The Problem with Economic Convergence

Poor countries with can sustain high levels of economic growth for decades as labor engaged in self-sufficiency farming migrates to more capital-intensive and productive urban jobs. This concept, which is at the core of Walt Rostow’s Stages of Economic Growth Model, has been a pillar of economics since the 1950s and a premise of the work of development institutions like the World Bank. The Solow model provides a simple framework for analyzing the successes and failures of developing countries.

Solow’s model is explained in the chart below. Over time, people move from rural to urban areas and contribute to capital accumulation and increased productivity. Concurrently, family size steadily decreases. Consumption follows a different pattern: initially, rural farmers consume 100% of what they produce. However, as abundant labor joins the modern industrial economy, significant capital accumulation occurs, and consumption as a share of GDP declines. Eventually, labor becomes scarce, wages rise, returns on capital decline, and a country enters a mass consumption phase. The time when labor becomes scarce and wages start to rise is called the Lewis Turning Point, and it heralds the beginning of the mass consumption society characteristic of developed economies.

This path of development has been followed faithfully by most countries. We can see in the chart below the surge in wages that has taken place in China around the Lewis Turning Point, which China reached around 2015.

The chart below shows the evolution of the consumption share of GDP for several successful Asian economies. It is noteworthy that China’s consumption share of GDP has not risen as expected. This is highlighted in the next chart, which shows the share of GDP for various countries at different income levels. The explanation for this is that China has found it difficult to abandon its debt-driven investment model, which channels resources into manufacturing exports, infrastructure, and armaments. This trend has been reinforced in recent years by policies aimed at promoting “productive forces,” particularly frontier industries considered to be the key sectors of the global economy in the future and military hardware. The two outliers in the data are China and the United States. While China has done everything to establish itself as the world’s dominant manufacturing power, the U.S. has prioritized finance and consumption.

The following chart shows the evolution of GDP, consumption, and manufacturing value-added for Europe, the United States, and China. This highlights the enormous growth in Chinese manufacturing that has occurred during the “China shock” of the past two decades. While GDP and manufacturing have surged, consumption has been repressed.

The Solow model assumes that over time countries will converge to similar levels of GDP per capita. This is premised on the idea that capital flows freely and that countries are institutionally prepared to attract this capital. In practice, this is not the case, which means that convergence is highly uneven.

Using the framework of the Solow Model, it is disheartening to see how uneven the process of convergence has been. As shown in the chart below, looking at averages for income classes, developing countries have tended to converge with high-income countries for the 1980-2023 period and even more so for the more recent 2001-2023 period of hyper-globalization started by China’s entry into the WTO in 2001. However, taking the United States as the benchmark for convergence, the results are less convincing. Over the 1980-2023 period, the U.S. handily outperformed all of the income classes when measured in USD terms. Economists generally attribute the absence of broader convergence to “institutional failure,” a vague term describing the difficulties many countries have in providing the appropriate conditions to attract investment capital.

Looking at the data on a country-by-country basis, the data is disappointing. This is shown in the chart below, which includes all the countries in the IMF database for the 1980-2023 period. Only one-third of the 135 countries in the IMF database grew GDP per capita at a faster annual rate than the U.S.

The data is much more supportive in the more recent 2001-2023 period, with 75% of the countries converging with the U.S. This can be attributed to lower growth in the U.S. and the widely shared benefits of hyper-globalization.

 In the two charts below, the focus is on the more economically important countries in both the rich world and emerging markets, as well as on some important outliers. The first chart covers the 1980-2023 period, which is characterized by the Washington Consensus for free trade and capital flows, the fall of the Iron Curtain and the subsequent integration of Eastern Europe and Western Europe, and the sustained financialization, indebtedness, and deindustrialization of most of the rich world, especially the Anglo-Saxon countries. The second chart covers 2001-2023, a period marked by “hyper-globalization,” the China “Miracle” and “China Shock” to global trade, the Great Financial Crisis, and the shale and Silicon Valley booms in the United States starting around 2015-2016, which brought about a powerful phase of “American exceptionalis

.”

Considering the entire 1980-2023 period, well over half of the countries grew GDP per capita at a slower rate than the 1.4% achieved by the U.S. The convergers are led by the “Asian Tigers” (China, Korea, Singapore, Taiwan, Indonesia, Vietnam, and Thailand), countries that benefited from the transfer of mass-production manufacturing capacity away from the rich countries . Ironically, these countries have been the primary beneficiaries of the “Washington Consensus” while also openly pursuing anti-liberal protectionist policies aimed at controlling both capital and trade flows. Eastern European countries have also been winners, benefiting from the transfer of mass-production manufacturing from Western Europe. The remaining winners include emerging market countries India, Brazil, and Peru, and a few special cases in Asia and Africa starting from very low bases (Sri Lanka, Bangladesh, Ethiopia) and in Latin America (Panama, Dominican Republic, and Costa Rica). Israel is a rare “rich” country that has achieved good GDP PC growth.

The list of non-convergers over the 1980-2023 period is long. It includes almost all of the rich world in Europe and Asia, most of Latin America, and several poor countries in Asia (Philippines, Pakistan). Middle-East oil producers show sharply negative GDP PC growth only because they have all come to rely on huge amounts of temporary contract workers.

The decline in prosperity relative to the U.S. for many rich countries is stunning. The chart below shows the GDP per capita of Japan and France relative to the U.S. over this 43-year period. Japan has gone from a GDP per capita 1.6 times that of the U.S. in 1995 to 0.4 times in 2023.

Considering the more recent 2001-2023 period, 64% of countries grew GDP per capita at a higher annual rate than the 1% achieved by the U.S. The winners include the beneficiaries of hyper-globalization: all the Asian exporter-led economies (China, Vietnam, Indonesia, Thailand, Malaysia, Korea, and Taiwan) joined by Bangladesh and the Philippines; and all of Eastern Europe plus Turkey. Even Latin America did much better over this period, boosted by high commodity prices, though Mexico sputtered, and Venezuela suffered a total institutional collapse with the Chavez Revolution.

The most glaring loser during this period has been the U.K., which has suffered from severe deindustrialization and the institutional breakdown of Brexit.