Wednesday, July 23, 2008

Why Poor Nations are Poor

Why? What we all agree upon

It's one of the biggest questions of the modern world: why are Western Europe, the United States, Japan, and certain British dominions so wealthy, while the rest of the world is so damn poor?

The answer largely depends on who you ask. If you ask a die-hard libertarian, its because the poor world did not embrace markets, whereas the wealthy Europeans have had a more...sophisticated respect for capitalism. A die-hard liberal might point to oppression and exploitation by the West, while more moderates might suggest that institutions (financial markets, democracy, allowing interest payments, etc) allowed the West to gain incredible amounts of wealth.

But we can all point to one point in history where the West started to take off: the industrial revolution. Starting in England and slowly migrating to other parts of Europe, the Industrial Revolution created incredible wealth, while most of the world has only recently begun industrializing.

So, we have our opinions colored by this industrial revolution. Economy policy prescriptions seem largely based on what we think allowed said industrial revolution occurred, which has largely been a rigorous treatment of markets, political reform, and the establishment of new economic institutions.

But, what exactly defined the Industrial Revolution?

A lot of people suggest that it is the development of new technologies, which allowed factories to be built as production was more advanced. Hence, we tend to think of the Industrial Revolution as being relatively capital-intensive: heck, just listen to the communists rant about capital and the means of production. Hence, we consider the development of industry and manufacture to be an essential part of economic development. Because of this, we tend to look at things like tariffs as being an essential part of early development, because it allows domestic industry to develop.

Gentlemen (and whatever ladies we have), this is poppycosh. It is true that capital stores have been enhanced somewhat since the beginning of the industrial revolution. It is not, however, true that the industrial revolution was primarily about industry, and that nations that developed heavy industry were the ones that ended up being the wealthiest by some inevitable process.

Why we buy capital

Capital reserves are based on two things: the real interest rate and the returns to capital. Much like supply and demand must equal each other, so must the interest rate equal the return to capital. If you are going to spend $1,000,000 on building a giant new factory, and earn $50,000 over the life of the factory (or 5%), you'll only build the factory if the interest rate during the same period of time is equal to or less than 5%. Otherwise, you'd invest your money instead of building a factory.

Real interest rates in England at the time of the Industrial Revolution were already relatively low, relative to those of the rest of Europe and of Asia. Declines in real interest rates are not the primary factor driving the industrial revolution. Therefore, we have to point to returns...

But why did returns suddenly increase? Is it, as some people suggest, England levied protective tariffs? Perhaps this is A factor, but probably not the primary one. The textile industry (which produced roughly half the gains England experienced in the early Industrial Revolution) was a highly competitive industry within England, since the optimum size of a textile plant was very small. Hence, returns to capital were low, as profits were very low.

Technology? Definitely the case, along with other innovations. Efficiency gains make the production possibilities increase, and also increase the returns to capital. Hence, there's a rush to buy MORE capital after a new technology comes out that makes spinning threads easier.

You might be thinking that I have just disproved my point. Au Contraire. Keep reading

Globalization in the Late Industrial Age
At first, England tried very hard to protect its markets, as well as keep technology within its own borders. This proved impossible, and technology slowly leaked to other nations around the world. Similarly, England steadily lowered its tariffs (in contrast to, say, France, where tariffs were low throughout to the 19th century).

Great Britain also committed itself to a policy of free markets and free® trade, and other European nations were also committed to building essential railroads within its colonies in order to safeguard gains. Hence, by the time the late 1800s rolled around, the world was surprisingly well-integrated. The globalization of the 1870-1914 era is hard to understate. This is largely the result of the two World Wars: if the economy was so well-integrated, why would the nations of the world fight each other? This is another question for another time, but suffice to say that trade compromised a large part of most European economies at the time. Exports and imports accounted for something like half of the French economy in 1914, compared to 54% of the French economy today. And Germany was the biggest trade partner in 1914, just as it is today.

The developing world was also well-integrated, at least for global capital markets. We can see this in the interest rate between nations at this time, which have absolutely nothing to do with income: India's interest rates were actually lower than those of the United States. India had access to all the capital she would ever need, and all the technology that her European peers had. Because of this, Indian railroads (which were subsidized by the Indian government) were actually better constructed than American railroads.

Yet, India did not develop. Nor did Africa, nor did the Ottoman Empire. In contrast, the United States, plagued by monopolies, corruption, and relatively BAD capital markets, did develop. What gives?

Efficiency: Not Just Technology
As previously stated, efficiency gains explain why countries would purchase more capital. What I did not mention is that efficiency gains also explain a large portion of economic growth in and of themselves (75% or more).

Efficiency, however, is not merely new production technology. I could give a group of three year olds access to a nuclear reactor, and they would be unable to produce even a watt of electricity. Technology means nothing if you can't utilize it properly, and that was the difficulty that less developed nations had. For instance, a textile mill in India would have 1 worker per loom. In contrast, a British or American loom would typically have 1 worker service 8 looms at once. Hence, productivity per worker was far higher in the developed world, and wages/income were higher as a result.

Intangible are things we undervalue greatly today. In part, this is the fault of economists, who concentrate largely on maximization and equilibrium rather than the spread of ideas. Yet, these intangibles are largely the reason why the West is developed today, while the rest of the world has not developed.

Hence, the American South, which had very little industrialization at all, would've rated as the world's 4th richest nation in 1860. Nations can make a fine dollar by exporting something that is not considered an industrial staple, as the general increase of wealth increases demand, and the nation can increase its own supply side through alternative means.

What intangibles are important
Of this, I am less than certain. "A Farewell to Alms," which this post is heavily based off of, suggests that labor quality in the undeveloped world was far inferior to that of the developed world. The example used, though, is hardly conclusive, and might be construed as inept management.

Labor quality probably was, however, inferior, just as it remains inferior today. Similarly, the undeveloped world did not have a core of entrepreneurs and experienced managers, unlike the developed world. This is highly important, as importing management is not as easy as it seems (the soft skills of a manager matter greatly). The lack of entrepreneurs might in turn be the result of lower literacy levels and the low social status of merchants in such times, whereas business became the playground of literate Samurai in Japan. (Indeed, literacy levels in India remain relatively low, barely higher than levels in 1700s England).

So, if we want to increase wealth in the developing world, what should we do?

First off, stop dumping aid on them. It doesn't actually increase their living standards. If anything, it actually REDUCES living standards, because parts of the world remain in a Malthusian trap. Any increase in resources(particularly medicine) actually reduces living standards.

Rather, we should focus on the intangibles of growth. That means discipline in the workplace. It means a strong respect for entrepreneurship, and higher literacy and experience in managing businesses. It also means more focus on how different societies operate, so that managers can make most effective use of their work face.

What am I not prescribing? I am not talking about democracy. I am not talking about free trade or free flow of capital. I am not suggesting high tariffs. Certainly, to some extent, these things are actually helpful (in fact, the reintroduction of globalization in the 1970s and 1980s probably set the stage for growth in India and China after they had experienced large growth in literacy and bureaucratization from their statist governments. Ironically, their socialist governments might have done an absolutely remarkable job in preparing them for the capitalist world). They are not, however, sufficient conditions.

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