The Five Keys to Progress (Part 5): High Value-Added Export Industries

If this is the first post that you have ever read on my blog, I would recommend starting with An Introduction to Progress: Mankind’s Greatest Accomplishment. Then I would recommend reading the first post of this series.

In the previous posts in this series, I argued that the concept of the Five Keys of Progress enables us to better under the history of how nations developed and what policies will work in promoting progress today.

I also argued that to transition from poverty to progress, a society needs to acquire and maintain the five keys to progress:

  1. A highly productive food production and distribution system. This enables societies to overcome geographical constraints to food production so that large numbers of people can focus on solving problems other than getting enough food to eat.
  2. Trade-based cities packed with a large number of free citizens possessing a wide variety of skills. These people innovate new technologies, skills and social organizations and copy the innovations made by others.
  3. Decentralized political, economic, religious and ideological power. Of particular importance are elites being forced into transparent, non-violent competition that undermines their ability to forcibly extract wealth from the masses. This also allows citizens to freely choose among institutions based upon how much they have offer to each individual and society in general.

So effective food production leads to cities, and cities lead to innovation and progress. Then if you are able to constrain the ability of elites to extract wealth from the masses, a society has really got something going. But that is still not quite enough.

Regardless of how productive agriculture or innovative cities are, a society must have at least one high value-added industry that exports to the rest of the world. These industries injects wealth into the region and accelerates economic growth. This wealth can then be spent by its employees locally generating demand for a gaggle of smaller local businesses. They also create a revenue stream for governments to invest in education, health, transportation, sanitation and energy infrastructure.

By exporting to the rest of the world, the industry radically increases the potential demand for their goods. If a farm or city is restricted to customers within their own borders, its economy has far less potential for growth. And the more value that the industry generates, the higher the potential profits. That is why high value-added industries that are competitive enough to export to the rest of the world are so critical to promoting progress.

The nature of industry varies greatly over time. In the distant past a mineral or crop might be sufficient. More typically, it requires some form of manufacturing. Textiles, steel, consumer electronics are all industries that played critical roles in nations that industrialize.

To successfully import a city needs the necessary technology, skills, organizations and capital. These factors are typically acquired by copying them from richer regions who already have them, modifying them for the local environment and then learning by doing. Often skilled immigrants from richer nations play a critical role in the development of new skills.

The emerging discipline of Economic Complexity gives us the best understanding of how this works. Cesar Hidalgo and Ricardo Hausmann have played pioneering roles in this field. They argue that modern societies acquire productive knowledge by distributing that knowledge among many specialized workers. Organizations and markets then combine that knowledge to make useful products. Skills needed for industries can only be taught face-to-face making knowledge transfer very difficult. If an industry is missing only one key skill, it cannot be competitive.

This places poorer nations in a “Catch-22.” They cannot create high value-added industries until they acquire the necessary skills, but they cannot acquire the necessary skills until they already have a functioning industry. This creates a fundamental gap that developing nations have difficulty bridging. On the fact of it, this appears to make economic growth impossible. Fortunately, we know from history that economic growth is possible.

Fortunately, the theory of economic complexity gives us the key intellectual breakthrough that industries are related to each other. For example, manufacturing shoes is closely related with manufacturing hats. Those same industries are unrelated to manufacturing tractors or pharmaceuticals. Industries are related to each other because they require similar technologies, skills and organizational needs. This makes it theoretically possible for poor nations to leverage the limited knowledge that they have from current sectors of the economy to other related sectors that offer higher value-added.

Hidalgo and Hausmann use the analogy of a monkey traveling through a forest in search of food. The monkey is on one side of the forest with few bananas (limited export options) and wants to get to the other side of the forest with many bananas (a number of profitable high value-added export industries). The monkey can only travel one branch at-a-time. So what does the monkey do. He gradually moves to the nearest branches with more bananas that the one he is currently on. He then uses the energy gained from the bananas (i.e. the technologies, skills, organizations and capital) to go to the next branch. It is a long, slow process, but eventually the monkey reaches the part of the forest with many bananas.

This viewpoint gives us a clear understanding of how economies developed both in the past and the present. Commercial societies in northern Italy, Flanders, Netherlands and England pioneered the innovations that created high value-added industries. This was a long, slow process because they had no one to copy at first. There was a huge amount of learning by doing with many mistakes along the way. As long to four of the Five Keys to Progress created the needed conditions for progress, they could keep experimenting and innovating for centuries.

Eventually, this led to the critical breakthrough of the Industrial Revolution in Britain. This Industrial Revolution largely involved the applications of fossil fuels to the critical transportation, communication, agricultural and materials sectors. This overcame some, but not all, of the geographical constraints on progress.

Today developing nations face a different problem. All of the necessary technologies, skills and organizations have already been invented, so they only need to copy them rather than create them from scratch. But because skills require face-to-face transfer, it is very hard for them to learn everything they need to know. Worse, they face highly competitive industries in the richer nations that are vastly more productive. The advantage that developing nations have is cheaper labor.

So this leaves only one option for developing nations:

  1. Identify key industries that they already have. This may be in very basic agriculture, mineral extraction or low-skilled manufacturing.
  2. Identify other industries that are closely related to those industries and which have equal or higher added-value.
  3. Leverage technologies, skills, organizations and capital from existing industries to learn the necessary skills in the new industry and use their advantage of cheaper labor to outcompete richer nations. This will often involve selling an existing product at a cheaper price than richer nations can produce. It also involves focusing on the low end of the market where price is more important than quality, while richer nations focus on high end of the market.
  4. Keep repeating the process for decades.

It is a nice theory, but does it work? Hidalgo, Hausmann and others give compelling evidence that economic complexity is a useful concept, but it is not yet clear whether it can be put into practice.

By statistical analysis, they show that complexity explains 73% of the variation in income across 128 countries. They also show that the difference between national income and level of complexity is the single best predictor of future economic growth. That is poor countries who have established a beach-head in higher value-added products experience much higher growth rates in the immediate future than those who do not.

What economic complexity theorists have not proven is that poor and developing nations can use their theory to bootstrap their way up the value-added ladder. I know of no nations who has intentionally implemented strategies derived from the theory of economic complexity and then showed clear results of higher economic growth. This likely is because the theory of economic complexity is new and relatively unknown to developing nations.

Nor have they shown that rich nations actually followed something close to their recommendations in the past. Of course, these nations could not possibly have been acquainted with modern economic theories, but the logic in their time would have been equally applicable. From my readings of economic history, I believe that Europe, the United States, Japan and other newly industrialized nations in Asia have functioned exactly as their theory predicts, but it is hard to present quantitative proof.

We need economic complexity data to reach further back in history. Currently, there is little data before 1970. Adding more data might allow us to prove that cities and nations have gradually ratcheted their way up from low value-added industries to related industries of higher value. They have done so by a blend of copying earlier innovations and local experimentation. Those nations then repeated the process in another related industry. It is difficult to see how it could have been any other way.

In the meantime, I believe that developing nations (and rich nations to a lesser extent) would be wise to tailor their national economic policies to the theory of economic complexity. It seems much more useful than the advice that other Western experts are currently giving them.

In the next, I will explain the fifth and final key to progress: widespread usage of Fossil Fuels.

If you would like to learn more about this and other related topics, read my book From Poverty to Progress.

ABOUT THE AUTHOR:

Michael Magoon is the author of the “From Poverty to Progress” series of books. The first book in the series is already published with many more to follow.

The writings above are under the same copyright as the main book “From Poverty to Progress”
Copyright © 2021 Michael Magoon

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