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Ricardo Hausmann on Growth, Inequality and Preventing the Next Financial Crisis

December 2015. GrowthPolicy staff member Devjani Roy interviewed Harvard Kennedy School Professor Ricardo Hausmann, focusing on three key questions motivating the GrowthPolicy website. Below is an edited version of Professor Hausmann’s comments.

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What are the challenges of economic growth? | What should we do about inequality? | How to prevent financial crises?

SECTION 1: What are the challenges of economic growth?

 Key points 
1. Successful countries do not grow by making more of the same. They change what they are good at. They become good at a more diverse set of industries and these industries tend to be increasingly complex.
2. The opportunities for diversification and the obstacles that impede it vary from country to country; there is no one-size-fits-all solution.
3. Not all industries are equally good as stepping stones into more diversification opportunities.
4. Countries that have more of these stepping-stone industries (e.g. China, India, Thailand, Vietnam) grow faster than others because these industries provide greater opportunities for diversification into more complex and sophisticated products.
5. Diversification always faces a chicken and egg problem because countries don’t naturally accumulate the capabilities that are needed by industries that do not yet exist and these industries cannot take off unless those capabilities are present.

Policy recommendations
1. For economic growth to be sustainable, countries need to change what they are good at by adding more and more sophisticated products to their export basket.
2. Economic growth policies should be focused on identifying new diversification opportunities.
3. In countries with fewer opportunities for diversification, the government should step in to play a facilitator role focused on solving coordination problems.

Discussion
The challenges of economic growth are very different in different countries. The U.S. and Europe face a certain set of issues that look very different from the issues faced in China or India, or the issues faced in the Americas or in Sub-Saharan Africa.

It would not be wise to cover all regions of the world with the same brush. There is a subset of countries in the developing world that are growing faster than the rest and are tending to converge towards the developed world, such as China, India, Thailand, and Vietnam, to name a few. These countries are poised for growth, so you could say “the check is in the mail.” They just need to keep the growth process going and they face a certain set of challenges in doing so.

By contrast, In Latin America and Sub-Saharan Africa, countries just ended a very successful decade of economic growth that was propelled by high commodity prices and cheap access to capital. Right now, growth in these regions has slowed down enormously and creating a more dynamic environment going forward looks much more challenging, because they lack non-resource dynamic export industries that can generate the dynamism that the resource sector no longer can.

So my question would be, “Why does Asia look more promising than the Americas and Sub-Saharan Africa?”

In the economic growth process, countries in the developing world do not grow by making more of the same. In fact, “more of the same” is not the way rich countries grow either. In the process of economic growth, countries change what they do. They change what they’re good at. They evolve their comparative advantage. So while Israel used to export oranges, now they export IPOs of high-tech firms. Turkey used to export olive oil. Now they export cars and electronics. They do this because they acquire new productive capabilities; they acquire knowhow and technology that allows them to do more diverse and valuable things.

Some industries are better stepping-stones than other industries for this process. So if a country is good at producing tea or at oil extraction, these industries don’t naturally prepare it for the next thing. But there’s a much more parsimonious path if you’re moving from garments, to textiles, to toys, to electronics, and to cars, because each new industry can build on the capabilities that were acquired for the previous industry.

To analyze which industries are ripe for the next phase of growth in a country we look at how “technologically close” are those industries to the ones the country already has. We have measured the relatedness of all pairs of exported products and we can look at what products a country is already good at and what are the most related products that they have yet to develop. This has already been automated in an online tool we call the “Atlas of Economic Complexity” (Footnote 1). There you can explore any country and any industry. It is this tool that lets me say that the opportunities for further diversification into more complex products are greater in India, Thailand, Indonesia, Vietnam, Mexico and China than in most of South America or Sub-Saharan Africa.

For countries in South America and Sub-Saharan Africa, the industries in which they excel are often lousy stepping-stones for further diversification, meaning that, they require capabilities that are not easily redeployed towards other industries. For these countries, the challenge is more significant. They need policies that more consciously address the chicken and egg problems that always bedevil the diversification process.

New activities always face this chicken-and-egg problem. A country cannot make watches if it doesn’t have watchmakers. But you don’t want to become a watchmaker in a country that doesn’t make watches. Even if you wanted to become a watchmaker, you wouldn’t have other watchmakers to learn from because nobody is making watches. This requires a government that can play a smart “coordinator” role, which most governments are not set up to do.

So I believe that growth policies need to be focused on identifying new diversification opportunities and having an activist government trying to solve the coordination failures that these face. It is not about substituting for the market but to solve the market failures associated with chicken-and-egg problems that are ubiquitous in this area. The jobs of the future will be in these new industries directly and in the multiplier effect in the rest of the economy that these industries will have by demanding inputs from others or through the local spending of the incomes that they generate.

For many countries in the developing world, growth is limited by the size and dynamism of the industries that can sell goods and services abroad. This requires these industries to be competitive enough so that foreigners are willing to buy from them, given that they have so many other options to buy from. The speed at which these activities grow eventually determines the speed at which the whole economy grows.

SECTION 2: What should we do about inequality?

Key points
1. The main cause of global inequality arises from differences in productivity, across regions, across countries, across cities, within cities and between social groups.
2. In terms of income inequality at the global scale, the richest countries are 200 to 300 times richer than the poorest countries.
3. Poverty is the consequence of low productivity and this happens when people are excluded from the inputs and the networks that make them productive.
4. Modern production requires the simultaneous access to many inputs, and the absence of few inputs condemns people to low productivity. These inputs include access to physical networks such as power, water, telecoms, roads, urban transport and logistics and to social networks such as the labor market, the goods market, banks, security and social services.
5. While it would be ideal for all places to have access to all of these inputs, this is not feasible. Countries face the dilemma of placing some inputs everywhere or placing all inputs somewhere. The former strategy leads to low productivity everywhere. The latter leads to unequal non-inclusive growth.
6. The obstacle to universalizing access to productive inputs is that these face fixed costs. To make these fixed costs affordable, providing the input should generate enough additional output.
7. This leads to a poverty trap: if you are poor, it does not pay to incur the fixed cost of placing the inputs. But if you don’t have access to the inputs you will be unproductive and hence, poor.

Policy recommendations
1. Promote innovations that can lower the fixed costs faced by the inputs as is happening with mobile phones or mobile banking.
2. Develop policies that can share the fixed costs so that richer areas pay for the cost of extending the networks to poorer areas.
3. Intelligent policy making and strategy is needed to determine the inputs for which universality of access will aid economic equality.

Discussion
Inequality is the result of many different phenomena. Some of them should be a source of policy concern while others should not. My main problem is the inequality that arises from differences in productivity—namely, differences in productivity across regions, across cities, within cities and across social groups. We know that there are huge differences in income across countries of the world: the richest countries are 200 to 300 times richer than the poorest countries in per capita terms. That’s inequality at the global scale.

That is mostly caused by differences in productivity. It’s not because there’s a global pie and it is shared unequally between the rich countries and the poor countries. These are just independent pies of radically different size. At the global level, the bulk of inequality across countries is inequality in productivity.

Our research has uncovered that in the developing world, there are enormous differences in productivity within countries, across their different regions. For example, in the US, the richest state, which is probably Connecticut, is about twice as rich as the poorest state, which is either Mississippi or West Virginia. The difference is a factor of two. In Mexico, the difference between Chiapas and Nuevo León is a factor of nine. Similar differences exist between the Indian states of Bihar and Goa or between the cities of Patna and Bangalore. These differences in income are mainly differences in productivity. It’s not the result of what share of the pie goes to capital and what size of the pie goes to labor. It is differences in the sizes of the pie.

So there are these enormous differences in productivity that make the productive places rich and the unproductive places poor. The poor people are not being exploited. They’re being excluded from the higher productivity activities. It’s not that the capitalists are taking a very large share of what they produce. It’s just that they produce very little in the first place.

Many of those that worry about inequality blame capitalism for it. Even Pope Francis has been framing the issue in this way. Now, let’s define capitalism the way Karl Marx did. It is a mode of production where some people own the means of production and others work as wage laborers for them. But if this is the case, capitalism hires 8 out of each 9 workers in the USA, 2 out of 3 in Nuevo Leon, 1 out of 7 in Chiapas and 1 out of 19 in India. Places where more of the labor force works for capitalist firms are richer, because capitalist firms allow for much higher productivity.

Poor places are characterized by the absence of capitalist firms and by self-employment, employment: these are small peasants and farmers or owners of small shop. In these settings, there are no wages, there’s no employment relationship. There are no pensions. There is no unemployment insurance. The trappings of a capitalist labor market do not exist.

While Marx thought that capitalism, as a form of organizing production, would take over the world, poor countries and regions are characterized by the absence of capitalism, of capitalist forms of production.

So the question we should ask ourselves is why did capitalism not succeed in these regions, leaving huge differences in productivity between the places where it succeeded and the places where it did not? The answer we have found is that modern capitalist production requires the simultaneous access to many different inputs.

For example, let’s look at Harvard Kennedy School: to operate, it needs electricity and access to the Internet. It needs an urban transportation system for its diverse staff to be able to go to work. It needs the ability to hire a faculty with very different talents, so as to produce what we produce. The lack of any one of these inputs has disastrous consequences. The day the lights go out, the school cannot operate. The day the Internet goes out, our productivity suffers: students will not know what to read for what courses, which events to attend, and we wouldn’t be able to do any research.

So access to all these inputs is necessary for productivity to happen. Absence of any one of these inputs has devastating effects. So this characteristic of modern production means that for places to be productive, they have to have everything.

The conditions for high productivity are very hard to achieve everywhere, but much easier to achieve in a few places. So governments are faced with the dilemma between concentrating all the inputs in a few places, and then getting the benefits of that concentration but also the inequality between those areas and the rest of the country, or trying to be very democratic in assigning inputs—say, electricity in a few places and roads in other places and internet access in some other places. Then no place has everything and if no place has everything, modern production becomes impossible everywhere.

I think that the deep underlying reason for this dilemma is the presence of increasing returns to the inputs. What do we mean by that? Simply that the cost structure of the input involves some fixed cost and then some variable costs. Consider each time we connect a house to the water network, the electricity network, the urban transport network, the road network, the educational system network, the labor market, or the banking system. All of these require someone to pay a fixed cost of connection. The fixed cost may be the copper wire or the pipes or the road that hooks up your home to these networks, the bus line that goes by your home, the accessibility to a labor market that you can go to work in and get back home in the evenings. These fixed costs are independent of whether a household is going to consume 100 kilowatts, 1000 kilowatts, or 5000 kilowatts [of electricity], or whether it’s going to consume 10 liters of water, 50 liters of water, or 1000 liters of water.

Then there’s a variable cost. That depends on how many kilowatts you consumed or how much water you consumed. But first you have to put in the wire or you have to put in the pipes or you have to build the road.

These fixed costs create increasing returns because the more you consume, the cheaper is the total cost per unit. Paying for these fixed costs becomes a headache because if somebody is expected to be poor, you don’t want to open a bank account for him because the fixed cost of opening a bank account is not going to be recouped through the little money or the few transactions that a poor person is going to make. So banks decide not to include the poor. The same thing happens with other services: if you are going to consume very few kilowatts or kilobytes, it doesn’t pay to connect you and if your expected wage is low relative to a bus ride, it does not pay to commute to work. As a consequence, this generates a trap in which you don’t connect people because they’re poor and because they’re not connected, they’re unproductive and hence poor.

This is a fundamental dilemma that needs to be addressed if we are to tackle the inequality problem and I think it is an issue that hasn’t been sufficiently emphasized.

There are two classes of solutions to this problem. The first one is that some technological innovations might reduce those fixed costs and if the fixed cost is reduced, more people can be included. For example, in India today, cell phone penetration is upwards of 80 percent. Landline penetration is, on the contrary, two percent. Why would this be the case? It’s not because landlines are a more recent technology that has not had the time to diffuse. It is because the fixed cost of connecting a home to the landline network is much higher than the fixed cost of buying a cell phone. As a consequence, cell phone technology diffused at light speed while landlines have not diffused. In fact, cell phones have a larger penetration than piped water, which covers less than 50 percent of the population. So technologies diffuse when the fixed costs are low and if technologies can be invented to lower these fixed costs, it facilitates diffusion.

Lowering the fixed cost was also the idea behind micro lending. Traditional banks don’t give small loans because the fixed cost of processing them is too high and would require unaffordable interest rates. So they exclude the customers that would have required a small loan, mainly the poor. Innovations in micro lending are all about reducing that fixed cost of lending, through ideas such as group lending. Mobile banking might allow us to further reduce these fixed costs.

The alternative to a technological solution is to have a policy that shares the fixed cost. A good example comes from the U.S. The Continental Congress in 1775, a year before the Declaration of Independence, decided to create a U.S. post office. They decided to put a post office in every incorporated city in the US. The postal system was the Internet of its time. They decided to pay collectively for that system and to have a flat rate so that any place within the country could communicate with any other place within the country. That is an example of sharing the fixed cost. Had it not been designed that way, small or poor towns would have been excluded and everybody else would have lost the opportunity to communicate with them. We can paraphrase the policy as saying: “We want a network where everybody is connected and we will use policy to make sure it happens.”

So policies can be very important in determining the universality of access to some inputs. I think it’s very important to have a serious discussion of what are these inputs that need to be accessed universally and what is a reasonable strategy to get there.

SECTION 3: How should we prevent the next financial crisis?

Key points
1. Learning from past financial crises is difficult because the rapid evolution of new financial instruments makes each crisis different.
2. The price of financial stability is eternal vigilance.
3. Countries in Latin America have learned from past financial crises but may have made their banking systems too safe.

Policy recommendation
1. There must be a balance between regulating the economy so as to prevent future financial crises and making it so excessively regulated that it affects the availability of finance.

Discussion
Financial crises are a bit like airplane crashes. Airplanes, and banks, operate well most of the time. But every so often they crash with very bad consequences and our strategy is to do a forensic study of the last crash, see what we learn, and incorporate that learning into the system so that we might prevent the recurrence of the same kind of crash. In aviation, that has made air travel incredibly safe, to the point that, right now, the Civil Aviation Board does not only analyze crashes but they also analyze “near misses” because there are so few crashes that it’s very hard to keep on learning. So near misses are a way to reduce the likelihood of bad things happening that have not really happened.

Banks are different from airplanes in that innovation in banks is happening much faster than innovation in airplanes. So every time there’s a financial crisis, the financial instruments that cause the problem did not exist at the time of the previous crisis. We have never had a repetition of a financial crisis that looks just like the last one.

So the 2008 financial crisis involved subprime mortgages that were packaged into asset-backed securities that were rated in a particular way. The previous banking crisis in 1998, the LTCM crisis, involved highly leveraged hedge funds (Footnote 2). The financial crisis in 1980s involved Savings and Loan entities. Every time the airplane that crashes is a completely different airplane and we fix that airplane that crashed, but the one that crashes next is a completely different airplane that was not even in existence at the time of the previous crash. Applying to financial crises the same strategy we apply to airplanes exposes us to the novelties in finance catching us by surprise through crises of types that have never occurred in the past. One of the founding fathers of the United States, Thomas Jefferson, said that the price of freedom is eternal vigilance and I would say that the price of financial stability is eternal vigilance.

I come from Venezuela. I finished my Ph.D. in 1981 just in time for the 1982 Mexican debt crisis that became the Venezuelan debt crisis in February 1983. That opened up a whole so-called “lost decade” of growth in Latin America because of the consequences of that financial crisis. There was a sequence of other financial crises around 1994, triggered around the so-called Mexican Tequila crisis. There was another financial crisis around 1998, triggered by the Russian crisis and its financial contagion. There was yet another sequence of financial crises around 2001-2002 in Argentina, Uruguay, and Turkey.

So while the 2008 financial crisis is the signal event of the U.S. post-war economy, financial crises of an order of magnitude greater are a much more common event in the countries that I have been looking at.

So for those countries, there is an enormous benefit in running their economy in a much safer way and I think that’s a lesson that most countries in Latin America have followed. Most of them are now investment-grade. Most of them have very hefty levels of international reserves. Most of them regulate their banking systems with enormous care.

If anything, they probably have made their financial systems too safe in the sense that there is not enough risk-taking in the system and bank lending to firms is highly restricted. The regulations make it safer for a bank to lend to a household to buy a Mercedes Benz than it is for a bank to lend working capital to a medium-sized firm.

I think that from a Latin American perspective, we really need to understand the trade-off between making sure that there is no financial crisis and making sure that there is enough finance for valuable but risky projects.

FOOTNOTES
[1] The Atlas of Economic Complexity is an interactive, web-based tool that enables users to visualize a country’s total trade, track how these dynamics change over time, and explore growth opportunities for more than a hundred countries worldwide. See more at http://atlas.cid.harvard.edu/
[2] The “LTCM” crisis refers to Long-Term Capital Management, a Connecticut-based hedge fund that collapsed in the late 1990s, leading to a joint agreement between sixteen financial institutions in 1998 for a $3.6 billion bailout from the Federal Reserve.

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