Tuesday, March 31, 2009

Why are the poor, poor?

Economists have tried to determine the reason some countries are wealthy while, relatively speaking, others are poor. They have eliminated a number of reasons that at first seem very logical.

1. Endowment of natural resources.
2. Quality of government and rule of law

However one major flaw is that studies comparing the endowment of natural resources compare current day reserves of resources currently in demand. If they had instead compared endowment of natural resources of use during the rise of agriculture some thousands of years ago, the answer may have been quite different.

I would propose that the reason some countries are poor, despite their current resource endowment, is that they were too slow to take advantage of those resources.

Consider the colonial powers of Europe during the 1600 and 1700s, namely the Dutch, German, English, the Spanish earlier on, the Italians a thousand year earlier, and the Greeks before that. The wealth of these nations grew from their own natural resources AND the quality of their government and rule of law. If there are rival tribes within a State, so many resources are devoted to war, that the accumulation of capital in the form of buildings, ship and machines is impossible.

Given time, any part of Africa could have achieved this type of emergence of civilization and wealth by developing cooperative States. In fact any less developed, or less wealthy, society could have followed this path. But there is a key reason why this did not occur.

The already wealthy European nations began trading, mostly through coercive force, with these less developed countries. Now trade itself is fine if we all start from equal positions and enter into it voluntarily, but history has shown that such ‘perfect markets’ are rare. Often one side has a clear advantage. And so it was with European traders.

If you have zoned out from reading, now is the time to pay attention. The reason trade between the already wealthy nation and the poor nation was not going to improve the situation of each player equally is because the wealthy nations brought with them capital. That is, they had tools, ships, weapons, and all manner of goods (and the knowledge of how to build them) that could be brought to the party, whereas the poor nation merely had labour and natural resources.

Since investment in capital generates a return, the wealthy country could maintain returns on the poor country’s endowment of natural resources. If they were wise (and most were very savvy) they would reinvest in the land itself. Thus the wealthy country would continue to preserve its wealth through the ownership of land and capital of other countries.

In absolute terms, the poor country would probably become ‘less poor’, but in relative terms, the gap in wealth between the rich and poor countries would in fact grow, not diminish. This is capitalism.

However, that is not to say that such a situation is inevitable. With an improved knowledge of the nature of capitalism, the Asian Tigers have been able to adopt the same strategies as the British colonial capitalists once did. By smartly investing in capital, both domestic and abroad, they have broken this historical trend.

Even as I type, China is making moves to acquire Australia’s mineral reserves. They are seeking to begin owning the capital, the physical means of production, by acquiring large shares of mining companies. Thus, they will generate a profit stream back to China from the use of Australia’s natural endowment of resources.

The same thing happens on a domestic level. Those who inherit wealth have a distinct advantage as they preserve their wealth in capital which can generate future returns, thus reinforcing the cycle. But that is not to say that those who start life relatively poor can never prosper. If they follow the simple rule of saving their earnings on labour and investing in capital, they too can prosper.

If economists could take a history lesson and broaden their perspectives a little they would see the simple explanation for the observed divergence in wealth. Given a stable political environment, rules could be attached to foreign aid that might require a proportion of domestic reinvestment in capital works. Poor nations, desperate for foreign capital, might want to rethink the advantages of allowing foreign investment in their natural resources, and instead promote the extraction and use by government owned companies that can keep profits within the country for further reinvestment.


  1. On an interesting side note to this - I was reading "The Upside of Down" and Thomas Homer-Dixon points out that people optimistically believe the poor are growing at a faster rate than the rich i.e. 3.5% vs 2.5% and that they are catching up.

    Sounds great, but when you do the numbers the gap actually continues to widen because they poor are coming off such a low base!

    Even if the poor grow at 7% p.a. (average income) it would take 48 years before the difference would stop widening.

    Incredible! see the below link for a demonstration...

  2. Re: the last paragraph, This is when, as history has shown many times, an imperialist power (or two) intervenes via overt or covert means & replaces the said government with a more democratic, read: 'puppet like' one. Remember, when you say 'this is capitalism' to allow for the AMORAL lengths that vested interests are happy to go to in advancing their own interests. POP QUIZ: Do you know how many dollars EXXON has paid in fines for it's notorious Alaskan oil spill?

  3. Stuart,
    Clearly coercive force for financial gain is a characteristic of international trade. And yes, a stable independent government is a prerequisite of the suggestions I have made.
    The point you raise about the power of wealth (and guns) to actually buy (threaten/remove) small governments is really getting to the heart of global geo-politics (aka war - politics by other means).
    It also raises an age old question. If we want global policing of international affairs (to avoid puppet governments) who will police the police?

  4. Is that really an age old question? I'm not sure when thoughts of global policing surfaced? Surely not ages ago!

  5. Hi Stuart,

    This is the first time we have considered the policing problem globally, but civilisation has pondered the conundrum at least since the time of Plato.

    Try -