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CAPACITY AND DIVERSITY: YOU WON’T GET AHEAD BY FOLLOWING THE CROWD

Date: 28/05/2018

Author(s): Borja Santos Porras, Gregorio Bustos Serrano, Jorge Díaz Lanchas



“Tell me what you can do and I’ll tell you what you’re worth.” While this sentence may come across as vague at first glance—something we could easily hear in a job interview or in the context of US doctorates—it can actually be applied as a tool to predict the economic growth of an area, region or country. At least, that’s what Ricardo Hausmann and César Hidalgo—academics from Harvard and the Massachusetts Institute of Technology (MIT)—thought when they began to develop their theory of economic complexity approximately a decade ago.

According to this theory, the basis for economic growth lies in an area’s capacity to produce both a greater variety of goods and increasingly complex products. This capacity is demonstrated by the products that an area is capable of competitively producing and exporting. Following this line of thought, it soon becomes clear that the most developed economies are also the most complex, as they are able to produce a more diverse range of products. Also, due to their complexity, some of these products are only available to a few economies. On the other hand, the economies that produce fewer and less-complex products are generally found to also be less developed.

To understand these concepts in the simplest way possible, Hausmann suggests taking the game Scrabble as a metaphor. The more letters (capacity) we have in our hand (area), the greater number of different words we can make (varieties), which in turn can be longer (more complex products). Therefore, the key to growth is the number of letters (capacity) that an area has, meaning they can create a higher volume of better products. An area’s ability to grow not only depends on their own factors (capital, labor and institutions), but also on how they combine these to exploit all the capacity available to them.

So far so good, but how does this idea stand up to the evidence? Very well, as it turns out. As we have mentioned, economic complexity is measured by two factors. Firstly, the diversity of products that a country exports, which reveals its productive capacity. And secondly, the products’ uniqueness (or ubiquity) compared to exports from other countries. Both factors are shown in the graph below. The horizontal axis displays the product diversity of each country’s economy, and the vertical their ubiquity. The lower their ubiquity appears on the graph, the more unique and exclusive an economy’s products are. Furthermore, there is a correlation between the two factors, as countries with greater product diversity also generate more exclusive products.

With regard to Spain, it is clear that the country is very well placed in terms of the diversity of their productive capacity. However, the corresponding ubiquity of its products is higher than you would expect, meaning many countries share the same knowledge and ability as Spain. In other words, the low exclusivity of Spanish assets makes it difficult to differentiate Spain from other countries, regardless of its high capacity.

Diversity versus ubiquity of Spanish industry products (2015)

Compiled by Borja Santos, with data from the Harvard Center for International Development.

The two factors that determine a country’s productive capacity can be combined into a single index called economic complexity. We can compare this complexity with various countries’ income to see if it can explain their growth. The graph below shows this relationship for 2014, where the gross domestic product (GDP) per capita—an indicator of productivity—is displayed on the vertical axis, and the countries’ economic complexities on the horizontal axis. To clarify, the countries above the diagonal line (adjustment) have a higher income than you would expect given their capacity. The countries below the line, however, receive a relatively low income given their overall capacity and know-how. Consequently, the first group of countries are expected to suffer a drop in their income in the coming years, while those below the adjustment line are likely to experience higher growth rates in the future.

Economic complexity by GDP per capita (2014)

Compiled by Borja Santos, with data from the Harvard Center for International Development.

It’s clear the relationship that exists between productivity (GDP per capita) and product complexity is quite powerful. Countries like Germany, Japan, China and India are expected to grow more in the long run, while Greece, Canada, New Zealand or oil-exporting countries are predicted to experience little growth in the coming years, given the smaller capacity available. As a result, the Economic Complexity Index is a good tool for predicting growth within the next 10 years. According to available estimates, India will experience the most growth, with an average of 7.6%, followed by Indonesia and Vietnam, with rates of 6%. China will continue with an average predicted growth rate of around 5%.
With regard to Spain, if we analyze its economic complexity compared to countries with similar per capita income, it performs better than expected. Countries with a similar income, like South Korea or Israel, have a greater complexity index, which could lead to more substantial economic growth in the future. Take the Global Ranking of Economic Complexity from the Harvard International Center or The Observatory of Economic Complexity, shown below. If we analyze this over time, it’s clear that Spain’s position is falling when compared to other countries. The complexity index has suffered a serious setback, especially in the last five years. What does this mean? Spain may have lost a large amount of production capacity during the years of the crisis, probably as a result of business closures, a deteriorating labor force or low political commitment to innovation. Alternatively, it could be that other countries—including emerging ones—are accumulating more capacity, which will lead to them growing more quickly in the future. Either way, Spain may be missing the proverbial boat.
Global Ranking of Economic Complexity (Harvard CID)

With all this in mind, how can we gain more capacity? Although the answer is neither simple nor unique, we can suggest some ideas as to how it may be done. Firstly, innovation may have a positive effect on capacity. This is because it involves both the generation of new skills, and also may lead to the discovery and creation of unique products that would give Spain a comparative advantage in a larger number of sectors. Secondly, retaining and attracting talent is critical to acquire new knowledge. Finally, as well as creating new capacity, we also need to better take advantage of those we already have. To do this it’s important to promote networks of collaboration between companies, institutions, workers and universities. Currently, there isn’t much cooperation between what universities are able to develop and what businesses actually need. What’s more, public administration needs to play a fundamental role in order to generate capacity, either as a driver of new ideas or as an agent that acts as a link for the generation of comparative advantages. In short, it would require having an active and dynamic attitude, as well as facilitating the flow of information between economic agents.

We are currently living in what seems to be economic recovery. Of course, we are excited to be back playing in the International Scrabble League, so to speak, but rather than continuing to generate unique and innovative capacity (letters), we are satisfying ourselves by putting the same letters on the board as we always have. While other countries have improved their economic complexity, Spain is losing steam. Our inability to decisively and strategically back improvements to our knowledge will be critical to our future economic growth. As you already know, you stand little chance of creating value if you just do the same as everyone else.