Why Nations Fail and How Poor Countries Develop Rich Countries

Leiden, Non. Ian. MMDCCLXX A.U.C.,

Recently the Guardian published about the massive flow of capital from less economically developed countries (LEDCs) to more economically developed countries (MEDCs), based on a report by Global Financial Integrity (GFI). This justifiably got a lot of attention, as it is  ironic, if not down right perverted, that capital is flowing from those countries who need it most to those countries who already have abundant capital stocks. In less economic terms, money which could be used to build roads, schools, businesses and sewerage in countries which painfully lack those is flowing to countries which already have those. However, the Guardian painted a very simplistic picture of this problem, which means they leave those most responsible for the poverty in LEDCs out of the picture. The article in the Guardian suggests that the West is responsible for this flow from developing to developed countries, and thereby also is to be blamed for the poverty in developing countries. However, the biggest plunderers and thieves in the world are not Western corporations, but the elites in developing countries, the dictators and their cronies, who get rich exploiting their own population. This aspect of why nations fail is crucial to eradicating poverty. As long as people in developing countries believe their poverty is due to evil Western capitalism, their corrupted elites do not have to worry about demands for more democracy and transparent governance. The fact that the Guardian is spreading and legitimizing neo-Marxist ideas is very unfortunate.

As said before, large sums of money are flowing from the developing world to the developed world. To start, developing countries have sent $4.2 trillion in interest payments to developed countries. As the Guardian puts it: ‘a direct cash transfer to big banks in New York and London’. It is this kind rhetoric which annoys me. Those developing countries willingly and knowingly agreed to take on debt, that means they had to pay interest, they knew that in advance. Those banks provided a service to those countries, why is this a problem? Yes, this is a large sum of money, but that is how borrowing money works. There is no reason to be particularly outraged about this. If developing countries or companies in those countries had invested this money wisely, they would no longer be developing countries by now (see Singapore, South Korea, Chile and Taiwan). Moreover, companies from developed countries made profits by investing in developing countries and repatriated these profits. Or, as the Guardian puts it: ‘Think of all the profits that BP extracts from Nigeria’s oil reserves, for example, or that Anglo-American pulls out of South Africa’s gold mines.’ Again there is a suggestion that it is problematic that developing countries sign deals with foreign companies. And again, there is no reason for outrage. The South African government was not forced to sign those contracts, and it retains a lot of money itself through those contracts. The largest flow of money consists of illicit capital flight, amounting to approximately $13trillion since 1980. In other words, tax evasion is a big problem (also for developed countries, by the way).

However, even if all this is shocking and perverted, we should not forget why so much capital is leaving the country. This probably due to a combination of two things. A lack of projects to safely invest in, and the capital leaving those countries predominantly consists of the ill-gotten gains of corruption and exploitation of the local elites. To start, in many of those countries there is a lack of projects which can be invested in. Without barriers to capital movement, capital flows to the place where the highest expected returns on that capital can be made. In non-economic terms, this means that people invest their money in those projects of which they expect the highest returns. Given two projects, one very risky but promising a high return, and one very safe, but with a low potential return, it is very well possible that the project which promises low but more secure returns is preferred by the investor. I think this is the reason that capital flows from developing countries to developed countries. Even if the money is much more needed in the developing world, which means there are far higher potential returns on investments in the developing world, in practice investors much rather invest in the developed world. It is much safer to invest in Estonia or Singapore than to invest in Mozambique or Nepal.

Then the question is why it is so unsafe to invest in developing countries. Why are there so few safe projects to invest in? The main answer has to do with how elites in developing countries rule. In developed countries we are used to governments which most of the time respect our property rights. The German or the Canadian government is very unlikely to steal our land, house, company, or money. Life in, for example, Ethiopia or Myanmar could not be more different: in most countries the government is a ‘stationary bandit’, elites orchestrate  the systematized plunder of their own country. What this does for people’s incentive to invest in their own skills or in businesses is not very hard to figure out. If you need to wait 200 days before you can start a business, you will not start a business. If you need to bribe 20 officials before you can get water to cool the machines in your factory, you do not have money left to invest in machines. If you get evicted from your land as soon as you have made it fertile, you will not try to improve your land. If you can only get contracts with companies and the government if you have personal contacts with people working in those companies and the government, those without the privilege of a network will never be able to sell their goods and services. If everything you build gets stolen by your own government, you stop building things. In short, those who want to invest in projects do not do so, because they fear that whatever they create will be expropriated by the government, while those that expropriate and engage in corruption send their money abroad.

Net Resource Transfers from LEDCs to MEDCs
capitalflight-e1480622572592Source: Global Financial Integrity, http://www.gfintegrity.org/press-release/new-report-on-unrecorded-capital-flight-finds-developing-countries-are-net-creditors-to-the-rest-of-the-world/

Looking at this graph, we see that the largest capital flows occurred after 1996. Companies from MEDCs have invested in LEDCs for a long time now, and tax evasion laws were even more lacks in the past than nowadays, so it seems unlikely that the major shift after 1996 is entirely due to those companies moving more resources from LEDCs to MEDCs. What seems more likely is that at least in part this shift has been caused by the elites of countries such as China, which became much richer, and whose elites suddenly had much more money to transfer abroad. Meanwhile, as globalization progressed, it became much easier for elites to transfer their money abroad, possibly also causing this large spike in transfers. Indeed the report mentions that $4.6trillion of the $16.3trillion transferred from LEDCs to MEDCs came from China alone. Moreover, the report by GFI notes that: “There is perhaps no greater driver of inequality within developing countries than the combination of illicit financial flows and offshore tax havens. These mechanisms and facilitating entities benefit the rich—we call them the “1 percent” for convenience—and harm the middle class and poor.” In other words, local elites benefit massively from those illicit financial flows and tax havens: they are moving their ill-gotten wealth abroad.

This is the ultimate tragedy behind the capital flight from LEDCs to MEDCs: LEDCs are very difficult and insecure places to invest in. They are LEDCs for a reason: they are plundered by their own elite. This has several implications. Firstly, the money flow from poor to rich countries is predominantly a consequence of the political-economic system in LEDCs. The outward capital flows are only partly a cause of the poverty in those countries, and predominantly a result of the same system which also causes the poverty in LEDCs. Secondly, even if capital was forced to stay in those countries, it would not achieve much. There is no actual demand for the capital, because nobody has an incentive to invest in projects. Thirdly, the longer the capital owned by individuals or companies who are not part of the elite stayed in those developing countries, the more likely it is to be stolen by the elite of that country to buy cars, or, indeed, to put it on their Swiss bank account. In other words, all the capital which is leaving those countries which has not been expropriated by the local elites yet, would probably be expropriated by the elite at a later point in time anyway, so this capital would do very little for the poor.

In short, while the flow of capital from LEDCs to MEDCs is ironic and perverted, it is simplistic to blame the developed world for what is happening. Most countries in history have had stationary bandits for a government. The fact that many countries still suffer from this, is predominantly not the fault of MEDCs, it is simply how most human societies have always worked. The suggestion that big mean corporations are exploiting those poor little developing countries is unnecessary and hides the bigger underlying problem. This frame is not present in the original GFI report, which is well aware of the importance of property rights. Moreover, the idea that we in the West could simply deliver justice to the developing world is a mirage. Democracy and rule of law need to be home grown to develop and to work, and the only way LEDCs will develop is if their own population demands representative and transparent governance. When the Guardian spreads and legitimizes the neo-Marxist idea that the core exploits the periphery and that this is the cause of the poverty in developing countries, it essentially spreads the propaganda which helps plundering elites to stay in power. The more citizens of LEDCs believe this propaganda, the less reason they have to hold their own corrupted elites accountable. The Guardian is effectively hurting the prospects of democracy and rule of law in developing countries by their simplistic moral outrage.


Bottom Line: LEDCs are poor because their elites plunder them. This means there are few safe investments in LEDCs, while much of the money that is sent abroad is the loot of the corruption and monopolization carried out by local elites. This is very problematic, but simply blaming the West is simplistic and harmful.

P.S. It is not entirely accidental that the Guardian published this a few days later. Again the Guardian promotes the idea that the West deliberately and actively tries to keep the rest poor.

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