What does “middle class trap” mean ?



As someone with 0 economics knowledge but keen interest I keep hearing this term “middle class trap” and how it is bad for countries long term economy and its people. What does it mean and why is it harmful for a country’s long term prospects ?

Thank you

In: 467

It’s not a for sure thing. There’s still debate. But the idea is that if an economy loses its industrialized/manufacturing base it must move to a high skill/service economy.

For example, the US saw a lot of manufacturing moving overseas in the last several decades. But that economic activity was replaced by high value industries like software. Similar story in China as it moves from agriculture to industrialization and manufacturing to software and consumer services. England as well – their biggest industry is finance and banking.

But these industries are extremely competitive and skill-intensive. A nation can’t just decide to create a financial capital of the world like London or NYC or Singapore. They would need decades to hundreds of years of experience navigating and even coordinating national/world economies. The US and England have that. You need a mass of highly educated people as well. How many finance and CS graduates are being produced by Ghana or by Portugal on the other hand? How many are they keeping? And what sort of global problems are they getting to experience?

In other words, it’s hard to make the leap to those “tier one” industries. Harder than it is to leave manufacturing.

And they can’t go back because manufacturing is now cheaper elsewhere. Why would companies build factories in the US when Mexico provides similar services at a lower price point?

So, what happened to a lot of countries is that they lost their “lower tier” manufacturing bases but failed to move that economic activity to sectors like software/banking/etc. So they’re stuck in this area of mid-level GDP per capita. Long term, because if you’re not moving forward you’re falling behind, being stuck in this space can set you even further behind. New “tier 1” industries will emerge and nations will be 2 steps behind. And other nations, maybe the ones you outsourced your manufacturing to, will make that leap.

Everyone who makes an income has to turn their money over continuously to maintain it’s balance. Even millionaires are three bad months from homelessness.

You might be referring to the “middle income trap”.

Low income countries generally have similar characteristics. Poor infrastructure, very low educational attainment in general, lack of institutions (legal and political), very basic trade and production that is predominantly agriculture. Families tend to be large and on average each person produces not a lot of value. At this point, GDP per capita is usually below USD5,000.

Although it isn’t easy, by any means, the pathway out of low income usually involves investment and development away from those characteristics. This typically involves infrastructure investment (energy, transportation), mandatory education (up to high school level) investment in manufacturing, healthcare, sound governance. This typically leads to higher degree of urbanization, smaller families, greater worker participation in the economy. This more productive economy (typically low to mid end manufacturing) raises the income of citizens generally. This can happen fairly rapidly (in some cases in less than 40-50 years) because a lot of the needed infrastructure and expertise can be “imported” through FDI and government loans and this investment directly adds to GDP. Generally speaking, industry focuses on exports rather than domestic consumption. GDP per capita is between 5,000-12,000 USD. Once GDP per capita gets to around 10,000 USD, a country is generally recognized as being a middle income nation.

This is where the “trap” happens. After 40-50 years the country would have developed many institutions that perpetuate this form of economy. Local successful companies lobby for protection. Political and economic stagnation can occur. After all, why change what has worked? Manufacturing is valued and many of the most talented citizens can migrate. The basics of food, shelter and security are present. There is a lot of institutional inertia. Generally speaking the poor still live in the countryside while a wealthier urban core develops.

The leap to a high income country is very difficult. There is no fixed path but generally the economy would need to migrate to high end services (engineering, finance, R&D) and higher education (need lots of college graduates). Women must participate in the economy, the country must be open for entrepreneurs and higher-end lifestyle services. Domestic consumption must become the biggest parts of the economy.

This is easy to describe but very hard to make happen. Higher incomes mean manufacturing has to transition to high value add, usually technical, with high capital requirements. A great deal of government stability and confidence in local institutions need to be established – no one pours billions of dollars into long term investments otherwise. Intellectual property must be protected. A well developed capital market and financial institutions are required. Few countries have crossed the gap to high income and even fewer with high populations. (There are some countries that have enormous natural resource wealth that have done so – but that is another story)

Sometimes a poor country will become attractive to companies looking for low-cost workers. (I say *become* attractive, because companies don’t simply look for the poorest country and build there; the country also has to develop a combination of enough infrastructure, enough education, low enough crime, enough long-term political stability, etc. to be worth the risk of building there.)

When this happens, the poor country will have companies investing in manufacturing plants, etc. and creating jobs. Those jobs won’t pay well compared to minimum-wage in rich countries, but the wages will be decent-to-good for the country they are in, and in particular they will be a more consistent and dependable paycheck than a lot of other jobs (like seasonal farming work, etc.) in the country.

If this business does well, other businesses may decide to also build facilities there and create more jobs. The effect of this is that more and more people make a decent-to-good dependable paycheck and a “middle class” begins to develop.

However, this process can’t continue forever. If everyone has one of these middle-class jobs, then some company building a new factory has to have higher-wages to get workers to work at *their* factory. This wage competition is good for the workers, and many companies may find that the labor costs are still better here than elsewhere even if they have to compete on wages, but it does mean that labor costs increase – possibly to a level where it isn’t as attractive as it used to be so fewer new companies will decide to invest. This also means less new companies will be competing for workers, and so wage growth will eventually stagnate.

That is the “trap”. The country can’t simply rely on that economic growth continuing on forever – eventually it will hit a plateau.

Overcoming the “trap” is hard because the country essentially has to find a way to develop more higher-paying jobs… which it can’t do by simply continuing to be one-of-many “cheap labor” countries. It has to develop some way to do more high-value-add work. That may involve investing in education, infrastructure, or something, but they somehow have to develop enough capability to compete with already-developed countries on *something* important enough to gain those new jobs. And even then, it’s tricky because, even if they develop enough to keep-pace with the gradual advances in various kinds of manufacturing… they’ll still be keeping pace decades behind the cutting-edge stuff of the highly-developed countries… leaving them stuck in a “middle class” kind of development rather than ever competing at the cutting-edge of any industry.

Furthermore, investing in a way to actually compete at the cutting-edge is a much harder hurdle to surmount – both in terms of total investment costs as well as the difficulty of predicting the future of various industries well enough to anticipate future in-demand skills and infrastructure necessities.