Monday, November 24, 2014

Development 3.0

BEIJING – Until the Industrial Revolution, the world was quite flat in terms of per capita income. But then fortunes rapidly diverged, with a few Western industrialized countries quickly achieving political and economic dominance worldwide. In recent years – even before the financial crisis erupted in 2008 – it was clear that the global economic landscape had shifted again. Until 2000, the G-7 accounted for about two-thirds of global GDP. Today, China and a few large developing countries have become the world’s growth leaders.

Yet, despite talk of a rising Asia, only a handful of East Asian economies have moved from low- to high-income status during the past several decades. Moreover, between 1950 and 2008, only 28 economies in the world – and only 12 non-Western economies – were able to narrow their per capita income gap with the United States by ten percentage points or more. Meanwhile, more than 150 countries have been trapped in low- or middle-income status. Narrowing the gap with industrialized high-income countries continues to be the world’s main development challenge.

In the post-colonial period following World War II, the prevailing development paradigm was a form of structuralism: the aim was to change poor countries’ industrial structure to resemble that of high-income countries. Structuralists typically advised governments to adopt import-substitution strategies, using public-sector intervention to overcome “market failures.” Call this “Development Economics 1.0.” Countries that adhered to it experienced initial investment-led success, followed by repeated crises and stagnation.

Development thinking then shifted to the neoliberal Washington Consensus: privatization, liberalization, and stabilization would introduce to developing countries the idealized market institutions that had been established in advanced countries. Call this “Development Economics 2.0.” The results of the Washington Consensus reforms were at best controversial, and some economists have even described the 1980’s and 1990’s as “lost decades” in many developing countries.

Given persistent poverty in developing countries, bilateral donors and the global development community increasingly focused on education and health programs, both for humanitarian reasons and to generate growth. But service delivery remained disappointing, so the focus shifted to improving project performance, which researchers like Esther Duflo at MIT’s Poverty Action Lab have pioneered with randomized controlled experiments.

I call this “Development Economics 2.5.” But, judging from experience in North Africa, where education improved greatly under the old regimes, but failed to boost growth performance and create job opportunities for educated youth, the validity of such an approach as a fundamental model for development policy is dubious.

The East Asian and other economies that achieved dynamic growth and became industrialized did not follow import-substitution strategies; instead, they pursued export-oriented growth. Likewise, countries like Mauritius, China, and Vietnam did not implement rapid liberalization (so-called “shock therapy”), which the Washington Consensus advocated; instead, they followed a dual-track gradual approach (and often continued to perform poorly on various governance indicators).

Both groups of countries achieved great advances in education, health, poverty reduction, and other human development indicators. None of them used randomized control experiments to design their social or economic programs.

Today, a “Development Economics 3.0” is needed. In my view, the shift from understanding the determinants of a country’s economic structure and facilitating its change is tantamount to throwing the baby out with the bath water. Remember that Adam Smith called his great work An Inquiry into the Nature and Causes of the Wealth of Nations. In a similar spirit, development economics should be built on inquiries into the nature and causes of modern economic growth – that is, on structural change in the process of economic development.

Development thinking so far has focused on what developing countries do not have (developed countries’ capital-intensive industries); on areas in which developed countries perform better (Washington Consensus policies and governance); or on areas that are important from a humanitarian point of view but do not directly contribute to structural change (health and education).

In my book New Structural Economics, I propose shifting the focus to areas where developing countries can do well (their comparative advantages) based on what they have (their endowments). With dynamic structural change starting from there, success will breed success.

In our globalized world, a country’s optimal industrial structure – in which all industries are consistent with the country’s comparative advantages and are competitive in domestic and international markets – is determined by its endowment structure. A well-functioning market is required to provide incentives to domestic firms to align their investment choices with the country’s comparative advantages.

If a country’s firms can do that, the economy will be competitive, capital will accumulate quickly, the endowment structure will change, areas of comparative advantages will shift, and the economy will need to upgrade its industrial structure to a relatively higher level of capital intensity. So successful industrial upgrading and economic diversification requires first-movers, and improvements in skills, logistics, transportation, access to finance, and various other changes, many of which are beyond the first-movers’ capacity. Governments need to provide adequate incentives to encourage first-movers, and should play an active role in providing the required improvements or coordinating private firms’ investments in those areas.

Structural change is, by definition, innovative. Developing countries may benefit from the advantage of backwardness by replicating the structural change that has already occurred in higher-income countries. Based on the experiences of successful countries, every developing country has the potential to sustain 8% annual growth (or higher) for several decades, and to become a middle- or even a high-income country in one or two generations. The key is to have the right policy framework in place to facilitate private-sector alignment with the country’s comparative advantages, and to benefit from latecomer advantages in the process of structural change.

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    1. CommentedMukesh Adenwala

      I wonder if this is not more than a bit idealistic. Such a course of development can be available to developing countries if and only if man is merely homo economicus. We are in a world where everything cannot be and will never be freely shared and where the likes of agricultural subsidies would prevail. Countries would, as they do, use exchange rates, pollution norms, taxation, corruption, etc. to gain and protect comparative advantage. There will be wars if and when these interest in the form of comparative advantage, or even consolidation thereof, is challenged or threatened.

    2. CommentedMoctar Aboubacar

      This is a little optimistic, but the possibility is certainly there. Oil-producing African countries have a rather bad track record for upgrading their industrial structures and shifting their competitive advantages. But at the same time these countries have large informal sectors, low ease-of-doing-business indicators, and the state does not seem to actively promote these so-called first-movers.

      Gabon is a pretty good example of this. With the country's new 'Emerging Gabon' plan for economic diversification, there seems to be a similar logic to this article in the works --it would be interesting to see if this case lends any credence to the thesis put forth by Mr. Lin.

    3. Portrait of Shriya Anand

      CommentedShriya Anand

      What about countries with large natural resource endowments? We have observed the consequences faced by economies that depend heavily on the extraction of natural resources (which according to your argument would be the optimal thing for them to do because it is consistent with their endowment structures).

      It does not seem feasible for developing countries to follow your advice without first strengthening domestic institutions. This is the area where Development Economics 3.0 should focus its thinking and research.

    4. CommentedProcyon Mukherjee

      Mr. Lin’s moot point on national endowments and incentivizing private sector alignment to the cause that comparative advantage stemming from such endowments could be gainfully used for growth is well taken.

      I think the question on private sector alignment in the developing world is put to far greater scrutiny by the polity than what it deserves, which is one of the reasons why we have supply side issues in the first place, which causes spiraling inflation that affects the poor more than the rich. It is also an excuse used to delay projects that involve land acquisition, environment clearances. Where poverty is overwhelming as in the areas where tribal people live in India, the mines for Bauxite, Iron Ore, and many other minerals are situated, where wealth is below the ground. In exploiting these endowments the private sector interests can hardly be questionable whether it serves the national interests or is aligned towards profiteering, Here one is reminded of Milton Freidman, where he pointed out that, ‘The purpose of corporate social responsibility is to make profits’, which is so apt as the only social relevance it has is that without profits no economic activity in capital intensive industry is ever possible and this is the only way to create jobs. Under the verbiage of ‘inclusive growth’ and with a long lens of misplaced wisdom we have attracted many sympathizers but precious little to the cause of growth and job creation in these parts of the world.

      Procyon Mukherjee

    5. CommentedJonathan Lam

      gamesmith94134: Development 3.0

      Mr. Lim stated the key is to have the right policy framework in place to facilitate private-sector alignment with the country’s comparative advantages, and to benefit from latecomer advantages in the process of structural change, or what policy framework can facilitate the private-sectors alignment with country’s comparative advantage gain profitability in order to grant an extended structural development after the cost of the structural developments 1.0 and 2.0.

      I would agree the comparative advantage and its endowment would improve its probability to grow; however, it is only up to a point only if it can afford it. Therefore, using the public sector intervention to overcome ‘market failure’ causes financial disruption like ClubMed to debt crisis; and nationalized marketing like privatization, liberalization and stabilization demolished the market system in shifting the weights of control through the functionary measures like inflationary and deflationary measure in the hand of a few, and the populace was forced to secure the comfort zones on accountability and affordability that the price and value they cannot disclaim, and such process had undercut the human resources when the market was overheated and unemployment climbed.
      Since development 1.0 and 2.0 by the governmental incentives caused errors in sustainability and redistribution of wealth in the stratified social networks, such structural development did not benefit private sectors alignment in extending the change to grow after the governmental incentives.

      Onward in the development 2.5 is just another interruption of credit or monetary measure like Quantitative Easing that created the micro/macro financial cliffhanger. By manipulating the currencies variables that application on import/export balance only made it insoluble for sovereignty and made it even harder for its populace to adapt. After the expansion of the economy with lesser option to devaluation or inflation, the private sector’s dependency on credit and workers’ compensation escalated; they minimized the fluidity in the cash flow or saving ; eventually the private sectors cuts R&D or fresh employment on the youth or the new productivity and it stops to grow. It was because the structuralism or monetarism defies the market system with its mechanism like nationalized marketing, zombie banks, and sovereignty debts that many populaces cannot sync with its government price control or disinflationary measures.

      It is questionable that structural development economics is the major factor to change to improve the nature and causes of modern economic growth if profitability, sustainability, and redistribution of wealth are in jeopardy throughout our current financial crisis and political turmoil. Perhaps, in development 3.0, the development thinkers must think of restoring the market system that ‘A well-functioning market is required to provide incentives to domestic firms to align their investment choices with the country’s comparative advantages.’ And also, all sovereignties should work on its developments providing faith in its populaces with a soluble formula, which can give affordability a comfort zone, and accountability to sustain its livelihood with a balance on the principle of price and value -----an intrinsic market system with fair trade for all.

      Hopefully, “too big to fall” would become a part of our financial history that our children can read and understand.

      May the Buddha bless you?

    6. CommentedStefan Siewert

      It is an excellent way of understanding development and the classification is very convincing. It frames the way of evolution in Western thinking and global development.
      First of all, since Industrial revolution, we have a global economy and poor and rich societies are part of a system. Changes in their relations are linked with advances in technology and, thus, the promise of greater welfare for the whole system - as is recently happened with China when it became the world's manufacturer of choice.
      One remark: Innovation is permanent. Some industries have a "natural" innovation rate higher than others, for example palm oil vs. logging. Thus, an emergent new global division of wealth and comparative advantages is defined by a technology component as well. We might wish to recognize the limits of changing an institutional path way when thinking about development.

    7. CommentedSergio Reuben Soto

      With an industrial structure "consistent with the country's comparative advantages", you can't have a "competitive market". You will have, at least, a corporate market in that conditions..., and then an ineffective distribution of resources.
      Those are the contradictions of the "scholastic economics” you endorse.