Convergence Between Rich and Poor Countries

Convergence hypothesis:Poorer countries will grow at faster rates than rich countries and the gap

between Poor and Rich country standards of living will close.

- Simulation model by Lucas (2000) in "Overheads Set 2":

- Assumed that the convergence hypothesis was correct. - He made the probability that a country will enjoy sustained growth

rise with World income. - Countries that launched into sustained growth grew faster than

countries that were already growing.

- Key questions addressed in this section:

- Why might convergence occur? What processes might give convergence?

- What might stand in the way of convergence?

- What does the statistical evidence say? is convergence happening?

Why Might Convergence Occur?

- Solow growth model:

Convergence in steady state GDP per worker (Y/L) will occur if:

- Poor country savings rates rise relative to Rich country savings rates.

- Poor country labour force growth falls relative to that of Rich countries.

- Poor country technology and institutions (form of the aggregate production function) become more like those of Rich countries.

- Long-run convergence if the variables determining the steady state converge

- If countries have the same steady state: Y/L differences are transitional and disappear over time.

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Open, Economies, Globalization and Convergence

- The original Solow growth model is a closed economy model.

- Closed economy? no economic interaction with other countries.

- Could interactions between the Poor countries and the rest of the world give convergence?

- Interactions of interest?

- flow of financial capital: access to foreign savings

- migration of labour

- transfer of technology

- trade in goods and services (indirect K, L mobility; some role in technology transfer)

- Does “Globalization” (move from a ‘closed’ to an ‘open’ economy) promote convergence?

- Can ‘openness’ cause problems? (see cases like India in R. Allen’s Global Economic History)

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- History: consider two major globalizations

(1) Mid-19th century to 1914: growth in trade, capital flows, international migration.

e.g. Canada: 37% of investment foreign financed; even higher share in Argentina; also high in Australia.

Mass migration: Europe to N. America, Argentina, Australia.

Trade: grew 3.8% per year 1850-1913.

(World War I and the Great Depression end and reverse this globalization)

(2) Current era: growing importance of trade and factor flows.

- Trade: Weil Fig. 11.1 “World Exports as a % of World GDP”

- substantial growth since 1950 (1950 6%; 2010 24%).

- changes in who the major traders are (rise of E. Asia).

- Capital flows: significant and growing

e.g. Foreign Direct Investment Inflows as share of GDP (World Bank)1980-85: 0.5% of World GDP2010-16: 2.75% of World GDP

- but some questions about their direction!( e.g. China to US in recent yrs.)

- Migration: flows increased late 1980s and early 1990s and remain relatively high. (see WTO World Trade Report 2008).World Bank: International migrants as share of world population rose from 2.8% to 3.3% 2000-16.

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- What drives globalization? Some determinants:

- Price differences and the “law of one price”.

- Flows of goods, services and inputs respond to price differences between countries.

- Trade in goods and services: import goods if cheaper Export goods if price abroad is high.

- Factor flows: factor owners transfer inputs from countries where prices are low to those were prices are high.

- Trade and factor flows tend to reduce price differences between countries (Supply & Demand!)

- Other important considerations:

- Transport costs: price differences must be sufficient to cover transport costs.

- falling transportation costs spur globalization. e.g. pre-1914 globalization and steamships; containerization since the 1950s; air travel.

- geography and location: remote or landlocked countries.

- Communication costs and transmission of information:

- Affects knowledge of foreign opportunities;

- Affects costs of dealing with those abroad.

- Pre-1914 globalization aided by telegraph; more recent globalization and new information technologies.

- Language?

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- Trade Policy and Regulation: often limits trade and factor mobility.

- Trade protection e.g. tariffs on imports or import quotas limit trade.

- Government policy can also affect factor mobility

- immigration policy affects labour mobility between countries: a big barrier in practice!

- tax policy, rules governing foreign investment can affect capital mobility.

- Global political factors: - trade and flows of finance require stability.

- Culture and long-term history: Spolaore and Wacziarg (2013)

- can they limit cross-border interactions?

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- Effect of Economic “Openness”: What does the data say?

- Weil Fig. 11.2: suggests that openness is associated with higher GDP per capita.

- High growth countries in recent years: China, East Asian “tigers” (HK, Singapore, Taiwan and S. Korea)

- producing for export an important part of the story.

- Late 19th early 20th century growth in Canada, US, Australia: factor mobility important (migration from Europe, foreign investment in K).

- Weil Figures 11.3 and 11.4: suggests that “open” countries show evidence of catch-up or convergence

i.e. low initial GDP per capita leads to fast growth if ‘open’.

- Regression approaches: some weak support for this result (see end of this set of notes on regression studies of convergence)

- Billmeier and Nannicini Review of Economics and Statistics 2013:- effect of liberalization on GDP 5 years and 10 years after

liberalization.

- compares countries that liberalize to a "control" group from the same region in the same time period.

- suggests: opening up (liberalizing) raised GDP growth (handouts).(but some exception especially in Africa)

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Opposition to Globalization: Some Reasons, i.e. what can go wrong?

- Distributional effects:

- Trade: some industries shrink as a result of trade (lower profits, wages, fewer jobs in these industries)

- Heckscher-Ohlin results: owners of scarce inputs lose due to trade with countries where that same input is abundant.

e.g. low skill workers in Rich countries may lose from trade with poor countries (where low-skill labour is abundant)

- Labour and capital mobility will reduce input prices in the countries labour and capital moves to (so input owners lose in these countries).

- Instability: do international (financial) capital flows makes crises more likely?

- can outflows lead to crises? e.g. East Asian in 1997-98, past Latin American crises. Greece and Spain.

- ‘Standard model’ (Allen) and start-up industries: do they need protection?

- Brain drain concerns: could selective migration damage development prospects of Poor countries?

- Environmental concerns: does production shift to where laws are weaker?

- Exploitation and market power concerns: are poor country producers and buyers likely to be exploited by large Rich country corporations and governments?

i.e. imbalances of political and economic power may make openness a bad deal (Radical/Marxist economics approaches stress this)

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How Might Globalization and Openness Affect Living Standards?

- Production function framework suggests via:

- Accumulation

- Openness has effects on inputs per unit of labour.

- Productivity

- Openness can affect total factor productivity (TFP)

e.g. technology transfer ; efficiency effects of international competition; producing for export as a new, possibly higher value use of inputs.

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The Model of Resource Allocation and Convergence - Convergence in savings and labour force growth rates may occur if factors of

production are mobile between countries.

- The microeconomic model of resource allocation predicts this result.

- diminishing returns: a key underlying assumption.

International Labour mobility:

- Migration from poor countries to rich countries.

- Sizable for some countries and in some time periods.

- Demand to move appears to be there! (but major barriers)

Migration in the Factor (Input) Allocation Model:

- Say have a fixed amount of labour of any given skill level: L*

- total amount of labour in Rich and Poor countries combined.

- Two uses of labour with a given skill level:- Work in a Rich country- Work in a Poor country

- Diminishing returns: value of marginal product (VMP) curves slope downward in both sets of countries.

(note: higher K/L, more advanced technology may make VMP higher at any given L in rich countries than in poor countries)

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- In the model: Wages = Value of Marginal Product

- competitive labour markets: this will hold.

- Wages are higher in Rich countries than in Poor countries for similar workers.

- Workers will want to migrate from Poor to Rich countries.

- Migration will lower Rich country wages and raise wages in Poor Countries

- The value of world output and income rises as a result of migration.(labour transferred from low to high VMP countries)

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- International migration and the Solow model steady state:

- Emigration from Poor countries lowers Poor country labour force growth.

- new Poor country steady state: higher K/L, higher Y/L !

(given: investment rate and technology)

- Immigration to Rich countries raises Rich country labour force growth.

- new Rich country steady state: lower K/L, lower Y/L.

(given: investment rate and technology)

- This will help close the steady-state standard of living gap.

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- How important a factor is migration?

- Historical importance?

Taylor and Williamson (1997)”Convergence in the Age of Mass Migration” European Review of Economic History.

- Substantial migration between Europe and the “new world”: 1870-1910.

- Simulates effects on real wages, GDP per capita and GDP per worker: reduced inter-country dispersion (convergence!).

- Potential importance?

- Rodrik (2001) “Immigration Policy and the Welfare State” (website)

- Potentially a bigger factor than trade liberalization and K flows.

- Why? “Price” difference is especially large between Rich and Poor country wages (more so than differences in goods prices or rates of return on capital).

- Hamilton and Whalley (1984) Journal of Development Economics study: allowing completely free labour flows could double world income.

(simulation model)

- Walmsley and Winters (2002): (see website)- Simulate effects of allowing additional immigration equal to 3% of

Rich country workforces:

- raises World GDP by $150 billion US (0.6%);

- this is 50% larger than estimated effects of world free trade.

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- Importance of migration in practice?

- International migration is heavily controlled.

(but a big factor for some countries: handout)

- Significant Rich country resistance:

- Model: depresses Rich country wages.

e.g. Aydemir and Borjas (2007) evidence for US, Canada and Mexico: 10% rise in supply gives 3%-4% fall in wages.

(if depressed economy: possibly job loss for domestic workers)

- Non-economic reasons for opposition.

- Seems unlikely to change soon:

pessimism about migration as a major world-wide factor promoting convergence between countries.

- Recent policy developments:

- current globalization: rose late 1980s, early 1990s (stayed high)

- measures allowing temporary migration from Poor to Rich countries.

e.g. US and temporary permits for Latin American immigrants. Similar discussions in Europe.

- Migration may prove important in specific cases:- Mobility within the Euro-zone now.

- Korea: if unification should occur in the future?

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- Importance of migration within countries:- migration between regions within a country can create regional

convergence.

- a current issue in China: coastal regions vs. in-land.

- Germany: East to West after unification.

- greater internal mobility as a possible source of growth. e.g. Lewis model

- Additional effects of migration on Poor countries:

- Remittances as a major benefit of migration to source countries.

World Bank: - total $ value of remittances largest China, India,

Philippines, Mexico, Nigeria.

Tajikistan remittances 48% of GDP ! Kyrgyz Republic 31% of GDP Lesotho and Nepal 25% of GDP

- “Brain drains” could harm Poor country growth prospects.

- who wants to migrate? Who is allowed to migrate?

- Selective immigration policies in Rich countries.

- Could this work against convergence?

- Migration flows: can it transfer skills and technology as well?

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International Capital Mobility and Resource Allocation

- Two uses for capital: Rich or Poor Country

- Physical capital is relatively abundant in Rich countries.

- Capital shortage in poor countries: potentially many high return opportunities.

- Abundant, cheap labour for capital to work with in Poor Countries.

- So assume diminishing returns:

VMP of capital low in Rich, high in Poor countries.

- So the return to investment in physical capital higher in Poor countries.

i.e. the return that K owners receive for K will be higher in Poor countries.

- Rich country K owners have incentives to invest in plant and equipment in Poor rather than Rich countries.

i.e., foreign direct investment, joint ventures etc.

- Poor country projects can afford to pay foreign savers a higher rate of interest for finance.

- Poor countries should be able to attract savings from Rich countries.

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- Result?

- financial capital (foreign investment and foreign saving) should flow into Poor countries from Rich countries.

- with complete mobility K flows continue until the return and VMP of K is the same across countries.

- This pushes up the effective savings and investment rate ("s" in Solow) in Poor countries.

- Solow model: this will help produce convergence (in K/L and Y/L).

- Capital inflows as foreign direct investment may also advance technology. i.e. foreign business bring their knowledge and methods.

- Policy?-This argument suggests that Poor countries should encourage capital inflows.

e.g. avoid restrictions on foreign ownership or borrowing from foreigners.

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How Important is K Mobility?

- Historical record: some cases where it was important for growth

- 19th century, early 20th century: international capital flows fuelled growth in US, Canada, Australia, N.Z., South Africa, Argentina etc.

- high returns from combining capital with abundant natural resources.

- are there similar high returns now to combining K with abundant Poor country labour?

- how about K with resources? (Collier: Africa underutilized natural resources)

- More recently? Singapore and foreign direct investment (FDI).

- Low investment returns in Rich countries in recent years: will it encourage Increased flows to poorer countries as Rich country investors hunt for higher returns?

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- Feldstein and Horioka exercise:

- Looks at correlation between domestic savings and domestic investment.

- completely closed economy: correlation perfect (+1) !

- capital completely mobile: no relationship between domestic savings and domestic investment.

(correlation = 0)

- What does the data say?

- Correlation very high 1960s to 1990s (Weil: +.89)

- inconsistent with much K mobility!

- Decline 1997-2006 to below +.3 (more K mobility!) but rebounded with crisis.

- see graph from Jen and Yilmaz (2012).

- This is not consistent with anything close to full K mobility.

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- Lucas (1990) exercise with a Cobb-Douglas production function (see Appendix to this set of notes).

- generate an estimate of VMP for poor and rich countries

- suggests substantial differences in “r” or VMP between countries.

- K mobility apparently too weak to eliminate these differences.

- Brad Delong’s “How Strong a Supporter of International Capital Mobility Can I Still Be?” (2004), “Capital and Its Complements” (2008)

- Makes standard arguments for capital mobility between countries,

- better allocation of capital: goes to where it is scarce and returns are high;

- barriers to mobility (controls): encourages corruption;- capital flows can encourage technology flows.

- But some apparent problems:

- is capital sometimes flowing the “wrong” way and why? (recent flows of capital into US from Asia: inconsistent

with the allocation model? What’s missing?)

- North American Free Trade Agreement (NAFTA):

- Expected effect on K flows:- encourage investment in Mexican industry (capital

inflows) -- seems to have happened.

- Unexpected effect? - flow of savings from Mexico to US. - Flight to security?

- Crises and capital flows: e.g. 1997 East Asian crisis, Argentina, Euro-zone crisis (flows to south and east: destabilizing?)

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- Others have suggested institutional reasons for why capital might not flow to Poor countries (LDCs):

- Delong: insecure property rights might cause flows from Poor to Rich countries.

e.g. since 1990s large flows into US from LDCs.

- Difficulties of enforcing contracts across international borders may hamper K mobility.

- Rodrik: in many Poor countries weak investment demand is a constraint on growth not a lack of finance for investment.

- why? - Individual investors unable to capture social returns

on investment.

- may be rooted in weak property rights, corruption, poor contract enforcement.

- Endogenous growth models: no diminishing returns to K investment- if correct: no reason for K to flow to LDCs.

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- Openness, globalization and accumulation:

- Both migration from Poor to Rich countries and capital flows from Rich to Poor countries can result in convergence.

- both work via ‘accumulation’, i.e. raising K/L in Poor countries and decreasing it in Rich Countries.

- Turn next to Productivity and why openness and accumulation might causeproductivity to converge.

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Productivity and Openness:

- Technology transfer: one avenue by which openness can aid convergence. (main concern next page)

- Efficiency and openness: other possible channels

- Greater competition: incentives to keep costs down, avoid waste, adopt best practices, etc.

- Economies of scale effects: serving larger international markets may make it possible to reap scale economies in some industries.

- Protectionist policy environment may encourage rent-seeking, corruption (wastes resources, lower average productivity)

e.g. via lobbying for import licenses, tariff increases, etc.

- Gains from trade in goods and services.

e.g. models of comparative advantage: trade allows for higher total output from same inputs.

- new opportunities:

- can buy some goods abroad for less (value of inputs in this use reduced);

- can sell some goods abroad for more. (value of inputs in this use raised).

- reallocating inputs in response to these opportunities can raise the value of output.

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Productivity, The Technology Gap and Diffusion of Technology

The Technology Gap: Is it the Key Explanation of Differences in Living Standards?

J. Fagerberg (1994) “Technology and International Differences in Growth Rates” Journal of Economic Literature (see website link)

- a good, readable survey of the role of technology.

- Historical views: often stress technology as the key to convergence.

R. Easterlin, "Why Isn't the Whole World Developed?" Journal of Economic History March 1981, pp.1-17.

- 18th century: productivity and standards of living were similar across countries.

- Industrial revolution in the U.K.

- New production methods developed in U.K. spread to other countries and are adapted.

- GDP per capita of these industrialized countries rise vs. the rest.i.e., industrialization and technology accounts for the

divergence in standards of living.

- The high growth rates achieved by some countries after industrialization began seems consistent with adoption of Rich country

technologies.

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- An alternative view:

“Information on existing technologies is readily available so all countries have access to the same techniques and have the same production function.”

- Once known, ideas are available to all.

- If so, differences in technology represent a poor explanation of Poor vs. Rich country income differences.

- Differences in technology only help when thinking about leading edge technologies.

- arguably most technological knowledge is not in this category.

- Is the problem ability to use the knowledge rather than availability?

- Is it expensive/difficult to transfer technology?

- Must some preconditions be met before knowledge can be used?

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When will transfer or diffusion of technology be likely?

(1) Suitability or appropriateness

- "best" technology can differ from country to country

Some determinants of best (best= most profitable):

- factor endowments (what inputs are abundant or scarce?)- market size (scale)- institutions: business organization, financial.

e.g. late 19th, early 20th century:

U.S. : natural resource intensive, large market

Europe, Japan: less resource intensive, smaller national markets.

- Some technologies may not be profitable to transfer.

- Others may need to be adapted to local needs.

- Allen: have recent innovations only shifted production function at high K/L?

- Do poor countries have the needed skilled workers?

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(2) Incentive issues

- Parties must be willing and interested in making the transfer.

- Businesses expecting to profit from the new technology

- Maybe a government with national goals.

- Foreign firms and foreign direct investment (FDI).

- Government role:

- Property rights, security, stability, taxation: can you keep your gains?

- Brander Canadian Journal of Economics 1992: - Soviet Union vs. Japan 1960s-1980s- both had many scientists, engineers, etc. - ability to innovate was much greater in Japan:

was it market incentives?

- Information/knowledge: externalities and incentives

- Introducing a technology: others observe and copy.- Initiator gets only part of the benefits: weakens

incentive to innovator or transfer.

- Does the government need to help in a more direct way?

- Training and education: are private incentives insufficient to build needed skills?

- Capital (financial) market failures: - inability to finance education, training, new technology?

- Japan and S. Korea are examples where the government played a role in technology transfer and industrialization (MITI)

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- World Bank: importance of openness

- International trade- foreign competition: incentives to adopt best-practice.- information: awareness of new techniques, new goods.

- Foreign Direct Investment: - transfer of expertise, training of local personnel

e.g., Malaysia and Intel: contracting with former employees

(3) Barriers to new technology: can technologies be blocked?

- This is a big story in Parente and Prescott’s book Barriers to Riches.

- See: Ch. 1, 7 and 9. Some similar arguments in Acemoglu and Robinson.

- Possible source of barriers?

- Industry-insiders who would lose from adoption of new technology create or lobby for barriers.

e.g., - Indian textile industry: - strikes in early 20th century - limits placed on use of power looms.

- US coal mining: - adoption of boring machines slowed by unions.

- Regulation in beer brewing industry in Germany: reflecting traditional producer interest.

- Ability to create barriers is affected by government.

- international trade policies: how much competition do firms face?

- willingness to adopt policies reflecting supplier group interests.e.g., regulation.

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- In Ch. 9 Parente and Prescott argue that this type of story can help explain several key facts:

- Why UK developed first rather than China, France or Spain?

- Why Japanese growth accelerated after WWII?

- In the successful cases governments did not aid in the creation of barriers.- diffuse political power important.

Technology and convergence some conclusions:

- Technology gap creates the possibility of convergence through borrowing technology.

- Technological gap can only close if preconditions are met:

- suitability including technical competence.

- correct incentives, policies and institutions.

- lack of barriers.

- Meeting these preconditions makes transfer difficult.

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Appendix: Details for Lucas (1990)

Lucas (1990) “Why doesn’t Capital Flow from Rich to Poor Countries?” American Economic Review

- Concerned with capital mobility between countries.

- Starting point: say India and US had the same production function.

Y = A K L1- (Cobb-Douglas)

- Now the value marginal product of capital is:

VMP = A (K/L)

= A kk=K/L

- Lucas calculates the ratio of Indian to US VMP.

- using data on US and Indian values of: K/L and the share of income going to capital ().

- Result? - VMP of capital is 58 times higher in India than the US !i.e. Indian K investment vastly more profitable.

- This suggests:

- huge barriers to financial flows OR

- calculation is missing something.

- What might be missing?

- Human capital:

- Allowing for differences in quality of labour (skills):

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- Measure labour in efficiency units.

- Otherwise same production function.

- Ratio of Indian to US VMP is: 5

- Indian return on K still much higher.

- Still suggests mobility issues.

- Maybe “A” is 58 times as high in US than India: different production functions.

- Say that: A = f(H/L) H = human capital. = (H/L)

- Lucas estimates from US data.

- With this adjustment Indian and US VMPs are equal.

- Consistent with limited financial flows.

- Knowledge and technology make capital more productive in the US.

- “Political (default) risk”

- Problems with enforcing contracts across borders.

- Incentive for receiving countries to default.

- This could limit capital flows and give very different VMPs.

- What about colonies? (same legal rules)

- why weren’t capital larger in the colonial period?

- does monopoly power create an incentive to restrict the

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supply of capital?

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