In the postwar era, many countries have managed to quickly reach middle-income status, but few have gone on to become high-income economies1. Rather, after an initial period of rapid ascent, many countries have experienced a sharp slowdown in growth and productivity, falling into what has been called a ‘middle-income trap’:
- The World Bank (2012) estimates that of 101 middle-income economies in 1960, only 13 became high income by 2008.
Those countries were Equatorial Guinea, Greece, Hong Kong SAR (China), Ireland, Israel, Japan, Mauritius, Portugal, Puerto Rico, the Republic of Korea, Singapore, Spain, and Taiwan, China (Figure 1).
Figure 1 Per capita incomes relative to the US, 1960 and 2008
Stuck in the middle
- Formal evidence on growth slowdowns2 and middle-income traps has suggested that at per capita incomes of about US$16,700 in 2005 constant international prices, the growth rate of per capita GDP typically slows from 5.6 to 2.1%.
- Using regression and standard growth accounting techniques, recent analysis (Eichengreen, Park, and Shin 2011) suggests that growth slowdowns are essentially productivity growth slowdowns, whereby 85% of the slowdown in the rate of output growth can be explained by a slowdown in the rate of total factor productivity growth; much more than by any slowdown in physical capital accumulation.
What causes the trap?
A common explanation of growth slowdowns is based on a Lewis-type development process (Canuto 2011; Eichengreen et al 2011; and World Bank 2012):
- Switching labour from low-productivity sectors (e.g. agriculture) to higher-productivity sectors (e.g. industry and modern services) provides a massive, but one-off, rise in per capita income.
- The switch in this initial phase of development is triggered by the application of imported technologies adopted in sectors producing labour-intensive, low-cost products.
- Once these countries reach middle-income levels, the pool of underemployed rural workers drains and wages begin to rise, thereby eroding competitiveness.
Productivity growth from sectoral reallocation and technology catch-up is eventually exhausted, while rising wages make labour-intensive exports less competitive on world markets – precisely at the time when other low-income countries become engaged in a phase of rapid growth.
Accordingly, growth slowdowns coincide with the point in the growth process where it is no longer possible to boost productivity by shifting additional workers from agriculture to industry and where the gains from importing foreign technology diminish significantly.
An overlapping generations perspective
We present an alternative characterisation of middle-income traps (Agénor and Canuto 2012)3. Our approach agrees with the idea that productivity slowdowns are a major cause of middle-income traps, but differs from the existing literature in terms of how to explain this and what public policies can do about it.
In particular, several factors may affect productivity growth, including individual decisions to acquire skills, access to different types of public infrastructure, and knowledge network externalities (defined as the possibility that a higher share of workers with advanced levels of education has a positive impact on performance, that is, the ability to benefit from existing knowledge, of all workers engaged in innovation activities)4.
By extension, there are a number of public policies that developing countries can employ to avoid or escape from middle-income growth traps. Such measures include developing advanced infrastructure in the form of high-speed communications networks, improving the enforcement of property rights through patent protections, and reforming labour markets to ensure that rigidities do not prevent the efficient firing and hiring of employees.
Fundamentally, these policies attract more high-ability workers into the design sector, improve productivity and wages in that sector, and increase a country’s capacity for innovation.
Access to advanced infrastructure
Escaping from a middle-income trap may be achieved by a sufficiently large increase in investment in advanced infrastructure, particularly in high-speed communications networks. The availability of good-quality information and communications infrastructure play an important role in fostering innovation, both by facilitating the cheap circulation of disembodied knowledge flows across and within national borders as well as by reducing the transaction costs of international trade and foreign investment. Thus, improving access to advanced infrastructure boosts productivity and wages in the design sector, which draws more labour and triggers the shift in labour supply, magnifying – at least temporarily – the benefit associated with exploiting the existing stock of ideas.
Enforcement of property rights
To create incentives for individuals and firms to engage in innovation and design activities, the enforcement of patents is essential; however, this is often lacking in developing countries. A poorly functioning system to administrate patents and enforce property rights may create a deadweight loss for the economy and make it more likely for countries to be caught in a middle-income trap. Conversely, improved enforcement of property rights enhances innovation and translates into higher wages in the design sector, which would draw more high-ability workers into that sector.
Consequently, it is more likely that the knowledge network externalities alluded to earlier would kick in and set the economy on a path to higher productivity and output growth.
Labour market reforms
By exacerbating the misallocation of talent, labour market distortions may make it more likely that the economy will end up in a lower-growth equilibrium. To be sure, some types of labour market restrictions, especially those on firing costs, may be particularly detrimental to design or innovation activities. The reason is that in such activities, it is often more difficult to observe the productivity of a worker before hiring – in contrast to routine tasks in manufacturing, where your ability to observe, both ex ante and ex post, is less costly. Thus, the risk of hiring a worker who turns out to be a poor performer is higher in activities where a college degree does not necessarily provide a reliable signal about future performance. In such conditions, the labour market distortion acts as a disincentive to seek higher education, with adverse consequences for innovation and growth.
Middle income traps and the East Asian experience
As mentioned earlier, only 13 countries were able to transition from middle- to high-income status since the 1960s. Of these countries, five were from East Asia – Hong Kong SAR (China), Japan, Korea, Taiwan, China, and Singapore – four of which comprise the so called ‘Asian Tigers’. Given their success, let’s reflect on their experience in order to draw lessons for other middle-income countries seeking to move into high-income status. Many of the public policies highlighted above – as well as a larger framework for innovation based on technological learning and public sector support of research and development investments – can be extrapolated from the East Asian success story.
- Of the East Asian economies that were able to escape the middle income trap, all have succeeded in developing advanced infrastructure, particularly in the form of high-speed communications networks and broadband technology.
For a number of countries, the evolution of these services has been fostered by the liberalisation of telecommunications markets and related regulatory framework reforms (Gill and Kharas 2007).
- The success of the East Asian economies that were able to transition from middle- to high-income status was based on their ability to push the technological frontier and move from imitating and importing foreign technologies to innovating technologies of their own.
Strong protection of intellectual property rights has been a major factor in facilitating this home-grown innovation. According to the World Bank’s Doing Business Database7, intellectual property rights in economies such as Hong Kong SAR (China), Korea, Singapore, and Taiwan, China, rival those in place in Japan, the US, and other high-income countries. As a result of a well-functioning system of intellectual property rights protection, many countries in the region have also become global leaders in patenting their own technologies.
- Flexible labour markets and open economic policies have allowed for the reallocation of labour across sectors within the most successful economies in the region.
Countries in the region have relied extensively on international trade to accelerate their labour transfer by inserting themselves into the labour-intensive segments of global value chains. Such a transfer was facilitated by advances in information and communication technologies, by decreasing transport costs and lowering international trade barriers (Canuto 2011). This labour market flexibility has facilitated a new labour transition that is increasingly directed toward innovative occupations.
The middle-income trap is avoidable if governments act early – rather than late, when the benefits of cheap labour and the gains from imitating foreign technology are all exhausted – and decisively to promote innovation.