Growth Theory and the Wealth of Nations (2)

Here's Ap with his second part of the article:

So, once again, why a country can be rich, and the other poor?

Most of research on growth empirics are trying to look how far do these variables explain the cross-country per-capita income differences: investment, human capital, population growth, or trade. Such analysis will be subject to the usual problems of empirical analysis: correlation does not mean causality!

True, the higher the country's investment, or schooling rate, or trade volume, and the lower the population growth rate, the higher is the GDP per capita. But can we say that education (or investment or trade) that makes a country rich, or vice versa? Or, perhaps, there are other unobservable things that affect both education and GDP per capita simultaneously.

Economic historian Angus Madison once show that the world has been unequal since even before the industrial revolution (see his graph here). That means, world's inequality is not just a recent issue. The question is, of course, what makes the world unequal? Some studies try to go further to find 'deeper' explanations. To do so, we must find an exogenous factor; something that affects countries' per-capita income differences, but not affected by per-capita income.

One possible explanation is geography. If we look at the distribution of countries by income per capita, almost all of the poorest countries are close to the equator, and most of the richest ones are in the temperate zone. Maybe it was not just a coincidence. Maybe something with the temperate climate that affects productivity (lower energy intake required to do a similar thing). Maybe being in the tropical zone has something to do with germs and contagious disease (virus and germs are less aggressive in cold weather; this is what Jeffrey Sachs keeps arguing).

Geographical position is also important in the sense isolation. If a region is isolated from the rest of the world by hills or mountains, lacking of access to the sea or navigable river, then the society won't be able to benefit from trade, technology and knowledge diffusion.

Another theory related to geography is what Jared Diamond proposed in his seminal Guns, Germs and Steel. He wrote that world inequality started as early as 13,000 years ago, when human invented the agriculture system and switched from hunting-gathering to food producing. Development of food production has enabled society to generate food surplus and live a sedentary lifestyle. Food surplus and sedentary lifestyle then led to division of labor and more complex political structure. Such lifestyle then paved the way for important inventions (wheel, alphabet) and technology.

The thing is, the earth has been exogenously unfair, meaning not all societies were lucky enough to get close to available domesticated plants and animals. That explains why Europeans, who were close to the Fertile Crescent, and China, had a head start than the Americas, Africa, Australia and New Guineas. That explains why it was the Europeans who sailed to the New World, not vice versa.

While geography hypothesis is interesting, it seems to be too deterministic. It also fails to explain why some big ancient civilizations (like Egypt, Aztec) failed to sustain, while the current rich were far behind those (read my account on this similar issue here).

If we see the history of modern economic growth, two main drivers are: i) commercial activities, and ii) the advance of knowledge, technology and innovations (the variable A in Solow's model). In both cases, there are some pre-requisites:

1. Individual freedom and autonomy, be it from the ruler or the church.
2. Incentives to pursue trade and innovations.

Both (1) and (2) were enabled by, among other things, the inventions of property rights. But property rights alone is not enough. One needs to find an agreeable mechanism on how to: i) acquire it, ii) prove it, iii) protect it, and iv) enforce (iii). All of those conditions require good and strong institutional setting (see Douglass North's 1990 book for more discussion).

To make the story short, the institutional hypothesis argues that the disparity of today's world income per capita is the product of the variations of institutional quality: rule of law, bureaucracy, governance regulatory quality, corruption, risk of property expropriation, even democracy.

One tricky question. How can we be sure that it is institution that affects economic performance? Can it be that when a country gets richer, it can afford to have better institution, better governance, lower corruption or better democracy?

This problem was answered by a paper by Acemoglu, Johnson and Robinson (2001). The authors argue that the quality of a country's institution today is shaped by the institutional setting brought by the colonial power. The decision to build different types of institution in the colonies were determined by the colonists' strategy, which range from 'extractive state' at one extreme (Congo, Latin America to a lesser extent) to 'New Europe' at the other extreme (USA, Canada, Australia, New Zealand).

What then determined different strategy? The challenges faced by the colonists. If the colonists faced hostile environment like tropical disease or resistance from indigenous people, they don't find an incentive to build settlements, and end up pursuing extractive state strategy. On the other hand, the Europeans in North America or Australia did not find hostile environment, and the indigenous population was relatively easy to defeat. In this circumstances, it was possible to build a New Europe, copying the same type of institution that they have had in the Old Europe.

There are other theories. For example, David Landes in his 2001 book explained that it was culture that matters. Culture, he argued, especially scientific and secular culture of the Europeans explained why it was Europe, not China nor the Islamic world who dominated the world. Other theory points to the ethnic, language or religious fractionalization of a country.

At the end, the question 'why a country can be rich, and the other poor' remains a mystery. But we don't have to find a single explanation, because it will be impossible. More important is the process on how do we get the answer.