Can cheap countries catch up?

CAMBRIDGE  —  Poor countries are cheap. In 2019, a dollar could buy more than twice as much in Argentina, Morocco, South Africa and Thailand as it could in the United States. It could buy more than three times as much in Vietnam, India and Ukraine, and more than four times as much in Afghanistan, Uzbekistan and Egypt. If a country is cheap, it should be more competitive and thus able to catch up with richer economies. In fact, many cheap countries are falling further behind.

At first glance, the fact that poor countries are cheap is counterintuitive. If poor countries are much less productive, shouldn’t things there cost more, because it takes more time and effort to make them?

This would be the case if salaries were the same in all countries. But they are much lower in poor countries than in rich ones. According to the OECD, average annual wages in 2019, in constant prices, were over $60,000 in Switzerland and the US; over $50,000 in Australia, Denmark, The Netherlands, and Germany; over $40,000 in France, South Korea and Sweden; over $30,000 in Spain, South Korea, Italy and Poland; over $20,000 in Greece and Hungary; and over $10,000 in Mexico.

Such differentials suggest there is a possible alternative universe in which highly productive countries pay higher wages and unproductive countries pay lower wages, so that all goods and services cost the same everywhere. It makes sense, but that is not the world we live in: a dollar buys more in a poor country than in a rich one.

The standard economic explanation for this is that, although poor countries may be unproductive across the board, they are particularly unproductive at making things that trade internationally, relative to those that do not. But how can this explain why poor countries are cheap?

The prices of internationally tradable goods, like coffee and cellphones, tend to be similar across countries. If the local price is too high, you might as well import the good. And if the local price is low, people can make more money exporting the product than selling it domestically.

By contrast, so-called non-tradable goods that can be sold only to locals, like cappuccinos, mobile-phone services and haircuts, can have very different prices in different countries. Such goods and services tend to be cheaper in poorer countries, because these economies are relatively less unproductive at providing them compared to tradable goods.

This raises the question of why poor countries are especially unproductive at producing things that trade internationally. The most persuasive answer is that productivity hinges on technology adoption and adaptation, which requires figuring things out. And the cost of doing this can be recouped only through a period of excess profits.

In a non-tradable sector, a pioneer at adopting a new technology will have a monopoly until successful imitators emerge, giving the pioneer the pricing power to recover the cost of the innovation. By contrast, a pioneer in a product that trades internationally will have to compete from the start with foreign firms that already make similar products. Without monopoly power, recouping the innovation costs will be difficult.

Technology is knowledge that can be used to do things such as produce food, provide entertainment or administer justice. It takes three forms: embodied knowledge in tools; codified knowledge in formulas, algorithms, recipes and how-to manuals; and tacit knowledge, or know-how, in the brains of teams of humans with complementary skills, like surgeons and anesthesiologists.

In principle, codified knowledge is costless to reproduce and, absent property rights, can move around the world as quickly as an email. So, this should not be the reason why poor countries do not catch up.

But tools are typically produced in rich countries, which embed the knowledge in them, and they account for over 40 per cent of world trade in goods. Because poor countries are cheap, machines look very expensive to them: the same machine appears four times more costly to an Egyptian firm than it does to a Swiss firm.

Moreover, know-how is key to implementing any technology, and a lack of it means that the costs of machines, materials, and labour can easily go to waste. Unfortunately, know-how moves with enormous difficulty from brain to brain. It is much easier just to move the brains.

Moving brains is a powerful mechanism of technological diffusion, as evidence from migration, diasporas and even business travel illustrates. Just look at the growing importance of so-called knowledge-intensive business services (KIBS), provided by firms like McKinsey & Company, Accenture, Halliburton, or Schlumberger. But, here again, the cheaper the country, the more expensive these services will look.

So, the fact that poor countries are cheap makes it harder for them to acquire the technology they need to catch up. As a result, they remain poor.

But maybe there is a way to turn being cheap into an advantage. If poor countries could develop the capabilities to export KIBS, their firms could be globally competitive while providing their employees with a higher standard of living, as Indian companies such as Wipro and Tata Consultancy Services have done.

Being cheap is no panacea for poorer countries. Quite the contrary: it may block the door to prosperity by making technology, whether tools or know-how, relatively more expensive. But cheapness may leave open a couple of windows on the third floor through which poorer countries could find a way to climb.

Ricardo Hausmann, a former minister of planning of Venezuela and former chief economist at the Inter-American Development Bank, is a professor at Harvard University’s John F. Kennedy School of Government and Director of the Harvard Growth Lab. Copyright: Project Syndicate, 2021. 

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