🎙️ Economic Complexity

Why do some countries become rich while others stagnate? Can you predict which countries will become wealthy in advance?

According to Harvard professor Ricardo Hausmann, the “complexity” of a nation's domestic economy may hold the answers.

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What Makes Countries Wealthy?

Comparing countries

As an econ and finance nerd, whenever I travel to new places around the world, I like to try and understand how a country has reached its current level of wealth. In some cases, that means basking in awe at the extreme wealth some nations like Singapore have built, and other times, wondering what went wrong?

Often, neighboring countries with centuries of overlapping or parallel history may have wildly different economies in the 21st century.

The most obvious and extreme example is South Korea and North Korea. But many examples of similar (admittedly less extreme) divides worldwide exist.

Economic complexity

There are, of course, unique factors at play in each country, but Harvard professor Ricardo Hausmann has a framework called “Economic Complexity” for understanding what makes countries wealthy.

He calls it “an attempt to measure how much countries or places know how to do…like trying to measure know-how.” College degrees tell you how much a person knows, but how do you measure how much a society knows?

For starters, a diversity of skills makes a big difference. A society of just dentists will “know” less than a society of half dentists and half lawyers.

The more complex the range of jobs and things a society produces, the more knowledge and skills it has. Some countries are great at manufacturing cars; others aren’t.

Some are good at building software companies, while others primarily rely on oil and commodity exports.

• As Hausmann puts it, “the way in which a society grows is it grows its knowledge by putting different bits of knowledge in different heads and then by bringing those heads together.”

Economic Complexity boils down to the “network of brains coming together to make something,” which “tells you something about how those economies are managing knowledge.”

Measuring complexity

Gross domestic product (GDP) figures illustrate how much a country produces. But that doesn’t tell why they can do what they do, and Economic Complexity focuses on answering that “why.”

Hausmann explains that he begins by looking at countries’ export data because exports tell you whether a society is good enough at doing something (i.e., building cars, making phones, sewing clothes, growing fruits, etc.) to sell abroad.

• He adds, “I don’t really care how much they make. I just care that they’re able to make it, so that the knowledge is somewhere in that society.”

In that vein, he tries to gauge how many different things a society makes. And then, he weighs how difficult it is to make those products based on how many other countries do.

• Chopping down forests and selling raw wood isn’t very complex, and any country can do it, but fewer countries export microscopes or X-ray machines.

With that, you can determine how common a country’s exports are comparatively. Ultimately, the point is to assess how many distinct things a country produces and how knowledge-intensive those products are.

Wealth correlation

In his research, Hausmann finds that the complexity of a country’s economy correlates “very highly” with how rich it is. It’s also a good predictor of the future: Countries with higher complexity scores tend to grow their income faster than peers with lower complexity scores.

The outliers, though, are countries with vast existing natural resource wealth. These primarily Middle Eastern countries, with their oil stores, are wealthy economies that typically score low on complexity.

• He puts it, “they get their income not so much by what they know how to do, but from the natural resource wealth that they happen to have.”

Successes and failures

Which countries actually embody this trend, growing their wealth through complexity? And conversely, which countries have been restrained by their low complexity?

Hausmann says his two favorite examples are India and Greece. If you took a snapshot in 2008, India was extremely poor with very high economic complexity, while Greece was quite wealthy for a country with such a low level of complexity.

• In the time since “India has been the fastest growing large country in the world…and Greece collapsed.”

Typical success stories are countries that increased their complexity over time, moving into a new set of product production.

In Thailand, they began primarily making garments and spent a decade learning how to make different garments for exports. Suddenly, they branched into electronics and then into cars and machines.

Japan and South Korea had similar stories, scaling up the ladder of manufacturing complexity from simple gadgets to advanced semiconductors.

That growing complexity translated into accelerating rates of economic growth.

By the numbers

Since 1970, Hausmann found that only about a fifth of poor countries narrowed their income gap versus the U.S. Meaning their gains in wealth over five decades didn’t outpace that of America’s, despite the U.S. already being a rich, industrialized nation.

But the 20% of countries that narrowed their income gap and gained ground versus the U.S. increased their complexity “very significantly.”

• He adds, “The other 80% did not.”

Building complexity

The critical question, then, is how do countries increase their complexity?

Hausmann says countries typically first move from doing what they’re good at to similar but slightly different activities.

A country might go from exporting raw cacao to embracing chocolate making and exporting candies at a higher premium than just selling the raw commodity.

He uses a metaphor to illustrate the point, comparing products to trees and firms to monkeys. Imagine a huge forest representing everything produced in the global economy, and when evaluating a country’s complexity, you can look at what trees its monkeys are on.

Or, in other words, what products do its businesses make for export?

Not every country starts with the same deck of cards or on the same trees in this metaphor, but jumping to nearby trees can increase their complexity.

Some countries will start in more advantageous parts of the forest, but that doesn’t mean they’ll capitalize on those opportunities.

Chicken and egg

This introduces a chicken and egg problem, though — how do you start, for example, producing watches without watchmakers? Migration plays a big role here.

• If Swiss watchmakers move to your country and start making watches, they’ll train people to make watches who’ll train others, and the economy will become more complex, adding watches to its list of exports.

Jumping to nearby trees gets the ball rolling for increasing complexity.

However, attracting people with knowledge and skills not prevalent in your country, and allowing them to spread that knowledge, is key to broadly increasing complexity.

Hausmann highlights Bangladesh to demonstrate this. Starting in the 1980s, some 90% of the country’s exports have been clothing garments.

This began when a company named Desh sent 126 workers to a training program in Korea for six months to study garment-making. They returned and “infected(ed) the system with knowledge.” 56 of those workers went on to launch their own garment-making startups.

• Bangladesh imported knowledge and became a world leader in that product niche.

Governments that succeed in helping their countries become wealthier facilitate increased complexity.

That can range from removing tariffs and other taxes to building robust power grids and extensive public transportation networks or incentivizing students and workers to study abroad and return home — anything that paves the way for industry to develop and knowledge to disperse.

Dive deeper

For more, check out Ricardo Hausmann’s interview on Bloomberg’s Odd Lots podcast. You can also visit his website The Atlas of Economic Complexity.

WHAT ELSE WE’RE INTO

📺 WATCH: 100 Baggers: How to find stocks that return 100-to-1

🎧 LISTEN: Charlie Munger & the psychology of human misjudgement

📖 READ: China needs to engineer a beautiful deleveraging, by Ray Dalio

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