On Tuesday, this column discussed the idea that the standard approach to development aid – what economist Manuel Montes calls the “international system” – actually hinders the economic progress of poor countries.
Today’s installment presents the other half of what might be considered one of those chicken-or-egg dilemmas with regard to economic development. In 1990, Robert Lucas, an economist at the University of Chicago and (a few years later) a Nobel laureate, published a landmark paper that asked a simple question: “Why does capital flow from poor to rich countries?”
What Lucas had discovered was a big flaw in neoclassical economic theory. A term like “neoclassical economic theory” doesn’t mean much to most people, but it should—it is essentially the “science” behind how the world’s economy is managed. The theory contains a number of assumptions, one of which is that if capital is allowed to flow freely between economic systems (i.e. between different countries), it will flow from richer systems to poorer ones, like water seeking its own level.
In the example studied in Lucas’ now famous paper, neoclassical theory predicted that India (based on data from the late 1980s) should have had a marginal product of capital (the return for each additional unit of capital invested, in simple terms) about 58 times higher than that of the United States. It was, however, actually lower, a paradox that is now known as the Lucas Paradox.
Despite having been known for a quarter of a century, the Lucas Paradox has so far eluded any solution and still persists; the most obvious evidence for it is the comparative current-account balances of countries. A current-account surplus represents an export of capital, while a current-account deficit represents an import of capital. Although there are a few exceptions, the poorer countries of the world are the ones that tend to have current-account surpluses, while the richer ones have deficits. For example, the Philippines presently has a current-account surplus of about $1.835 billion, while the US current-account deficit is about $98.5 billion. Some tangible examples of capital “flowing uphill” include the persistent high level of remittances and the growth of BPO activities in the Philippines—in both cases, the labor adds more capital value to the countries employing it than it returns—and the consistently high level of foreign reserves accumulated by the central bank, which is essentially an export of the country’s currency.
Economists have debated for years about what the causes of the Lucas Paradox really are, and the various explanations boil down into two basic groups. The first says that shortcomings in fundamental structures of an economy—government policies, institutional efficiency, and the factors of production (land, labor, capital, enterprise, and knowledge)—are responsible. The second says that imperfections in international capital markets, specifically sovereign risk and asymmetric information, are to blame. To understand this explanation, it is important to remember that neoclassical theory also assumes that markets naturally are perfect—function logically, to put it in different terms—in the absence of external intervention, such as price controls or regulations on trade. “Market imperfections” as a cause of the Lucas Paradox assumes that capital would be productive and have a high return in poorer countries if not for the market flaws, an argument that Lucas himself disproved in a different paper.
What this all means in practical terms is that the world economic system by design works against disadvantaged economies, and where the chicken-or-egg conundrum comes into play is whether the flawed approach to development aid discussed in the previous column—an approach that basically only addresses the results of impoverishment, not its underlying causes—is an outcome of the flawed economic theory or one of its contributing causes.
Whichever it is, the practical effect is an insidious modern form of colonialism; resources of the weaker economies are being exploited by the stronger ones. Some would undoubtedly argue that this is intentional, but that is a political assertion that makes the assumption of a high degree of competence and cooperation—some call it the “new world order”—that hardly seems justified, given the developed world’s penchant for shooting itself in the foot economically.
Instead, what the Lucas Paradox and complementary ideas like Manuel Montes’ “international system” appear to be evidence of is a fundamental flaw in the approach to economics in general: To put it in stark terms, the economic system of the world from the start of the Industrial Age has contained a self-destructive glitch; Adam Smith’s Wealth of Nations contained an error in the grand code, which we have yet to find, and which has compounded itself through the years. It will continue to do so in spite of grand ideas like the upcoming Asean integration and other large-scale trade agreements, the Basel accords on banking regulation, and whatever “development orthodoxy” is developed to replace the disappointing Millennium Development Goals until some brave, bright minds are willing to drop neoclassical assumptions and seek another path.