Catchingup

The implication of the theory is that countries will be rich if they do not constrain pro­duction units as to which technologies can be operated and the manner in which a given technology can be operated.

5.1. Catch-up facts

Catching up is not uniform across regions, as can be seen in Figure 1. Latin American countries began modern economic growth in the late nineteenth century, and this set has not subsequently closed the living standard gap with the industrial leader; the per capita income of this set remained at roughly 25 percent of the industrial leader throughout the twentieth century. In comparison, Asian countries with the exception of Japan began modern economic growth later. This set of countries experienced significant catch-up in the last half of the twentieth century.

The large Western European countries, namely, Germany, Italy, and France, caught up to the industrial leader in the post-World War II period after trailing the leader for 100 years. Modern economic growth in these countries began about 1840. At that time, their living standard was about 60 percent of the industrial leader, which at that time was the United Kingdom.

Another important example of catching up is the U.S. development experience in the 1865-1929 period. In 1870, U.K. per capita GDP was nearly a third higher than that of the United States. By 1929, the United Kingdom’s per capita GDP was a third lower than that of the United States. The dramatic growth performance of the United States in this period is an important fact that needs to be explained.

5.2. Reasons for catching up or not catching up

5.2.1. TheUnitedStates

We begin with the question of why the United States caught up with and surged past the United Kingdom in the 1865-1929 period. Our answer to this question is that the United Sates was and continues to be a free trade club, while the United Kingdom was not a member of a free trade club in this earlier period. Our definition of a free trade club is as follows. A set of states constitutes a free trade club if it meets two conditions. Member states cannot impose tariffs and other restrictions on the import of goods and services from other member states. In addition, member states must have a considerable degree of economic sovereignty from the collective entity. Just as no single state is able to block the movement of goods between states, the collective entity cannot block the adoption of a superior technology in one of its member states. Thus, a free trade club in our definition is far more than a set of countries with a free trade agreement.

The 50 United States certainly satisfy these two conditions, and thus, are a free trade club. The individual state governments have a considerable degree of sovereign power over the federal government. Additionally, the interstate commerce clause gives the fed­eral government the right to regulate interstate commerce and prevent individual states from imposing tariffs and other restrictions on the import of goods and services. With the formation of the North American Free Trade Agreement and the recent approval of the free trade agreements with Chile and Singapore, the set of states constituting the free trade club to which the United States as a whole belongs may be getting larger.^[272]

A free trade club, which prohibits individual states from discriminating against the goods produced in other member states and against producers from other member states operating within their borders, has the advantage that industry insiders in the various member states face elastic demand for what they supply. As a consequence, they are not hurt by the adoption of more efficient production methods as the increase in output leads to an increase in the employment of the factor they supply in that industry. If demand were inelastic, an increase in efficiency would lead to a fall in employment, something that industry insiders would strongly oppose.^[273] Thus, a free trade club provides less incentive for groups of factor suppliers to form insider groups and block the adoption of more efficient technologies.

A free trade club need not be composed of individual democratic states, as is the case with the United States. However, in democratic states with legislatures representing districts, vested interests in other districts have a limited ability to block the adoption of technology in a given district if the citizens of the given district want that technology adopted. In the United States, for example, Toyota was able to locate an automobile plant with its just-in-time production in Kentucky in 1985.

5.2.2. WesternEurope

Western Europe caught up to the United States in terms of labor productivity in the 1957-1993 period for the same reason. With the creation of the European Union, West­ern Europe became an equally important free trade club. Its states enjoy even greater sovereignty than do U.S. member states. The German state cannot block the Toyota in­troduction of just-in-time production in Wales even though German politicians would if they could in response to domestic political pressure. If Toyota starts gaining mar­ket share, it will not be long before the auto industry throughout Europe adopts the superior technology, and productivity in the automobile industry increases. This is just competition at work.

The historical statistics lend strong empirical support to the theory that a trading club arrangement results in greater efficiency of production. Table 4 reports labor produc­tivity defined as output per work hour for the original members of what became the

Table 4

Labor productivities of European Union members as a percentage of U.S. productivity³

^aThe prewar numbers are population weighted labor productivity numbers from Maddison (1995). The postwar numbers are also population weighted and were obtained from Maddison’s Web page, http://www.eco.rug.n1/GGDC/index-series.html#top.

European Union and the labor productivity of members that joined in the 1970s and 1980s. Productivities are reported for an extended period before the EU was formed as well as for the period subsequent to its creation.

The Treaty of Rome was signed in 1957 by Belgium, France, Italy, Netherlands, Luxembourg, and West Germany to form the union. In 1973 Denmark, Ireland, and the United Kingdomjoined. In 1981 Greece joined, followed by Portugal and Spain in 1986. They were followed by Austria, Finland, and Sweden in 1995. In 2004, the EU was expanded from 15 to 25 countires as Cyprus, the CzechRepublic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Sloveniajoined.

One striking fact is that prior to forming the European Union, the original members had labor productivity that was only half that of the United States. This state of affairs persisted for over 60 years with no catching up. However, in the 36 years after forming what became the EU, the Treaty of Rome signers caught up with the United States in terms of labor productivity. The factor leading to this catch-up is an increase in the ef­ficiency with which resources are used in production. Changes in capital/output ratios are of little significance in accounting for the change in labor productivity.³² Productiv­ity of the EU countries that joined in 1973 has also been catching up to the U.S. level since these countries joined the EU.

Another interesting comparison is between the productivity performance of the set of original EU members and the set of Western European countries that either joined in 1995 or still have not joined the EU. This latter set consists of Switzerland, Austria,

32

See Prescott (2002).

Table 5

Labor productivity of other Western European countries as a percentage of original EU members^a

^aThe prewar figures are from Maddison (1995).

Finland, and Sweden.^[274] We label this set of four countries the others. Table 5 reports labor productivities of the others to the original EU countries.

The important finding is that the original EU countries and the others are equally productive in the pre-World War II period. In the 36 years from 1957 to 1993, the others fell from 1.06 times as productive as the original EU countries to only 0.81 times as productive in 1993. This constitutes strong empirical evidence that membership in the EU fosters higher productivity.

If history is any guide, the 10 newest EU members will narrow the productivity gap with the original EU members and the United States. Some of these countries such as the Czech Republic, Hungary, Poland, and Slovakia, have a considerable amount of catch­ing up to do. Maddison (2001, p. 337) estimates that their per employee GDP, which is a good proxy for productivity, was about 40 percent of Western Europe in 1998. Others do not. Cyprus, Malta, and Slovenia, already have relatively high GDP per capita and have little catching up to do. They are all small countries that are highly economically integrated with Western European states and have been de facto members of the Western European trading club for a number of years. Countries that are economically integrated with other sovereign states can be rich, even if no formal treaty exists.

5.2.3. LatinAmerica

Latin American countries failed to catch up because they have failed to develop into a free trade club. For this reason, Latin American per capita income has remained at the same level relative to the leader for the last century. There is no free movement of goods and people between the set of relatively sovereign states. A consequence of this is that often industry insiders in the sovereign states face inelastic demand for their products or services, and this leads them to block the adoption of more efficient production prac­tices. IfLatin American countries were to decentralize and restrict the authority of their central governments to be like the United States in the 1865-1929 period, then they too would quickly become as rich as Western Europe and the United States, or maybe richer.

5.2.4. SoutheastAsia

The reasons for catch-up in Asia are slightly more involved. Countries such as South Korea, Taiwan, and Japan were forced to adopt policies that did not block efficient production as a condition for support from the United States. Further, the need to finance national defense made protecting those with vested interests in inefficient production too expensive to South Korea and Taiwan. These development miracles along with the Hong Kong and Singapore growth miracles made it clear to the people of the democratic states in the region that the policy that their elected representatives followed mattered for their living standard. Their elected representatives had no choice but to cut back on protecting industry insiders with vested interests in inefficient production or be voted out of office.

5.2.5. China

The recent catching up done by China is primarily a result of it becoming a free trade club. The rapid development of China began in 1978 when the Chinese government became more decentralized, with much of the centralized planning system dismantled. Although the central government gave more power to regional governments, it did not give the regional governments the right to restrict the flow of goods across regions. In fact, when individual regions attempted to erect trade barriers in the late 1980s and early 1990s, the central government immediately took steps to restore the free flow of goods and services.³⁴ The resulting competition between businesses in various provinces led to rapid growth in living standards.

5.2.6. Russia

While China’s performance since its transition to capitalism has been spectacular, the same cannot be said for Russia’s performance since its transition to capitalism. Whereas China has closed some of its income gap with the leader, Russia has fallen further behind the leader. Between 1985 and 1998, Russia’s per capita GDP fell from 30 percent to 22 percent of the U.S. level. [See Heston, Summers and Aten (2002, p. 62).] Why has Russia failed to catch up to the leader following its switch to capitalism?

34

See Young (2000).

Russia is not a free trade club and does not belong to a free trade club. It is not economically integrated with Western Europe. It is large enough both in terms of popu­lation and land that its regions could make up a free trade club. However, this is not the case. Local and regional governments in Russia have the power to discriminate against producers from other member states operating within their borders and to restrict the flow of goods and people into and out of their region. For example, in response to the financial crisis of August 1988, regional governments prohibited exports of food goods from their regions and put in place price ceilings for many of those items. Regional governments further have the discretion to use federal funds for purposes they see fit. Often, these funds are used to keep inefficient industries afloat. Local governments also have control over the use and privatization of land. There are essentially no land and real estate markets. In general, the purchase of land and the conversion of nonindustrial structures for new commercial activity are not possible. During the privatization phase, local governments refused to lease any property that had not been used commercially.^[275]

6.