Naked Economics

by Wheelan, Charles

  Now for more bad news. In Chapter 6, I described an economy in which skilled workers generate economic growth by creating new jobs or doing old jobs better. Skills are what matter—for individuals and for the economy as a whole. That is still true, but there is a glitch when we get to the developing world: Skilled workers usually need other skilled workers in order to succeed. Someone who is trained as a heart surgeon can succeed only if there are well-equipped hospitals, trained nurses, firms that sell drugs and medical supplies, and a population with sufficient resources to pay for heart surgery. Poor countries can become caught in a human capital trap; if there are few skilled workers, then there is less incentive for others to invest in acquiring skills. Those who do become skilled find that their talents are more valuable in a region or country with a higher proportion of skilled workers, creating the familiar “brain drain.” As World Bank economist William Easterly has written, the result can be a vicious cycle: “If a nation starts out skilled, it gets more skilled. If it starts out unskilled, it stays unskilled.”13

  As a side note, this phenomenon is relevant in rural America, too. Not long ago, I wrote a story for The Economist that we referred to internally as “The Incredible Shrinking Iowa.”14 As the working title would suggest, parts of Iowa, and other large swathes of the rural Midwest, are losing population relative to the rest of the country. Remarkably, forty-four of Iowa’s ninety-nine counties had fewer people in 2000 than they had in 1900. Part of that depopulation stems from rising farm productivity; Iowa’s farmers have literally grown themselves out of jobs. But something else is going on, too. Economists have found that individuals with similar skills and experience can earn significantly higher wages in urban areas than they can elsewhere. Why? One plausible explanation is that specialized skills are more valuable in metropolitan areas where there is a density of other workers with complementary skills. (Think Silicon Valley or a cardiac surgery center in Manhattan.) Rural America has a mild case of something that deeply afflicts the developing world. Unlike technology or infrastructure or pharmaceuticals, we cannot export huge quantities of human capital to poor countries. We cannot airlift ten thousand university degrees to a small African nation. Yet as long as individuals in poor countries face limited opportunities, they will have a diminished incentive to invest in human capital.

  How does a country break out of the trap? Remember that question when we come to the importance of trade.

  Geography. Here is a remarkable figure: Only two of thirty countries classified by the World Bank as rich—Hong Kong and Singapore—lie between the Tropic of Cancer (which runs through Mexico across North Africa and through India) and the Tropic of Capricorn (which runs through Brazil and across the northern tip of South Africa and through Australia). Geography may be a windfall that we in the developed world take for granted. Development expert Jeffrey Sachs wrote a seminal paper in which he posited that climate can explain much of the world’s income distribution. He writes, “Given the varied political, economic, and social histories of regions around the world, it must be more than coincidence that almost all of the tropics remain underdeveloped at the start of the twenty-first century.”15 The United States and all of Europe lie outside the tropics; most of Central and South America, Africa, and Southeast Asia lie within.

  Tropical weather is wonderful for vacation; why is it so bad for everything else? The answer, according to Mr. Sachs, is that high temperatures and heavy rainfall are bad for food production and conducive to the spread of disease. As a result, two of the major advances in rich countries—better food production and better health—cannot be replicated in the tropics. Why don’t the residents of Chicago suffer from malaria? Because cold winters control mosquitoes—not because scientists have beaten the disease. So in the tropics, we find yet another poverty trap; most of the population is stuck in low-productivity farming. Their crops—and therefore their lives—are unlikely to get better in the face of poor soil, unreliable rainfall, and chronic pests.

  Obviously countries cannot pick up and move to more favorable climates. Mr. Sachs proposes two solutions. First, we ought to encourage more technological innovation aimed at the unique ecology of the tropics. The sad fact is that scientists, like bank robbers, go where the money is. Pharmaceutical companies earn profits by developing blockbuster drugs for consumers in the developed world. Of the 1,233 new medicines granted patents between 1975 and 1997, only thirteen were for tropical diseases.16 But even that overstates the attention paid to the region; nine of those drugs came from research done by the U.S. military for the Vietnam War or from research for the livestock and pet market.How do we make private companies care as much about sleeping sickness (on which no major company is doing research) as they do about canine Alzheimer’s (for which Pfizer already has a drug)? Change the incentives. In 2005, British Prime Minister Gordon Brown embraced an idea that economists have long kicked around: Identify a disease that primarily afflicts a poor part of the world and then offer a large cash prize to the first firm that develops a vaccine that meets predetermined criteria (e.g., is effective, is safe for use in children, doesn’t need refrigeration, etc.). Brown’s plan was actually more sophisticated; he proposed that rich governments precommit to buying a certain number of doses of the “winning” vaccine at a certain price. Poor people would get lifesaving drugs. The pharmaceutical company would get what it needs to justify the vaccine research: a return on investment, just as it does when developing drugs that consumers in rich countries will buy. (The British government has been thinking this way for a long time. In 1714, after two thousand sailors drowned when a fleet got lost, crashed into the rocky coast, and sunk, the British government offered 20,000 pounds to anyone who developed an instrument for measuring longitude at sea. The prize led to the invention of the chronometer.)17

  The other hope for poor countries in the tropics, says Mr. Sachs, is to step out of the trap of subsistence agriculture by opening their economies to the rest of the world. He notes, “If the country can escape to higher incomes via non-agricultural sectors (e.g., through a large expansion of manufactured exports), the burdens of the tropics can be lifted.”18 Which brings us once again to our old friend trade.

  Openness to trade. We’ve had a whole chapter on the theoretical benefits of trade. Suffice it to say that those lessons have been lost on governments in many poor countries in recent decades. The fallacious logic of protectionism is alluring—the idea that keeping out foreign goods will make the country richer. Strategies such as “self-sufficiency” and “state leadership” were hallmarks of the postcolonial regimes, such as India and much of Africa. Trade barriers would “incubate” domestic industries so that they could grow strong enough to face international competition. Economics tells us that companies shielded from competition do not grow stronger; they grow fat and lazy. Politics tells us that once an industry is incubated, it will always be incubated. The result, in the words of one economist, has been a “largely self-imposed economic exile.”19

  At great cost, it turns out. The preponderance of evidence suggests that open economies grow faster than closed economies. In one of the most influential studies, Jeffrey Sachs, now director of The Earth Institute at Columbia University, and Andrew Warner, a researcher at the Harvard Center for International Development, compared the economic performance of closed economies, as defined by high tariffs and other restrictions on trade, to the performance of open economies. Among poor countries, the closed economies grew at 0.7 percent per capita annually during the 1970s and 1980s while the open economies grew at 4.5 percent annually. Most interesting, when a previously closed economy opened up, growth increased by more than a percentage point a year. To be fair, some prominent economists have taken issue with the study on the grounds (among other quibbles) that economies closed to trade often have a lot of other problems, too. Is it the lack of trade that makes these countries grow slowly, or is it general macroeconomic dysfunction? For that matter, does trade cause growth or is it something that ju
st happens while economies are growing for other reasons? After all, the number of televisions sold rises sharply during extended spells of economic growth, but watching television does not make countries richer.

  Conveniently for us, a recent paper in the American Economic Review, one of the most respected journals in the field, is entitled “Does Trade Cause Growth?” Yes, the authors answer. All else equal, countries that trade more have higher per capita incomes.20 Jeffrey Frankel and David Romer, economists at Harvard and UC Berkeley, respectively, conclude, “Our results bolster the case for the importance of trade and trade-promoting policies.”

  Researchers have plenty left to quibble about. That is what researchers do. In the meantime, we have strong theoretical reasons to believe that trade makes countries better off and solid empirical evidence that trade is one thing that has separated winners from losers in recent decades. The rich countries must do their part by keeping their economies open to exports from poor countries. Mr. Sachs has called for a “New Compact for Africa.” He writes, “The current pattern of rich countries—to provide financial aid to tropical Africa while blocking Africa’s chances to export textiles, footwear, leather goods, and other labor-intensive products—may be worse than cynical. It may in fact fundamentally undermine Africa’s chances for economic development.”21

  Responsible fiscal and monetary policy. Governments, like individuals, will get themselves in serious trouble if they consistently overspend on things that do not raise future productivity. At a minimum, large budget deficits require the government to borrow heavily, which takes capital out of the hands of private borrowers, who are likely to use it more efficiently. Chronic deficit spending can also signal other future problems: higher taxes (to pay back the debt), inflation (to erode the value of the debt), or even default (just giving up on the debt).

  All of these problems are compounded if the government has borrowed heavily from abroad to finance its profligate spending. If foreign investors lose confidence and decide to take their money and go home—as skittish global investors are wont to do—then the capital that was financing the deficit dries up, or becomes prohibitively expensive. In short, the music stops. The government is left on the brink of default, which we have seen in countries ranging from Mexico to Turkey. (There is, by the way, some modest concern that this could happen to the United States.)

  On the monetary side, Chapter 10 made clear the dangers of letting the money party get out of control. It happens often anyway. Argentina is the poster child for irresponsible monetary policy; from 1960 to 1994, the average Argentine inflation rate was 127 percent per year. To put that in perspective, an Argentine investor who had the equivalent of $1 billion in savings in 1960 and kept all of it in Argentine pesos until 1994 would have been left with the equivalent spending power of one-thirteenth of a penny. Economist William Easterly has noted, “Trying to have normal growth during high inflation is like trying to win an Olympic sprint hopping on one leg.”

  Natural resources matter less than you would think. Israel, which has no oil to speak of, is a far richer country than nearly all of its Middle Eastern neighbors that have large petroleum reserves. Israeli GDP per capita is $28,300 compared to $20,500 for Saudi Arabia and $12,800 for Iran. Meanwhile, resource-poor countries like Japan and Switzerland have fared much better than resource-rich Russia.22 Or consider oil-rich Angola. The country takes in some $3.5 billion a year from its oil industry.23 What has happened to the people who might benefit from this treasure in the ground? Much of the oil money goes to fund a never-ending civil war that has ravaged the country. Angola has the world’s highest rate of citizens maimed by land mines (1 out of 133). One-third of Angola’s children die before age five; life expectancy is forty-two. Large swathes of the capital have no electricity, no running water, no sewers, and no garbage pickup.24

  These are not anecdotal examples carefully picked to make a point. Economists believe that a rich endowment of natural resources may actually be a detriment to development. All else equal, it is great to discover the world’s largest zinc deposit. But all else is not equal. Commodity-rich countries are changed by the experience in ways that can do more harm than good. One study of economic performance in ninety-seven countries over two decades found that growth was higher in countries that were less endowed with natural resources. Of the top eighteen fastest-growing nations, only two were rich in things that can be taken out of the ground. Why?

  Mineral riches change an economy. First, they divert resources away from other industries, such as manufacturing and trade, that can be more beneficial to long-term growth. For example, the Asian tigers were resource-poor; their path to prosperity began with labor-intensive exports and progressed into more technology-intensive exports. The countries grew steadily richer in the process. Second, resource rich economies become far more vulnerable to wild swings in the price of commodities. A country built on oil will have a rough stretch when the barrel price drops from $90 to $15. Meanwhile, demand for a nation’s currency rises as the rest of the world begins to buy its diamonds or bauxite or oil or natural gas. That will cause the currency to appreciate, which, we now know, makes the country’s other exports, such as manufactured goods, more expensive.

  Economists started referring to the perverse effects of abundant natural resources as “Dutch disease” after observing the economic effects of an enormous North Sea natural gas discovery by the Netherlands in the 1950s. The spike in natural gas exports drove up the value of the Dutch guilder (as the rest of the world demanded more guilders in order to buy Dutch natural gas), making life more difficult for other exporters. The government also used the gas revenues to expand social spending, which raised employers’ social security contributions and therefore their production costs. The Dutch had long been a nation of traders, with exports making up more than 50 percent of GDP. By the 1970s, other export industries, the traditional lifeblood of the economy, had grown far less competitive. One business publication noted, “Gas so distended and distorted the workings of the economy that it became a mixed blessing for a trading nation.”25

  Last, and perhaps most important, countries could use the revenues from natural resources to make themselves better off—but they don’t. Money that might be spent on public investments with huge returns—education, public health, sanitation, immunizations, infrastructure—is more often squandered. After the World Bank helped to build an oil pipeline that originates in Chad and runs through Cameroon to the ocean, Chad’s president, Idriss Déby, used the first $4.5 million installment of oil money to buy weapons for fighting rebels.26

  Democracy. Does making the trains run on time matter more to the economic growth of poor countries than niceties like freedom of expression and political representation? No; the opposite is true. Democracy is a check against the most egregious economic policies, such as outright expropriation of wealth and property. Amartya Sen, a professor of economics and philosophy at Harvard, was awarded the Nobel Prize in Economics in 1998 for several strands of work related to poverty and welfare, one of which is his study of famines. Mr. Sen’s major finding is striking: The world’s worst famines are not caused by crop failure; they are caused by faulty political systems that prevent the market from correcting itself. Relatively minor agricultural disturbances become catastrophes because imports are not allowed, or prices are not allowed to rise, or farmers are not allowed to grow alternative crops, or politics in some other way interferes with the market’s normal ability to correct itself. He writes, “[Famines] have never materialized in any country that is independent, that goes to elections regularly, that has opposition parties to voice criticisms and that permits newspapers to report freely and question the wisdom of government policies without extensive censorship.”27 China had the largest recorded famine in history; thirty million people died as the result of the failed Great Leap Forward in 1958–1961. India has not had a famine since independence in 1947.

  Economist Robert Barro’s seminal study of economic growth i
n some one hundred countries over many decades found that basic democracy is associated with higher economic growth. More advanced democracies, however, suffer slightly lower rates of growth. Such a finding is consistent with our understanding of how interest groups can promote policies that are not always good for the economy as a whole.

  War is bad. Now there is a real shocker. Still, the data on the proportion of extremely poor countries involved in armed conflict are strikingly high. Paul Collier, head of the Oxford Center for the Study of African Economies and author of the book The Bottom Billion, points out that nearly three-quarters of the world’s billion poorest people are caught in a civil war or have recently been through one. It’s hard to run a business or get an education in the midst of a war. (Obviously the causality runs in both directions: War devastates countries; nations in a shambles are more likely to collapse into civil war.) Once again, natural resources can make things worse by financing weapons and giving the factions something to fight over. (Collier coined the sadly clever phrase “Diamonds are a guerilla’s best friend.”)28 The important point is that security is a prerequisite for most of the other things that have to happen for an economy to flourish. In 2004, The Economist published a story about the challenges of doing business in Somalia, a country that had been in the throes of civil war for thirteen years. The story noted, “There are two ways to run a business in Somalia. You can pay off the local warlord, not always the most trustworthy of chaps, and hope he will stop his militiamen from murdering your staff. Or you can tell him to get stuffed and hire your own militia.”29