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CHAPTER 28

WHY ARE SOME NATIONS RICH AND OTHERS POOR?

Growth Models, Miracles, and the Determinants of Economic Development

. . . the causes of the wealth and poverty of nations—the grand object of all enquiries of Political Economy.

—Thomas Malthus in a letter to David Ricardo, January 26, 1817¹

¹ The Works and Correspondence of David Ricardo, ed. Piero Sraffa with the collaboration of M. H. Dobb (Indianapolis: Liberty Fund, 2005), vol. 7, p. 122.

The Europeans, they say, were smarter, better organized, harder working; the others were ignorant, arrogant, lazy, backward, superstitious. Others invert the categories: The Europeans, they say, were aggressive, ruthless, greedy, unscrupulous, hypocritical; their victims were happy, innocent, weak. . . .

—David Landes²

² The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor (New York: W. W. Norton, 1998), p. xxi.

Adam Smith . . . showed convincingly how the principles of free trade, competition, and choice would spur economic development, reduce poverty, and precipitate the social and moral improvement of humankind.

—Eamonn Butler, Director, Adam Smith Institute³

³ See www.adamsmith.org/smith/won-intro.htm. The full title of Adam Smith’s most famous book is An Inquiry into the Nature and Causes of the Wealth of Nations.

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With more than 850 million people worldwide going to bed hungry each night,⁴ and with the richest 16 percent consuming 80 percent of the world’s resources,⁵ the determinants of wealth and poverty constitute pieces in one of the world’s most important puzzles. As the pieces come together, the goal is to promote economic development, which is a sustained increase in the standard of living experienced by a country’s population. In order to compare development levels in different countries, Pakistani economist Mahbub ul Haq created the Human Development Index (HDI) on the basis of life expectancy, adult literacy rates, school enrollment rates, and GDP per capita.⁶ Since 1993, the United Nations Development Program has used the HDI as a gauge of well-being in its annual reports. In the 2005 report, Norway received the highest HDI value of the 177 countries studied, Niger received the lowest, and the United States came in 10th.⁷

⁴ See www.pbs.org/wgbh/rxforsurvival/series/diseases/malnutrition.html.

⁵ See www.cnn.com/US/9910/12/population.cosumption/.

⁶ For details on the HDI, see http://hdr.undp.org/docs/statistics/indices/stat_feature_2.pdf#aboutthisyearshumandevelopmentindex.

⁷ See http://hdr.undp.org/reports/global/2005/pdf/presskit/HDR05_PKE_HDI.pdf.

Economic growth, commonly measured by increases in GDP, is necessary but not sufficient for economic development. Advances in health and education require expenditures that increase the level of growth. However, as explained in Chapter 21, GDP also increases with expenditures on crime, disease, and natural disasters and fails to capture leisure, income distribution, and some resource depletion problems. Despite these flaws, the relative objectivity and purely financial basis of GDP and other growth measures make them prominent in economic studies.

Economists have looked at the available data and tried to identify patterns of characteristics among rich and poor nations. Varying findings and interpretations have generated several broad schools of thought, with emphases that include technology, skills and knowledge, geography, outside influences, and governance.⁸

⁸ For a concise overview of modern research on this topic, see Elhanan Helpman, The Mystery of Economic Growth (Cambridge, MA: Harvard University Press, 2004).

Economist Robert Solow set forth the neoclassical conception of growth in developing countries.⁹ Solow’s model attributes growth to technological change, and each country is assumed to have the same technology. Thus, productivity differences among countries are explained by differing amounts of capital per worker. Solow suggested that productivity in poor countries would catch up to that in rich countries because resources are allocated to the place where they are valued most highly, and (as implied by diminishing marginal returns, explained in Chapter 7) capital would be more valuable in countries that have little of it.

⁹ See “A Contribution to the Theory of Economic Growth,” Quarterly Journal of Economics (1956), no. 70, 65–94, and “Technical Change and the Aggregate Production Function,” Review of Economics and Statistics (1957), 39:3, 312–320.

As an example, the first tractor in a country would be employed for the most valued tasks, whereas the 100th tractor would be used for less important work, and the 100th tractor would be more useful than the 1,000th or the 10,000th. Rational, profit-maximizing investors would take tractors as they came off the assembly line and place them into the country that had the highest marginal productivity. Given the higher return from 1 more tractor in poor countries, where many fields are still cultivated by hand, and similarly high returns for other types of capital where it is most needed, this model predicts that capital would flow from rich countries into poor countries, thereby reducing the inequalities between them.

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Economist Robert Lucas pointed out the inconsistencies between the Solow growth model and reality.¹⁰ In fact, capital moves mostly among rich countries, and Lucas explained that the marginal product of capital between, as an example, India and the United States differs by a factor of 5, even when differences in human capital (skills, education, experience, etc.) are taken into account. So why isn’t all the new capital flowing into places such as India? Lucas points out that capital market imperfections, such as taxes on incoming capital and monopolies that control foreign trade, impede the free flow of capital to its most efficient use.

¹⁰ See “Why Doesn’t Capital Flow from Rich to Poor Countries?” American Economic Review (1990), 80:2, 92–96.

There are also reasons why the marginal product of capital may not be relatively large in poor countries even though they have relatively little capital. Lucas suggests that positive externalities (that is, beneficial side effects, as discussed in Chapter 11) from human capital may equalize the marginal product of capital between India and the United States. The idea is that workers’ skills, education, and experience rub off on other workers. One country may have twice the average education level of another, but by working with more knowledgeable people, the workers in the education-oriented country end up with more than twice the human capital. By Lucas’s estimates, a 10 percent increase in the human capital of your co-workers will increase your own productivity by 3.6 percent.

Human capital and imperfect capital markets are two possible explanations for the difficulty some countries have in attracting capital investment and achieving economic growth. In related research, economists Greg Mankiw, David Romer, and David Weil found that by augmenting the Solow model to accommodate differences in human capital, savings rates, and population growth, they could explain most of the international variation in incomes.¹¹ However, the development of human capital is no silver bullet: Several other studies have found no association between an increase in the average level of education and economic growth.¹² The following sections provide an overview of alternative schools of thought about productivity differences among nations.

¹¹ See “A Contribution to the Empirics of Growth,” Quarterly Journal of Economics (1992), 107:2, 407–437.

¹² See Pritchett, L., “Where Has All the Education Gone?” World Bank Policy Research Working Paper No. 1581 (1997); and J. Benhabib and M. Spiegel, “The Role of Human Capital and Political Instability in Economic Development: Evidence from Aggregate Cross-Country Data,” Journal of Monetary Economics (1994), no. 34, 143–173.

They say that the three things most important to success in business are location, location, and location. The same could be said about growth and development on a larger scale. The fertile heartland of the United States and the oilfields of Saudi Arabia convey advantages not found in impoverished Laos or Haiti. But it is important to note that geographical problems are surmountable. A benefit of globalization is that transportation and communications reach around the world, helping countries with the narrowest comparative advantage in the production of a few goods or services (as discussed in Chapter 27) to trade for virtually anything made anywhere. Japan and Singapore are examples of countries that have used export-oriented economies to overcome resource constraints and become wealthy nations, with per capita GDP levels of $29,400 and $27,800, respectively. Size needn’t be a problem, either. Many small countries have very high standards of living, including tiny Luxembourg, where the GDP per capita is $58,900. Undesirable location and size are more than speed bumps on the road to success,¹³ but other factors have proven to be more important determinants of a country’s potential for development.

¹³ For a discussion of geographical handicaps in Africa, see www.frontpagemag.com/Articles/ReadArticle.asp?ID=18760.

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Without foreign involvement, poor countries sometimes languish in poverty, but when foreigners do become involved in the commerce of developing nations, the poor countries often get the short end of the stick. Corporations from rich countries sometimes find relatively lax rules or corruptible governments that allow them to exploit the natural resources and labor of poor countries.¹⁴ Consider the experience of countries sarcastically referred to as banana republics—generally small, politically unstable countries whose economies are dominated by foreign corporations that produce and export a single good, such as bananas. In 1871, an American named Minor Keith arrived in Costa Rica to build a railroad and soon began planting bananas. Minor went on to found the United Fruit Company (UFCO), whose plantations extended throughout Central America, South America, and the Caribbean. UFCO owned 112 miles of railroad and 11 ocean steamers; in its home-base country, Guatemala, it controlled telegraph lines, mail delivery to the United States, and all shipments in and out of the trade hub of Puerto Barrios. By 1944, the poorest 90 percent of Guatemalans owned only 10 percent of the country’s land. When Jacobo Arbenz was elected president of Guatemala in 1950, he proposed a redistribution of some land from the richest to the poorest farmers, including land owned by UFCO. Using its connections—including a U.S. secretary of state whose former law firm represented UFCO, a top public relations officer married to the private secretary of President Dwight Eisenhower, and a board member who was the head of the CIA¹⁵—UFCO lobbied for U.S. protection, saying that Guatemala was a “satellite” of the Soviet Union. The CIA orchestrated a coup in Guatemala in 1954 and installed a new leader who opposed land reform. UFCO later changed its name to United Brands and, in the 1970s, sold its land holdings in Guatemala to Del Monte Corporation.

¹⁴ In addition, well-intentioned efforts by capital-intensive nations can introduce chemical- and machine-intensive agricultural practices that are less appropriate for the labor-intensive recipients.

¹⁵ See Walter La Feber, Inevitable Revolutions: The United States in Central America, 2nd ed. (New York: W. W. Norton, 1993), pp. 120–121.

It is unfair to assume that all foreign business operations are hurtful to local populations. The United Fruit Company, like many other multinational corporations, created jobs, built schools, and paid its workers well. But the lion’s share of the revenues from its operations escaped Guatemala, leaving that country poor. The same phenomenon occurs when Nike shoes are made in Indonesia and Folgers coffee beans are grown in Brazil. Do foreign operators stand in the way of domestic entrepreneurs who would otherwise have created the same jobs and retained the bulk of the wealth at home? The answer is “sometimes.” The United Fruit Company controlled critical communications and transportation infrastructure and land, making it difficult for domestic industries to excel. Without such barriers from foreign capitalists, the East Asian countries discussed later in the chapter became wealthy with minimal intervention from foreign entrepreneurs. Elsewhere, foreigners have served as movers and shakers, ushering in advances in health care, agriculture, and technology. For example, the 300-megawatt San Pedro de Macorís power plant in the Dominican Republic received $233 million in financing from Cogentrix Energy, Inc., of North Carolina and Capital Partners of Great Britain, and engineering, procurement, and construction services from both Siemens of Germany and Motherwell Bridge of Scotland.¹⁶ The affordable electricity delivered by this international team is a boon to schools, hospitals, and factories on one of the poorest islands in the Western Hemisphere.

¹⁶ See www.cogentrix.com/company/article_1.html.

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Poorer nations tend to produce primary products in the agriculture, forestry, fishing, and mining industries that have many sources, inviting competition and low prices. Raw materials, such as iron ore, coffee beans, and timber, are purchased by rich nations for processing into automobiles, instant coffee crystals, and fine furniture, which are then sold globally (including back to the poor nations) at a high markup thanks to brand and quality distinctions and a scarcity of substitutes.

Nations that produce primary products also face competition from government-subsidized production in wealthier countries. During the past 10 years, U.S. wheat farmers have received federal subsidies of $19.8 billion, corn farmers have received $41.8 billion, and soybean farmers have received $13 billion.¹⁷ Subsidies encourage the production of commodities even where substantial irrigation and soil enhancement are required, and surpluses are sold to Mexico and other relatively poor countries where farmers have difficulty competing with the subsidized prices. Likewise, Japanese farmers sell subsidized rice in Vietnam and other developing nations. The subsidies keep prices down, but in countries where most of the consumers are agricultural workers, lower prices on imported grains don’t compensate for the loss of farm wages needed to purchase everything.

¹⁷ See http://www.healthyschoolscampaign.org/news/media/food/2006-0222_hatin-it.php.

Foreign involvement and farm subsidies are mixed blessings; as highlighted in Chapter 27, the arguments for trade are more compelling. President George W. Bush has suggested a decrease in trade barriers as a means of assisting people around the world. He advocates a Free Trade Area of the Americas (FTAA) that would constitute the world’s largest open market, including more than 800 million consumers. President Bush writes that lowering trade barriers by one-third would “strengthen the world’s economic welfare by up to $613 billion and that of the United States by $177 billion.”¹⁸ There are currently about 150 free-trade agreements worldwide, less than 25 percent of which involve countries in the Western Hemisphere and only 3 of which involve the United States. It may be that more cross-pollination between rich and poor nations would better serve the interests of both categories, with the important caveats discussed in Chapter 27 about thwarting the negative aspects of globalization and trade.

¹⁸ See www.whitehouse.gov/news/releases/2002/05/20020517-13.html.

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Terry S. Semel, the CEO of Yahoo Inc., received $109 million in compensation in a recent year, and the average CEO of a major company earned about $10 million.¹⁹ Some criticize the high salaries of leaders, and some leaders may well be overpaid, but it is difficult to overstate the importance of the person at the top. Leaders of corporations and nations orchestrate success stories, handle setbacks, and set the tone for ambition and morale. Most new businesses fail, and most countries are not wealthy. It took the guidance of CEO Greg Brenneman to turn Burger King around in 2005 and the genius of President Sir Quett Ketumile Joni Masire to lead Botswana through democratization and three decades of rapid economic growth at the end of the twentieth century.²⁰ In developing nations, leaders also determine whether international aid and trade revenues go toward investments in human and physical capital or into the pockets of corrupt officials. A change in leadership provides troubled countries and corporations with an immediate change in outlook and is often a first step for nations seeking reform.

¹⁹ See www.aflcio.org/corporatewatch/paywatch/.

²⁰ See www.news.cornell.edu/stories/Nov05/botswana.cover.ak.html.

No positive characteristic is likely to guarantee a country’s development and no negative characteristic inevitably spells doom, but a preponderance of either is the ticket to boom or gloom. Just as Hawaii beat the jinx of tropical geography (tropical areas contain a vastly disproportionate amount of the world’s poverty) with the triple virtues of extraordinary agriculture, military bases, and tourism, many nations on the continent of Africa struggle with the triple threat of despotic or corrupt governance, disease, and violence. Many nations stand in the middle, with much going for them but enough negatives to halt a developmental breakthrough. The trick, then, is to tip the scale. The next section describes such a transition in East Asia.

Between 1970 and 1996, the historically poor countries of China, Hong Kong, Indonesia, Malaysia, Singapore, South Korea, Taiwan, and Thailand experienced GDP growth that averaged about 8 percent per year, compared to the 2.7 percent average growth rate of the rich industrial countries.²¹ The World Bank’s 1993 report The East Asian Miracle attributes the development of these nations largely to public-policy decisions. The countries had high levels of savings and investment, high-quality labor with an increasing labor force participation rate, and rising productivity based on imported capital and technology. The governments placed a high priority on secondary education in order to improve human capital and on improved infrastructure in order to make transportation and communications networks more efficient. Export-oriented government policies lowered trade barriers for the purchase of raw materials and fostered competition in order to improve efficiency and reduce prices. Budgetary restraint limited the need to print money and kept inflation in check, bolstering investor confidence. Stable prices and government encouragement prompted high household savings rates. Finally, exchange rates were managed so as to avoid sustained overvaluations of the Asian currencies and to promote investment from abroad. Several of the “Asian Tiger” economies were also revved up by cheap credit and, as the Solow model would suggest, vast inflows of foreign capital.

²¹ See www.economist.com/surveys/displayStory.cfm?story_id5114999.

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Partly motivated by the economic growth in East Asia, economists Paul Romer, Robert Lucas, Sergio Rebelo, and others developed a new model, dubbed the endogenous growth model, in the late 1980s and early 1990s.²² In contrast to Solow’s model, which holds that technological change is determined by forces outside the economy, this model treats the level of technology as endogenous, meaning that it is determined within the economic system. For example, private investment in research and development could hasten technical progress. Government policies could assist in that process by promoting education and training programs that build human capital and by providing patents and protecting property rights so that those who innovate and increase the productivity of capital and labor could reap greater rewards.

²² See http://economics.about.com/cs/economicsglossary/g/endogenous_g.htm.

There is contention over the root cause of Asia’s rapid growth. In 1994, economist Paul Krugman wrote an essay called “The Myth of the Asian Miracle,” in which he suggested that the growth was the result of increases in the quantities of labor and capital inputs and not because of higher productivity of these inputs, the latter being necessary for sustained economic growth. As predicted, the Asian economic miracle lost its momentum in the mid- to late 1990s when inadequate bank regulation, cronyism, sliding exchange rates, and slow government responses to these problems dealt a blow to the rapid accumulation of capital. As Krugman had posited, existing productivity growth could not compensate for the waning flow of capital. The details of the downturn in Asian economies are outside the scope of this chapter, but the point is that developing nations can indeed become developed nations, regardless of whether they can sustain a rapid rate of growth in the long run.

Money alone is not the missing piece for a poor, isolated nation aspiring to prosperity. Consider the tiny island of Barbareta off the coast of Honduras, on which there are coconut palms, fish, firewood, and very few people—for simplicity, let’s imagine there are only 3. Suppose that by specializing, the first islander can catch enough fish to feed 3 people for a day, the second can harvest enough coconut milk to provide a day’s beverages for 3 people, and the third can collect enough firewood for 1 day’s cooking and heating fires for 3 people. With no money, the 3 islanders could make in-kind trades for what they want from each other, as long as each wants what the others have.

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Money provides convenience as a medium of exchange, a store of value, and a unit of account, as discussed in Chapter 22. With 2 shells apiece that served as money, each islander could purchase the items made by the other 2 for 1 shell per item, and in the end each would have 2 shells again. It is rumored that the notorious buccaneer Sir Henry Morgan buried treasure on the string of islands that includes Barbareta.²³ If our 3 islanders discovered Morgan’s buried treasure worth, say, $6 million, they would be “wealthy,” with $2 million apiece, but they would not necessarily be better off. Having more money with which to purchase the same goods, they would each simply be able to pay more for their daily rations—up to $1 million per unit of fish, coconuts, or firewood—but this would create nothing but inflation.

²³ See www.roatanonline.com/moreroatan/roatan_treasure.htm.

This approach, of introducing more money into the equation, has been tried. In Bolivia in 1985 and in Hungary in 1946, for example, the governments printed large amounts of money in attempts to remedy financial crises. The end result was hyperinflation that in Bolivia amounted to 12,000 percent in 1985 and in Hungary reached a height of 200 percent per day in July of 1946.²⁴ Development does not spring from more money chasing the same amount of goods and services. As another example, on the classic situation comedy Gilligan’s Island, Thurston Howell, III’s, suitcases of money couldn’t get the marooned characters off a tropical island because, despite all the cash, they simply had no boat.²⁵ Rather than looking for buried treasure, the Barbareta islanders should focus on improving their production levels and establishing international trade agreements with countries that can supply what the islanders desire, be it food, health care, or a small yacht on which to flee the island. Solving the mystery of income inequality is thus a matter of explaining why poor countries can’t make more stuff or improve their prospects for international trade.

²⁴ See www.econlib.org/library/Enc/Hyperinflation.html.

²⁵ See www.gilligansisle.com/thurston.html.

Keeping in mind the caveats expressed in Chapter 27 about good and bad coming from outside influences and in Chapter 21 about how GDP growth can differ from improvements in social well-being, economists have much to say about recipes for economic development. Under the right conditions, investors would earn higher returns on capital where availability is sparse, and poor countries, therefore, would receive more capital and grow faster than rich ones. However, these conditions include adequacy in the areas of governance, education systems, entrepreneurialism, savings rates, population growth, and inflation control, not to mention compatible cultural, religious, and trade practices. The convergence of income levels predicted by neoclassical economic models is impeded in practice because many poor countries don’t meet these conditions.

International aid and the forgiveness of debt can offer short-term relief, but they seldom provide long-term solutions. The eradication of agonizing poverty requires a confluence of changes, considerable time, and care to sidestep the pitfalls of corruption and exploitation. Economist David Landes summed up the chronology of advances in Britain’s development this way: “Institutions and culture first; money [for capital investments] next; but from the beginning and increasingly the payoff was to knowledge.”²⁶ Economic growth stems chiefly from improvements in human and physical capital in an environment that is conducive to development.

²⁶ The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor (New York: W. W. Norton, 1998), p. 276.

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