Getting Out of The Middle-Income Trap

Will poor countries ever catch up with rich countries? Some have. But will the rest do? In a 2000 paper entitled “Some Macroeconomics for the 21st Century,” Bob Lucas suggests that, yes, by 2150, all countries will be rich. The reason: the recipes for growth are known and gradually productive ideas and technologies will seep into the most remote corners of the globe, while the resisting forces against progress will be swayed by economic forces. Globalisation in trade and the increased mobility of capital can only speed up this process. This pre-supposes that there is no trap in the development process: no ‘poverty trap’ for poor nations, and no ‘middle-income trap’ for middle-income nations. In a recent NBER Working Paper, Jan Eeckhout and Boyan Jovanovic raise the possibility of the latter trap. They explain how the integration of the world’s labour markets creates big gains for rich and poor countries alike (blueprints flow from California to China, while manufacturing goods flow in the opposite direction), leaving middle-income countries in limbo: they are not technology-savvy enough to compete with rich countries and are not cheap enough to compete with China.

The argument made by Eeckhout and Jovanovic runs like this. Nowadays, with communication and transportation technologies, people do not need to be physically together to produce together. In rich countries, there are better managers, engineers and designers. These people now have access to a pool of cheap labour in poor countries. This makes them more productive as they can produce more with the same resources. The higher wages to high-skilled individuals represent the gains to rich countries of an integrated global labour market. Poor countries also gain: they produce better and more thanks to the technology, design and managerial skills brought in from rich countries. The wages of their unskilled rise and this represents their gains from globalisation.

Obviously, this may be a gross simplification as the net gains to both types depend also on second-order (general equilibrium) effects (for example, one claim is that rich countries may lose from globalisation as the wages of their unskilled can be driven down by low wages in poor countries).

It is interesting to see what happens to middle-income countries (lower middle-income to upper middle-income). With the integration of labour markets, middle-income countries are likely to experience “the smallest change in factor-price ratio“, i.e. neither the wages of the skilled go up, nor the wages of the unskilled. The World Bank call this the “middle-income trap“: middle-income countries find themselves squeezed between low wage competitors in poor countries and cutting edge innovators in rich countries.

Portugal is, it seems, one such country. The choices it faces is put clearly in a paper of Olivier Blanchard:

A large proportion of Portuguese exports is in “low tech” goods, roughly 60% compared to an average of 30% for the euro area, goods where competition with emerging economies is strongest…Is it essential for Portugal to improve productivity in the high tech sector and increase its share of high-tech exports?

The answer is, I suspect, no.

First, Portugal does not have an obvious comparative advantage in high-tech. Labor market institutions imply low labor mobility, and thus a limited ability to reallocate resources as the high-tech frontier moves on.

The solution according to him:

An obvious comparative advantage, and one which is likely to remain for a long time, is in tourism. Many Portuguese balk at the idea of the Florida model, the scenario in which Europeans come to retire in Portugal. The experience of Spain suggests that this can be a major source of private transfers (as retirees transfer funds from their country of origin). The “Florida model”, as opposed to traditional tourism, also comes with derived demand for many products, for example sophisticated health care.

Another solution (which is out-of-reach, given that Portugal’s membership to the EMU) is competitive devaluation, i.e. allowing the currency to adjust downwards to allow exports to compete with lower cost countries. Blanchard therefore predicts a gloomy period of competitive deflation, in which unemployment stays high,wages decline in real terms to restore competitiveness.

Over the years however, Portugal has chosen a different route: to become competitive in high-tech. There has been increased investment in higher education (especially in the Sciences), important investments in R&D, and reforms of the education system. Currently the help of the MIT is been enlisted in a vast programme of enhancing the technological capabilities of Portugal on a wide range of areas, including Transportation, Sustainable Energy, and Bio-Engineering. And, according to the Financial Times, in a special report on Portugal published yesterday, there are already signs of rewards:

For the first time in its history, Portugal is exporting more technology than it imports. Business services have overtaken cheap textiles and footwear, the country’s traditional industrial breadwinners, as export earners. More money is being invested in science and research than ever before.

Other trends, including a shift in investment away from labour-intensive industry to more technologically-advanced sectors, suggest Portugal has reached the tipping point in a gradual transition from a low-cost manufacturing economy to a provider of knowledge-based services.

In the energy sector, investment is moving away from fossil fuels into wind, solar and wave power … Portugal is among Europe’s top five producers of energy from renewable sources and is well placed to reap the benefits of a coming “industrial revolution” geared to the use of clean energy.

The growth in the size and competence of Portugal’s scientific community is becoming increasingly attractive to foreign investors. In a recent example, Malaysian-based Agni has opted to invest €65m in a hydrogen fuel cell plant and research centre, choosing Portugal after a two-year search for the best location for its first European operation.

Mauritius, another country trying to get out of a middle-income trap, is playing a different set of cards: low and flat taxes, ease-of-doing business (it takes 3 days to start a business there), a competitive currency (until recently), and a stunning natural beauty. It is hard to see this as a long-term solution that will bring convergence with high-tech giants, but then again, it is perhaps too early to think technology when the tipping-point is not within sight.