By Shreya Bajaj

Edited by Liz Maria Kuriakose, Associate Editor, The Indian Economist

Convergence or ‘catching up’ effect is a theory speculating that, all economies in time will converge in terms of per capita income since poorer economies tend to grow more rapidly than wealthier economies. In other words, the poorer economies will literally “catch-up” to the more robust economies.

Neoclassical growth theory establishes a presumption that countries with access to identical technologies should converge to a common income level. Neoclassical theory relied heavily on the concept of diminishing returns.

If there are diminishing returns, then a poor economy, an economy with a very small amount of capital, will tend to have a large marginal product. If the poor economy tends to have large marginal product, this means that poor economy will tend to grow very fast.

Therefore, an important test was to see whether it is true that poor countries grow faster than rich countries or that inequality across countries gets smaller and smaller. When a poor country grows faster than a rich economy we say there is beta convergence’ and when wealth differences diminishes among countries, then we say there is ‘sigma convergence’.

If we look at the world, we immediately see that it is not true that poor countries grow faster. In fact there is no relation whatsoever between how a poor country is and how fast it grows. We see a lot of countries, such as in Africa, which are not only very poor but have the lowest growth rates in the world and other countries that are growing very fast, for example Indonesia over the last 40 years. We see rich countries growing quickly and very well; in other words, there is basically no relation between the growth rate and the level of income of a country.

Moreover, if you compute inequality at a world level with countries as units, you see that this inequality is rising over time. This we can see in figure 7.1 which shows that over time, if we take every country as one data point, compute the standard deviation of the logarithmic of income of each country for every year and plot it over time, the variance grows continuously.

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Empirical work has not been very kind to this proposition. There is no tendency for poor countries to grow faster than rich ones, over any reasonably long time horizon for which we have data.

However if we go back to the intuition that says that a poor country should grow faster according to the neoclassical theory, you will see that implicitly we made the assumption that all countries invest the same amount. In other words, the fact that there are diminishing returns mean that if you invest one unit of capital in a poor country, it will generate huge growth if the country has a low capital. Of course, the total amount of growth the country will get depends not on only how much one unit of capital delivers but how many units you actually invest. You might have a huge marginal product and a very small investment, in which case the growth rate will not be very high. In other words, in order to test the theory we not only want to see how poor countries grow relative to rich economies, but how poor countries grow relative to rich countries conditional on how much they actually invest. Hence the regression we used should not be univariate rather multivariate regression that holds constant, for example, the savings rate.

Once we introduce this concept of conditional convergence, most data sets that people have analysed in the world delivers the strange answer that actually neoclassical theory is more consistent with the data and cannot be easily rejected. This can be tested with various methodologies. One is to look at economies that appear to invest more or less the same amount, has more or less the same technology, to approach more or less the same steady state. In this category we can put the studies related to European regions.

The most important concern of the economists is welfare of the people around the world. The lack of convergence implies the world is becoming a more unequal place. If we observe figure. 7.1, we see that if we take countries as units, inequality across countries have increased over time. We have seen that the ratio of GDP for the five richest countries relative to the five poorest countries in 1960 was 35. This ratio computed 40 years later is 65. So the ratio of rich to poor is actually growing tremendously. This is seen as a major failure of the world economic system in which we live.

Using figure 7.1 to make such statements is wrong. It is wrong because it is admissible to use countries as units when you try to test theories. It is even admissible when you want to discuss government policies but if you are worried about the welfare of the people, you should not be using countries as units. You should be using persons. If we use countries as units, then when you say poor countries are not growing faster than rich countries, you are giving same weight to China with 1.2 billion people as to Luxembourg with .5 million people. In fact if we are worried about welfare, we should take into account that when China grows at 10% or when India grows by 10%, many people in the world are actually converging to USA and Europe and are improving their welfare. Therefore we should be giving people with more countries larger weight. This is what has been done in figure 7.2. This figure shows that inequality was rising all the way in 1970s, but after 1980s, China and India began growing. China and India represent one- third of the world and when that one- third starts growing rapidly, inequalities across citizens of the world obviously go down because a lot of poor are becoming richer. Not surprisingly, we see that the world inequality, instead of going up more and more, actually falls after these two countries have started to grow rapidly. Therefore it is not true that we live in an ever more unequal world, of course one might argue that the process of growth for India and china has generated increases in inequality within these countries. Obviously, not everyone in China and India are enjoying the benefits of this growth. Therefore it is true that inequality is rising within India.

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We can actually compute the rise in inequality within countries. The studies conducted by the World Bank and other institutions show that inequality within countries is rising. But still the rise in inequality within countries doesn’t offset the decline in inequality across countries.

We see that the variance is far greater than you would imagine, because it includes the variance within countries, not only across countries. We see that inequality grows all the way to 1980s and declines continuously after that.

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Hence it’s clear that if we wish to reduce the world inequality we need to ensure that poor countries grow faster than focussing on reductions of within country inequality, moreover when we induce big, poor countries to grow, inequality at the world level declines. Therefore the next step is to bring the billion people living in poorest countries in the world, up to the levels of Europe and to have them grow as fast as possible for the next few decades. If we can do that the world inequality will actually decline.

Shreya Bajaj is currently pursuing B.A hons. Economics from Jesus and Mary College, Delhi University. She is currently working hard to improve her research skills and learn something new each day. Her main area of interest is analysing current economic issues.

Posted by The Indian Economist | For the Curious Mind