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American Economic AssociationWhy Doesn't Capital Flow from Rich to Poor Countries?Author(s): Robert E. Lucas, Jr.Source: The American Economic Review, Vol. 80, No. 2, Papers and Proceedings of theHundred and Second Annual Meeting of the American Economic Association (May, 1990), pp.92-96Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/2006549Accessed: 07/01/2009 14:22Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available rms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unlessyou have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and youmay use content in the JSTOR archive only for your personal, non-commercial use.Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained herCode aea.Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printedpage of such transmission.JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with thescholarly community to preserve their work and the materials they rely upon, and to build a common research platform thatpromotes the discovery and use of these resources. For more information about JSTOR, please contact support@jstor.org.American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to TheAmerican Economic Review.http://www.jstor.org
Why Doesn't Capital Flow from Rich to Poor Countries?By ROBERT E. LUCAS, JR.*The egalitarianpredictionsof the simplestneoclassicalmodels of tradeand growtharewell known and easy to explain, as theyfollow from entirely standardassumptionson technologyalone. Considertwo countriesproducingthe samegood with the sameconstant returns to scale productionfunction,relatingoutput to homogeneouscapital andlabor inputs. If productionper workerdiffers between these two countries,it must bebecause they have differentlevels of capitalper worker:I havejust ruledeverythingelseout! Then the Law of DiminishingReturnsimplies that the marginalproductof capitalis higher in the less productive(i.e., in thepoorer) economy. If so, then if trade incapital good is free and competitive,newinvestment will occur only in the poorereconomy, and this will continue to be trueuntil capital-laborratios, and hence wagesand capitalreturns,areequalized.We do, of course,see some investmentbywealthy countries in poorer ones, but anexamplewith some roughnumberswill helpto make clearjust how far the capitalflowswe observe fall short of the flows predictedby the theory I havejust sketched.According to Robert Summersand Alan Heston(1988, Table 3, pp. 18-21), productionperperson in the United States is about fifteentimes what it is in India. Supposeproduction in both these countriesobeys a CobbDouglas-type constant returns technologywith a commonintercept:(1)capital per worker,and thus:(2)in terms of productionper worker.Let ,B 0.4 (an averageof U.S. and Indian capitalshares), again for both countries.Then theformula(2) implies that the marginalproduct of capital in India must be about (15)1'5 58 times the marginalproductof capitalin the United States.If this model wereanywhereclose to beingaccurate,and if world capital marketswereanywhereclose to beingfreeand complete,itis clear that, in the face of returndifferentials of this magnitude,investment goodswould flow rapidly from the United Statesand other wealthy countries to India andother poor countries.Indeed,one would expect no investmentto occur in the wealthycountriesin the face of returndifferentialsofthis magnitude.I workedout the arithmeticfor this exampleto makeit clearthat thereisnothing at all delicate about this standardneoclassicalpredictionon capitalflows. Theassumptionson technologyand tradeconditions that give rise to this examplemust bedrasticallywrong,but exactlywhat is wrongwith them, and what assumptionsshouldreplace them?This is a centralquestionforeconomic development.I considerfour candidate answersto this question.I. Differencesin HumanCapitalThe samplecalculationin my introductiontreats effective labor input per person asequal in the countriesbeing compared,ignoring differencesin laborqualityor humancapital per worker.The best attemptto correct measuredlabor inputsfor differencesinhuman capital is Anne Krueger's study(1968). Her estimatesarebasedon data fromthe 1950s, but the percentageincome differentials between very rich and very poorcountrieshave not changedall that muchiny Ax#,where y is income per worker and x iscapital per worker.Then the marginalproduct of capital is r Af3x-',r #Al/By( - /Pin terms of*University of Chicago, Chicago, IL 60637. I amgrateful to Nancy Stokey for helpful criticism, and forresearch support under NSF grant no. SES-8808835.92
VOL. 80 NO. 293THE "NEW" GROWTH THEOR Ythe last 25 years and, in any case, a roughestimate is better than none at all. Hermethod is to combine information on eachcountry's mix of workers by level of education, age and sector with U.S. estimates ofthe way these factors affect worker productivity, as measured by relative earnings.Krueger's main results are given in herTable III (p. 653), that gives estimates of theper capita income that each of the 28 countries examined could attain, expressed as afraction of U.S. income, if each country hadthe same physical capital per worker endowment as did the United States. The estimatesrange from around .38 (India, Indonesia,Ghana) to unity (Canada) and .84 (Israel).These numbers have the dimension of therelative human capital stocks raised to thepower of labor's share, so taking the latter at.6 (as I did in my introductory example), theestimated relative human capital endowments ranged from about .2 to unity. That is,each American or Canadian worker was estimated to be the productive equivalent ofabout five Indians or Ghanians. (Compensation per employed civilian in the UnitedStates in 1987 was about 24,000, so thisestimate implies that a typical worker fromIndia or Ghana could earn about 4800 inthe United States.)To redo my introductory example withKrueger's estimated human capital differentials, reinterpret y in equations (1) and (2)as income per effective worker. Then theratio of y in the United States to y in Indiabecomes 3 rather than 15, and the predictedrate of return ratio becomes (3)15 5 ratherthan 58. This is a substantial revision, buteven so, it leaves the original paradox verymuch alive: a factor of 5 difference in ratesof return is still large enough to lead one toexpect capital flows much larger than anything we observe.If it had turned out that replacing laborwith effective labor had entirely eliminatedestimated differences in the marginal product of capital, this would have answered thequestion with which I began this paper, butonly by replacing it with an even harderquestion. Under constant returns, equal capital returns implies equal wage rates forequally skilled labor, so that if there were noeconomic motive for capital to flow, therewould be no motive for labor flows either.Yet we see immigration at maximal allowable rates and beyond from poor countriesto wealthy ones. We do not want to resolvethe puzzle of capital flows with a theory thatpredicts, contrary to the evidence providedby millions of Mexicans, that Mexican workers can earn equal wages in the United Statesand in Mexico.II. ExternalBenefitsof HumanCapitalObviously, we could resolve the puzzle ofthe inadequacy of capital flows at any timeby assuming that marginal products of capital are equalized, and using equation (2) andthe estimated income differential to estimatethe relative levels of the intercept parameterA (often called the level of technology) inthe two countries being compared. This isalmost what I will do in this section, but Iwill do so in a way that has more content, byassuming that an economy's technology levelis just the average level of its workers' human capital raised to a power. That is, Iassume (as in my 1988 paper), that the production function takes the form(3)y Ax%hy,where y is income per effective worker, x iscapital per effective worker, and h is humancapital per worker. I interpret the term hy asan external effect Oust as in Paul Romer,1986). It multiplies the productivity of aworker at any skill level h', exactly as doesthe intercept A in (3).The marginal productivity of capital formula implied by (3) is(4)r PA-Iy( - l)Ifh /I propose to estimate the parameter y usingEdward Denison's (1962) comparison of U.S.productivity in 1909 and 1958, and then toapply this estimate to (4) using Krueger'scross-country estimates of relative humancapital stocks in 1959 to obtain a new prediction on relative rates of return on capital.The estimation of y is as reported in myearlier paper (1988, p. 23). Using Denison's
94AEA PAPERS AND PROCEEDINGSestimates for the 1909-59 period-in theUnited States, output powerman-hourgrewabout one percentagepoint fasterthan capital per man-hour. Denison estimates agrowth rate of h, attributed entirely togrowth in schooling,of .009. With the technology (3), this impliesthat (1- , t y) timesthe growthrate .009 of humancapitalequals.01. With a capital's share ,B .25, thesenumbersimply -y .36. That is to say, a 10percent increase in the average quality ofthose with whom I work increasesmy productivity by 3.6 percent. (This estimate isbased on the assumptionthat the total stockof human capital grows at the same rate,.009, as that part of the stockthat is accumulated through formal schooling. I do nothave any idea how accuratean assumptionthis is.)Now takingthe Kruegerestimatethat fiveIndians equals one American,the predictedrate of return ratio between India and theUnited States becomes(3)1.55-l 1.04. Thatis, takingthe externaleffectsof humancapital into account in the way I have doneentirely eliminatesthe predictedreturndifferential.Notice that this resultis in no waybuilt into my estimationprocedure.Thevalueof y estimatedfrom the 1909-58 U.S. comparison exactly eliminatesthe returndifferential in a 1959 India-U.S. comparison.One might accept this calculation as aresolution of the question I posed in mytitle. This was the argumentin my earlierpaper, based on U.S. data only, and I amsurprisedhow well it worksin a cross-country comparison.But it is importantand troublesome,I think,to note that the cross-country comparisonis based on the assumptionthat the externalbenefitsof a country'sstockof human capital accrueentirely to producers withinthat country.Knowledgespilloversacross national boundariesare assumed tobe zero. Ordinaryexperiencesuggests thatwhile some of the externalbenefits of increases in individual knowledge are local,confinedto single cities or even smallneighborhoods of cities, others are worldwideinscope. But, without some real evidence onthe scope of these externaleffects,I do notsee how to advancethis quantitativediscussion any further.The argumentof this sec-MA Y 1990tion and the preceding one suggests thatcorrectingfor humancapitaldifferentialsreduces the predicted return ratios betweenvery rich and verypoorcountriesfromabout58 at least to about5, andpossibly,if knowledge spilloversare local enough,to unity.MarketImperfectionsIII. CapitalI have been discussing capital flows instatic terms, taking it for grantedthat differencesin marginalproductsof capitalat apoint in time imply flows of capital goodsthroughtime. In the one-goodcontext I amusing, such flows are simplyborrowingcontracts:the poor countryacquirescapitalfromthe rich now, in returnfor promisedgoodsflows in the opposite directionlater on.Suppose countries A and B are engagedin such a transaction,and that the capitalstocks in the two countriesare growingonpaths that will eventuallyconvergeto a common value. If we look at goods flowsthroughtime between these two countries,we see aphase in which goods flow from advancedAto backwardB, followedby a phase (whichlasts forever)in whichgoods flow from B toA in the form of interestpaymentsor repatriated profits. This sort of patternwas implicit in my statement of the capital flowproblem.For such a patternto be a competitive equilibrium,it is evidentthat theremustbe an effective mechanismfor enforcinginternational borrowing agreements. Otherwise, country B will gain by terminatingitsrelationshipwith A at the point where therepayment period begins, and, foreseeingthis, country A will never lend in the firstplace. A capital marketimperfectionof thistype is often summarizedby the term"political risk."A serious difficultywith political risk asan explanationfor the inadequacyof capitalflows lies in the noveltyof the currentpolitical arrangementsbetweenrich and poor nations. Until around1945, muchof the ThirdleWorld was subject to European-imposedgal and economic arrangements,and hadbeen so for decades or even centuries.AEuropeanlending to a borrowerin India orthe Dutch East Indies could expect his contract to be enforced with exactly the same
VOL. 80 NO. 2THE "NEW" GROWTH THEORYeffectivenessand by exactlythe same meansas a contractwith a domesticborrower.Evenif political risk has been a force limitingcapital flows since 1945,why were not ratiosof capital to effective labor equalized bycapital flows in the two centuries before1945?I do not know the answerto this questionbut, in seeking one, I see no reason to assume that the role of the colonial powerswas simply to enforce a laissez-fairetradingregime throughoutthe world.The followingmonopoly model, very much in the spirit ofAdam Smith's (1776/1976) analysis of anearlier phase of colonialism, seems to mesuggestivein severalways.Consider an imperial power whose investors have access to capital at a (first)world returnof r. Assumethat the imperialist has exclusive control over trade to andfrom a colony, but that the labor marketinthe colony is free. Now suppose, at oneextreme,that the colony has no capitalof itsown, and no abilityto accumulateany. Thencapital per worker, x, in the colony can bechosen by the imperialist,and the entireincome repatriated.Under these conditions,what value of x is optimal from the viewpoint of the imperial power, viewed as amonopolist?Let the productionfunctionin the colonybe y f(x). Then the monopolist's problemis to choose x so as to maximize(5)f (x) - [f(x)-x'(x )]-rx,or total productionless wage paymentsat acompetitivelydeterminedwage less the opportunitycost of capital.The first-ordercondition for this problemis(6)f'(x) r - xf"(x),so that the marginalproductof capitalin thecolony is equatedto the worldreturnr plusthe derivativeof the colony'sreal wage ratewith respect to capital per worker.It is theimperialist'smonopsony power over wagesin the colony that is crucial. His optimalpolicy is to retard capital flows so as tomaintainreal wages at artificiallylow levels.95With the Cobb-Douglas technology assumed in my earlierexamples,the formula(6) implies that r /32x'-/ 3f'(x).With a,B value of .4, then, the returnon capitalinthe colony should be about 2.5 times theEuropean return. These are quantitativelyinteresting rents. The possibility that suchrents were importantis, I think, reinforcedby many of the institutionalfeaturesof thecolonial era: the carving up of the ThirdWorld by the Europeanpowers, and thefrequentgrantingof exclusivetradingrightsto monopolycompanies.'In a countrylike Indiaor Indonesia,wheremost of the workforcewas (and still is) engaged in traditionalagriculture,it is hard toimagine that the ability to control capitalinflows from abroad gave the imperialistsmuch monopsony power over the generallevel of wages. Put anotherway, the valueofcapital imported from Europe must-havebeen a small fraction of capital in thesecountries as a whole, most of which wasland. If monopoly control over capital imports was an importantsource of colonialreturn differentials,it must have been because only a small part of the coloniallaborforce was skilled enough to work with imported capital in, say, goods manufacturing.But to explore this possibility, we wouldobviously need a more refinedview of thenature of human capital than one in whichfive day-laborersequalone engineer.2Insofar as monopolycontrolover tradeincapital goods was an importantfactorin thedeterminationof capital-laborratiospriorto1945, I do not see any reason to believe itceased to be a factor after the political endof the colonial age. Monopoly returns are1With its emphasis on capital investment, MauriceDobb's (1945) discussion of late nineteenth and earlytwentieth-century colonialism is closer to the model inthe text than is Smith's. According to Lance Davis andRobert Huttenback (1989), investment in the late Britishempire was open to firms from any country on competitive terms, which would obviously be inconsistent withthis model. Moreover, they do not find rates of return inthe British colonies that exceeded European returns forsimilar investments.2See Nancy Stokey (1988) for a model in which highhuman capital workers do qualitatively different thingsthan do low human capital workers.
96AEA PAPERS AND PROCEEDINGSnot of interest to Europeansonly. T-hereismuchunsystematicevidenceof heavyprivatetaxation of capital inflowsin Indonesia,thePhillipines, in the Iran of the Shah, andother poor economiesthat are otherwiseattractiveto foreigninvestors.Restrictionsoncapital flows imposed by the borrowingcountryare often explainedas arisingfromamistrustof foreignersor a reluctanceto letdevelopmentproceed"too fast,"but I thinksuch explanationswarranta Smithianskeptism.IV. ConclusionsWhy does it matter which combination,if any, of the four hypotheses I have advanced is adequate to account for the absence of income equalizinginternationalcapital flows? The central idea of virtuallyallpostwardevelopmentpoliciesis to stimulatetransfersof capital goods from rich to poorcountries. Insofar as either of the humancapital-based hypotheses reviewed in Sections I and II of this paperis accurate,suchtransferswill be fully offsetby reductionsinprivate foreigninvestmentin the poor country, by increases in that country's investments abroad,or both. Insofaras returnsoncapital are not equalized,but where returndifferentialsare maintainedso as to securemonopoly rents, capital transfers to poorcountries will also be fully offset by reductions in privateinvestments.Givinggoods toa monopolist does not reducehis interestinexploitingpotentialrents.Only insofar as politicalrisk is an important factor in limiting capital flows can weexpect transfersof capitalto speed the international equalizationof factor prices. In aworld of largelyimmobilelabor,policies focused on affecting the accumulationof hu-MAY1990man capitalsurelyhavea muchlargerpotential. So too, I think,do policiesin whichaidof any form is tied to the recipient'sopenness to foreign investmenton competitiveterms.REFERENCESDavis, Lance E. and Huttenback,Robert A.,"Businessmen, the Raj, and the Pattern ofGovernment Expenditures: The BritishEmpire, 1860 to 1912," in David W.Galenson, ed., Markets in History, Cambridge: Cambridge University Press, 1989.Denison, EdwardF., The Sources of EconomicGrowth in the United States, New York:Committee for Economic Development,1962.Dobb, Maurice, Political Economy and Capitalism, Westport: Greenwood, 1945.Krueger,Anne 0., "Factor Endowments andPer Capital Income Differences AmongCountries," Economic Journal, September1968, 78, 641-59.Lucas, Robert E., Jr., "On the Mechanics ofEconomic Development," Journal of Monetary Economics, January 1988, 22, 3-32.Romer, Paul M., "Increasing Returns andLong-Run Growth," Journal of PoliticalEconomy, October 1986, 94, 1002-37.Smit, Adan, The Wealthof Nations, Chicago:University of Chicago Press, 1976.Stokey, Nancy L., "Learning by Doing andthe Introd
American Economic Association Why Doesn't Capital Flow from Rich to Poor Countries? Author(s): Robert E. Lucas, Jr. Source: The American Economic Review, Vol. 80, No. 2, Papers and Proceedings of the Hundred and Second Annual Meeting of the American Economic Association (May, 1990), pp. 92-96 Published by: American Economic Association
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