Divergence and the Reality of Economic Growth

Divergence, Big-time:

The industrial core of world economy saw its level of material productivity and standards of living explode in the 19th and 20th centuries. Elsewhere the growth of productivity levels and standards of living and spread of industrial technologies was slower. As industrialized economies grew whereas industrial technologies spread slowly elsewhere, world became a more and more unequal place. As development economist Lant Pritchett puts it that dominant feature of world economic history is "divergence, big-time." In terms of productivity levels and relative incomes, world today is more unequal and more divergent than ever before.

World Distribution of Income Today: Selected Countries

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Legend: In some places modern economic growth has taken hold and propelled levels of productivity and living standards upward. In other places people on average live little if any better than their ancestors did. The world is a more unequal place, in relative income terms, than it has been since there were some human tribes that had fire and others that did not.

Those who live in relatively poor regions of the world today have higher material living standards than their predecessors who lived in those regions a century ago. However the relative gap regarding the industrial core has grown extravagantly and extraordinarily. In the first half of 19th century the average inhabitant of an average country had perhaps one-half the material standard of living of a citizen of the world's leading industrial edge economy. Today average inhabitant of an average country has just one-sixth the productivity level and material standard of living of the leading edge.

An Exception: OECD Economies

It isn’t inevitable that there be such divergence. United States--with its 14 to 25-fold increase in output per worker over the years since 1870—hasn’t been the fastest-growing economy in the world. Some other economies at different levels of development, industrialization and material productivity a century ago have now converged and their levels of productivity, economic structures and standards of living are now very close to those of the US. The six largest of these converging economies are today with United States so called Group-of-Seven the G-7 economies whose leaders gather for annual summit meetings. Their steady process of convergence to U.S. level from 1950 till 1990 is displayed in Figure below:

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Most of these economies were considerably poorer than U.S. back in 1870 and even in 1950. The Japanese economy, for illustration went from a level of output per capital equal to sixteen percent of U.S. level in 1950 to 84 percent of U.S. level in 1992--before falling steeply backwards at the time of Japan's recent recession. Italian levels of GDP per capital have gone from 30% of the U.S. to 65% of the U.S. level; German levels have gone from 40% to 7%; Canadian levels have gone from 70 percent to 85 percent; and British levels of GDP per capita have gone from 60 to 70 percent of U.S. levels in the past half century.

Policy: Why Have These Economies Converged?

By and large economies which have converged are those which belong to OECD: the Organization for Economic Cooperation and Development that was started back in first post-WWII years in the days of Marshall Plan as a club of countries which received (or gave) Marshall Plan aid to help reconstruct and rebuild after World War II. Countries which received Marshall Plan aid adopted a common set of economic policies: large private sectors freed of government regulation of prices, investment with its direction determined by profit-seeking businesses, large social insurance systems to redistribute income and governments committed to avoiding mass unemployment.

The original OECD members all wound up with mixed economies. Markets direct the flow of resources whereas governments stabilize the economy, provide social-insurance safety nets as well as encourage enterprise and entrepreneurship. They arrived at this institutional setup largely because of good luck partially because of the Cold War and partially as a result of post-World War II institutional reforms.

This post-World War II institutional configuration was basically the price countries had to pay for receiving Marshall Plan aid. U.S. executive was unwilling to send much aid to countries which it thought were likely to involve in destructive economic policies, largely because it did not believe that it could win funding from Republican-dominated congress for a Marshall Plan that didn’t impose such strict conditionality upon recipients. By contrast nations which were relatively rich after World War II however that didn’t adopt OECD-style institutional arrangements—such as Venezuela and Argentina --have lost relative ground.

As OECD economies became richer they completed their demographic transitions: population growth rates fell. The policy lay emphasis on entrepreneurship and enterprise boosted national investment rates so OECD economies all had healthy investment rates as well. These factors boosted their steady-state capital-output ratios. And diffusion of technology from U.S. did rest of the job in bringing OECD standards of economic productivity close to U.S. level.

Policy: The East Asian Miracle

However the set of extraordinarily successful economies isn’t limited to the set of original OECD economies. Economies of the East Asian miracle have over the past two generations exhibited stronger growth than has ever before been seen any place in world history. They haven’t yet converged to the standards of living and levels of economic productivity found in world economy’s industrial core. Though they are converging.

Just before World War II the regions which are now South Korea, Hong Kong and Singapore and Taiwan had output per worker levels less than one-tenth of the United States. Today Singapore's GDP per capital is 90%, Hong Kong's is 70%, Taiwan's is 50%, and South Korea's is 45% of U.S. level. A second wave of East Asian economies--Malaysia, Thailand--now average more than one quarter of United States’ level of GDP per capital.

The successful East Asian economies have some similarities in economic policy and structure to OECD economies. Resource allocation decisions are by and large left to the market. Governments regard the encouragement of enterprise and entrepreneurship as a major objective. And high savings and investment rates are encouraged by some different government policies.

However there are also a number of differences concerning the OECD as well.

Governments in East Asia have been more aggressive in pursuing industrial policy and somewhat less aggressive in establishing social insurance systems than OECD economies. Though they have also had more egalitarian income distributions, hence less need for redistribution and social insurance. They have subsidized corporations that they believe are strategic for economic development so thinking that their bureaucrats know better than market--heresy to economists. (Though it is worth noting that they have focused subsidies on those companies which have proved successful at exporting goods to other countries--hence their bureaucrats have in a sense been rewarding the judgment of foreign markets.) The instances of successful catching-up suggest that things could have been otherwise for world economy. Economies--even very poor economies--can rapidly adopt modern machine technologies and move their productivity levels close to first-world leading-edge standards.

The Rule: Divergence behind the Iron Curtain

However Convergence is the exception whereas Divergence is the rule. And perhaps the most significant diving force behind divergence is Communism: being unlucky enough to have been ruled by communists in the 20th century is a virtual guarantee of relative poverty.

There used to be a zigzag geographic line across Eurasia that Winston Churchill had once called ‘Iron Curtain’. On one side there were regimes that owed their allegiance to Karl Marx and Marx’s viceroys on earth. While on the other side were regimes claiming in 1946-1989 Cold War to be of free world--that were, if not good but at least less-worse guys.

The Iron Curtain: GDP per Capita Levels of Matched Pairs of Countries

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Notice as you walk that to your right outside the Iron Curtain, countries are far better off in terms of GDP per capital. They aren’t necessarily better off in education or health care or in the degree of income inequality. If you were in poorer half of the population then you probably received a better education and had access to better medical care in Cuba than in Mexico. However countries fortunate enough to lie outside what was the Iron Curtain were and are vastly more prosperous. Depending on how you count and how unfortunate you are, 40 and 94% of the potential material prosperity of a country was annihilated if it happened to fall under Communist rule in the 20th century. The fact that a large part of globe fell under Communist rule in the 20th century is one key factor responsible for the world's divergence.

Policy: Post-Communism

Demolition of the Berlin Wall and take-down of the Iron Curtain hasn’t significantly improved the situation in what are optimistically and euphemistically called ‘economies in transition’ [from socialism to capitalism which is]. Figuring out how to move from a stagnant, ex-Communist economy to a dynamic and growing one is very difficult and no one has ever done it before.

A few of the "economies in transition" appear on the path to rapid convergence to Western Europe: Slovenia, Hungary, Czech Republic and Poland have already clearly and successfully maneuvered through enough of ‘transition’ to have advanced their economies beyond the point reached before 1989. It seems clear that their economic destiny is about to become effectively part of Western Europe. Lithuania, Slovakia, Latvia and Estonia appear to have good prospects of following their example.

Somewhere else, though, the news is bad. Whether reforms have been step-by-step or all-at-once or whether ex-communists have been excluded from or have dominated the government or whether governments have been internationalist or nationalist, results have been similar. Output has fallen, corruption has been rife and growth hasn’t resumed. Material standards of living in the Ukraine today are less than half of what they were when General Secretary Gorbachev ruled from Moscow.

Economists debate ferociously the appropriate economic strategy for unwinding the inefficient centrally-planned Soviet-style economy. The fact that this ‘transition’ has never been undertaken before should make advice-givers cautious. And there is one other observation that must make advice-givers depressed: the best predictor of whether an eastern European country's transition would be rapid and successful or not appears to be its distance from western European political and financial capitals such as Frankfurt, Vienna and Stockholm.

The Rule: Divergence in General

Though even if attention is confined to non-communist-ruled economies there still has been huge divergence in relative output per worker levels over the past hundred years. Since 1870 ratio of richest to poorest economies has increased six fold. Back in 1870 two-thirds of all countries had GDP per capital levels between 60 and 160 percent of the average. Today the range which holds two-thirds of all countries extends from 35 to 280 percent of the average.

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