# **I. Introduction**

A booming theoretical literature has proposed a variety of mechanisms capable of generating vicious cycles of poverty and stagnation – referred to as poverty traps.<sup>2</sup> Broadly, the idea underlying such models is that poverty prevents a significant share (or even all) of the population from helping ignite the growth engine. Under appropriate conditions, this may lead to multiple equilibria, making it possible for poverty to become self-reinforcing.

Such situation may arise through a number of channels. A prominent one involves the existence of ‘threshold effects’, resulting for example from indivisibilities or increasing returns to scale, so that below a certain level of income or wealth society is too poor to afford the investments (in human or physical capital) or the technologies necessary to set the growth process in motion. Along these lines, Galor and Zeira (1993) present a model in which credit constraints and indivisibilities in human capital investment hamper aggregate growth. The reason is that only sufficiently wealthy individuals can afford education, which is the force driving growth in the model.<sup>3</sup> Another poverty-perpetuating mechanism is related to risk. As noted by Banerjee (2000), the poor are typically more risk averse than the rich because losses hurt them more severely. In the absence of well-functioning insurance and credit markets, the poor will skip profitable investment opportunities that they deem too risky.<sup>4</sup> Such behavior makes poverty self-reinforcing as the poor minimize risk at the expense of their mean earnings. In this vein, Dercon (2003) notes that existing empirical estimates (typically based on country case studies) suggest that if the poor could shelter themselves from shocks as well as the rich do, their incomes could be on average 25 to 50 percent higher.

Institutions are another potential source of poverty traps. Institutional arrangements that place the economic opportunities created in the development process beyond the reach of large segments of society are likely to result in reduced growth rates, as modern economies require broad participation in entrepreneurship and innovation. Along these lines, Engerman and Sokoloff (2004) argue that persistent poverty in former European colonies can be traced to the organization of production and the institutional arrangements originally created by the colonial powers.

However, as noted by Durlauf (2004), in spite of the diversity and growing popularity of these analytical models, little is known about their empirical relevance. A few empirical studies have attempted to assess it taking an indirect route. In this vein, Quah (1993) and Azariadis and Stachurski (2004), among others, have explored the existence of convergence clubs by assessing the bimodality of the cross-country distribution of per capita income. On the whole, their findings lend support to the existence of rich and poor clubs at

> 2 See Azariadis and Stachurski (2005) for a survey.

> 3 See also Dasgupta and Ray (1986), who develop a model focused on investments in health, and Banerjee and Newman (1994), who consider threshold effects in a model with physical capital.

> 4 The argument that risk aversion leads to underinvestment goes back to Stiglitz (1969).

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