Chapter Nine

The Great Divergence

Why Isn't the Whole World Developed?

The Great Divergence

Poverty continues to be a global problem. Efforts to alleviate global poverty typically define it as living on less than $1.90 per day in 2011 dollars, which means living on what $1.90 per day could buy you in a typical U.S. city in the year 2011. Accounting for inflation since 2011, in 2020, this was equivalent to about $2.19 per day. However, if you live in the United States, poverty is considered to be living on less than $30 per day (~$11,000 per year). By that measure, only around 15% of the global population is living above the poverty line.

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As we have said, for most of human history, almost everyone lived on less than $3 per day, plus or minus a dollar or two, which we refer to as the subsistence level of consumption. And while the Industrial Revolution set off an explosion of economic growth that has lifted the typical person in those economies out of poverty, not all countries in the world have succeeded in industrializing. As the world entered the 21st century just a couple decades ago, nearly two-thirds of the global population was still living at this subsistence level. Since the 1970s or so, there have thankfully been significant reductions in the share of the global population living in extreme poverty at less than $2 per day. In 1981 over 40% of people lived in those awful conditions, where starvation is a continual threat. By 2017, that had fallen to less than 10% of the global population. And since the year 2000, progress is finally being made again on lifting people out of poverty altogether, and around 2012, for the first time in human history, more than half the earth’s population had risen above subsistence living. --Average income differs greatly between countries of the world. In Ireland, Singapore, and Luxembourg, GDP per Capita – adjusting for purchasing power parity – was over $90,000 per year in 2020. The United States had a GDP per Capita of $63,500. Formally impoverished nations like China and Thailand had pushed their GDP per Capita to over $15,000. And yet there remain many countries with average incomes below $2,300 per year like Uganda, Afghanistan, Madagascar, and Burundi. The end of poverty is starting to appear over the horizon, but you have to wonder why – more than 200 years since the Industrial Revolution – the problem persists. --Consider what the Solow model would predict. All of the ideas and technology are out there. Other countries should be able to adopt those ideas and catch up. And in fact, that is exactly what countries did once Britain stumbled upon the formula for economic growth. France, Germany, the United States, Australia, Japan, and more just copied the progress and continued to learn from each other. Over time there should be a convergence as countries get the physical and human capital they need to be rich. But that isn’t what really happened.--Instead, there has been a great divergence over time. Where once there was little difference in the average incomes of different nations, everyone was at the subsistence level, after 1800 some lifted off while others stayed poor. But again, why? Industrialization brings with it untold riches which are shared widely, lifting whole populations out of poverty. Why would some nations not embrace this? --It’s time to bring together our understanding of economic growth under a more general theory. The Solow model describes what we would call the proximate causes of prosperity. Capital, human capital, and ideas are what spur on economic growth. But the Solow model can only work if these ingredients are planted in the soil of the fundamental causes of prosperity, which include geographic conditions, cultural attributes, and good institutions. Only when these fundamental causes are aligned with economic growth can the proximate causes begin to fuel that economic growth.

Geography

Geographic difference can help explain why industrialization came easier to people in Eurasia than elsewhere. Simply put, the answer is privilege. Eurasian geography bless the people there with more domesticable animals and crops, while people in Africa, the islands of the Pacific, and the Americas faced bigger hurdles when it came to economic development.

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The first of our fundamental causes of prosperity is geography. When we look at this map showing the differences in GDP per capita around the world, there is something noticeable about their location. Countries which are closer to the equator tend to have lower average incomes. The climates in these countries are hotter, which might make the factory work required for industrialization more difficult to transition to. In many of these countries, there are also fewer navigable waterways for trade. But luckily modern advances like air travel and air conditioning are beginning to mitigate those factors. --Nevertheless, geographical differences may also help us explain why “Western civilization”, or the nations of western Europe, where the ones to colonize the globe and stumbled upon industrialization. The geographer and historian Jared Diamond frames it this way in his classic 1997 book Guns, Germs, and Steel. In 1532 a small Spanish force of about 100 men and 60 horses led by Francisco Pizzaro massacred thousands of the Inca people in the great plaza of Cajamarca and captured the Inca ruler Atahualpa, defeating an army of 80,000 soldiers. How is this possible? Why did this happen? What was so special about the Europeans that when they showed up on the shores of the rest of the world, the people who greeted them stood no chance against their weaponry and disease?--The case Diamond lays out is that the geography of Eurasia bestowed upon the Europeans a sequence of advantages. First, Diamond notes that not all regions have animals which can be domesticated. Sheep, goats, cows, pigs, and horses are really the only major domesticable animals in the world which help grow human civilization. There are some more, like camels, llamas, and buffalo, but among the viable candidates only one – the llama – was indigenous to a region other than Eurasia. There are no animals indigenous to Africa which can be domesticated (Romans like Mark Antony – in defiance of the wisdom of the Africans - tried and failed to domesticate lions and zebras). Without domesticable animals, farming is much, much harder. The available plants which could be domesticated also differed greatly by region. Wheat is native to the fertile crescent, and rice is native to China. Add to those corn, barley, and sorghum and you have all the major cereal crops. Only corn is native to the Americas, the rest were all native to Eurasia. And corn took a very long time to develop into what we know today. Originally, corn looked like those little baby-corns you get sometimes, and it was barely edible. It took centuries for the indigenous people of the Americas to cultivate the crop. Domesticable animals and crops make it easier to build your civilization and grow your population. In that respect, the peoples of Eurasia had significant geographic advantages which set them centuries ahead of the peoples in Africa, the Americas, or the islands of the Pacific. --Beyond the advantages of resources, Eurasia also had an advantageous shape. Because the earth rotates along an axis, climates at similar latitudes tend to be similar. A continent like Africa spans more lines of latitude than lines of longitude, or said simply, its tall not wide. That means that climates on the African continent are very different. That makes it difficult for ideas about agriculture to spread. What improves farming yields in Egypt won’t work in Uganda or Madagascar. However, the continental axis of Eurasia runs across, not up and down. The climates of France and Germany do not differ much, and so advances and ideas are easily adapted between different groups of people on the continent. By making it easier to spread ideas, advancement was faster. --Still, Europeans might not have succeeded in their conquest of the Americas and other places if were not for germs. These diseases all came from animals in Eurasia, and Europeans had developed immunity towards them over the centuries. In 1520 it took just one sick person to bring Smallpox to South America where it may have killed 90% of the indigenous population. The same story played out later in North America. John Winthrop, the governor of Massachusetts way back when, wrote about how it was clear that God had sided with the Europeans and sent the plague to the native peoples to wipe them out. Indeed, unaware of the advantages their geography had granted them, Europeans tended towards racist explanations of their success. But the truth really is that Europeans inhabited a part of the globe which made progress just a little bit easier than it was everywhere else. And we must continue to be wary of racist explanations for the differences we still see today. Some places simply have bigger hurdles to jump when it comes to economic growth.

Malaria

Malaria is a disease spread by mosquitos in regions of the world close to the equator. Malaria kills over 400,000 people annually, mostly children under 5 in sub-Saharan Africa. But Malaria is both preventable and curable.

Diseases like Malaria are tragically deadly, harm people's health, and hold back the very economic growth which could help solve the problem. But the disadvantages of geography can be overcome by human ingenuity, and human kindness.

If you find yourself in a position to help, check out the top charities identified by GiveWell, a nonprofit dedicated to identifying the charities which are most effective at saving lives.

Visit GiveWell.org

Culture

In 2005, Steve Jobs gave the Commencement Address at Stanford. He said:

"Your time is limited, so don’t waste it living someone else’s life. Don’t be trapped by dogma — which is living with the results of other people’s thinking. Don’t let the noise of others’ opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary."

If he had made that statement in almost any other time in human history, he would have been run out of town. Challenging dogma was shunned and punished. But in California in 2005, he was met by roars of applause.

Here is First Lady Michelle Obama's Full Commencement Address from the video.

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Culture is an important part of economic prosperity as well. In Western Europe, the Enlightenment pushed against the conventional wisdom and challenged the status quo. The economic historian Joel Mokyr refers to these enlightenment thinkers as cultural entrepreneurs. Before business entrepreneurs could disrupt industry and devise new ways of manufacturing, these cultural entrepreneurs had to make that a culturally acceptable thing to do. Mokyr emphasizes that what the enlightenment thinkers challenged was a reverence for the past. There was a deep-set dislike of changing the way things were done until these thinkers pushed the culture towards a greater acceptance of commerce. --We have explored this already with the Bourgeois Revaluation, perhaps the most important explanation for the Industrial Revolution. It is not important that a culture adopt the specific conventions and customs and oddities of white European culture. As with geographic explanations, we have to keep our guard up for those who want to weaponize something universal for their own racist intentions. The piece of culture that matters is simply how we treat those among us who wish to try something new. When innovation is met with scorn and ridicule, then it won’t happen. --You can turn to just about any commencement address and find what I am referring to. When we say culture matters, we mean inclusivity and acceptance of differences and change, not that we all must return to the horrible repression of 18th century Britain or France. Take, for example, this commencement address delivered by former First Lady Michelle Obama. “We don’t build up walls to keep people out because we know that our greatness has always depended on contributions from people who were born elsewhere but sought out this country and made it their home -– from innovations like Google and eBay to inventions like the artificial heart, the telephone, even the blue jeans; to beloved patriotic songs like “God Bless America,” like national landmarks like the Brooklyn Bridge and, yes, the White House -– both of which were designed by architects who were immigrants.”It is this sort of rhetoric, the praise for innovation and the conferring of dignity and acceptance to the innovators, whomever they are, that was the cultural innovation that brought on economic growth. And it is a flame we must take great care to keep lit.

Institutions

As the saying goes, "If you want to move the mouse, move the cheese." People respond to incentives, and those incentives are set by the formal and informal institutions in our society. Those institutions include government, legal systems, and property rights. They also include regulations, the lending practices of private banks, and social support systems. Economic growth is created by people, and people will only do the work if it is worth the trouble. Good institutions make it worth the trouble.

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The last piece of our puzzle of economic growth is institutions. Institutions are the formal and informal rules governing the organization of a society, including its laws and regulations. Institutions are important because they create the incentives that people face. For example, when we talk about institutions, we aren’t just talking about the legal and political system that gives you the right to start a business, but also the regulations and legal hurdles you face when trying to start that business for real, and the social pressures that you might face as well. When institutions encourage innovation and help people to try new ideas, allowing them to fail or succeed on their own merits via free markets and consumer demand, then economic growth becomes possible. But if institutions discourage competition, pick winners, or allow only certain people to start businesses while others are denied out of prejudice or class, then growth is very unlikely. In our modern times, debates often rage about the quality of our institutions. Many people don’t like the free market and want to see lots of government intervention and regulation in the name of protecting jobs or helping the poor. But these interventions rarely succeed as intended. Likewise, others want our institutions to protect a “way of life” and support one group at the expense of other groups. This too is a recipe for disaster when it comes to economic growth. --The difference between good institutions for growth and bad can literally be seen from space. Viewed from orbit, the Korean peninsula is visibly divided at night. South Korea is lit up with economic prosperity, filled with wealthy cities and human flourishing. North Korea, on the other hand, is almost completely dark, except for the capital city of Pyongyang, where all economic activity is directed from. In 1947, Korea was split along the 38th parallel by the U.S. and the Soviet Union. Prior to this, Korea has been one country, they had the same climate and geography, and they had a fairly homogenous culture, especially economically. Nevertheless, after more than 70 years, the two countries have gone down two very different paths. GDP per capita in South Korea is well over $35,000 today, while in North Korea it remains at the subsistence level of around $1,800. This is what economists often call a natural experiment. An event which happens that splits similar people into two groups and changes something for one of the groups. The differences we see over time should then be a result of that change. In the case of Korea, the change wasn’t in geography or in culture, but rather in their institutions. --In South Korea, the U.S. installed a government which supported a market-based economy. Initially growth was slow, as the U.S. had installed a military dictator. But when South Korea finally broke free of that and instituted their own democracy, growth and innovation has flourished, and the commitment to the market-based economy strengthened. Today, South Korea has a huge cultural footprint, with K-Pop and other music becoming global sensations, and a film industry which has been pumping out masterpiece after masterpiece. Bong Joon Ho’s 2019 film Parasite was the first non-English film to win the Academy Award for Best Picture. And all of that doesn’t even mention business mega-successes like LG, Samsung, Hyundai, and Kia. Odds are pretty good that you have more than one product of South Korea in your house right now, and you may even be watching this video on one of their devices. Heck, I’m reading my little script here off my Samsung monitor! Three cheers for that! --Contrast this with North Korea, which adopted communism and a powerful state dictatorship. North Korea implemented the Juche system under Kim Il-Sung, which translates roughly to “self-reliance”. It is a political philosophy that the country should be politically, militarily, and economically independent. The government controls every aspect of the economy, setting prices, telling you what your job is and what to produce, and providing you with the compensation they designate. They control what you eat, what you see, and what you do. Everything in designed to serve the power structure controlled by the Kim family, and they use what little productive capacity the country has to produce enormously wasteful military projects to antagonize the world with. Where most countries set rules on who is allowed to move in, North Korea has to strictly guard their borders to prevent people from leaving. People who are trying to flee political persecution which put their families in brutal prison camps or the frequent famines that an unknown number of people have died from, because the North Korean government goes to great lengths to hide the dysfunction. I’m willing to say it: life in North Korea is objectively worse than life in South Korea. There is no dimension on which North Korea is succeeding unless you are part of the ruling family. And the reason is the institutions which formed, and which are reinforced by the incentives every person in the country faces to keep quiet and not dissent or challenge the status quo. --We can see this story again in the Caribbean. Haiti and the Dominican Republic share an island, but the standard of living in the two countries has diverged greatly since the 1960s. In the Dominican Republic, they adopted institutions which supported entrepreneurship and a market economy. They invested in human capital through education, achieving 99% literacy compared to 61% in Haiti. They invested in physical capital like roads and promoted trade with other nations. Their government has maintained political stability and low inflation. They have been rewarded with an economy that has lifted the typical person out of poverty and into the middle class. In Haiti, there has been no economic progress at all, with GDP per capita only sufficient to provide the typical person with $3 or so per day. When an earthquake hit Haiti in 2010, the damage was immense, and the death toll tragic. Without any modern infrastructure, there was nothing to protect people. And so, 200,000 people died because political instability, poor land-use management, and corrupt leaders have kept the nation in poverty with institutions that benefit the ruling class at the expense of everyone else. The thing about institutions is that they are hard to get right, and even harder to keep in place. But they are an indispensable cornerstone of economic growth.

Growth Miracles

The good news is that the Great Divergence is starting to become the Great Convergence, as more and more countries establish the institutions they need for growth. Over the past 50 years, billions of people have been lifted out of poverty, especially in countries like China and India.

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Since the 1960s, the developed world has offered help to poor countries to try and get them on the path to economic prosperity. The World Bank provides financial products and services to poor and developing countries and encourages the creation of strong economic institutions, and the U.N. has programs aimed at aiding poor nations, feeding the hungry, providing education, and fostering institutions which promote basic human rights. --Unfortunately, for most of their history these programs have largely been a disaster. Take Sub-Saharan Africa for example, where most of the world’s poorest nations are located. From 1960 to 2000, the amount of money given in aid grew and grew, and while there was some benefit in GDP per capita, it was not nearly enough to lift anyone out of poverty, and after the mid-80s the growth completely stalled. There was little effort to see what sort of aid helped, and what was happening to the money that was sent. When researchers finally did investigate, they found that only about 15% of the money was making it to its intended destination. The rest was being siphoned by corrupt leaders, mismanagement, and incompetence. --However, there is a theoretical foundation to the idea that the aid simply wasn’t enough to work, and if we simply increase aid we will see better results. We are already familiar with the Solow Growth model, where depreciation and investment square off to set a steady state level of capital and GDP. In this model, we assumed that the production function should have diminishing marginal returns for capital. That is a pretty good assumption, but it might not be true at the lowest levels of capital and GDP, where some initial capital is especially productive, and shows increasing returns to scale. --That could create a situation called a poverty trap. With a period of increasing marginal returns for capital, the production function would have to be wavy like this. You can see that, at first, there are diminishing returns to capital, and then it picks up and we see increasing returns, but eventually it levels out with diminishing returns again. There is some reason to believe this might be a better representation of the situation in poor countries. If so, it has important implications, because our investment will be wavy too, meaning that there are multiple steady states. If we start at this low steady state, we will have a low GDP. But if foreign nations send a bit of aid, allowing us to increase our capital a bit, we will only enjoy a temporary increase, because beyond our steady-state depreciation is too high. But if the push is big enough to get us through those increasing marginal returns and put us on the other side of depreciation, our own economy will be able to start building on the improvements and growing even further, perhaps kick-starting the catch-up growth the Solow model would predict. --Indeed, since the year 2000, Aid to sub-Saharan Africa has increased significantly, and this has been met with additional increases in GDP per capita. We can only hope that soon these poor countries will foster better institutions and more stable governments, which will ignite their engines of growth. --Figuring out what sort of aid actually works has also been a point of focus. The economists Abhijit Banerjee and Esther Duflo started the Poverty Action Lab, which seeks to experimentally test whether or not certain interventions are effective in promoting economic development. For their incredible and continuing insights, they were both awarded the Nobel prize in Economics in 2019. A lot of their work has been influential to policymakers and charities alike. For example, if our goal is to increase education, we might try paying parents to send their kids to school, buying uniforms for kids, giving them scholarships, paying for an extra teacher, paying for school meals, or proving kids with iron supplements. Esther Duflo showed that all of these increase years of education obtained by only a little per $100 spent. But providing health care services like deworming children in places where intestinal parasites are a problem, and simply providing information on how big the returns to education can be, were far more effective ways to spend that $100. --We also have the incredible growth miracles in Asia, where countries like Japan, South Korea, Taiwan, China and even more like Hong Kong and Singapore have been able to industrialize and catch up with western countries. These miracles did not all happen at once, and so we can look and see what policies were common at the points where growth finally started. First is land use reform. In each of the successful countries, farmland was taken away from landlords and given to peasant farmers. This allowed those farmers to see the returns on investments they made into improving yields and adopting better technology. In countries that haven’t seen miracle growth like the Philippines, most of the farmland is controlled by just a few powerful families. And of course, in China during the 50s and 60s, as they imposed communist policies where no one owned the farmland, it was a complete disaster. Only when they revised these policies and adopted a market economy did they see growth. Another important policy is export discipline. Against the advice of many economists, these countries often imposed steep protective tariffs to keep foreign competition out. However, they paired those policies with strict rules about exporting a certain percentage of what is produced to other countries. In South Korea and Japan, for example, they limited imports of automobiles to support their growing automobile industry. At first this was bad news for consumers, as Japanese and South Korean car companies produced low quality vehicles. But because they needed to export vehicles to other countries, these companies had an incentive to figure things out and learn how to make quality cars that foreigners would want to buy. Eventually, we got some new world-class automakers like Toyota and Honda in Japan, and Kia and Hyundai in Korea. Lastly, it was important for these countries to establish good financial policies which promoted long-term investments. With free-market finance, the money goes to the projects with the highest short-term profit, which is usually just resource extraction. But these countries created policies which incentivized banks to keep interest rates low, incentivizing longer-term projects. To maintain these rates, the countries had to impose capital controls to prevent money from going to overseas to invest in places with higher returns. Like the protective tariffs though, eventually these policies need to be lifted. You can’t stop capital outflows forever, and so Japan got rid of them in 1990, South Korea in 1993, and Taiwan in the late 80s. But China has tried to keep them, which has been a continued source of anxiety for onlookers who worry they are tempting a financial disaster. --While there is still a great deal of poverty in our world, things have never looked as good as they do now. Finally, growth had started to take off everywhere, and the poorest countries have been the ones with the highest growth rates over these past two decades. There is a billion people who will be lifted out of poverty or near-poverty in the coming decade or two. Ideas, art, inventions, and so many other things can be shared, they will only need people to make them. Think of how amazing and enriching life in this world will be with a billion more people contributing to those things. I can’t wait for it.

Quick Quiz

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Dr. Goegan Explains...

Example Question
Use the Solow model below to answer the question.

Suppose that Y₁ is 2,344, Y₂ is 6,724, and Y₃ is 11,434. The savings rate for this economy is 24% and the depreciation rate is 5.4%.

If this economy is currently at a GDP of 2,344, what is the smallest amount of foreign aid which would move the economy up to a GDP of 11,434?

Assume that all foreign aid becomes investment. Round your final answer to two decimal places.

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