Income, investment and saving
Date
2010
Authors
Doss, Tanuja
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Abstract
In the last fifty years, the gap in incomes per capita between rich countries and poor countries has widened. There is an evolving literature on the reasons why some countries grow faster than others, while yet other countries appear not to be growing at all. Models of economic growth vary with respect to the determinants of growth and the relative importance of these determinants, however, there is generally a consensus that physical capital is an essential input. Given this, one of the arguments advanced for the growing gap between rich and poor countries is that poor countries are caught in a saving trap - average incomes are too low for saving, meaning that these countries simply cannot afford the investment in physical capital necessary for growth.
This argument immediately raises two questions: firstly how today's rich countries were able to afford the investment in physical capital necessary to grow, when they were once poor themselves; and secondly, how being unable to afford the necessary investment in physical capital can be a meaningful constraint on growth in a world where capital is internationally mobile. If the saving trap were truly a barrier to growth confronting today's poor countries, then the following must be true: a country's rate of saving should increase with the level of income, demonstrating that households will save more if they can afford to; and the rate of investment should be closely linked to the rate of saving, demonstrating that a low rate of investment is due to insufficient saving. Importantly, any increase in saving should be retained as investment.
This thesis finds that while rates of saving rise with incomes in developing countries, this saving is not always retained as investment. This means that low levels of investment in physical capital cannot be attributed solely to lack of affordability due to low incomes and low rates of saving. Borrowing the gravity equation from the international trade literature on intra-industry trade, this thesis develops and tests an alternative model to find that while low incomes and low rates of saving are a barrier, they are neither the sole nor the primary barrier to growth.
Further, the application of the alternative model finds that the rate of investment in physical capital across countries is linked to the determinants of the return on that investment - capital flows out of countries with relatively low marginal products of capital and into countries with relatively high marginal products of capital. Poorer countries not only have less physical capital per capita, but also have disproportionately poorer health, and political and economic institutions compared to developed countries. The ability of physical capital to drive growth in incomes is limited in the absence of a healthy, educated workforce to operate it and generate a return, or the political and economic conditions necessary to ensure that the return that is generated is repaid to investors. As capital markets become more open, developing countries must compete with more developed countries to attract and retain investment.
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