Economic complexity, institutions and income inequality

NAECCésar Hidalgo and Dominik Hartmann, Macro Connections, The MIT Media Lab

Is a country’s ability to generate and distribute income determined by its productive structure? Decades ago Simon Kuznets proposed an inverted-u-shaped relationship describing the connection between a country’s average level of income and its level of income inequality. Kuznets’ curve suggested that income inequality would first rise and then fall as countries’ income moved from low to high. Yet, the curve has proven difficult to verify empirically. The inverted-u-shaped relationship fails to hold when several Latin American countries are removed from the sample, and in recent decades, the upward side of the Kuznets curve has vanished as inequality in many low-income countries has increased. Moreover, several East-Asian economies have grown from low to middle incomes while reducing income inequality.

Together, these findings undermine the empirical robustness of Kuznets’ curve, and indicate that GDP per capita is a measure of economic development that is insufficient to explain variations in income inequality. This agrees with recent work arguing that inequality depends not only on a country’s rate or stage of growth, but also on its type of growth and institutions. Hence, we should expect that more nuanced measures of economic development, such as those focused on the types of products a country exports, should provide information on the connection between economic development and inequality that transcends the limitations of aggregate output measures such as GDP.

Scholars have argued that income inequality depends on a variety of factors, from an economy’s factor endowments, geography, and institutions, to its historical trajectories, changes in technology, and returns to capital. The combination of these factors should be expressed in the mix of products that a country makes. For example, colonial economies that specialised in a narrow set of agricultural or mineral products tend to have more unequal distributions of political power, human capital, and wealth. Conversely, sophisticated products, like medical imaging devices or electronic components, are typically produced in diversified economies that require more inclusive institutions. Complex industries and complex economies thrive when workers are able to contribute their creative input to the activities of firms.

This suggests a model of heterogeneous industries in which firms survive only when they are able to adopt or discover the institutions and human capital that work best in that industry. According to this model, the composition of products that a country exports should tell us about a country’s institutions and about the quality of its human capital. This model would also suggest that a country’s mix of products should provide information that explains inequality and that might escape aggregate measures of development such as GDP, average years of schooling, or survey-based measures of formal and informal institutions.

With our colleagues from the MIT Media Lab, we used the Economic Complexity Index (ECI) to capture information about an economy’s level of development which is different from that captured in measures of income. Economic complexity is a measure of the knowledge in a society that gets translated into the products it makes. The most complex products are sophisticated chemicals and machinery, whereas the least complex products are raw materials or simple agricultural products. The economic complexity of a country depends on the complexity of the products it exports. A country is considered complex if it exports not only highly complex products  but also a large number of different products. To calculate the economic complexity of a country, we measure the average ubiquity of the products it exports, then the average diversity of the countries that make those products, and so forth.

For example, in 2012, Chile’s average income per capita and years of schooling ($21,044 at PPP in current 2012 US$ and 9.8 mean years of schooling) were comparable to Malaysia’s income per capita and schooling ($22,314 and 9.5), even though Malaysia ranked 24th in the ECI ranking while Chile ranked 72nd. The rankings reflect differences in these countries’ export structure: Chile largely exports natural resources, while Malaysia exports a diverse range of electronics and machinery (see illustration here). Moreover, these differences in the ECI ranking also point more accurately to differences in these countries’ level of income inequality. Chile’s inequality as measured through the Gini coefficient (0.49) is significantly higher than that of Malaysia (0.39)

We separated the correlation between economic complexity and income inequality from the correlation between income inequality and average income, population, human capital (measured by average years of schooling), export concentration, and formal institutions. Our results document a strong and robust correlation between the economic complexity index and income inequality. This relationship is robust even after controlling for measures of income, education, and institutions, and the relationship has remained strong over the last fifty years. Results also show that increases in economic complexity tend to be accompanied by decreases in income inequality.

Our findings do not mean that productive structures solely determine a country’s level of income inequality. On the contrary, a more likely explanation is that productive structures represent a high-resolution expression of a number of factors, from institutions to education, that co-evolve with the mix of products that a country exports and with the inclusiveness of its economy. Still, because of this co-evolution, our findings emphasize that productive structures are not only associated with income and economic growth, but also with how income is distributed.

We advance methods that enable a more fine-grained perspective on the relationship between productive structures and income inequality. The method is based on introducing the Product Gini Index or PGI, which estimates the expected level of inequality for the countries exporting a given product. Overlaying PGI values on the network of related products allows us to create maps that can be used to anticipate how changes in a country’s productive structure will affect its level of income inequality. These maps provide means for researchers and policy-makers to explore and compare the complex co-evolution of productive structures, institutions and income inequality for hundreds of economies.

Useful links

This article is based on Linking Economic Complexity, Institutions and Income Inequality, by D. Hartmann, M.R. Guevara, C. Jara-Figueroa, M. Aristarán, C.A. Hidalgo.

The Atlas of Economic Complexity

The OECD is organising a Workshop on Complexity and Policy, 29-30 September, OECD HQ, Paris, along with the European Commission and INET. Watch the webcast: 29/09 morning29/09 afternoon30/09 morning

Rio+20=0?

Click to find out more about OECD work of relevance to Rio+20

Today we publish the third in a series of articles on the OECD’s contribution to the  RIO+20 UN Conference on Sustainable Development

Many politicians “cannot resist the power of the Invisible Demons, because they Secretly Serve the Invisible Demons”, according to one comment on the Rio+20 outcome document on the blog of Kumi Naidoo, Executive Director of Greenpeace International. I had a more lurid image of Satan and his minions, but it’s true that an eternity spent affirming, acknowledging, underscoring, stressing, recognising and recalling the need for holistic and integrated approaches to this and that would qualify as a reasonable definition of Hell in most religions.  And speaking of definitions, Greenpeace’s political director Daniel Mittler described Rio+20 as an “epic failure … developed countries have given us a new definition of hypocrisy”. Other civil society organisations agree, including Oxfam, WWF, and the International Trade Union Confederation (ITUC).

How about the OECD? The document you can click on at the top of this article opens with a message from OECD Secretary-General Angel Gurría saying that 20 years on from Rio 1992, sustainable development  remains a powerful message but it still isn’t a reality. It’s unlikely to become a reality unless we start changing what can be changed now, but as Gurría points out,  “even the best policies are nothing without the political will to implement them”.

It’s not that the political will for change doesn’t exist. On the contrary, governments are always looking for new ways to develop the economy, but what we’ve seen since Rio 1992 is that economic growth on its own isn’t enough to address problems such as inequality, and it can even make environmental and other problems worse. And as we saw with Rio+20, countries at different stages of development and with different natural resources do not share a common view as to what the best policies are, even when they agree on the scale and causes of environmental degradation and climate change.

There’s also a problem of time scales and a related one of habit. It’s a bit like the character played by Marcello Mastroianni in Fellini’s 8½ (or 8.5 as the OECD Style Guide would have it). Somebody tells him about this great method to quit smoking in a fortnight. “It’s taken me 40 years to get up to two packets a day,” he replies, “So why do you think I’d want to quit in two weeks?” Our current model of economic growth has brought enormous progress to billions of people, and we’re hooked, even though the costs keep growing. Today’s technologies and ways of doing things will be expensive and difficult to replace, and many of the benefits may not appear for some time, or be so diffuse that the impact on individual people (or businesses) may not be very noticeable. The effects of the crisis and anything that would slow growth are, however, immediate.

The OECD proposes green growth as a way to meet the challenges. A report prepared with the World Bank and UN for the G20 summit that preceded RIO+20 starts from the fact that structural reform agendas exist already, so green growth and sustainable development policies could be incorporated into them. The main elements of a “green” policy package are those of any structural reform – investment, tax, regulation, innovation and so on, but the report is accompanied by a toolkit of policy for different national situations. For example in many OECD countries, the main energy issue may be reducing greenhouse gas emissions, whereas in a developing country, access to electricity supplies may be the priority.

The report provides a good overview of the main questions, but even if you’re familiar with the subject, take a look at the last section on the strengths, weaknesses and conditions for using the various market-based policies and non market-based policies, for example if you want to compare taxes on pollution with stricter technology standards.

Finally, what do you think Rio+40 will be? A shout of triumph or a cry of despair?

Useful links

OECD’s contribution to Rio+20

OECD work on green growth

OECD Economic Outlook: Global economy weakening

In today’s post, OECD Chief Economist and Deputy Secretary-General Pier Carlo Padoan talks about the Economic Outlook, released today

In your baseline scenario, GDP growth across the OECD countries is projected to slow from 1.9% this year to 1.6% in 2012, before recovering to 2.3% in 2013. In some economies, especially the euro area, a mild recession is projected in the near term. Why are you so pessimistic?

The global economy has deteriorated significantly since our previous Economic Outlook. Advanced economies are slowing and the euro area appears to be in a mild recession. Concerns about sovereign debt sustainability in the European monetary union are becoming increasingly widespread. Recent contagion to countries thought to have relatively solid public finances could massively escalate economic disruption if not addressed. Unemployment remains very high in many OECD economies and, ominously, long-term unemployment is becoming increasingly common.

Emerging economies are still growing at a healthy pace, but their growth rates are also moderating. In these countries falls in commodity prices and slower global growth have started to mitigate inflationary pressures. More recently, international trade growth has weakened significantly. Contrary to what was expected earlier this year, the global economy is not out of the woods.

What factors underpin this assessment?

Deleveraging in the financial and government sectors remain with us. Likewise, imbalances within the euro area, which reflect deep-seated fiscal, financial and structural problems, have not been adequately resolved. Above all, confidence has dropped sharply as scepticism has grown that euro area policy makers can deal effectively with the key challenges they face. Serious downside risks remain in the euro area, linked to the possibility of a sovereign default and its cross-border effects on creditors, and loss of confidence in sovereign debt markets and the monetary union itself.

Another serious downside risk is that no action will be agreed upon to counter the pre-programmed fiscal tightening in the United States, which could tip the economy into a recession that monetary policy can do little to counter.

If this is the “baseline” scenario, are the others?

Alternative scenarios are possible, and may be even more likely than the baseline. A downside scenario would be characterised by materialisation of negative risks and the absence of adequate policy action to deal with them. An upside scenario could arise if policy action were successful in boosting confidence and no significant negative events occurred.

In the downside scenario, the implications of a major negative event in the euro area depend on the channels at work and their virulence. The results could range from relatively benign to highly devastating outcomes. A large negative event would, however, most likely send the OECD area as a whole into recession, with marked declines in activity in the United States and Japan, and prolong and deepen the recession in the euro area.

Unemployment would rise still further. The emerging market economies would not be immune, with global trade volumes falling strongly, and the value of their international asset holdings being hit by weaker financial asset prices.

What would be required for an upside scenario to materialise?

A credible commitment by euro area governments that contagion would be blocked, backed by clearly adequate resources. To eliminate contagion risks, banks will have to be well capitalised. Decisive policies and the appropriate institutional responses will have to be put in place to ensure smooth financing at reasonable interest rates for sovereigns. This calls for rapid, credible and substantial increases in the capacity of the European Financial Stability Facility together with, or including, greater use of the European Central Bank’s balance sheet. Such forceful policy action, complemented by appropriate governance reform to offset moral hazard, could result in a significant boost to growth in the euro area and the global economy.

An upside scenario also requires substantial and credible commitment at the country level, in both advanced and emerging market economies, to pursue a sustainable structural adjustment to raise long-term growth rates and promote global rebalancing. In Europe, such policies are also needed to make progress in resolving the underlying structural imbalances that lie at the heart of the euro area crisis.

Deep structural reforms will be instrumental in strengthening the adjustment mechanisms in labour and product markets that, together with a robust repair of the financial system, are essential for the good functioning of the monetary union. By raising confidence, lowering uncertainty and removing impediments to economic activity, rapid implementation of such reforms could raise consumption, investment and employment.

If combined, stronger macroeconomic and structural policies might raise OECD output growth by as early as 2013. The largest benefits would be felt in the euro area, though these could take some time to emerge. Stronger activity and trade, and the consequent rise in asset values in the OECD economies, should boost activity in the emerging market economies as well.

What is your advice to policy makers?

In view of the great uncertainty policy makers now confront, they must be prepared to face the worst. The OECD Strategic Response identifies country-specific policy actions that need to be implemented if the downside scenario materialises. The financial sector must be stabilised and the social safety net protected; further monetary policy easing should be undertaken; and fiscal support should be provided where this is practical. At the same time, stronger fiscal frameworks should be adopted to reassure markets that the public finances can be brought under control.

The difference between the upside and the downside scenarios reflects the impact of credible, confidence building policy action. Such action, as we have seen, requires measures to be implemented at the euro area level as well as at the country level throughout the OECD, especially in the structural policy domain. In the case of a downside scenario, policy action would clearly be needed to avoid the worst outcomes. But then the question arises of why policy efforts are not taken to deliver the upside scenario even if the worst case does not materialise. Why, in other words, should we settle for less?

Useful links

Country summaries from the Economic Outlook

The Chief Economist’s presentation