Wednesday, November 26, 2014

In Search of Convergence

CAMBRIDGE – One puzzle of the world economy is that for 200 years, the world’s rich countries grew faster than poorer countries, a process aptly described by Lant Pritchett as “Divergence, Big Time.” When Adam Smith wrote The Wealth of Nations in 1776, per capita income in the world’s richest country – probably the Netherlands – was about four times that of the poorest countries. Two centuries later, the Netherlands was 40 times richer than China, 24 times richer than India, and ten times richer than Thailand.

But, over the past three decades, the trend reversed. Now, the Netherlands is only 11 times richer than India and barely four times richer than China and Thailand. Spotting this reversal, the Nobel laureate economist Michael Spence has argued that the world is poised for The Next Convergence.

Yet some countries are still diverging. While the Netherlands was 5.8, 7.7, and 15 times richer than Nicaragua, Côte D’Ivoire, and Kenya, respectively, in 1980, by 2012 it was 10.5, 21.1, and 24.4 times richer.

What could explain generalized divergence in one period and selective convergence in another? After all, shouldn’t laggards grow faster than leaders if all they have to do is imitate others, even leapfrogging now-obsolete technologies? Why didn’t they grow faster for so long, and why are they doing so now? Why are some countries now converging, while others continue to diverge?

There are potentially many answers to these questions. But I would like to outline a possible explanation that, if true, has important implications for development strategies today.

The economic expansion of the last two centuries has been based on an explosion of knowledge about what can be made, and how. An apt metaphor is a game of Scrabble: Goods and services are made by stringing together productive capabilities – inputs, technologies, and tasks – just as words are made by putting letters together. Countries that have a greater variety of capabilities can make more diverse and complex goods, just as a Scrabble player who has more letters can generate more and longer words.

If a country lacks a letter, it cannot make the words that use it. Moreover, the more letters a country has, the greater the number of uses it could find for any additional letter it acquired.

This leads to a “quiescence trap,” which lies at the heart of the Great Divergence. Countries with few “letters” lack incentives to accumulate more letters, because they cannot do much with any additional one: you would not want a TV remote control if you didn’t have a TV, and you would not want a TV broadcasting company if your potential customers lacked electricity.

This trap becomes deeper the longer the alphabet and the longer the words. The last two centuries have seen an explosion in technologies – letters – and in the complexity of goods and services that can be made with them. So the techies get techier, and the laggards fall further behind.

Why, then, are some poorer countries now converging? Is the technological alphabet getting shorter? Are products getting simpler?

Obviously not. What is happening is that globalization has split up value chains, allowing trade to move from words to syllables. Now, countries can get into business with fewer letters and add letters more parsimoniously.

It used to be that if you wanted to export a shirt, you had to be able to design it to the taste of people you didn’t really know, procure the appropriate materials, manufacture it, distribute it through an effective logistical network, brand it, market it, and sell it. Unless you performed all of these functions well, you would go out of business. Globalization allows these different functions to be carried out in different places, thereby allowing countries to participate earlier, when they still have few locally available capabilities, which can then be expanded over time.

A recent example is Albania. Known as the North Korea of Europe until the early 1990s, when Albania abandoned its quixotic quest for autarky, it started cutting and sowing garments and shoes for Italian manufacturers, gradually evolving its own fully integrated companies. Other countries that started in garments – for example, South Korea, Mexico, and China – ended up reusing the accumulated letters (industrial and logistical capabilities) while adding others to move into the production of electronics, cars, and medical equipment.

Consider this a stylized version of the sale of IBM’s Thinkpad to China’s Lenovo. Once upon a time, IBM asked a Chinese manufacturer to assemble its Thinkpad – using the components that it would supply and following a set of instructions – and send the final product back to IBM.

A couple of years later, the Chinese company suggested that it take responsibility for procuring the parts. Later, it offered to handle international distribution of the final product. Then it offered to take on redesigning the computer itself. Soon enough, it was no longer clear what IBM was contributing to the arrangement.

Learning to master new technologies and tasks lies at the heart of the growth process. If, while learning, you face competition from those with experience, you will never live long enough to acquire the experience yourself. This has been the basic argument behind import-substitution strategies, which use trade barriers as their main policy instrument. The problem with trade protection is that restricting foreign competition also means preventing access to inputs and knowhow.

Participating in global value chains is an alternative way to learn by doing that is potentially more powerful than closing markets to foreign competition. It enables a parsimonious accumulation of productive capabilities by reducing the number of capabilities that need to be in place in order to get into business.

This strategy requires a highly open trade policy, because it requires sending goods across borders many times. But this does not imply laissez-faire; on the contrary, it requires activist policies in many areas, such as education and training, infrastructure, R&D, business promotion, and the development of links to the global economy.

Some dismiss this strategy, arguing that countries end up merely assembling other people’s stuff. But, as the famous astronomer Carl Sagan once said: “If you want to make an apple pie from scratch, you must first invent the universe.”

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    1. CommentedL.J. Huang

      The big players during the Imperial Age where European countries subjugated poorer countries and made them their colonies are British, Dutch, Spanish, Portuguese and French governments. During this age some historians calculated that the British East India Company, for example, earned an average return of 20% annually for their shareholders over a span of 200 years. If you do your maths, a growth rate of 20% a year over 200 years is out of this world. It can never happen again. Not in a world where the flow of information is available at the click of a mouse.

      It is obvious the rapid growth of the Western countries is a result of the exploitation of Third World countries over a long period of time. Together with their accumulated monopolistic power built up over time it isn't difficult to figure out they will be growing faster than poorer countries.

      When exploitations slowed down or even regressed the poorer countries, starting from a lower base, will then have a faster growth rate.

      Of course this is not to say the network effect can be totally discounted as an agent of growth. It is an important variable that can contribute to the growth of the economy.

      However, it is not the most important factor. The most important factor is protection of property rights. Without this protection there will be no long term investors. Short term investments, by definition, must be even more exploitative than long term investments.

    2. CommentedCamila Franco

      This is the same idea behind "learning by doing" and what middle-low income countries have been doing last years. This is not a new idea.
      The big deal for these countries is that there is non-economic inertia: institutional and political structures that keep the same economic model based on raw (low tech) exportations and those activist policies in different areas stay lagged.
      In my opinion the hierarchy must be different, that means, policies focused on education, health, infrastructure and innovation.
      On the other hand, policymakers should get over copy-experiences fetish, and to start stimulating the finding of ownpath to development.

    3. CommentedNichol Brummer

      Distributed renewable energy should help many places jump ahead. No need for a grid and some large and complicated electricity plant if you want to provide reliable electricity. A lot can be done now very reliably with solar panels, or wind, and grids may be quite small. You can now have phone, internet connections, with TV, radio, a computer and electric light, all without an electric grid or even a fixed phone line.

    4. CommentedJohn Shin

      Imitate to Innovate is the story of Korea's fast-follower strategies which exemplify the efficacy of parsimonious progress.

    5. CommentedM A J Jeyaseelan

      There is actually no convergence. It is still the very same divergence process, which is at work. Rich getting richer is a very natural osmotic process, which occurs not only between economies but also among individuals and groups within an economy. In India for example, reservations in education and employment was used to uplift the under-privileged. But, the main result has been the emergence of a creamy layer among the underprivileged, which has managed to get richer and richer

      In order to apply the science of osmosis to economic processes, one must however, understand the subtle difference in the definition of rich; in the context of osmosis rich will mean higher concentration of the concerned solute. So achieving higher growth is not case of acquiring all kinds of alphabets, that would help increase the chances of making different words as in game of scrabble. The focus has to be on enriching the concentration of the missing solute. Even in a scrabble game one would always miss the vowels most. So the poor countries will have to aim at achieving higher concentrations in areas like technology and capital. Education becomes particularly important for countries, which want to overcome the challenge of technology constraints.

      The reason why I say that there is no convergence process is because, world trade has not yet become a win-win exchange. If countries like China are getting richer, there are countries like the US, which are getting poorer. In fact, what China is doing right now, is similar to what the US did prior to the Great Depression. China is keeping the aggregate demand in the US going by not extending credits to buyers as the US did, but by buying up a very large part of its public debt. The reason why China can hope to continue to use developed economies as milch cows for long and avoid dangerous depressions as a consequence is because of its labour surplus.

      Even now, most developed countries are managing to take the sting out of wage the inflation by permitting the inflow of immigrant labour. Any country, which wishes to escape the ill effects of wage inflation must adopt an open door policy towards immigrant workforce, which adds to productivity and keep wages at a level, which does not erode the global competitiveness of its production facilities.

      The big boom before the great depression in the US actually drove up wage levels because of the limited availability of human resources to meet the growing demand from within and from higher imports resulting from the credits extended to poor countries at low interests. The wage inflation made both domestic consumption and import demand non viable. It was clearly a case of prices overshooting the available gross purchasing power.

      What must be understood clearly is that there is an additional variable, which is relevant to the natural process of osmosis by which the rich get richer. If external pressure exceeds the osmotic pressure then the osmotic process will be reversed. Wage inflation can be an external pressure which disrupts the natural process of rich getting richer.

      Without a ray of doubt, poor countries will have to find a way to connect with the global economy. One of the important channels for establishing such connectivity will certainly be to participate in the global value chains. As brought out by Hausmann, such participation will also need to be supported by 'activist policies in many areas, such as education and training, infrastructure, R&D, business promotion, and the development of links to the global economy'.

      In generic terms, achieving growth by connecting to the global economy requires that there is net transfer of purchasing power from the rich countries to the poor countries. It need not be always in the form of increasing the level of participation in global production. Poor countries must also learn to take full advantage of raw materials, which they supply to the world. Just as most oil producing countries have done, poor countries can also use their raw materials strategically to create osmotic processes which result in a net transfer of purchasing power from the rich to the poor.

    6. CommentedJonathan Lam

      gamesmith94134: In search of convergence

      I think the convergence might be the "Z" factor of the circuitry of wealth that margin of affordability created the have and have not. As you said in the case of IBM and Lenovo that patent or know how is not significant to accumulation of wealth. In term of price and value, inequality was found on the labor capital that consumes. The accumulated wealth became a liability to growth if inflation and exchange rate are not comparative to external growth.

      China have a better redistribution model that labor got a raise and spent it all; and American would have a bubble in the equity market that saving and subsidies are sacrificed to compensate the social developments that whined. China imported was favored by volume in second to the best; and the American best then limited by the margin of affordability. Convergence may not engraved in the trade policy as production is no longer incur with regional know how or material resources since we arrived at the communication age that is enforced by computer and hired hands.
      Perhaps, you may imply labor capital that we did not allow to consume through the redistribution of wealth. It is just my point of view in another angle of circuitry of wealth that I called the "Z factors"
      May the Buddha bless you?

    7. CommentedJonathan Lam

      Gamesmith94134: Dr. Doom Warns Wall Street and Washington---- Heed Karl Marx's Warning!

      • Gert van Vugt
      The discourse in my opinion is almost unanimously tilted towards "saving the economy" and recovering from the crisis. Not just in the US, but in basically every industrialized country this is directly assumed as the way forward. However; I do not see how this follows from life, liberty, and the pursuit of happiness. Challenging the growth paradigm allows for two options to emerge:
      1) redistribution of wealth and stimulus packages can kick-start demand driven consumption, and this proportionally creates sufficient jobs in due time, with a growing standard of living for all.
      2) redistribution of work and profit, as well as deflation create a sustainable standard of living for all, where elimination of jobs due to technological and scientific progress introduces the end of work without falling standards.
      Both solutions can be debated: the first depends on the assumption that consumer demands are infinite, although this is not what most data is showing. The second option is widely dismissed as causing a drop in the competitiveness of the economy, although empirical proof is unavailable up to date.
      I understand that the second option is controversial in a country that still labels Marx's predictions as "wrong, of course", but I challenge intellectuals such as yourselves to be a bit more introspective.

      Read more:

      Gamesmith94134: Dr. Doom Warns Wall Street and Washington---- Heed Karl Marx's Warning!

      Mr. Gert van Vugt,
      You make the best description on the theory on the economical growth Paradigm that the economic change seems like Malthusian’s diminishing return, and I agree. However, Mr. Roubini makes his point on the social disruption reverse itself through the diminishing demand. If we can put away the elements like the Ponzi scheme and benefactors in social caused deficiency or defects to growth. Corruption by capitalism and the dependency by socialism among societies both caused failure in the economical and societal development.
      Perhaps, we focus on the circuitry on the accumulation of wealth and consumable wealth that runs the economy. It seems both the capitalism and socialism ran short and proven wrong in the economical model or social model that became self-destructive; eventually, the economy runs from diminishing demand to diminishing return, or vice versa. So, if we use the living standard as the equilibrium position to the supply line of the circuitry of wealth balanced by both of the diminishing return and diminishing demand.
      How about I call my paradigm on the wealth circuitry in economical and social growth that supports and balances both accumulated wealth and consumable wealth; and it created a “Z” shaped development running both on the diminishing demand and diminishing return; which is based on the assumption, the route above the standard of living equal in length with the one below the standard of living is in agreement of its living standard to sustain a viable growth, which contains;
      • The base line as the diminishing return where the societies kept peace with its populace that consumable wealth that cause economical displacement like with its negative growth or no growth; it provides entitlement or social programs with non-productive individual citizens for example, 27% of its population on welfare with add-on with subsidies to sustain a standard of living.
      • The top line as the diminishing demand that ended with accumulated wealth favors of concentrated wealth owned by individuals that ended with profitless, 1% holds 27% of the global or national wealth, plus those with extra wealth is not in production yields to no growth.
      • And the diagonal line that connected to both ends is the support of the price and value in the middle is the standard of living which contains the most of the productive individuals who is moving up and down the ladder of growth.
      If more of the wealth accumulated than the wealth consumed, then it causes saturation of the wealth. The diminishing demand under the standard of living agreement made the demand idle because of the shortage of consumption. In the process, the standard of living will go down to meet its demand after the deflationary measure to make it consumable. In reverse, the wealth consumed is over the wealth accumulated, as it is less profitable. Then, it triggers the inflationary measures to aggregate demand to accumulate more wealth in its diminishing return mode; eventually it will balance itself again with the agreement of the standard living with a viable growth.
      It is not the supply and demand. It is rather the circuitry of wealth under the spells of the lower living standard that diminishing demand is being part of the deflationary measure. If the accumulated wealth became saturated, then it means the lower living standard that made the demand finite like lesser demand in loan of dollars in ECB.
      I am certain I am not being introspective; I may twist the theory a little; but the proof of the lower living standard in Europe made it plausible.
      May the Buddha bless you?

    8. CommentedJose araujo

      Hausmann Colonial economics...

      Sure Adam Smith and David Ricardo and many other at the time defended colonialis... caugh caughh... free trade, but I hoped mentalities changed.

    9. CommentedPaul Jefferson

      "Participating in global value chains is an alternative way to learn..." This benefits the emerging nations who learn, not the advanced nations who teach. And will the learners eventually become teachers? Or will they guard their value chains and keep them entirely domestic?

      China is now an advanced manufacturing nation, thanks largely to it's low wages, and the technology it has acquired from around the world. But will Chinese firms allow USA-based firms to participate in the Chinese firms' value chains? That seems doubtful. We are going to learn that technology transfers can be exclusively one-way -- and permanent.

      In any case, Chinese firms will have less incentive to allow international participation in their value chains as oil becomes increasingly scarce and transportation costs increase. High oil prices will make globalization less economically appealing, especially for heavy or bulky items. Here's a fascinating New York Times article on the topic, and it comes to an interesting conclusion:

    10. Commentedslightly optimistic

      The reference to Michael Spence's 'Next Convergence' was apt. 'The Security Deficit' was the Nobel laureate's essay last month on this website. In light of recent events he suggested that the greatest threats to prosperity are political - "regional tensions, conflict, and competing claims to spheres of influence".
      How these political disputes can be addressed will no doubt be discussed at the NATO summit next month in Wales.

        Commentedslightly optimistic

        DC: Schumpeter warned us of creative destruction in economic competition. Security was a separate subject in his time, but recent events are leading to an intense - holistic - interest in NATO's future. To be decided at the summit?

        CommentedDouglas Costello

        This general area has also been examined as to why the developed countries continue to out perform the less developed and this article describes the path/process by which the less developed or wealthy countries can shift themselves economically and reduce this gap. Albania and the IBM/China examples describe the process but fail to acknowledge that the two countries concerned are developing the tacit knowledge to build these services or items on their own and avoid loosing the economic growth opportunities previously held by Italy and the US.

        IBM's quest for greater shareholder returns by outsourcing basic assembly eventually created an enterprise that became a direct competitor and eventually would cut them out of the activity the result being lower shareholder returns effectively a case of shooting oneself in the foot and likewise the Italian clothing firms.

        Sharing of tacit knowledge is not inherently wrong ethically but if you wish to maintain your own business such sharing will create a competitor. It is an interesting ethical issue.