Why Doesn’t Capital Flow From Rich to Poor Neighborhoods?

Excerpt from Principles of Macroeconomics: An Evolutionary Approach,

by Max Gillman, Published by Kendall Hunt; 2017.

Explaining urban blight remains part of the urban policy’s main challenges. Support has been found for how public capital amenities such as transportation aides the development of city centers during expansionary periods. Evidence also suggests that prices tend to rise faster in urban city centers than in more outlying areas during expansionary periods.

Taking a hypothesis from macroeconomics, human capital theory can be applied to urban development to explain why blight exists and how business cycles affect it. In a famous article, “Why doesn’t capital flow from rich to poor countries?” Lucas (1990) suggests that financial/physical capital does not flow into poor countries because the human capital is insufficient to support such inflows of physical capital. The human capital basis is insufficient to allow a sufficiently high return on capital simply by importing the capital into the less developed country.

The lack of the human capital foundation to support physical or financial capital increases explains why we don’t observe rapid capital inflows and rapid development. Instead nations develop slowly. And this slow development may be in line with their ability to build their education systems and their human capital, such that they gradually can absorb new physical capital profitably.

Development based on the return to investing in human capital is an idea put forth in the human capital theory of Nobel Laureate T. W. Schultz’s (1964) “Transforming Traditional Agriculture”. The Schultz growth theory is formalized in Lucas’s (1988) “Mechanics of Economic Growth”. The theory says human capital investment only occurs once the return to human capital investment is positive, and then it results that in equilibrium the returns to physical capital and human capital become equal.

The theory of equilibrium capital returns requires that the physical capital to human capital ratio in each of the economy’s sectors is proportional, so that both the human capital basis is sufficient to support the physical capital investment and likewise the physical capital investment is sufficient to support the human capital investment.

The answer to Lucas’s question about why financial capital does not flood into undeveloped economies, or areas of an economy, is that there is insufficient human capital to support the subsequent physical capital development. This feature may also occur with the development of cities, where the blighted neighborhoods are taken to be one “economy” that trades labor and capital with the “rest of the well-developed neighborhoods”. Physical/financial capital does not flow rapidly from the well-developed neighborhoods to the blighted neighborhoods because the blighted neighborhoods do not have sufficient human capital to support it. Conversely, the low property values of the blight means the physical capital is insufficient to warrant the investment in human capital, or an inflow of relatively more educated people into the neighborhood.

Blighted areas within urban centers, such as St. Louis, Cleveland and Detroit, show that neighborhood “gentrification” can be held off for generations at a time. During this prolonged period of “lost decades”, these neighborhoods continue to be stuck with a low aggregate human capital of their residents. These neighborhoods are unable to support higher quality housing, groceries, and trendy shops typical of the gentrification process that necessarily involves significant physical capital inflow into the neighborhoods. Since education relies to a large extent on property taxes within each neighborhood, the low property values where blight exists keeps grass-roots education funding relatively low and creates a vicious cycle of low education, low human capital levels and low income.

Blighted neighborhoods may tend to have the worst schools because the property value of such neighborhoods is low by definition of blight. Residents of blighted neighborhoods easily can get stuck in a “lost-generations” cycle of growing up and going to school at the worse schools. Then comes the cycle of having low human capital levels, job opportunities, and income levels.

One solution in economics in the face of externalities is to eliminate the source of the externality. In blighted neighborhoods this means eliminating the abandoned commercial and residential buildings. However, many cities allow owners to hold onto such property indefinitely. This creates externalities that property owners of abandoned buildings are imposing upon those residing in the blighted neighborhoods.

A solution is to legislate changes in property laws such that abandoned properties can more easily become city, state, or federal property, and then be torn down and rehabilitated. This could include creation of temporary green spaces, redevelopment or social amenities as in parks. This could break the cycle of low human capital because of low property values that in turn finance the neighborhood schools.

With blight eliminated, development that rushes into city centers during business cycle expansions could encompass the previously blighted neighborhoods rather than leaving them ever further behind. As developed city center prices rise relatively quickly, so can the property values of “un-blighted” neighborhoods, along with the human capital of their residents.

Lucas, Robert Jr., 1988. “On the mechanics of economic development,” Journal of Monetary Economics, 22(1, July): 3-42.

Lucas, Robert E, Jr, 1990. “Why Doesn’t Capital Flow from Rich to Poor Countries?,” American Economic Review, 80(2, May): 92-96.

Schultz, T. W., 1964. Transforming Traditional Agriculture, New Haven: Yale University Press.