Why are poor countries poor?

How far can globalization raise the incomes of poorer countries? How far can foreign aid help? A new NBER paper (pdf) by James Feyrer and Francesco Caselli sheds interesting light on these questions.
Their first contribution is to estimate the marginal product of capital (MPK) in 53 developed and developing countries. They estimate that low income countries - those poorer than Portugal - have an average MPK of 27 per cent, whilst richer countries have an average MPK of 11 per cent.
This is just what you'd expect. Capital is scarce in poorer countries, so its return should be higher.
However, what you'd also expect to happen is that these higher MPKs would attract capital flows from the rich countries to the poor ones, thus enriching the poor countries.
This, of course, doesn't happen. The US's massive current account deficit means it is sucking in capital from poorer countries. And FDI flows much more between rich countries than it does from rich countries to Africa; the data's here (reg. reqd).
This capital immobility is enormously expensive. If capital did flow to equalize MPKs, estimate Caselli and Feyrer, developing countries would see a 25 per cent rise in their incomes.
So why is capital immobile? One view blames capital market imperfections; the (undiversifiable?) risk of investing in poorer countries is too high. This is the origin of Michael Dooley's view that the US current account deficit is sustainable because it's a source of collateral for poorer countries.
However, Caselli and Feyrer have two other explanations.
First,they say, poorer countries lack essential complentarities with physical capital, such as skilled labour (one could add transport links as well).
Second, they say, the price of physical capital is higher in poorer nations, because it attracts taxation, exortioners and rent-seekers.
These explanations, they believe, more than suffice to explain capital immobility. Indeed, they say, credit market frictions, far from impeding capital flows into poorer countries might actually impede outflows - by, for example, limiting the use of offshore accounts.
There's something in this for everyone. The anti-globalizers can take away the message that the orthodox neoclassical case for globalization is too optimistic, at least in one respect.
The anti-foreign aid brigade can take the message that financial aid to poorer countries will not raise incomes much because financial returns on investment aren't as great as MPKs would suggest.
Me? I take the message that our overwhelming moral responsiblity to help the poor should means we should encourage institutional change to reduce the cost of investing.
If it's worth doing in Iraq, it's worth doing elsewhere... 

Comments

[Curious]

"Me? I take the message that our overwhelming moral responsiblity to help the poor means we should encourage institutional change to reduce the cost of investing.
If it's worth doing in Iraq, it's worth doing elsewhere... "

My thoughts precisely! I will link to this article from my blog

[Mr. Econotarian]

I buy the argument that the risk of investment in poorer countries is too high, but it isn't unidentifiable.

All you need to do is ask "how big is the informal sector?" If the informal sector is big, then unsustainable regulation is pushing people and business into the informal sector and is keeping productivity and formal sector employment low there.

The most important investments in poor countries come from their own entrepreneurs. If they don't feel they can invest in the formal sector, then something is badly wrong.

I really don't believe that in a country with a large informal sector that one can not actually effectively compute the return on capital, because people are trying to hide that capital from the government, and the bit you can measure is probably rent-seeking and protected by bribes.

Poorer western countries have their own problem - unemployment because of labor regulations. This shows up as unemployment in Europe, because they have such good unemployment compensation, but shows up as informal sector work in very poor countries (and in the US as illegal alien labor).

To become rich, you need regulation that matches your socio-economic state, or else the informal sector will boom, and the country will stop growing rich. As a country grows richer, it can afford to regulate itself more, not the other way around.

[Rob Hayward]

I guess one question to answer is - why does capital flow to China and not to Africa? Presumably there is a belief that large returns are available in China but not so in Africa. However, the MPK in China must have fallen sharply in recent years. I suspect the Chinese authorities have overcome some of the problems that James Feyrer and Francesco Caselli identify, like ensuring there is skilled labour and subsidising the cost of physical capital with cheap loans. There also seems to be a sort of bubble effect in China, with firms worried that they will be criticised if they do not have a "China Strategy" as they would previously have been criticised for not having an "Internet Strategy".

[xfdgdfg]

"I guess one question to answer is - why does capital flow to China and not to Africa? Presumably there is a belief that large returns are available in China but not so in Africa."

Because the Chinese are genetically more intelligent than Africans. Africa will always be poor because of this.

[Ken]

The previous comment is definately from a wimp.
Can you show any study that points even a single fact to support what you post.

American and EU companies are investing in China due to the fear that the Chinese (Who have no respect for patents and intellectual property) may eventually produce competing products better and at a cheaper cost than them.

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[Peter Mwenda]

I would guess that living in a poor country, and being born under harsh conditions, it is what people know as life. When one is exposed to the outside world and start looking at life in other peoples dimensions then, they term themselves or are termed poor. But how do you explain so many people from these 'rich countries' coming to africa to watch wild beest migration, has any african gone to new york or berlin to witness snow fall. We are all poor or rich depending on what perspective we view our lives, the other person sees you being poor.