Once upon a time there were a number of Asian countries. They had scarce natural resources, hardly any notable capital accumulation, were heavily overpopulated and most of their people lived in extreme poverty. In fact, the situation of these Asian countries was so miserable, that development economists were betting on South America and Africa for rapid development. But then, one day, came the economic growth fairy and blessed the Asian countries with decade-long, (close to) double-digit growth rates and all was good and everyone was happy – except for the development economists, who didn’t know how this could possibly have happened. And after decades of research, … we still don’t really know. However, there are some new interesting approaches at the frontier of development economics. Justin Yifu Lin’s idea of the new structural economics is one of the ground-breaking ideas that shed some light on how economies develop. In this blog I will outline the main ideas and some personal points of criticism, but if you’re interested in more, you can look at the following paper or, if you need a more integrated perspective, at his newest book: Demystifying the Chinese Economy. Both are highly recommended readings.
So what are the main ideas behind the new structural economics and what’s new? As the name suggests, the framework is built on the importance of structural change for economic development – something that is in itself not particularly new. However, Lin combines it with the concept of comparative advantages determined by endowments. At each stage of development countries have different endowment structures and there are some similarities across development stages: i.e. developing countries generally have a low capital-labour ratio compared to developed countries. According to Lin’s theory countries have to develop according to their comparative advantage. This implies that low income countries with large pools of unskilled labour should not attempt to waste all their resources in an attempt to build capital-intensive, heavy industries of the type that exist in Western economies. These industries would not be viable in developing countries without continuous assistance from the government, which in turn requires resources that have to be diverted away from other parts of the economy, potentially harming viable industries and introducing further distortions into the economy (he gives excellent examples in the book). To some of you, this may sound familiar, because such strategies have been tried repeatedly in many parts of the world. They are generally known as “structuralist approaches” or “import substitution approaches”. With his framework Lin can explain WHY these policies focusing on capital-intensive industries were doomed to fail from the start. Following a strategy consistent with the comparative advantage, on the other hand, means supporting viable businesses and freeing resources for more sensible development policies.
So, what are sensible development policies? Lin does not argue for laissez faire similar to the liberal, “Washington Consensus”-type policies. Instead, he argues that while the intuition of following the market is good, very liberal approaches deny that there is room for government intervention at all. This ignores two main issues. Firstly, many developing economies are distorted by previous policy choices and therefore the prevailing conditions (i.e. factor prices) may not provide the best market signals. Secondly, developing economies are prone to coordination and information failures. One often cited example is that innovation and investment are below their optimal level. Innovations are often associated with large positive externalities that cannot be internalized by the innovating firm. Without all the economics jargon, this means that if firm A comes up with innovation X it may have a very small expected return due to the associated risk of innovation and i.e. a lack of protection for its innovative ideas. At the same time, the innovation X by firm A may lead other firms to have (possibly large) returns from the innovation, but clearly, firm A does not take these returns into account when innovating. Therefore it is the policy makers job to provide to intervene and correct such market failures to ensure development in line with the comparative advantage of the country.
While Lin’s framework built on comparative advantages certainly sounds plausible and can explain many development experiences I want to discuss two of the main problems I see with it. Firstly, it is hard to verify. In Asia, for instance, most countries followed first an import substitution strategy or combined comparative advantage defying (CAD) with consistent (CAC) strategies. Taiwan and China, for instance, followed a clear dual track approach continuing to support large state-owned enterprises while developing SMEs at the same time. Clearly, CAD strategies alone did not lead to successes, but it is not possible to rule out that the interaction between pushing capital-intensive industries and labour-intensive industries did have overall positive effects on growth. Secondly, even if the theory is true, there is no measure for comparative advantages. In economics, the most widely used concept when dealing with comparative advantages are revealed comparative advantages, which are calculated from trade statistics, not endowments, and depict the status-quo instead of showing latent comparative advantages. In a different paper, Lin therefore proposes six steps in the Growth Identification and Facilitation Program of how to design policies that are CAC. However, these recommendations are rather vague and hard to implement. They essentially urge countries to identify products other developing low income countries have specialized and succeeded in and adapt these strategies to the domestic economy. While this sounds simple on paper, it is certainly tricky to come up with the appropriate policies and the reasoning rests on the assumption that the latent comparative advantages of low income countries are similar, particularly when their endowment structure is also similar. However, endowment structures and development policies are complex and Lin (2011, p.33) may be overly optimistic, when stating that “[t]he lessons from history and from economic theory are now clear. Regardless of size, location, or natural resources, all developing countries can achieve annual growth rates of 8 per cent or more for decades.” While this should be in principle true, due to the enormous catch-up potential it clearly downplays how complicated development still is and how much it relies on internal conditions – i.e. political stability and governance – and external conditions – i.e. competitors and the situation of the world economy. Development is not only a question of the right policies, but rather of the right policies at the right time. Despite its flaws Lin’s perspective certainly opens up new ways to look at the issues faced by developing countries and potential paths of development.