Middle Income Trap

SANTIAGO – Aside from an established tradition of bad macroeconomics, what do Greece and Argentina have in common? One answer is that they were the world’s longest-held captives of the so-called middle-income trap – and remain within its reach to this day. With countries in Asia, Eastern Europe, and Latin American fearing that, having reached the international middle class, they could be stuck there, Greece and Argentina shed light on how that might happen.

A recent paper by economists from Bard College and the Asian Development Bank categorizes the world economy according to four groups – with the top two categories occupied by upper-middle-income and high-income countries – and tracks countries’ movements in and out of these groups. Which countries were stuck for the longest period in the upper-middle-income category before moving to high income? You guessed it: Greece and Argentina.

Correcting for variations in the cost of living across countries, the paper concludes that $10,750 of purchasing power in the year 1990 is the threshold for per capita income beyond which a country is high income, while $7,250 makes it upper-middle income. (These thresholds may sound low, but the World Bank uses similar cutoffs.)

By these criteria, Argentina became an upper-middle-income country all the way back in 1970, and then spent 40 years stuck in that category before reaching high-income status in 2010. Greece joined the international upper middle class in 1972, and then took 28 years to reach the top income group, in 2000.

No other country that became upper middle income after 1950, and then made the transition, took nearly as long. In fact, the average length of that transition was 14 years, with economies such as South Korea, Taiwan, and Hong Kong taking as little as seven years.

Data in the paper stop at 2010, but the story may well be worse today. According to IMF figures, Greece’s never-ending crisis has cut per capita GDP (in terms of purchasing power parity) by 10% since 2010, and by 18% since 2007. Indeed, Greece may have dropped out of the high-income category in recent years.

Argentina’s per capita income has risen, albeit slowly, during this period, but the country was never far from a full-blown macroeconomic crisis that could reduce household incomes sharply. So it seems fair to conclude that both countries are still caught in the middle-income trap.

What kind of trap is it? In Greece and Argentina, it is both political and economic.

Start with the politics. In their book Why Nations Fail, Daron Acemoglu and James A. Robinson argue that societies with political arrangements that concentrate power in the hands of a few seldom excel at innovation and growth, because innovators have no guarantee they will keep the fruits of their labors. And, to the extent that outsiders cannot generate wealth, they have few resources with which to challenge the power of insiders; as a result, exclusionary political arrangements are mostly self-sustaining.

That is a useful account of why there is a poverty trap – which is the question the book seeks to answer – but it does not clarify why there is a middle-income trap. Greece and Argentina are, after all, democracies, however imperfect, and so are most of the countries in Latin America or East Asia that worry about being stuck at middle-income level. The Acemoglu-Robinson account of a single small elite pulling all the strings needs to be replaced by a different narrative, in which an array of politically powerful groups exercise veto power over decisions that affect their economic interests.

Think of powerful business groups vetoing moves to improve tax collection or strengthen competition policy. This helps explain why the Greek and Argentine governments are perennially in deficit (until borrowing options dry up and adjustment is inevitable), or why prices – and profits – are high in sectors (for example, transportation and telecoms) that provide would-be entrepreneurs with crucial (but often unaffordable) inputs.

Or think of public-sector unions vetoing changes in benefits for their members. That goes a long way toward explaining (add a bit of ideology to the mix) why the current Greek government has gone to the brink of default before agreeing to restrain public-sector pensions, as its European Union partners demand. It also helps explain why both Greece and Argentina have sizeable governments (public spending accounts for 46% and 39% of GDP, respectively) but puny public investment and outdated infrastructure.

This is not a case of too much democracy, as conservative commentators sometimes claim, but of too little. Underdeveloped democratic institutions allow for decisions that are individually rational but collectively shortsighted and harmful.

And bad politics makes for bad economics. To go from middle-income to high-income status, countries have to redeploy resources to high-productivity, knowledge- and skill-intensive sectors. That is a transition that Greece and Argentina, with their financial instability, poor infrastructure, and weak education systems, have never made.

Greece exports refined petroleum products, olive oil, raw cotton, and dried fruit. Argentina exports corn, soybeans, fruits, and wine – as well as cars and auto parts to the rest of the regional Mercosur trade bloc, where it enjoys ample tariff protection against third-country competition.

According to the Atlas of Economic Complexity, developed by Ricardo Hausmann and colleagues at Harvard University, the 2008 gap between Greece’s income and the knowledge content of its exports was the largest in a sample of 128 countries. By 2013, Greece ranked 48th in the Atlas’s index of complexity of exports – by far the lowest of any developed country in Europe – while Argentina ranked 67th.

Sluggish exports mean slow growth, which in turn places limits on social mobility and the expansion of an entrepreneurial middle class. That helps preserve the political power of entrenched veto-wielding players, closing the trap. Perhaps a weighty tome entitled Why Middle-Income Nations Fail will tell the story in full. Societies will then understand why high-income status eludes them – and what they might do differently.

Andres Velasco

Read more at http://www.project-syndicate.org/commentary/greece-argentina-middle-income-trap-by-andres-velasco-2015-05#YxEEGa8u1I80lWZD.99