Unit 4 Macro: The Middle Income Trap

The middle income trap exists for some countries that make significant progress in reducing extreme poverty and experience structural change and growth but then find it difficult to make the climb from being a middle-income country to achieve high-income fully-developed status. GDP growth rates often slow down and a country can struggle to build and maintain international competitiveness. Research from the World Bank finds that only 13 of the 101 countries deemed to be middle-income countries in 1960 had achieved high-income levels in 2011. Different studies find different thresholds for where growth tapers off, ranging from $8,500 to $18,500 at 2010 prices, adjusted for purchasing power parity.

Possible causes of the middle income trap

Rising wages / unit labour costs

• The surplus supply of labour dwindles
  
• Labour migration can run dry including rural-urban movement
  
• Demographic transition model - falling natural population growth
  

Gains in productivity growth slow down / failure to achieve innovation

• Possible failure to invest in human capital
  
• Early growth tends to be input-driven rather than productivity-driven
  
• Technology needs to become more sophisticated
  
• Can the private sector generate sufficient innovation?
  
• Innovation creates goods and services than get higher prices in world markets
  
• Innovation is harder than simply copying what wealthier countries already do
  

Institutional Failures and Social Capital weaknesses

• Institutions may not support an adaptive and creative economy and society
  
• Social capital may not support sustained growth especially in knowledge sectors
  

Maintaining macro-economic stability

• Main fast growing countries suffer from high inflation
  
• Credit bubbles can develop as speculative investments take hold
  

Key to avoiding the trap is for each country to find the right mix of demand and supply-side policies to sustain a further lift in per capita incomes and to achieve balanced growth sourced from domestic and overseas markets. Every country has a different set of economic, social, cultural, demographic and political circumstances so there is no unique policy mixes to avoid the middle income trap – some of the approaches often mentioned include the following:

1. The growth that brings a country out of extreme poverty is not always the type of growth that makes a country richer and lifts their per capita income above middle-income levels
   
2. The middle income trap is largely the result of a country’s inability to continue the process of moving from low value-added to high value-added industries
   
3. The advantages of low-cost labour and imitation of foreign technology can disappear when middle- and upper-middle-income levels are reached
   
4. The focus switches towards improving competitiveness rather than narrow emphasis on input-driven growth (i.e. just adding more land, labour and capital into the production process)
   
5. Many middle-income countries experience a “growth slowdown”. Leading economist, Professor Barry Eichengreen has found that growth slowdowns typically occur at per capita incomes of about $16,700 in 2005 constant international prices. At that point, the growth rate of GDP per capita slows from 5.6 to 2.1 percent, or by an average of 3.5 percentage points
   

• Sufficiently large middle class / rising incomes
  
• Foreign direct investment inflows
  
• Investment in human capital to lift productivity
  
• Improving working conditions and welfare safety nets
  
• Investment in “hard” and “soft” infrastructure
  
• Opening up an economy to international competition
  
• Effective macro policies e.g. to control inflation
  
• Regional Trade Blocs to boost trade & investment
  
• Research and Development to boost innovation
  
• Diversification - a broader base of industries - less dependence
  
• Incentives to stimulate new private sector businesses
  
• Measures to tackle income and wealth inequalities