Taking the implications of this model to their absolute end in conjunction with the increasingly global nature of the world economy, per capita income should converge between nations in the long run. The historical data for economic growth, however, does not reflect our expectations. Using data from the World Development Indicators, we can regress country GDP growth from 1970 to 2005 on GDP in 1970. Keeping the Solow-Swan model in the back of our heads, we would expect the coefficient on GDP in 1970 to be negative because that would mean that having high income was worse for growth over time compared to low income.
Yet, the regression:
generates a β1 value of 0.32. The data are telling us that high-income countries were more likely to grow faster than low-income countries in the past forty years. Given that the International Institute of Finance has observed that net capital inflows into emerging markets have been in the hundreds of billions of dollars over the same period of time, the regression’s results make little sense based on normal assumptions of economic growth.
Instead of living with this confusion, we can, instead, question the conventional expectations about the political and economic factors that surround emerging economies. By looking at the data and facts on the ground, the real answer to why emerging markets are underperforming compared to what our standard models predict.
Rising levels of national income are typically associated with higher living standards and higher qualities of life ratings. But, when compared to international improvements, are emerging markets doing anything drastically different? The amount of countries that have entered the highest category of human development, according to the United Nations, has been sizable. What is more concerning, though, is the fact that very few countries that were categorized in the lowest category of human development have not budged from their former positions. And this trend rings true for all countries. While there have been modest gains for quality of life and living standards worldwide over the past forty years, mainly through improvements in medical technology, there is no meaningful difference between the gains of low and high income countries.
Under regular circumstances, anyone would expect that increased investment in these countries would correspond to increasingly higher levels of quality of life and standards of living. In reality, these improvements are not being actualized. The dissonance between expectation and reality becomes especially problematic since it means that, as far as investment goes, the benefit of additional capital must be benefiting some otherwise unexpected group.
Perhaps, what better explains the fact that living standards in emerging markets are not improving at a quicker rate compared to developed economies is the rampant income inequality in emerging markets. A report from the Organization for Economic Cooperation and Development (OECD) notes that income inequality in emerging markets is actually substantially higher than that of developed economies. Additionally, as the report notes, the central reasons for the high levels of economic inequality are very systematic such as enormous education gaps and notable differences between agricultural and urban income. The issues that emerging markets face with regard to income inequality are not same issues that developed countries face such as tax differences between income levels. In the end, these systemic problems leave significant majorities unable to reap the true benefits of national economic growth.
So, where are these gains being made?
A report by the IMF points to the fact that only the largest firms and the wealthiest households are the real winners in many developing countries because they have the best access to credit. This reigns true despite the fact that there is, increasingly so, more credit in developing financial systems. This sort of inequality cuts deeper than just the same drivers of economic inequality that the OECD noted. But what opens the door for extreme income inequality?
One strong explanation for extreme income inequality is corruption. Joel Hellman’s paper, entitled Winners Take All: The Politics of Partial Reform in Postcommunist Transitions, gives a great deal of insight into income inequality in transitioning states. In this, Hellman describes the political process of free-market reform as an undertaking that follows a J-Curve trend. The general effect for the whole economy is that minor economic losses must be made before the economy can start to benefit from opening up.
There is one caveat. Hellman notes that not everyone faces the economic losses in the beginning of the process; in reality, there is a small sliver of the population — which is likely politically connected — that actually makes more income in the early stages of free market reform. What is even more interesting is that these same people have the most to lose as reforms are continued.
The same conclusions that Hellman reached in his paper, sadly, apply to many governments of emerging markets as well. Using levels of political corruption as a proxy measurement for political pay-offs to the wealthy populations in emerging markets, it becomes very clear that the BRICs (Brazil, Russia, India, China) and the MINTs (Mexico, Indonesia, Nigeria, Turkey) still suffer from high levels of corruption in the face of persistently soaring levels of economic growth. Even though the BRICs and MINTs may not be the most corrupt nations in the world, they are seen as the most prominent nations among emerging markets, which is significant in its own right.
The true scourge of the issue that arises from political corruption is not persistent income inequality, but rather, the fact that the regular people of these countries are unable to access the resources necessary to bring about small business activity that drives more powerful economic growth. To clarify, that is not to say that small business activity in developing nations has not grown. Many people and households in emerging markets are beginning to earn more money and open more businesses. Even so, small business activity — similar to that in the United States, which provides services to communities and adds value to local economies — has not grown nearly as much as it could have. Small business activity like this is far more important and valuable for long-term, sustained economic growth that has the potential to set an emerging market onto the path to becoming a developed economy.
With all of this in mind, it comes to no surprise that Brazil, Russia, China, Indonesia, Nigeria and Turkey — to name a few — have economies that are currently slowing down significantly; leading many analysts to change growth forecasts for the worse. Although some of these cases can be attributed to poor monetary policy, politics or external economic influences, it remains true that bottom-up economic activity, through the activation of strong local economies, has the potential to stave off the full force of these slowdowns.
Steps toward local economic progress cannot occur without the necessary structural reforms that place the state’s welfare above the needs of a politically connected minority. When emerging markets begin to focus on the necessary political reforms that lead them into the territory of true, long-term economic growth and development as our neoclassical models would suggest — the entire world will be able to see emerging markets join the ranks of developed economies. Until then, any breakout countries will likely be the exception rather than the rule.