Costly Intermediation and the Poverty of Nations

Distortions in private investment due to credit frictions, and in public investment due to corruption and bureaucratic inefficiencies, have both been suggested as important factors in accounting for the cross-country per capita income distribution. We introduce two modifications to the standard one-sector neoclassical growth model to incorporate these distortions. The model is calibrated using data from 79 countries to examine the quantitative implication of these margins. We find that financial frictions account for less than 2% of the cross-country variation in relative income. Even accounting for mismeasurement, financial frictions can typically explain less than 5% of the income gap between the five richest and the five poorest countries in the world. Distortions in the public investment process, on the other hand, seem more promising. There is both more variation in the measured value of the public capital distortion and it can account for more than 25% of the income gap between the richest and poorest countries in our sample.