Was Prometheus Unbound by Chance? Risk, Diversification, and Growth

Abstract

This paper offers a theory of development that links the degree of market incompleteness to capital accumulation and growth. At early stages of development, the presence projects limits the degree of risk spreading (diversification) that the economy can achieve. The desire to avoid highly risky investments slows down capital accumulation, and the inability to diversify idiosyncratic risk introduces a large amount of uncertainty in the growth process. The typical development pattern will consist of a lengthy period of “primitive accumulation” with highly variable output, followed by takeoff and financial deepening and, finally, steady growth. “Lucky” countries will spend relatively less time in the primitive accumulation stage and develop faster. Although all agents are price takers and there are no technological spillovers, the decentralized equilibrium is inefficient because individuals do not take into account their impact on others' diversification opportunities. We also show that our results generalize to economies with international capital flows.