How do poor countries get rich?

An overview of 4 theories

Photo by Mihály Köles on Unsplash

How do poor countries get rich 

When I’m talking to people who don’t know that much about development economics I quite often find myself trying to give a broad overview of the different theories about how countries get rich. I’m going to give an overview of these different theories in this post. In later posts I’ll dive into each of them more deeply, and hopefully this post will provide a good overview before going into the weeds in later posts. This post will also focus on poor countries now and in the latter half of the 20th century, rather than thinking about how rapid economic growth got started at all. This post isn’t an attempt to adjudicate between these different theories, and in fact they often aren’t in direct conflict with one another, rather it seeks to provide an overview of the main theories I’ve come across. I’ve excluded natural resource led growth from this overview because, broadly, the point of this post is to go over strategies that states can actively try to follow and development institutions try to encourage. This post goes over 4 strategies: breaking poverty traps, economic liberalisation, improving institutions and export led growth and East Asian development model. 

Get richer

This theory argues that poor countries are poor because they get stuck in poverty traps. A poverty trap is a situation where being poor now makes you even poorer, or keeps you equally poor,  up to some threshold - once you’re above that threshold, being poorer now makes you richer or equally rich later on. To give some intuition for this, think about starting a business. There are some large upfront costs to starting a business - buying premises, getting licences - but then if you have a good idea you start making money. 

If you start out as a poor labourer without access to banking that allows you to save. This is a very common situation in low income countries, itself another poverty trap. Now, when you get income above your subsistence needs you’re only able to spend it on consumption goods because of this inability to access financial institutions. Maybe you even get poorer because you’re occasionally randomly hit with shocks to your income - maybe your son gets TB and you have to pay their medical expenses - and now you’re even poorer because you have to go into debt to pay for their medical bills. But, maybe there’s a bumper crop one year, or the government signs a new trade deal which gives your crops access to EU markets, and now you have enough money to start a business. Now you’re able to invest more into your business with the profits you make and get richer, and this goes on maybe until you run the best shop in your village and it’s too costly to expand into another village, leaving you at a new equilibrium.

This model is the theory behind a lot of the randomised controlled trial development economics. The theory is that there are specific barriers to poor people increasing their incomes and but beyond a certain point this barrier is no longer a problem. This was the promise of microfinance. Because of imperfections in financial markets, for instance the very weak legal system in many poor countries, banks couldn’t reliably get their money back if borrowers defaulted. This means borrowers don’t have any incentive to pay back their loans, meaning the banks have no incentive to give out the loans in the first place. The promise of microfinance hasn’t been borne out so far, but other interventions with the same theory behind them, such as cash transfers and lots of health inventions have proven to be extremely effective. 

Liberalise your economy

This theory says that the way to get rich is to open up your economy to forigen investment and trade, float your currency, slash regulation, slash subsidies, get an independent central bank and get it to crush inflation. 

There are three basic parts about why this strategy would work. The first part is reducing static inefficiencies. Getting rid of static inefficiency is an economist's favourite pastime. You get these sorts of inefficiencies when a different allocation of all the current resources in an economy gives higher output for the same inputs. In this context this will come out about when there’s a gain from trade that can be made but government regulation is preventing that trade from occurring, or there’s a government granted monopoly that’s using its market power to restrict output to increase prices and its profits. A really classic example of this is international trade. Because of how much better rich country economies are at producing technologically complex goods relative to simple ones, 

Then there’s the somewhat separate case of planned economies. The thing that markets do really well is they take information about the costs of producing goods and services, and how much people want those goods and services, and convert it into a very small, very legible piece of information; prices. This theory argues that prices are much better at telling people what they should be producing than central planners because central planners. When prices are above cost for a good, produce more of that good, when prices are lower produce less of it. Whereas a central planner has to get all of the information by hand as it were to try to find the best allocation of resources. 

A really interesting example of this happening in practice was during Mao's Great leap forward. Millions and millions of people starved to death in the countryside while at least some factories in cities had so much food it went rotten. In the early years of the great leap forward, so much rice was produced that Mao encouraged people to eat 5 bowls a day, and by the end 45 million were dead, mostly because of starvation. Lots of those people died for political reasons, but I think some of them died genuinely because the government was bad at allocating resources in the economy. I think this is especially true of all the people who starved because so much farm equipment had been turned into low quality steel goods because of Mao’s drive to industrialise, and because the techniques that led to the bumper crops meant much lower yields the next year. 

The second part of this is creating better incentives for innovation. Lots of this comes down to making profit cuts more sharply, for instance by allowing businesses and whole industries to fail instead of bailing them out. If what makes firms successful is the degree to which they’re able to curry favour with the government rather than the quality of their products, this shifts incentives to people competing for control of the state rather than in product markets. At worst this can lead to a delegitimization of the state and civil war.  

Finally, there’s stabilisation of the macroeconomic environment. For our purposes this comes down to keeping inflation low and stable and making sure you don’t have a foriegn debt crisis. Inflation makes the price system function less well because money becomes less of a good store of value (in theory this wouldn’t happen if everyone kept their savings in assets rather than as cash but, especially in poor countries, lots of people have their savings in cash) and a less good unit of exchange. Prices are only meaningful relative to one another. But because prices for different goods are differently sticky - the price of labour for instance changes much more slowly than the price of oil - inflation means that these prices can change in ratio to one another even when the economic variables underlying them are the same, eventually leading to a collapse in the price system if you get hyper-inflation. 

There have been a few rounds of these styles of reform that look like they were really successful. India is probably the poster child for this kind of reform that started in the late 80s but really got going in 1991. India substantially liberalised its economy by removing barriers to foreign investment by making it easier for foreigners to buy controlling shares in Indian firms, dramatically reducing the number of industries which require licences to operate and devaluing the rupee. 

Get better institutions 

The institutional theory of development argues that the variable for development is the quality of economic institutions which are mostly determined by political institutions. The first step in getting institutions which can lead to economic growth is a state with sufficient power to control violence in its territory. Without the costs of paying for security to defend your property and the risk of your property being destroyed or expropriated create very weak incentives for innovation. Ability to monopolise violence is the most basic of a broader set of things a strong state can do which are necessary for economic growth. Rule by law - where the law is a predictable way to dissolve disputes between actors of equal political power - creates a framework in which individuals can meaningfully have property rights and so are able to expand their business if they’re successful and reap the rewards of their profitability. Finally, and relevant to especially 20th century economic growth, is that a strong state can get some or all of growth that comes from capital accumulation and directing capital and labour into the most productive industries, before being limited by their inability to accept creative destruction. 

Iraq in the 70s is a pretty good example of the sort of growth that can come from gaining basic state capacity. Iraqi GDP grew 10 fold in dollar terms from 1970 to 1980. The institution's story of this growth is that Saddam was able to create a strong enough state to stop the incessant Kurdish uprisings, direct money to basic state services like courts and police as well schools and hospitals and poor capital into the oil industry. Egypt in the 50s and 60s is another good example of this sort of growth. Nasser, Egypt's dictorical president, was able to build a strong enough state to get capital accumulation via large, government funded infrastructure projects. 

Within the institutions model, the next second element after state capacity required for growth are inclusive economic institutions, the key part of which is to support creative destruction. Creative destruction is the process by which new ways of providing goods and services outcompete old ones, like the car becoming a better way to travel than the horse, or uber disrupting the traditional taxi hire industry. Within the institutions model, this is key to frontier growth - i.e growth that involves creating new technologies that drives growth in rich countries - and catch up growth beyond what can be achieved by channelling capital in sectors with higher productivity. The connection to political institutions is that, very often, creative destruction is bad for economic and political incumbents. It is bad for them economically because they’re outcompeted by individuals from outside the nexus of economic and political power. It’s also bad politically because it harms members of the alliance who keep the current regime in power meaning that those with formal political power risk losing it and the rents it allows them to earn; a base of economic power can create a base of political power; and those with new economic power increase their bargaining power because of the difficulty of taxation without the consent of the taxed. Without these sorts of institutions it becomes comparatively more valuable to compete over control of the state rather than to compete for market share, further reducing the incentives for innovation. 

One of the most unusual predictions that this model makes is that those with power will actively prevent the adoption of new technologies even when it doesn’t directly affect their commercial interests. A really good example of this is ban on ocean going ships in 1421 in China and the long history of aggressive clampdowns on merchant incomes in China which used the justification of merchants being harder to control than farmers very explicitly. 

The Philippines is a good relatively recent example of an improvement in domestic political institutions leading to an improvement in economic growth. The Philippines became a democracy in 1986 after the fall of the dictator Ferdiand Marcos after a popular protest movement. Prior to 1986 the Philippines was a classic plantation-agriculture dictatorship. Plantation agriculture is a particularly pernicious political-economy because it encourages the formation of large estates which are able to convert their economic power into political power via employment of effectively private armies to control the local population, coerce their labour and bribery. This sort of political economy is also very poor for economic growth in the long run because agriculture is a technologically simple sector making it hard to move up the value chain, and the state doesn’t provide public goods to those outside of the elite making it exceptionally hard for the masses to gain human capital. It also makes it hard for them to start businesses because the state doesn’t provide core public goods like an efficient court system and protection of private property, and all the capital is in the hands of the elite and capital markets have very substantial frictions.

After the 1986 revolution the Filipino economy began to diversify significantly and has now transitioned to an industrialised economy. The central government now in much more democratic hands, subsidies to the large landowners, embarked on a (troubled) process of land reform, liberalised the economy by privatising state owned sectors which had been used for rent seeking and liberalising trade. This combination of economic and political reform broke the power of the landlord class and the Philipenses has now shifted from a linear to an exponential growth path. 

The East Asian development model and export oriented manufacturing

When a country has good enough institutions - rule by law, protection from expropriation ect - the key problem they face in getting rich is adopting the technological practices of rich countries, and secondarily accumulating physical and human capital. Export oriented manufacturing does this really well. Manufacturing at a level high enough to compete with firms in rich countries forces is a technically complex process both in terms of technology as we normally think of it and management technology. The second benefit of exporting is it makes it increases the returns to innovation because the world market is such a large prize and a prize that can only be won by creating better products, while decreasing the benefits to rent seeking in domestic politics because the the ability to gain monopoly profits in low income country is a relatively small prize. The final benefit of exporting is that it gives access to rich people. Rich people are willing to spend more on goods and services than the low income people in the domestic market, meaning there’s more demand, and due to lower labour costs low income countries are able to outcompete high income countries in areas that require less human capital. 

The East Asian development model adds to export oriented manufacturing financial repression and land reform. Financial repression in this context is the state controlling people’s savings and through a combination of law and incentives, increasing the amount that’s invested in domestic manufacturing firms. Key tools of this are capital controls, which prevent capital from leaving the country to get higher returns internationally, political influence over bank lending, and currency devaluation which in addition providing advantages to exports reduces consumption and increases savings. The economic logic behind this is that there are extremely large positive externalities from investing in domestic firms which provide the opportunity for learning by doing - becoming more productive essentially via practice and iteration within an industry. Initially this is likely to have lower returns than, for instance, agraculture, meaning that financial repression has to be used to force investment to go to these areas. The positive externality comes from the gains in productivity being diffused throughout the economy when workers move firms, and that the improvements in productivity persist through time.  

Taiwan and South Korea are the most famous exponents of this method of growth. Taiwan and South Korea are particularly interesting cases because they’re only examples of countries with large populations that don’t have access to huge amounts of natural resources per capita to go from being among the poorest countries in the world to among the richest, in the post world war 2 era. They shared the advantage of having strong states by 1960. Neither faced the possibility of civil wars for instance and both had the state capacity to meaningfully control the economy. Taiwan started with light manufacturing which is relatively technologically simple before bootstrapping itself up the technological chain of complexity within manufacturing. South Korea had a much earlier initial focus on heavy manufacturing and used private companies with deep state links such as receiving heavy state subsidies, rather than the more often state owned firms in Taiwan, to bootstrap up the value chain. After Asian financial crisis in 1997 South Korea liberalised its economy substantially under IMF auspices as a result of the loan it needed to cover its foeign currency debts after the financial crisis.