Why are some poor countries still poor? A technological reason...

I was mistaken in my blog entry yesterday. Professor Ricardo Hausmann did not gave a talk in the afternoon on his discovery theory, but something else that is also very related: product space. In addition to what has been shared in my previous post, the products space is one way of explaining why poor contries continue to be poor and failt to converge to the income levels of rich countries. It is based on a standard notion that what a country produces matter for subsequent economic performance because industrialization creates spillover benefits that fuel subsequent growth.

In the history of mankind, new products are created out of raw materials, and then newer, more sophisticated products are likewise created from these previously created products. This and other possible factors cause one product to be related to another. Obviously, only rich countries specialize on these more sophisticated products, whereas poor countries can only produce less-sophisticated ones. And so, this is where Professor Hausmann, Cesar Hidalgo, Bailey Klinger, and Albert Lazlo-Barabasi point out the answer to the question posed by the title. The network of relatedness between products (the product space) show that more-sophisticated products are located in a densely connected core whereas less sophisticated products occupy a less-connected periphery. Poorer countries tend to be located in the periphery, where moving toward new and more sophisticated products is harder to achieve.

Much entertained and enlightened by Professor Hausmann's talk, he ended his discussion of product space by pointing to the consequences for economic policy. As the product space can show, as well as several case studies, it is difficult for production to shift to products far away from the periphery, where poor countries find themselves. The challenge really is to identify correct government policies that would help the country make large jumps toward that space where more sophisticated products lie. As mentioned in my previous post, this may involve encouraging entrepreneurship and investment in new activities, as well as push out unproductive firms. For Professor Hausmann and his colleagues, it is precisely these long jumps that generate subsequent structural transformation, convergence, and growth.

Professor Hausmann's work makes a huge economic sense. My only reservation is that it seems this whole product space concept centers on tradeable goods. What about the sophistication level of non-tradeable goods? What about much of the service sector? Human capital? Although we can easily argue how tradeable goods are likewise related to non-tradeable goods (sophisticated computers breeds smart computer geeks), it would give a more complete picture if they show how services come into play. As the case of the Philippines would show, for example, one particular good has helped push the country's growth rate upwards and it's not "tradeable"--overseas workers.

If you need more technical details about what product space is and how it's done, check Cesar Hidalgo's excellent website.

A talk with Ricardo Hausmann

Ricardo Hausmann, Director of the Center for International Development in Harvard University, visited the Asian Development Bank (ADB) to present his latest research on development as a process of learning to produce and export sophisticated products. He first met with the economists before lunch time, and I indulged myself in listening to the excellent development economist.

I have not particularly seen the actual paper or presentation itself, but I recon that it is related to Professor Hausmann's 2005 paper with Jason Hwang and Dani Rodrik ("What you export matters," CID Working Paper no. 123, December 2005, Harvard University Center for International Development), which is driven by his earlier work with Professor Rodrik in 2003 ("Economic development as self-discovery," Journal of Development Economics 72: 603-33; an earlier NBER version can be downloaded here). Basically, it's not enough that countries should promote policies that would increase access to foreign trade and investment and imported capital equipment and intermeiate goods (access to state-of-the-art technologies) as well as secure property rights (good governance). Learning what one is good at in terms of which products to produce is an equally important determinant of structural change. Some traded goods are associated with higher productivity levels than others and that countries that latch on to higher productivity goods will perform better. This process of product specialization involves entrepreneurs exploring and discovering the underlying cost structure of the economy.

The problem is is that this discovery process is unlikely to be adequately provided under laissez-faire. As Professor Hausmann's 2003 paper notes:

"... [L]aissez-faire leads to underprovision of innovation. Governments need to play a dual role in fostering industrial growth and transformation. They need to encourage entrepreneurship and investment in new activities ex ante, but push out unproductive firms and sectors ex post."

Professor Hausmann didn't actually discussed much about his presentation, but opened the forum for questions regarding any of his latest research. Among which is his work on growth diagnostics. His most significant insight was how it relates to the Washington Consensus. Coined by John Williamson in his 1990 work, "Latin American Adjustment: How Much Has Happened?" (Washington: Institute for International Economics), the Washington Consensus is a list of ten policy reforms he suggested as needed for Latin American countries hit by the debt crisis of the 1980s:

1. Fiscal discipline
2. Reordering public expenditure priorities
3. Tax reform
4. Liberalizing interest rates
5. A competitive exchange rate
6. Trade liberalization
7. Liberalization of inward foreign direct investment
8. Privatization
9. Deregulation
10. Property rights

So, Professor Hausmann mentioned that each of these are well and good, and may actually result to positive outcomes to countries. His whole point, however, is obvious in the title. Williamson meant for these reforms to be applied to Latin America only. So Professore Hausmann, like other economists, was surprised that multilateral agencies such as the World Bank and the International Monetary Fund adopted the Washington Consensus as the generic solution to all economic problems faced by developing nations. Professor Hausmann stressed that these policy recommendations have to be taken into context. What is really needed is to sit down, ask specific questions to a development country, and get down to the details on what is actually going wrong. And so the growth diagnostic literature is born.

For a retrospective view of the Washington Consensus, here's what John Williamson himself has to say.

Introducing the product space

Ever heard of product space? It's one of the new frontiers in the field of international trade and economics spearheaded by Ricardo Hausmann, Cesar Hidalgo, Bailey Klinger, and Albert Laszlo-Barabasi. It basically tries to map a country's endowments and technology, and shows where the country's comparative advantage lie (in terms of products) and where the country is currently situated in vis-a-vis its comparative advantage. One very interesting finding is that based on this new form of analysis, they find that the way countries develop comparative advantage is far from random, and that there might exist a lack of convergence in international income levels given the structure of the product space. Still developing countries might find themselves in the outer periphery of the product space with few opportunities for diversification, whereas other better-off countries find themselves near the central core of the product space and have developed capabilities easily deployable in a wide range of products, creating a path to convergence.

Wikipedia's entry on Ricardo Hausmann provides a simple analogy that would give you a picture of what product space is:

"Think of a product as a tree and the set of all products as a forest. A country is composed of a collection of firms, i.e., of monkeys that live on different trees and exploit those products. The process of growth impliesmoving froma poorer part of the forest, where trees have little fruit, to better parts of the forest. This implies that monkeys would have to jump distances, that is, redeploy (human, physical, and institutional) capital toward goods that are different from those currently under production. Traditional growth theory assumes there is always a tree within reach; hence, the structure of this forest is unimportant. However, if this forest is heterogeneous, with some dense areas and other more-deserted ones, and if monkeys can jump only limited distances, then monkeys may be unable to move through the forest. If this is the case, the structure of this space and a country’s orientation within it become of great importance to the development of countries."

It's actually a very exciting and interesting new field, and it surprisingly has economic sense. Too bad though, as Niny Khor of the Asian Development Bank mentioned, much still needs to be done in terms of its theoretical foundation. But the fact that it is built upon the basic models of international trade, it won't be long before a firm and strong theory will come out and support the product space field.

In the meantime, you can check Cesar Hidalgo's excellent website for a snapshot of what a country's product space would look like...as well as his other materials on this subject.