Generalising the middle-income trap

The middle income trap has recently come (back) into vogue as a theoretical construct for understanding why some countries seem to stagnate at the middle-income level. The middle-income range is relatively common among contemporary emerging markets globally, so it is not surprising that ‘trap’ discussions focus on this income bracket. But middle income trap theory also holds some very valuable lessons for development policy more generally, at all income levels. 

The middle income trap is characterised by reform stagnation. This is arguably because the institutions that are helpful for reaching middle income can actually inhibit development to upper-income status. Examples of such institutions include limited exposure to volatile international capital flows, interest rate controls to shift savings from households to firms, and electoral institutions that favour incumbents and thus promote long-term planning.

These policies tend to assist with capital deepening, which is a relatively straightforward way to achieve middle-income status. Infrastructure development and urbanisation reduce transaction costs. Investments in factories and industry allow an economy to operate more efficiently through the sheer brunt of giving labour some capital to work with.

By the time countries reach middle-income status, the gains from better utilising labour inputs by simply providing them with more capital have run out. More must be done with fixed inputs by enhancing productivity. Among other things, this requires education to improve the quality of labour. Deregulating markets and opening them to foreign firms allows competition to end struggling firms and release their resources to more productive ones. And liberalising financial markets frees up capital so it can find the highest return in the most worthwhile investments.

Each of these reforms can involve overturning an institutional arrangement that was helpful in achieving middle income. This is part of why middle-income countries, like China today, are often described as needing a ‘new growth model’.

Middle-income countries find the transition to these new growth models doubly challenging because the institutional arrangements that helped them arrive at middle-income created vested interests who benefit from the status quo. These vested interests resist changes that would see them de-throned, even if it means the country as a whole would become more prosperous. If middle-income nations cannot uproot these vested interests, they fall into the trap and stagnate.

China provides an instructive example of a country at risk of the trap. Firms that have benefited from cheap access to credit thanks to financial repression, cheap labour thanks to wage repression for migrant workers as part of the Hukou system, and easy land acquisition thanks to state control of the legal architecture, are now resisting the transition to a more liberal, competitive and consumption-driven economy.

While middle-income countries can suffer acutely from the challenge of reforming in the face of vested interests, this challenge can be found at all income levels. At numerous points throughout a nation’s development, structural reforms must be made in order to advance. These reforms see new vested interests empowered and need to be challenged in turn in the next wave of reforms down the track.

For example, Australia engaged in a range of deep structural reforms during the Fraser, Hawke and Keating administrations. These included deregulating the financial sector, floating the dollar, massively reducing tariffs and instituting compulsory superannuation as part of broader reforms to industrial relations. This did away with vested interests in the farming and manufacturing sectors who were impeding the transition to a high-income economy. But these reforms in turn empowered new vested interests in the property, finance and mining industries that now block important structural reforms in taxation and carbon pricing. Is Australia in danger of an upper-income trap?

Japan certainly seems to be. Japan has dragged its feet on a suite of reforms since the beginning of the so-called lost decades. These include pensions, agricultural liberalisation, workplace practices, female labour force participation and the labour market. Despite the potential payoffs to these reforms and ongoing economic stagnation in Japan, the political apparatus has not responded vigorously. This is at least in part because these reforms would upset vested interests among the elderly, industrial conglomerates and the Japan Agricultural Cooperatives, who rose to influence on the back of Japan’s growth model prior to the lost decades.

Across the advanced economies of Europe and in lower-income countries like India and the ASEAN nations, one hears of the need for ‘deep structural reform’. Macroeconomic painkillers in the form of fiscal and monetary stimulus have lost their effectiveness. Efforts must instead focus on long-festering microeconomic policies. Yet progress is slow because of the resistance of vested interests.

Clearly then, there is some sense in which ‘traps’ pertaining to institutional change and vested interests occur at multiple points along the development trajectory. The question for development studies is what factors predict success in reform efforts and what factors predict failure. And do these factors differ across income-levels, state structures and cultures? The identification of institutions that actively encourage reforms and entrench a virtuous cycle of institutional dynamism would be particularly useful.

Reforms as a theoretical concept and the parameters that govern a society’s ability to enact them has hitherto been under-studied in development science. The silver lining of the middle income trap’s contemporary salience is that it is bringing this issue to the fore.

Mark Fabian is a doctoral candidate in economics at the Crawford School for Public Policy, The Australian National University.

This article was first published here, at the East Asia Forum.