Structural change is, by definition, innovative

Development 3.0

By Justin Yifu Lin

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.