Why Isn’t the Whole World Rich?

The economic growth model Opens in new window tells us that economies grow when the quantity of capital per hour worked increases and when technological change takes place.

This model seems to provide a good blueprint for developing countries to become rich:
  • increase the quantity of capital per hour worked and
  • use the best available technology.

There are economic incentives Opens in new window for both of these things to happen in poor countries.

The profitability of using additional capital or better technology is generally greater in developing country than in a high-income country.

For example, replacing an existing computer with a new, faster computer will generally have a relatively small payoff for a firm in Australia. In contrast, installing a new computer in a Zambian firm where records have been kept by hand is likely to have an enormous payoff.

This observation leads to the following important conclusion:

The economic growth model predicts that poor countries will grow faster than rich countries.

If this prediction is correct we should observe poor countries catching up to the rich countries in levels of GDP per capita (or income per capita).

Catch-up is the prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries.

Has this catch-up—or convergence—actually occurred? Here we come to a paradox: of all the countries that are classified as higher-income countries, the relatively lower income countries among these have been catching up to the relatively higher income countries, but the developing countries as a group have not been catching up to the higher-income countries as a group.

Are the Developing Countries Catching-Up to the Industrialized Countries?

There does not appear to be a consistent relationship between the level of real GDP in the mid-twentieth century and economic growth in developing countries since then.

For example, countries such as Niger, Madagascar and the Democratic Republic of the Congo had low levels of real GDP per capita in 1960, but have actually since experienced negative economic growth: they had lower levels of real GDP per capita in 2012 than in 1960.

Other countries that started with low levels of real GDP per capita, such as Malaysia and South Korea, have grown rapidly.

Some middle-income countries, such as Venezuela, have hardly grown at all since the mid-twentieth century, while others, such as Brazil, have experiences significant growth.

Why Don’t more Low-income Countries Experience Rapid Growth?

Why are many low-income countries growing so slowly? There is no one answer, but most economists point to five key factors:

  1. Failure to enforce the rule of law
  2. Wars and revolutions
  3. Poor public education and health
  4. Slow technological development
  5. Low rates of saving and investment

Failure to Enforce the Rule of Law

In the years since 1960 increasing numbers of developing countries, including China, have abandoned centrally planned economies Opens in new window in favor of more market-oriented economies. For entrepreneurs Opens in new window in a market economy Opens in new window to succeed the government must guarantee private property rights and enforce contracts.

Property rights is the rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.

Unless entrepreneurs feel secure in their property they will not risk starting a business and investors are unlikely to lend their funds to entrepreneurs.

It is also very difficult for businesses to operate successfully in a market economy unless they can use an independent court system to enforce contracts.

Many developing countries do not have a functioning, independent court system. Even if a court system does exist a case may not be heard for many years. In some countries bribery of judges and political favoritism in court rulings are common.

If firms cannot enforce contracts through the court system they will insist on carrying out only face-to-face cash transactions.

For example:

Further, in many developing countries the rule of law and property rights are undermined by corruption. With corruption, government officials may require bribes to carry out their obligations or steal government property and resources.

For example, in some developing countries it is impossible for an entrepreneur to obtain a permit to start a business without paying bribes, often to several different officials.

In some countries tax revenues and foreign aid also frequently end up in the pockets of government officials.

Research has shown that countries where corruption is most widespread grow much more slowly than countries where corruption is less of a problem.

Property rights are unlikely to be secure in countries that are afflicted by wars and civil strife. For a number of countries increased political stability is a necessary prerequisite to economic growth.

The rule of law refers to the ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts.

The World Bank is an agency of the United Nations whose role is to provide financial aid and policy advice to low-income countries.

Economists at the World Bank have developed an index that ranks countries of the world from those with the strongest rule of law (the least corrupt) to those with the weakest rule of law (the most corruption).

Wars and revolutions

Many of the countries that were very poor in 1960 have experienced extended periods of war or violent changes of government during the years since.

These wars made it impossible for countries such as Afghanistan, Angola, Ethiopia, the Central African Republic and the Congo to accumulate capital or adopt new technologies. In fact, conducting any kind of business was very difficult.

The positive effect on growth of the end of war was shown in Mozambique, which suffered through almost two decades of civil war and declining real GDP per capita. With the end of civil war Mozambique experienced a healthy annual average growth rate of 3.6 percent in real GDP per capita from 1990 to 2012.

Poor Education and Health

We have seen that human capital is one of the determinants of labor productivity. Many low-income countries have weak public school systems, so many workers are unable to read and write. Few workers acquire the skills necessary to use the latest technology.

Several researches show the important interaction between health and economic growth.

As people’s health improves and they become stronger, and less susceptible to disease, they also become more productive.

People who are sick work less and are less productive when they do work. Poor nutrition or exposure to certain diseases in childhood can leave people permanently weakened and can affect their intelligence as adults.

Poor health has a significant negative impacts on the human capital of workers in developing countries.

Many low-income countries suffer from diseases that are either non-existent or treated readily in high-income countries. For example, few people in developed countries suffer from malaria but more than half a million Africans die from it each year.

Recent initiatives in developing countries to increase vaccinations against infectious diseases, to improve access to treated water and to improve sanitation have begun to reduce rates of illness and death.

Treatments for AIDS have greatly reduced deaths from this disease in Australia, the United States and Europe, but millions of people in low-income countries continue to die from AIDS.

Low-income countries often lack the resources, and their governments are often too ineffective to provide even routine medical care, such as childhood vaccinations.

Slow Technological Development

One of the lessons from the economic growth model Opens in new window is that technological change is more important than increases in capital in explaining long-run growth. Government policies that facilitate access to technology are crucial for low-income countries.

The easiest way for developing countries to gain access to technology is through foreign direct investment in which foreign firms are allowed to build new facilities or to buy domestic firms.

Recent economic growth in India has been greatly aided by the Indian government’s possible for India to have access to the technology of Dell, Microsoft and other multinational corporations.

In the high-income countries government policies can aid the growth of technology by subsidizing research and development.

In Australia, for example, the federal government conducts some research and development on its own, through organizations such as the Commonwealth Scientific and Industrial Research Organization (CSIRO) and also provides grants to researchers in universities. Tax concessions to firms undertaking research and development also facilitate technological change.

Low Rates of Saving and Investment

For economic growth to occur a country must have a well-functioning financial system. To invest in factories, machinery and computers firms need funds.

Some of the funds can come from the owners of the firm and from their friends and family, but firms in high-income countries raise most their funds from bank loans and selling shares and bonds in financial markets.

In most developing countries share and bond markets do not exist and often the banking system is very weak. In high-income countries the funds that banks lend to businesses come from the savings of households and many households are able to save a significant portion of their income. In developing countries many households barely survive on their incomes nad therefore have little or no savings.

The low savings rates in developing countries contribute to a vicious cycle of poverty.
Tax incentives also can lead to increased savings.

In Australia, workers are required by law to save for retirement by placing funds in superannuation accounts, and withdrawals for most people are tax free if the money is not withdrawn until after the age of 60 years. Because the funds can be withdrawn free of tax and the contributions are taxed at a relatively low rate, this raises the incentive to save.

Governments also increase incentives for firms to engage in investment in physical capital by allowing expenditure on capital to be deducted from gross company income, thereby reducing the amount of taxation payable on profits earned.

Investment tax credits allow firms to deduct from their income some fraction of the funds they have spent on investment. Reductions in the taxes firms pay on their profits also increase the after-tax return on investments.

Benefitting from Globalization

We have seen that one way for a developing country to break out of the vicious cycle of low saving and investment and low growth is through foreign investment.

  • Foreign direct investment occurs when corporations build or purchase facilities, such as factories, in foreign countries.
  • Foreign portfolio investment occurs when an individual or firm buys financial securities, such as shares or bonds issued in another country.

Foreign direct investment and foreign portfolio investment can give a low-income country access to funds and technology that would otherwise not be available. Until recently, many developing countries were reluctant to take advantage of this opportunity.

From the 1940s to the 1970s many developing countries sealed themselves off from the global economy. They did this for several reasons. During the 1930s and early 1940s the global trading and financial system collapsed as a result of the Great Depression and World War II.

Developing countries that relied on exporting to high-income countries were hurt economically. Also, many countries in Africa and Asia achieved independence from the colonial powers of Europe during the 1950s and 1960s and were afraid of being dominated by them economically.

As a result, many developing countries imposed high tariffs on foreign imports and strongly discouraged or even prohibited foreign investment. This made it difficult to break out of the vicious cycle of poverty.

The policies of high tariff barriers and avoiding foreign investment failed to produce much growth, which refers to the interaction and integration between businesses, governments and people of different countries as they become open to foreign investment and international trade.

If we measure globalization by the fraction of a country’s GDP accounted for by exports, we see that globalization and growth are strongly positively associated. Globalization has benefited developing countries by making it easier for them to get investment funds and technology.