By Daniel Archibald | CFA
Human behaviour, both individual and in groups, often dictates the trajectory of progression. When an economic system is established well, it can lead to continual growth in wealth and prosperity for society and its constituents. However, in some cases it can lead to a course that is more cyclical in nature; always moving, but never going anywhere.
There are numerous types of such systems or 'economic traps'. One of the greatest ills in societies around the world manifests in the inability of individuals and communities to break free out of the cycle of poverty. Such 'poverty traps' result in low, multi-generational standards of living and are caused by self-reinforcing mechanisms. These can be opportunity paradoxes (e.g. you need a suit to get a job, but you need a job to get a suit), a general lack of resources or limited access to key development elements (e.g. education). These mechanisms might be overcome where conditions are right, but can often be ingrained through internal factors (e.g. behavioural and social factors) or external factors (e.g. political instability, institutional corruption and geographical constraints).
Other economic traps, include:
- Middle-income trap - This occurs at the national level and often captures countries as they develop out of poverty. This initial development is usually accomplished by taking advantage of a low-income labour force, which allows the country to be competitive in many labour-intensive industries (e.g. low-end manufacturing). However, such industries and lack of progress towards high value goods and services, can limit a country's progression; falling short of becoming a fully-developed economy.
- Productivity trap - This is linked to the above and is generally the result of a country failing to diversify away from industries that offer little in the way of productivity growth. These are generally mature industries (technologically) such as agriculture and resource extraction. For example, Nauru's reliance on its dwindling phosphate reserves led to its inability to remain productive over time.
- Value Trap - Investors can often fall for buying stocks that seem undervalued, but are actually priced appropriately. For example, companies whose share price has fallen considerably will often start to capture the attention of value investors who might be looking for a good recovery story. Often, however, value can be lost permanently leaving value hunters holding a stock that will never return to its previous levels.
The conditions that lead to these economic traps might largely be the result of poor decision-making (by policy makers, investors, etc). But understanding these, and planning accordingly, can help in avoiding or breaking free of such common traps.