once more . . . exactly what it has done over the last 14 years. Right now, comparatively speaking, Japan and the EU countries on an average are back where they were in the early 1960s.

For the moment, though, put the US exception on the backburner. Look instead at . . .

 

. . . More Illustrations of Convergence Theory's Basic Soundness

We've already mentioned some examples on this count. Consider some others.

Think of Japan --- its per capita income about 35% of the US's in 1950 after post-war reconstruction was over, only to close the gap rapidly to around 90% by 1990. South Korea, to clarify its impressive growth record, was once so poor that in 1959 the World Bank's report on its economy claimed that it would be an economic basket-case forever, utterly dependent on foreign aid. Three decades later, its 50 million people exported cars, trucks, TVs, DRAM memory chips, pc's, and a range of advanced consumer electronics; its steel industry was and remains one of the most efficient in the world; the same is true of its shipbuilding industry. In per capita income, it is roughly at the level of affluence enjoyed by Portugal and Greece in the EU: all three about $18,000 in purchasing power parity terms (PPP).

For that matter, the record of convergence in the European Union is clear here too.

Ireland, once the poorest country in West Europe, now is the richest in the EU except for tiny Luxembourg (250,000 people vs. 4 million Irish): while the EU average per capita income for the 15 West European members at the start of 2004 was about $26,000, Ireland's was an astonishing $32,000. (The US level, as a point of comparison, is around $39,000.) Stated differently, Ireland when it joined the EU in 1973 had a per capita income that was only 62% of the EU average; even Greece when it joined in 1981 was better off comparatively, its level around 64% of the EU average at the time. Today, Ireland's is 21% higher, an astonishing economic performance. And though Greece's per capita income isn't much higher percentage wise, that of Spain, another poor country when it joined the EU in the mid-1980s, has leapt ahead of the richer northern Europeans in its rate of growth since then and can now boast of a per capita income around 90% of the EU average. Spain's is at around 90% of the EU average.

Note that the new EU members in East Europe --- Poland, the Czech Republic, Hungary, the Baltic States, Slovenia, and Slovakia --- have per capita incomes that average around 45% of the EU's. In that respect, they are worse off than Ireland or the poorer Mediterranean countries that joined the EU in the 1970s and 1980s. Even so, if they continue to reform their economic institutions, convergence catch-up growth should work for them as well. Above all, they will likely enjoy big inflows of capital and technology as West European firms relocate there to take advantage of their disciplined, far cheaper wages and far lower taxes. In the process, they would no less likely benefit from faster growth of their GDP and per capita income.



All of which prompts a pivotal question:

 



What Explains Convergence Catch-Up Growth? Or Why Do Follower Countries Grow Faster
Than the Lead Countries

There are several convergence processes that account for catch-up growth, again always for the countries whose people have enough skills to work with modern technologies and --- no less important --- whose institutions and policies are sufficiently efficient or reformed to launch their economies onto a path of sustained long-term economic development.

(i.) Bold Innovation Is Costly, Risky, and Often Disruptive. Much of the Investment Won't Pan Out, and Eventually Follower Countries Can Import the Lead Country's Breakthrough Technologies At Bargain Rates

The lead country is almost always at the technological frontier, with the most dynamic of the follower countries not far behind. Given the higher wages of its work force, it has to invest at hefty levels in R&D and try to continually innovate if it's to sustain its lead in productivity and per capita. By contrast, follower countries with good institutions, policies, and human talents can rely on technological transfers (imports) and then diffuse the innovations made by the leader to their economies in less costly ways.

How so?

Well, much of that R&D and initial investments made by the lead country's firms to bring its leading-edge technologies to the market will be wasted.

In particular, lots of promising R&D expenditures --- at times even in a production-stage --- never really pan out. Even when radical innovations do lead to brand-new products that are profitable in the market-place, whole new industries probably need to be established before that happens: think of electrification, autos, airplanes, radio, TV, movies, airlines, computers, the Internet, E-Commerce, and so on. That takes time. Time is costly. Most established big firms, moreover, aren't effective vehicles for such radical undertakings. They have too many vested interests in the status quo: to invest in entirely new products, their managers will risk disrupting their existing line of products. Suppose, though, they go ahead and make the investments. In that case, the managers have to contend with another problem: resistance from their existing work forces at all levels. Lots of workers won't be able to be re-trained; many will be superfluous and have to be laid off or fired; among those who stay on, morale may sag anyway. In the EU and Japan nowadays, it's worth noting, such labor practices are virtually impossible --- for both social and legal reasons.

The result? Usually, to bring revolutionary products to the market-place successfully, start-up firms created by bold, risk-taking entrepreneurs and funded by venture capitalists will be needed. Thus 75% of the US Fortune Five Hundred Companies in 1999 didn't even exist in 1975. In Germany and Japan, by contrast, the equivalent ranks of top corporate firms scarcely altered over the same period.

 

Nor is this all. For radical innovators, there are other risks to contend with.

This is the 3rd of a 8-article mini-series on economic development, the mini-series itself part of a much longer series that began at the end of April and deals with the democratic prospects of the Arab countries.

The argument in the first couple of articles on economic development, you might recall, unfolded in a trio of major divisions --- Part One, Part Two, and Part Three. The current article begins with Part Four. Naturally. And though you can follow the argument here pretty clearly without having read the first three parts, your grasp of its main points will be all the more sure-footed if you've worked your way through them.

More specifically, the current argument is something of a summary statement of what we've learned in the first two articles 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.

Keep in Mind Something

Observe that the convergence doesn't have to be complete. To be blunt, that outcome is unlikely for most countries in the world --- now or in the future.

Come to that, it's even true of the group of rich countries themselves. Despite their wealth and talents, none of the West Europeans or Japan has fully converged with the levels of productivity and per capita income in the US . . . the country with the highest income of this sort for the last 125 years, roughly half the time since the industrial revolution of the late 18th century erupted full-tilt. Japan and Germany aren't exceptions, just the opposite. As recently as 1990, they had closed the gap with the US to around 90% each. By then, lots of observers predicted that they would both match the American level of per capita by 2000, then go on to exceed it.

The reality? Over the decades by 1990, a small mountain of market inefficiencies had cumulatively piled up in each of their economies. Huge vested interests protected the status quo in both Germany and Japan; in each, it has proved stubbornly resistant to change. In the upshot, neither country has adjusted effectively to the dramatic changes in global capitalism, caused by new breakthroughs in information-and-communication technologies and rapid shifts around the world in economic dynamism. Small wonder that right now, half way through 2004, their levels of per capita income have fallen back to less than 70% of the USA's.

That's also true of per capita income in Britain, Italy, and France compared to the USA's. Two or three of the tiny EU countries, plus Singapore, peak around about 75-85% of the American level.

Still, all these countries --- not to forget Israel, Taiwan, and South Korea --- are justly regarded as affluent industrial democracies. By any standard, they're rich. A generation ago, these latter three countries were poor and struggling to develop. South Korea was even described by the World Bank in 1959 as something of a permanent basket-case, unlikely to do without lavish foreign aid for decades on end.

Could anyone have been more wrong?

Something Else Too

Narrowing the gap with the US and other rich countries is still going on. Take China and India, the two together numbering 2.3 billion people --- roughly half the total in the developing world. Starting from a very low level of per capita income only a couple of decades ago, they have been outgrowing the US and West Europe and Japan ever since. In the process, poverty has fallen in China to around 10-20% of the population, and in India it's been halved since 1980 to 25%.

Agreed: the gap with the rich countries is still large. Even so, it might be far less for these two countries in another generation, exactly as Japan had been able to do in the first generation or two after its Meiji Revolution of the 1870s or what South Korea, Taiwan, Hong Kong, and Singapore did after 1960. It all depends on their ability to overhaul their institutions and cultural habits --- not to forget their economic policies --- in innovative or creative ways that do not stray too far from the logic of long-term development enshrined in the four propositions about to unfold here, even as the reforms are adapted to their own specific national conditions.

 

PART FOUR:
LONG-TERM SUSTAINED GROWTH REFINED THEORETICALLY: FOUR SUMMARY PROPOSITI0NS

If the various strands of the argument are pulled together now, the following four theoretical propositions --- with some added clarification --- capture, it appears, the essential conditions of successful long-term development.

First Though, A Series of Clarifyhing Remarks Are In Order.

First Clarification: Three of the four propositions that follow --- 1, 2, and 4 --- are borrowed from a book by Charles I. Jones, Introduction to Economic Growth (Norton, 2nd ed., 2002), especially chapter 10. His model is sketched out in a suggestive way in one page, nothing more --- a barebones model if you want. And though the borrowing from Jones' work needs to be underscored, the elaboration of the model and the extensive comments that follow are strictly the responsibility of the buggy prof's cogitations, for good or bad. As for Jones' book, it's well worth buying and working your way through his clearly written analysis of various growth models, with one proviso in mind: the book's ordinarily used in upper division courses in economics --- possibly even in first year grad seminars --- and so to make sense of Jone's analysis, you need to have a good basis in statistics and multiple regression modeling --- the heart of econometrics. Some basic calculus would also help.

Second Clarification: After writing the previous paragraph, the buggy prof went to Prof. Jones' web site at UC Berkeley, where it turns out that he and Robert Hall of Stanford have published a lengthy, fully mathematical treatment of the first three propositions , "Why Do Some Countries Produce So Much More Output per Worker than Others?" Quarterly Journal of Economics, February 1999, Vol. 114, pp. 83-116.

In line with the buggy analysis that is about to begin here, the two writers find that the huge differences in productivity and per capita income across well over 100 countries in the world can be overwhelmingly explained by the quality of their institutions and governmental policies. One big difference though: Jones and Hall do not deal with culture. Not even one reference to it.

The Third Clarification: No surprise really, this lack of reference to culture as part of institutions . . . the two concepts defined carefully in both the 2nd and 3rd articles in this buggy mini-series.

Almost all economists shy away from the concept. For one thing, it's hard to find quantitative measures for it, something essential to formal economic modeling these days. For another thing, economists prefer to look at how concrete incentives --- the benefits or costs of alternative courses of behavior --- shape the decisions of rational economic agents like workers, consumers, firms, and even government policymakers in situations of choice, irrespective of cultural influences, between alternative courses of behavior. Incentives, rationality, and self-interest do all the explanatory work.

In Jones' and Hall's case, though --- as with more and more economists specializing in economic growth these days --- institutions also pay a role in shaping the incentives and choices of policymakers and economic agents. All the more curious, then, is the failure to deal with cultural influences. After all, the actual choices made within an institutional context by economic agents will be shaped not just by formal rules and formal enforcement mechanisms --- the latter meaning courts, the police, constitutionally specified elections, or private organizations legally authorized to hire, fire, promote, and reward (such as firms, banks, schools, universities, chuches, medical, legal, or other professions accrediting their members, trade unions, and so on) --- but also by informal social norms. Defining what is appropriate behavior in specific social contexts, they may even prove more powerful than formal rules and enforcements.

But note: social norms are part of inherited culture, reinforced by actual or anticipated group pressures to conform to them. What else could they be?

Like the basic beliefs and values and world-pictures that are widely shared in a society --- in short, a community-sanctioned culture that distinguishes, say, the average Chinese from the average Japanese or Egyptian --- social norms are the products of learned forms of behavior from early infancy on. In particular, they are transmitted across generations by a host of socialization mechanisms like the family, schools, churches, peer groups, the media, professions, and what have you. In the process, an individual learns what is appropriate behavior in specific situations. They are then maintained by group pressures within specific instititutional contexts, legal, political, administrative, economic, religious, and so on. More to the point, in most developing countries, prevalent social norms will even likely trump formal rules --- say, laws that make corruption, nepotism, and tax evasion illegal --- whenever the two are in conflict.

How so?

In plain English, the failure of an individual to act in conformity with group expectations can lead to a loss of face, severe shame and dishonor, ostracism, dismissal from a job, or even violent retaliation. It all depends --- on the nature of the social norms, plus the sanctions that groups will use by way of punishment.

Consider some examples. In societies where Islamic law prevails informally, extra-marital sexual relations by a woman can even lead to death by stoning; a sister or daughter raped by a stranger might have to be killed to save the family's honor. In societies where tax evasion is a national sport, anyone who pays taxes voluntarily will be considered a fool --- a sucker. As a third example, consider what goes on in the crony clientele-networks that dominate the political and economic life in most developing countries whether they're formally democratic or not. Anyone who refuses to cooperate with the higher-ups in the crony network --- say, by engaging in lavish corruption for mutual benefit whatever the law says --- will likely be regarded as wholly undependable; he can count on being quickly elbowed out of any position of influence within the larger society. No other form of social advancement may exist. In an outright Mafioso-like network, needless to add, the punishment will likely be far severer.

It's the prevalence of such informal social norms in well over a hundred or even a hundred and fifty countries these days that undermine a rule-of-law. By comparison, formal rules like constitutions, statutes, or regulations --- or the courts and police (themselves likely to be entangled in corruption) as enforcement mechanisms --- count for little.

Oppositely, as we'll now see, the gap between social norms and formal rules like the law is much narrower in rich industrial countries . . . mainly because the wider community-sanctioned culture that gives meaning to social life within specific national contexts is more friendly to a rule-of-law --- to less corruption, nepotism, and tax evasion. If there are group pressures at work, they are likely to work as incentives to obeying the law. True, pressures of this sort are greater in Denmark or Holland, traditionally, than in Italy or France. What's more, changes can occur that harm civic discipline and obedience of the law. Even in Holland or all the Scandinavian countries, high taxes have encouraged a big underground economy --- roughly twice as high as in the US with its lower taxes (15% of GDP vs. 8.0% in the US), and only slightly higher than in the Latin countries of the EU at around 20%.

It's an example of how misguided policies, over time, can backfire in even the most law-abiding of civic-minded countries.



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.

This is the 2nd in a 8-article mini-series on economic development --- the mini-series itself part of a wider series, weeks old now, on the democratic prospects of the Arab countries.

To follow the argument here, you need to have read the 1st article in the mini-series. The current article even starts with Part Three --- the first two parts, plus some introductory comments, set out in that initial article. A 3rd article will then summarize what we've learned about the conditions essential for sustained long-term economic development --- institutional, cultural, and policy-oriented --- in four sets of simple propositions, each carefully clarified. Since those four summary propositions continue the overall argument, that 3rd article will begin with Part Four.

And the 4th article? It will look at the way in which convergence catch-up growth favors developing countries compared to the growth rates of the rich leader countries . . . at any rate, if developing countries are able to implement the necessary institutional and policy changes that go along with successfully sustained long-term economic growth.

These terms need to be clarified --- obviously. So too does the specific thrust of the argument unfolded here, a continuation of the major points set out and analyzed in the first article. And hence some . . .

INTRODUCTORY COMMENTS

The Economic Advantages of Backwardness And Convergence Theory

The original work in this area, pioneered by a former professor of the buggy prof himself back in the 1950s and early 1960s--- Alexander Gerschenkron --- even explicitly used the term "the advantages of backwardness". See this link for a good review of Gerschenkron's key book. Gershenkron's thesis overlapped with a related theoretical approach to development, convergence or catch-up growth --- the main pioneers here two prominent scholars in the 1950s, Robert Solow (a Nobel-prize winner) and Moses Abramovitz of Stanford.

The third article in this series, remember, will deal with convergence theory and catch-up growth at length.

 

New Growth Theory

Abramovitz went on to help fashion an alternative to the Solow standard Neo-Classical growth-model, developed originally in the mid-1950s. The Solow model focused on the growth of capital and labor inputs ---later augmented to take into account improved human capital --- as the determinants of long-term economic growth, plus technological progress. (Economic growth, note, really means not just the growth of a country's GDP, but even more of its per capita income.) Over the long-haul in the model, technological progress --- whether radically new innovations like cars or computers or airplanes or improvements in the production process of existing products (along with their diffusion in the innovating country and transfers to other countries) --- is the big driving force of dynamic growth.

Solow stressed this from the outset. He justifiably won a Nobel prize for his pathbreaking work.

In his model, however, there's a major explanatory drawback: technology is treated as an exogenous variable, operating on economic growth from outside the Solow mathematical model itself. Technological innovation, to explain this briefly, keeps the growth rate of a national economy from invariably slowing down and heading ultimately for a stationary state --- the slow-down caused, Solow stressed, by the growing impact of diminishing returns as capital accumulation within a national economy piles up and up with a given set of technologies. What this means, in plainer English, is that when an economy, say the Soviet Union in the Stalinist era, doubles the number of steel plants from one to two, then steel output itself might double; by the time you create the 11th plant in the steel industry using the same technology, the 11th plant might cost as much as the 2nd did, but steel output itself might barely grow. Such is the inevitable force of diminishing returns.

If, then, an economy's per capita income growth rate doesn't fall off and head towards zero, the stationary state, it's because of technological innovation. Enter the model's drawback: technology's salvaging impact here isn't itself explained. Treated as an exogenous variable outside the formal multi-variable regression model, rather than appearing as an explicit independent explanatory variable that interacts with capital and labor inputs to explain fully economic growth, technological innovation in the Solow model remains mysterious. Its benign impact, if it occurs and saves an economy from landing in a stationary state of growth as capital accumulation goes on, is like Manna from Heaven . . . a blissful gift that remains as mysterious as Heaven's blessings.

The model that Abramovitz worked out in the 1950s --- to which he returned three decades later ---- foreshadowed what has become known as "New Growth Theory."

In contrast to the still very influential Solow growth model --- particularly when it is augmented with human capital improvements --- New Growth Theory endogenizes technological change as an explicit independent variable in its formal mathematical model. In this way, technological innovation itself is then something New Growth theorists seek to explain; and that effort invariably leads them to examine the institutions of a country --- not just those in its economy, mind you, but within its much wider socio-political systems. Paul Romer of Stanford was the first to formalize the theory in mathematical terms, back in the mid-1980s. (See the easily followed interview with Romer that appeared in 1999: it's very good on New Growth Theory vs. the Solow Neo-Classical Model.)

 

Beyond New Growth Theory: Institutions and Culture as Wider Influences
on Long-Term Economic Growth

Even then, despite these new theoretical developments in growth theory, the impact of institutions and culture on technological progress and economic growth remains fairly shadowy even in New Growth Theory.

Enter explicit theoretical work that focuses on institutions.

Their pivotal influence in either fostering or hindering long-term economic growth --- not just economic and financial ones, but legal and political and administrative --- has been explained most effectively by Douglass North of Washington University in St. Louis, himself a Nobel Prize winner. Increasingly influential the last decade, North's work is reflected in the articles or books by Dani Rodrik and William Easterly that appear on the political science 121 syllabus and were discussed at length in the previous article. For that matter, they are discussed again in this second article in the series.

A wider ranging variant --- a country's "social capability" ---- was also worked out by Moses Abramovitz to explain successful or failed long-term economic development: institutions and culture, including attitudes toward change and risk-taking across each country of the world. Although it's used a fair amount in developmental work, the Abramovitz concept was never as rigorously defined as the more narrow, but carefully applied institutional work of Douglass North and his followers over large historical epochs and across different civilizations --- above all, in order to explain why parts of West Europe pioneered the big breakthroughs in long-term economic development and industrialization --- and so it has generally lacked North's growing impact.

 

So Where Are We?

Well, in the buggy argument that follows, the role of institutions --- clarified in detail --- comes close to the North view as a jump-off point . . . only to range more ambitiously by stressing the cultural influences on long-term economic development. In that sense, the argument here draws on the wider views of social capability and culture of the Abramovitz sort. Note that this isn't an idiosyncratic view. Even the World Bank and the influential work of William Easterly --- see the previous buggy article where Easterly figures prominently in the argument there --- now recognize that institutions and culture are important here. The same is true of Rodrik, even if he introduces culture and social capability as explanatory concepts indirectly, referring to the need to adapt institutional changes to "specific national conditions" within each country.

Note quickly: the words in quote here are the buggy prof's, not Rodrik's --- not that they distort his views. On the contrary, he refers several times to the need to adapt institutional and policy changes to "local opportunities and constraints" within each country. As Rodrik also notes --- a further concession to cultural and social influences --- institutional innovations and new policy-packages that a country's policymakers have to introduce to sustain short-term economic dynamism over the long-run do not travel well. They have to be carefully tailored to each country's wider context --- which is obviously a reference to the social, political, and cultural condition in that country.

 

The Current Article's Aim

In summary, then, the argument here in this 3rd article seeks to clarify the changes and innovations in a country's culture as well as its institutions and its economic policies that are needed to sustain short-term spurts in economic growth over the long haul, transforming any such spurts into successful long-term development that converges on the levels of productivity and per capita income of rich leader countries. Don't worry: all these terms --- institutions, culture as part of them, and policies --- will be clarified as the argument unfolds. Remember too: the institutions in question aren't confined to the economy of a country; they encompass the legal, political, administrative, and educational systems no less.

Remember something else: the reason the analysis begins with Part Three now is that the overall argument was left hanging fire exactly at the end of Part Two, it and part one both set out at length in the initial article.

 

PART THREE:
INSTITUTIONS AND RULES-OF-THE-GAME FOR DOMESTIC LIFE WITHIN A COUNTRY CLARIFIED --- SOCIAL, ECONOMIC, AND POLITICAL --- ITS CULTURE INCLUDED

So Far, So Good: But Something's Missing In Our Analysis of Development So Far

Namely? In all these analyses of successful long-term development --- whether those of the rich Japanese, Europeans, and English-speaking peoples, or the newly rich in East Asia or Israel, and those elsewhere likely to join them in three or four more decades--- something crucial to such developmental outcomes has been absent up to now: the role of national cultures. And for the influence of culture on long-term economic development to be spelled out, it's necessary to clarify both its meaning and the related concept of institutions

 

1. Introduction: Culture and Institutions.

Note: none of the writers on the political science 121 syllabus go into the need for cultural adjustments of the sort emphasized in our lectures, yet national cultures are impossible to separate from the ways in which institutions --- political, economic, or social --- actually operate in practice. We'll explain this in a moment. For now, simply note in passing that cultural influences in economic development is a difficult challenge for economists, and for a pair of reasons: first, most economists tend to think in terms of incentive systems that overwhelm cultural influences --- crudely put, incentive systems mean the costs and benefits of doing something (eg, working hard will occur if it pays off in rising income) --- and second, culture is a concept that's hard to codify, quantitatively, for use in statistical equations, the latter essential to rigorous economic work these days.

Still, in the ps. 121 lectures, we've dealt directly with cultural influences on development over the long-haul. In particular, we've emphasized the need as countries develop to adapt their inherited belief-and-value systems (transmitted culture through socialization) in these ways:

• a much wider radius of trust, and less cynicism, than exists in most developing countries

• more spontaneous cooperation across wide sectors of the citizenry,

• a hard-work ethos among the well-to-do and powerful: in most developing countries --- East Asia with its Confucian heritage something of an exception --- the wealthy and influential aren't hard-working and lead lives of luxury and conspicuous consumption,

• social and economic advancement based on merit and accomplishment, not family and wider clientele connections --- rife again in most developing countries

• and ultimately a vigorous civil society of voluntary associations and professions in charge of their own criteria.