Mitchell: The economics of convergence

A key insight of international economics is that there should be “convergence” between rich countries and poor countries, which is just another way of saying that low-income nations – all other things being equal – should grow faster than high-income nations and eventually attain the same level of prosperity.

The theory is sound, but it’s very important to focus on the caveat about “all other things being equal.” As I have explained, countries with bad policy will grow slower than nations that follow the right policies.

When I discuss convergence, I often share the data on Hong Kong and Singapore because those jurisdictions have caught up to the United States. But I make sure to explain that the convergence was only possible because of good policy.

I also share the data showing that Europe was catching up to the United States after World War II, just as predicted by the theory, but then convergence ground to a halt once those nations imposed some bad policy – such as costly welfare states.

In other words, convergence is a choice, not destiny.

Countries with small government and laissez-faire markets are the ones that grow and converge. The nations with statist policy languish and suffer. Or even de-converge (with Argentina and Venezuela being depressing examples).

Simply stated, partial liberalization can lift people out of poverty.

But it takes comprehensive liberalization for a nation to become genuinely rich.

Some new research from the St. Louis Federal Reserve examines the topic. They want to understand why some nations converge and some do not.

They examined 10 fast-growing economies and 10 “development laggards” and found that “institutional barriers” played a key role. Researchers found, “unnecessary protectionism, government misallocation, corruption, and financial instability have been key institutional barriers causing countries to either fall into the poverty trap or lag behind without a sustainable growth engine. Such barriers have created frictions or distortions to capital markets, trade, and industrialization, subsequently preventing these countries from advancing …. By reviewing the previous country-specific details, one can see that the 10 fast-growing countries have all adopted an open policy … Their governments have undertaken serious reforms, particularly in both labor and financial markets …. Thus, the establishment of correct institutions and individual incentives for better access to capital markets, international trade, and industrialization can be viewed as crucial for a country to advance with sustained economic growth.”

Interestingly, the study includes some country-specific analysis.

About India, which suffered during an era of statism but has enjoyed decent growth more recently thanks to partial liberalization, researchers found that major economic reforms in the 1990s tripled the annual growth rate of per-capita income. (For what it’s worth, I am semi-pessimistic about India. Simply stated, there’s has not been enough reform.)

Regarding Argentina, which is mostly a sad story of ever-expanding government, the research showed per-capita income fell by more than 20 percent from 1875-90, as a government spending spree, rising wages and inefficient production combined to produce chronic increasing inflation – ultimately resulting in the economy’s eventual collapse.

They found some good news in Chile, where free market reform led to rapid increase in exports and per-capita income – leading Chile to become one of Latin America’s healthiest economies.

Not only has Chile become the richest nation in Latin America, it also has enjoyed significant convergence with the United States. About 40 years ago, according to the Maddison database, per-capita GDP in Chile was only about 20 percent of U.S. levels. Now it is 40 percent.

The bottom line is that there is a recipe for growth and prosperity. That is the good news.

The bad news is that very few nations follow the recipe since economic liberty means restricting the power of special interests and the political elite.

Daniel J. Mitchell, chairman of the Center for Freedom and Prosperity, is on the Editorial Board of the Cayman Financial Review.

Comments are closed.