Falling into the Middle Income Trap

The Problem of Observing “Growth”

Growth: The Holy Grail

Why some countries grow while others stagnate is perhaps the most important question in all of economics.  Part of the allure of this question comes from the continuing challenge of countries to attain economic growth, as well as the fact that the path to growth appears to change. Indeed, growth paths have not been self-sustaining in many countries over the past 40 years, and plateaus after certain thresholds of per capita income have been attained. This phenomenon has been observed in nearly every region of the world and at every income level, and even the countries that had attained a standard of living above subsistence found difficulties in raising the standards of living further. Indeed, this “start-stop” growth has been the real story in economic development over the past two decades; researchers from the World Bank have dubbed this problem of fading growth for middle income countries exclusively “the middle income trap,” to distinguish it from the “poverty trap” that afflicts poorer countries.[1]

While there are many methodological issues with the “middle income trap” (MIT), there is a much more problematic methodological issue at its heart. In all of the seminal papers on the MIT, growth has been defined entirely as changes in per capita gross domestic product (GDP) or gross national income (GNI) at a highly aggregated country level. Thus, ascertaining whether or not a country is in “the trap” is entirely dependent upon the level of per capita GDP, and how long a country has been at this level of GDP relative to richer countries.  However, is GDP the proper way to even measure economic activity? Even though it is treated as Holy Writ by the media and most economic literature, it has many major failings that call into question the validity of the whole middle income trap idea. If we look beyond GDP, we may see that there are major differences in what we actually mean when we say “growth”. This reality means it’s also time to re-appraise the reality of a middle income trap.

GDP and Its Discontents

The issues with GDP are well-known, especially in relation to the fact that it is an accounting identity with many assumptions behind it that are often ignored. Perhaps the definitive take on this issue from an Austrian standpoint came from Frank Shostak in 2001, when he argued that “because the supply of goods is taken for granted, th[e GDP] framework completely ignores the whole issue of the various stages of production that precede the emergence of the final good.”  Moreover, Shostak correctly notes that the inclusion of consumption is defensible as a way to infer economic activity, but in reality it leads to “the view that what drives an economy is not the production of wealth but rather its consumption.” Thus, an attempt to “back-out” data on what is going on in an economy leads to policy prescriptions that increasing consumption will lead to growth.

Similarly, and in another context (as I argue in my book on institutions), GDP isn’t the right metric when you’re examining an economy in transition: given that a country moving from communism to capitalism is (or should be) undergoing a gigantic diminution of the state apparatus, government spending should plummet. However, using GDP as a measure of economic activity would count that loss in government spending as a “contraction,” and thus overstate the decrease in activity in the economy. Besides, and perhaps more importantly, in transition there needs to be a contraction in old, inefficient production and an expansion in new, market-based production, and this doesn’t happen overnight. Looking at GDP as a metric of activity obscures the quality of activity and investment, as well as skewing its actual direction.

Beyond GDP

But is there actually an alternative to GDP? Of course there is, but, unfortunately, other metrics that have been suggested in recent years also place the emphasis in an economy away from where it should be. For example, Michael Porter’s “social progress index” proposes to focus on “the extent to which countries provide for the social and environmental needs of their citizens” by aggregating 52 indicators across three dimensions (basic human needs, foundations of well-being, and opportunity) into an index. While, when looked at in a much more comprehensive way, an economy suffers, because of focusing on outcomes rather than activity; moreover, the hubris under some of the headings (such as “basic human needs,” which includes “ecosystem sustainability”) refers to issues that are also by-products (or in some cases inputs) to economic activity, and not actually crucial for measuring economic activity itself. These issues plague most other alternatives to GDP, including “Gross National Happiness,” the “Genuine Progress Indicator,” “the Human Development Index,” and others of that ilk.

A satisfactory alternate way of measuring an economy’s economic activity that addresses this issue has been suggested by economist Mark Skousen. Skousen’s approach, while admittedly introducing some double-counting into the tally, is instead based on looking at the intermediate goods that are utilized before final products are created. Skousen calls it “Gross Domestic Expenditures” (GDE) and proposes that regular GDP (recognizing final production) be combined with the value of intermediate sales or expenditures to form the all-inclusive measure of economic activity within a country’s borders (he uses data from the US International Revenue Service on “gross business receipts” to reach the GDE number). He thus replaces the familiar GDP formula with:

GDE =  C + GBE + G + (X-M)

Where GBE is gross business expenditures, or investment plus intermediate expenditures.

Under this formulation, Skousen finds that GDE is three times more volatile than GDP in the United States, while also properly showing the role of investment in driving economic activity forward. However, as a universal metric of growth, it suffers from some problems, the biggest being availability of standardized data across a large number of countries.

Skousen’s approach also recognizes that investment, not consumption, is what drives an economy forward (indeed, it is the only component of GDP that is encapsulated in a growth accounting framework). Newer approaches to measuring output should also focus on investment and savings, and shy away from consumption and government spending, as a determinant for country-level growth.

So Does “the Trap” Even Matter?

Bringing this discussion back to the idea of a middle income trap, with a different way of looking at “growth,” we can see that the “trap,” at least as encapsulated in the current literature, is framed incorrectly. If it is in fact investment that is the proper metric of healthy economic activity, growth is just a second-order effect, and policymakers should look at the barriers to investment (the inputs) rather than stimulate “aggregate demand” and consumption (the outputs). Indeed, if we consider investment blockages as the problem that countries are facing, the middle income trap suddenly becomes a familiar problem: too much government intervention in both the fiscal and monetary realms, combined with stunted market institutions and barriers to trade, emerge as the major explanations for low investment and, thus, slow growth.

And even if growth has been impressive in the past and now has slowed down or reversed (the true heart of the MIT argument), this too can be explained away by a focus on investment. Growth slowdowns can be traced back to diminishing marginal returns, as accumulation of capital to labor (put simply, more equipment for workers) can only take a country so far. During a period of increasing accumulation, economic gains can be brilliant, but they rarely last in the long run: eventually there aren’t enough workers to run all the existing machines.[2] The only way to upgrade then is via improved technology and increased productivity (including at the level of the individual worker); this can only be done through longer-term investment. But the incentives for this investment need to be incentives that come from the market.

In truth, the middle income trap is just another exposition of how government policy can bring an economy to ruin. It is no paradox, nor is it novel. And its solutions are the same for nearly every other economic malaise facing an economy.

[1] I. Gill and H. Kharas, An East Asian Renaissance, World Bank, 2007 is often considered a wellspring of the MIT literature.

[2] This point – made in the context of the Soviet Union by Paul Krugman and in East Asia by Alwyn Young – that “the rise in participation rates, investment to GDP ratios, and educational standards and the intersectoral transfer of labor from agriculture to other sectors (e.g., manufacturing) with higher value added per worker” can get a country to a certain level, but then it takes technological change to push the frontier even further. See Young, A. (1995). “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience,” Quarterly Journal of Economics, 110:  641-80.