Today’s post is the second in a series examining why developing countries have difficulty moving up the economic ladder.
Yesterday’s post examined the “low- and middle-income traps” that have caught many developing nations. Today’s post will look at some of the explanations for these traps.
Assistant Vice President and Economist Yi Wen and Senior Research Associate Maria Arias explained that many nations have experienced significant growth in the postwar period. However, few have been able to catch up with the developed world in terms of per capita income levels.
The authors noted that the literature lacks systematic explanations for the lack of rapid convergence. In their article in The Regional Economist, they discussed the some of the most prominent theories. “The general theme underlying these theories is that there are barriers to technology spillovers and frictions in resource reallocation.”
One theory of the lack of rapid convergence is that trapped countries don’t open their markets internationally. As the authors pointed out, local interest groups have little incentive to open up the domestic market to foreign firms with more advanced technologies. However, even when nations open their borders, they often still remain trapped in low- or middle-income levels. “In fact, many nations have tried to attract foreign direct investment (FDI) but have not been very successful; even if they do attract FDI, they are still unsuccessful in climbing out of the income trap.”
Wen and Arias gave Mexico as an example. Mexico adopted financial liberalization in the 1970s, accumulating a large amount of debt. But when the U.S. hiked interest rates in the early 1980s, Mexico suffered a debt crisis, partly because of its lack of capital controls.
Another theory posits that bad political institutions, such as a dictatorship, stop some nations from developing. As the authors explained, the elite class takes wealth away from the working class, leaving it with little incentive to accumulate wealth and adopt new technologies to improve productivity.
Wen and Arias also pointed out that institutional economists also apply this theory to explain why the Industrial Revolution took place first in England instead of other parts of the world. According to the authors, this theory argues “that this was because England had the best political institutions in the world, thanks to the 1688 Glorious Revolution, which strengthened private property rights by restricting the British monarch’s extractive power on the British economy.”
However, Wen and Arias noted that many economic historians have criticized this theory. One argument is that other nations were just as secure as England in private property rights and rule of law, but the Industrial Revolution didn’t start there.
The authors also argue that this institutional theory does not entirely explain the mechanism of economic development. After all, Russia didn’t grow after shock therapy economic reform in the 1990s, and China has grown significantly since 1978 despite being under an authoritarian political regime.
Wen and Arias noted: “Instead, both regional economic inequality and the failure or success stories of nations that have attempted industrialization could be explained by the specific development strategies and industrial policies adopted, rather than by the political institutions per se.”
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