New growth perspectives on spillovers and poverty January 1999 by William Easterly

Over very long run, poor countries stay trapped in poverty

A puzzle: even if national policy incentives explain national growth differences, Why do we observe persistently poor areas within a given country?

If “people respond to incentives” why don’t the poor respond to the same incentives as the rich? Proposed thesis: poor people stay poor because their incentives to grow are poor; their incentives are poor because of spillovers from other poor people.

Outline u Direct evidence of poverty traps and spillovers between people u Theory of Increasing Returns (poverty traps) versus Diminishing Returns (no poverty traps) u More Testing predictions of increasing versus diminishing returns models

Testing predictions of diminishing versus increasing returns models Diminishing returns: u Wealth and poverty depend on individual characteristics; there is no reason to expect concentrations of wealth and poverty Increasing returns: u Wealth and poverty are concentrated in particular areas

Direct evidence for spillovers u Rauch 1991 found that identical workers have higher wages in US cities with high average human capital than in cities with low average human capital. u Borjas 1994 found that identical workers have different wages if they belong to different immigrant groups (average human capital of ethnic group = “ethnic capital”)

Direct evidence for spillovers Households in the Tangail/Jamalpur district of Bangladesh have 47 percent lower real consumption than identical households in Dhaka.

Anecdotes of poverty concentrations u Where are the poorest all-white counties in the US? u 18 of the 20 all-white counties with the worst poverty rates are in Southeastern Kentucky. u The poorest county, Owsley, has 52 percent of the population under the poverty line and only 35 percent are high school graduates.

The poor in Southeastern Kentucky remain poor because they are surrounded by other poor people Southeastern Kentucky

Anecdotes of poverty concentrations Indigenous Mexicans have a poverty rate of 81 percent; non-indigenous Mexicans 18 percent

Anecdotes of poverty concentrations In China, 5 percent of the population are below the poverty line in Guangdong while Guangxi has 37 percent below the poverty line.

Anecdotes of poverty concentrations u In Malaysia, non-Bumiputras (Indians/ Chinese) earn 68 percent more than Bumiputras u Poor remain poor because they associate mainly with other poor people.

High income is also concentrated in space u The most economically dense 10 percent of global land area produces 54 percent of global GDP; the least dense 50 percent of land area produces 11 percent of global GDP u The most economically dense 2 percent of US land area produces 50 percent of US GDP; the least dense 50 percent of the land produces 2 percent of GDP

High income is concentrated in space u US metropolitan counties are $3300 richer per capita than rural counties. u Metropolitan counties in the BosWash corridor are $5874 richer per capita than other metropolitan areas (2.4 standard deviations). Boston- Washington corridor

High income is concentrated in space u Even within the Washington DC metropolitan area there are huge differences across space. u Wealth concentrations are reinforced because rich associate with each other u Poverty concentrations are reinforced because poor associate with each other

A journey through the DC area Andrews AFB Potomac

High income is concentrated in space

Still see mild divergence with more recent data:

Theory of Increasing versus Diminishing Returns u Diminishing Returns Production Function: y=Ak a u k is individual’s own physical capital, y is individual’s own output u a<1 u Increasing Returns Production Function: y=Ak a h b u k is individual’s own broadly defined capital, h is average level of broad capital in society u in equilibrium, k=h u a + b > 1

Incentives with Diminishing vs Increasing Returns

Ingredients of Increasing Returns Knowledge spills over between people (Desh Garments story)

Ingredients of Increasing Returns Technology is only as strong as its weakest link (Kremer ’s O-ring theory)

Ingredients of Increasing Returns u “Weakest link” theory implies strong complementarity between people u Your productivity is higher if you work with other high productivity people u High human capital people tend to segregate themselves into an exclusive group, leaving low human capital people to associate with other low human capital people

Incentives with Diminishing vs Increasing Returns

Testing predictions of diminishing versus increasing returns models Diminishing returns: u Poor catch up to rich Increasing returns: u Country poverty traps

Incentives with Diminishing vs Increasing Returns

Testing predictions of diminishing versus increasing returns models Diminishing returns: u Initial conditions don’t matter Increasing returns: u Initial conditions matter

Incentives with Diminishing vs Increasing Returns

Over very long run, poor countries stay trapped in poverty

The rank correlation across 36 countries of income per capita in 1820 and income per capita in 1992 is.85 The poor nations stay poor because individual incentives are poor; individuals’ incentives are poor because they associate with other poor individuals.

Testing predictions of diminishing versus increasing returns models Diminishing returns: u Capital flows to poor areas Increasing returns: u Capital flows to rich areas

Incentives with Diminishing vs Increasing Returns

Portfolio capital gross inflows per person, annual average u Annual inflow to poorest quintile of countries: six cents per person u Annual inflow to richest quintile of countries: $189 per person

Total gross capital inflows, 1990 u The richest 20 percent of world population received 88 percent of gross capital inflows u The poorest 20 percent of world population received 1 percent of gross capital inflows

Testing predictions of diminishing versus increasing returns models Diminishing returns: u National policies have weak effect Increasing returns: u National policies have strong effect

Incentives with Diminishing vs Increasing Returns

How strong are policy effects? They are strong, as we have seen in previous presentations

Caveats u “Conditional convergence” seems to contradict increasing returns, although the two can be made consistent u Causality is an open question about strength of policy effects u Failure to find spillovers from FDI in firm- level studies u Growth rates can’t increase without bound

Conclusions u Most of the evidence supports the existence of spillovers between people and increasing returns. u Poverty itself creates poor incentives for the poor with increasing returns: the poor are poor because they get spillovers only from other poor people.

Policy implications u Need to subsidize return to physical capital, human capital, and technology adaptation in poor areas. u Have subsidy increase as poor raise their incomes, not decrease. u Market-friendly government policies matter even more under increasing returns than under diminishing returns.