2.3 The middle-income trap as an undesirable steady state

claim: over the long term, economies with identical fundamentals (e.g. factors of production, preferences, economic policy) will reach the same level of development, irrespective of where they started from. It is important to note here that endogenous growth models do not contain convergence to developed economies, as there is no mechanism in the model that would decelerate a developed economy. This means that the disappearance of initial income disparities is not guaranteed on the basis of these models.

Chart 2-5: Stylised chart of states and transitions

system, integrate into global trade and adopt more developed foreign technologies. In the case of Hungary, it is more important to compare the middle-income trap and the state of equilibrium of developed economies, and accordingly this is discussed in more detail below. Before becoming stuck in a trap, a middle-income economy may be able to transition to another convergence path towards developed economies through significant technological development.

Accordingly, innovation is a key issue for middle-income economies.

Growth Developing countries

Institutions, Openess, Imitation of technology

Poverty trap Innovation Convergence

Middle income trap GDP per capita

Convergence

Developed countries

Source: Based on ITO (2017).

In addition to the above, so-called club convergences are

also often mentioned, 22 according to which various clubs come into being: countries with similar fundamentals and starting levels move towards the same level of development. This means that not only similar characteristics are important, but the current/initial state as well. Accordingly, on the whole, an economy that starts from a very low level is unable to completely catch up with the most developed one, i.e. income trap. There are several possible approaches to determine

disparities will never disappear in the world as a whole.

These considerations lead us to the so-called multi-equi

librium approach. Chart 2-5 presents the various states and equilibria. GDP per capita and the rate of growth are measured on the horizontal and vertical axes, respectively. If an economy starts from a lower level of per capita development, but its growth gradually cools off, it becomes initial income level. In the case of low-income economies, it may even mean getting stuck in the poverty trap. In their case, it is important to set up an adequate institutional

What is this trap? Various studies address the middle-income trapped. What state it arrives at also depends greatly on the

which country is considered as a middle-income country. The World Bank’s breakdown by income groups is used most often. A key question in these studies is why a middle-income country is unable to grow further. Agenor (2016), for example, provides a good summary. Several factors can be identified among the reasons:

According to the law of diminishing returns on physical capital, initially the GDP-increasing effect of investment is higher, but later its contribution declines steadily.

According to Eichengreen et al. (2012), however, capital is less responsible for the deceleration of a country’s growth; in their opinion, it is typically related to the slowdown in total factor productivity.

Remaining in the middle-income trap can also be

caused by short-sighted approach, i.e. in the short run, it is much cheaper to imitate others instead of innovating. Although this increases income in the short run, it does not stimulate investment in education, which is the basis of innovation and thus of long-term growth.

Poor-quality human capital prevents the country from adopting more advanced technologies from abroad and contributing to innovation.

Unsuccessful incentives and incorrect allocation of

capabilities. If in a country, capable people who are apt for innovation activities choose another sector, it smothers the possibility of innovation.

Lack of access to advanced infrastructures. There are two groups of infrastructures. The first one, i.e. basic infrastructure, means roads, electricity and basic telecommunications. The second set of advanced infrastructures comprises advanced information and communication technologies. Lack of the latter may be an obstacle to further development.

Lack of access to finance. Innovative companies mainly have intangible assets, which are difficult to consider as collateral for creditors. On the other hand, they do not want to make their innovation public for others, and they try to protect it. These processes strongly hinder the companies concerned. In addition, the limited amount of information and the higher risk expected of the creditor entails higher interest rates as well. Moreover, these firms are typically young, small enterprises, for which borrowing is more costly anyway.

Income disparity. In the early stages of economic development, the price of rapid growth is income disparity.

However, when a medium level of development is reached, income disparities start to decline as a result of education and continued industrialisation. Nevertheless, while income disparities are significant, they hinder development, because access of the less well-off to vocational training is more limited. Agenor and Canuto (2015) analysed the middle-income groups of workers are distinguished: average workers, who do simple jobs and thus participate only in the production of final products, and above-average workers, who can continue their studies if they want to. As a result, they can acquire special knowledge, with which they can work in the innovation sector. However, to make them want to invest in education, wages need to be relatively higher in the innovation sector than in the other sectors.

The authors find that the key to the convergence of an economy is the innovation sector. The underlying reason is that labour productivity is the highest in this sector. The higher the number of people who work there, the more dynamic growth is. Whereas in other models the marginal productivity of knowledge or ideas is constant or diminishing, in this model it is increasing in one section. On the one hand, this is explained by the nature of knowledge, while on the other hand, in the case of developing countries the phenomenon of ‘learning by doing’ is more typical of the innovation sector, i.e. participants learn the processes as they are doing them.

Understanding the findings is facilitated by Chart 2-6, which shows the changes in the knowledge-to-capital ratio ( ) from one period to another (continuous curved line). It can be divided into several sections. In the first section, between

S and L , the productivity of knowledge is low. In the second section, between L and H , productivity grows as a result of increasing knowledge and thus as a result of the network externality inherent in knowledge (e.g. Internet). However, as its level exceeds a threshold, H , network externalities become utilised, and productivity settles at a low level again. The minimum value of the knowledge-to-capital ratio is S when people who work above the average do not wish to work in the innovation sector. And the maximum value is C , when everybody would like to work in this sector. There is a balance when the knowledge-to-capital ratio remains at an unchanged level. The various equilibria are determined by the points of intersection of the curve and the 45-degree straight line. If we are above the 45-degree straight, the knowledge-to-capital ratio increases from one

period to another, while if we are below it, the ratio declines. growth trap in an overlapping generations model.

Two

Chart 2-6: Escaping from the middle-income trap

3

+1 3

2

2

1

1

0

45

1 2 0 3

Sources: Agenor and Canuto (2015), MNB compilation.

defined by the authors as the middle-income growth trap, where a low knowledge-to-capital ratio is coupled with low

knowledge to capital ratio entails high growth. However, the second equilibrium, A 2 , is not a stable point; therefore, if the knowledge-to-capital ratio is lower than 2 , on the basis of the model we arrive at the A 1 equilibrium, rather than at To illustrate exiting from the status of medium development, let us assume that initially the economy is at the 0 knowledge-to-capital ratio. Without economic policy

measures, the model would converge to point A 1 , and the economy would become stuck in the status of medium

development. By contrast, for example as a result of high-volume investment and development in advanced technologies, the curve of the knowledge-to-capital ratio shifts upwards and becomes the dashed curve. Until now the economy was to the left of equilibrium point A 2 , but now it shifts to the right side of B 2 . As a result, the processes no longer pull the economy into the middle-income trap, but propel it instead towards a higher growth path (B 3 ). The most important question for Hungary is, of course, how it is possible to escape from the middle-income growth trap or to avoid being trapped. As the middle-income growth

with small steps, as major measures are needed. In the case of Hungary, this means competitiveness reforms in

the coming period. Accordingly, this may be the key thrust of economic policy in the coming decade and more. The main question is whether the Hungarian economy is able to move on a growth path that leads to a higher level of development over time.

Looking ahead, high growth rates will slow down, but it

does matter at what level of development this occurs. If competitiveness reforms are implemented, Hungary will embark on a path of catching up with the developed economies (Chart 2-5, red band). However, if reform measures are not taken, the currently high growth may come to an end, and Hungary may find itself stuck in the middle-income growth trap: the economy may stabilise at a lower level compared to developed economies (Chart 2-5, blue band). Consequently, reform measures are needed in

A1 and A 3 are different stable equilibrium points. Point A 1 is

growth. Its opposite is the

A3 equilibrium, where a high point A 2 . If, in turn, we are above 2 , we arrive at A 3 .

trap is also a state of equilibrium, 23

exiting it is not possible

order to avoid this trap.

23 Although this conclusion is disputed by many, there are people who consider it a transitional stage rather than an equilibrium, including, e.g. Shekhar et al. (2018). At the same time, many economies are able to stay in a status of medium development for a longer period of time, and thus it can be considered much more a state of equilibrium (although it is undoubtedly undesirable).

Box 2-1: Medium level of development: a trap that can be avoided with a comprehensive turnaround in competitiveness

If reform measures are not realised, the Hungarian economy may remain in the current state of medium development, i.e. Hungary’s relative development would not change significantly in the future. This state is called the middle-income (growth) trap. Based on international experience over several decades, it can be established that it is difficult to break free from this and exiting the trap is not automatic. Over the last more than one half century many more economies were unable to escape the trap than were successful in catching up. Of the European countries, Austria, Ireland and Finland belong to this latter group: their economic performance was steadily improving for nearly 20 years (Chart 2-7). The Asian Tigers also belong to this group. Hong Kong, Taiwan, South Korea and Singapore have shown very significant, strong economic expansion for a long period. From the 1960s until the early 1990s Japan also achieved dynamic growth.

Chart 2-7: Changes in the level of development of economies that developed successfully

%, compared to USA

140

120

100

80

60

40

20

0

5 190 1 191 7 191 3 192

Austria

Hong Kong 9 192 5 193 1 194 7 194 3 195 9 195

Finland

South Korea

Note: PPP based per capita GDP. Sources: Maddison database, MNB calculation. 5 196 1 197 7 197 3 198 9 198

Ireland

Singapore 5 199 1 200 7 200 3 201

Japan Taiwan

The countries that implement successful convergence are rather heterogeneous and different in terms culture and geographical location as well. At the same time, in addition to the application of advanced technology, operation with high economic efficiency is observed. Accordingly, the conditions of escaping medium-level development include the

realisation of this common feature as well as efforts to avoid various traps.

Growth traps are examined, for example, by Eichengreen et al. (2013). Negative demographic developments, financial instability and unsustainably high investment rates are mentioned as underlying reasons. Various traps are identified in the case of Hungary as well, which are discussed in more detail in Chapter 1 of the Report. Firstly, demographic limits will become increasingly effective if steps are not taken. The number of those in active age will decline significantly in the coming decades, and the so-called old age dependency ratio 24 may rise considerably. Further traps may evolve as a result of the phenomenon of brain drain, i.e. the struggle for qualified employees. With low ability to create added value, various social traps may result in becoming stuck at a medium level of development.

If the competitiveness reforms are not implemented, the Hungarian economy may remain in the status of medium development and might follow the path of comparison outlined in the chapter in the next decade. Avoiding the middle-income

growth trap requires a broad-based, comprehensive turnaround in competitiveness.

24 An indicator applied to demonstrate the ageing of the society, showing the number of old people per one active-age person.