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New Structural Economics and Development
Tuesday, 07 June 2011 23:09

Over the decades, development theories have swung from one extreme to the other – from a belief in state-driven development to free-market fundamentalism.  World Bank Chief Economist, Justin Yifu Lin, is now promoting the “new structural economics” as a framework for rethinking economic development.

 

In short, it is not a question of the state versus the market.  Rather, it is the role of government to facilitate market-based development.  However, one issue that Lin does not discuss is the need for a government which is well-intentioned, competent and not corrupt.  Such governments are few and far between in the developing world!

 

In the 1950s and 1960s, most developing countries believed that government-led industrialization was the path to development.  For example, in 1945 Mao Zedong declared that “without the establishment of heavy industries in China, there can be no solid national defense, no well-being for the people, no prosperity and no strength for the nation”.  In a similar vein, in 1946 Indian leader Jawaharlal Nehru said: “No country can be politically and economically independent, even within the framework of international independence, unless it is highly industrialized and has developed its power resources to the utmost”.

 

In this context, the market-failure thesis became the core of development economics after World War II.  Economists advocated that the state should overcome market failures by playing a leading role in the industrialization push, directly allocating the resources for investment, and setting up public enterprises. They argued that the way for a developing country to avoid being exploited by developed countries was to develop manufacturing industries through import substitution.            

 

Despite these good intentions, the results were disappointing.  Income levels in developing countries stagnated or even deteriorated.  In order to implement these strategies, developing country governments had to protect numerous non-viable enterprises by granting market monopoly status, suppressing interest rates, controlling the prices for raw materials, etc.

 

The reason why these developing countries failed to achieve dynamic growth was that they attempted to defy comparative advantage.  They gave priority to the development of capital intensive heavy industries when capital was scarce and their real comparative advantage was in labor-intensive production.

 

These misguided strategies were behind the debt crisis in Latin America and the failure of communism in central and eastern Europe.  The consequence in economic thinking was the rise of the “Washington Consensus” which promoted economic liberalization, privatization and the implementation of rigorous stabilization programs, often referred to as market fundamentalism.  But the results of Washington Consensus policies were also not impressive.  It missed the importance industrial upgrading and technological change. 

 

As Lin argues clearly, economic development is a dynamic process along a wide spectrum from a low-income, subsistence agrarian economy to a high-income industrialized economy.  It requires continuous structural change, upgrading and diversification.  The market is the most effective mechanism for allocating resources.  But the market needs to be complemented by an active role by government in providing both hard and soft infrastructure. 

 

Market-based development depends on an economy’s resources, or factor endowments.  Traditionally, we think of land, labor and capital.  Another element in a nation’s resources is its infrastructure.  Examples of hard infrastructure are highways, port facilities, airports, telecommunications systems, electricity grids and other public utilities.  Soft infrastructure consists of institutions, regulations, social capital, value systems, etc.

 

Countries at different stages of development have different economic structures due to differences in their resource endowments.  Endowments for countries at the early stages of development are typically characterized by a relative scarcity of capital and a relative abundance of labor or natural resources.  Their production activities tend to be labor-intensive or resource intensive.  They tend to use and absorb existing technologies and knowhow from the rest of the world -- this is the advantage of backwardness, being able to achieve fast growth by absorbing existing knowledge and technology.  The hard and soft infrastructure required for this stage of development is simple and rudimentary. 

 

While resource endowments are fixed at any point in time, they will also change over time, and the structure of the economy will change in consequence.  Thus, at the other extreme of the development spectrum, high income countries typically have an abundance of capital, rather than labor or natural resources.  Being situated on the global technology and industrial frontier, they rely on creative destruction or the invention of new technology and products for achieving technological innovation and upgrading.  Thus, governments in developed countries subsidize research and development by funding basic research in universities, granting patents for new inventions, etc.  High income countries also need more sophisticated educational, financial and legal systems. 

 

A competitive market should be the economy’s fundamental mechanism for resource allocation at each stage of its development.  Following comparative advantage is the fastest way to accumulate capital and upgrade resources.  But the critical thing is for the government to upgrade the economy’s infrastructure in parallel.  This is the role of the “facilitating state”.  Industrial upgrading in a developing country should be consistent with the change in a country’s comparative advantage that reflects the accumulation of human and physical capital.  Industry policy should identify industries that have operated successfully for some time in countries that have higher income, but similar resource endowments, should coordinate related investments across different firms and nurture new industries through incubation and encouragement of foreign direct investment. 

 

This is how East Asia has succeeded.  Countries have specialized in labor-intensive manufacturing and/or tourism, and governments have facilitated this process by providing infrastructure.  They adopted export-oriented strategies, rather than import substitution.  They progressively climbed the development ladder by upgrading their technological and industrial structures. 

 

Japan has gone from a labor-intensive manufacturer to a high-tech manufacturer in the space of 50 years.  Korea and Taiwan then traced the same path, and are now being followed by China, India and the ASEAN countries.  In all these cases, the market has played the fundamental resource allocation role, but this has been facilitated by state provision of infrastructure.  

 

To some extent, Justin Lin’s theory of new structural economics brings us back to undergraduate microeconomics.  We all learn that markets are not perfect.  There are externalities and public goods.  And as an economy develops, and upgrades its technology and knowledge, the nature of those externalities and public goods also changes.

 

This evolving nature of the role of the facilitating state presents challenges for many developing countries.  Liberalizing trade and investment, and doing business is not so difficult.  Same goes for building a few roads, ports and airports, especially if a foreign investor provides some help.  But upgrading a country’s hard and soft infrastructure over time also requires an increasingly competent government, and many governments simply lack capacity.  Many Asian countries are now at this point.  Their role of facilitating development requires greater sophistication, and it is not easy.  They risk falling into a “middle income trap” of stagnating growth. 

 

As we have covered in many other articles, the effectiveness of government can also be limited by corruption.  In the early stages of development, corruption can actually help grease the wheels of business, and help get things moving.  Again, as development proceeds, corruption can then become a negative for development.  Many emerging Asian economies are at this point.  It is time to clean up corruption, but very difficult to do so when political and business elites believe that they can get away with it, and even believe taht they have a right to the spoils of corruption. 

 

Lastly, there are some governments, like North Korea, Myanmar and much of North Africa and the Middle East which are dominated by elites who are plainly not serious about development.  Their objective is maintaining their monopoly on power and repressing their populations.  The only way to get a facilitating state is to have a revolution, like we are now seeing in North Africa and the Middle East.

 

So, to summarize, the theory of the facilitating state and the new structural economics is a good theory, though perhaps not so new.  But a facilitating state must be competent, clean and well-intentioned to be effective.  Not so easy!

 

 

 

Reference:

“New Structural Economics: A Framework for Rethinking Development”, Justin Yifu Lin.  Policy Research Working Paper 5197.  World Bank.

http://siteresources.worldbank.org/INTMOZAMBIQUE/Resources/New_Structural_Economics.pdf

 

 

 

 

 


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