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[6.3 Conference] Justin Yifu Lin: The Role of State in New Structural Economics

2017-07-04

 

After WWII, many developing countries gained political independence and started their drive to modernize. In response to the need fornation building in developing countries, a new sub-discipline in modern economics emerged: development economics. The hope of development economics is to guide developing countries in their nation building.

 

However, among nearly 200 developing economies after WWII, by 2008, only two countries had moved from low-income to high-income: Korea and Taiwan, China. In all likelihood, the Chinese main land will become the third one around 2025. And among the 110 middle-income economies in the 1960s, by 2008, only 13 moved from middle-income to high-income. Of those 13 economies, eight were either European countries surrounding Western Europe, whose gaps with developed countries were small to begin with, or oil-producing countries. The other five were Japan, Korea, Taiwan, Hong Kong, and Singapore. Most developing economies, in spite of various efforts, fail to catch up with the high-income economies. The result certainly is disappointing.

 

Modern income growth is a process based on continuous structural transformation in technologies and industries, which increases labor productivity, and continuous improvement in soft and hard infrastructure in the economy, which reduces transaction costs. Developing countries have the advantage of backwardness in technological innovation, industrial upgrading, and institutional innovation. So they should have the potential to grow faster than developed countries and achieve convergence. However, most developing countries have not benefited from this potential and have been trapped in low-income or middle-income status since WWII. This phenomenon is puzzling. 

 

As Keynes said, “It is ideas, not vested interests, which are dangerous for good or evil.” There must be something wrong with our ideas on development.  

 

In this talk, I will first review the previous ideas of development economics, with a focus on their view of the role of the state. I will then present the main ideas of New Structural Economics and discuss the role of the state from the perspective of New Structural Economics.


1. Review of development economics
Development Economics 1.0: Structuralism
The first approach to development economics was Structuralism. After the WWII, developing countries all shared a common aspiration to catch up with the developed countries so that their people could have the same income level. To achieve that goal, it was necessary to have the same labor productivity as the developed countries; which in turn required having the same advanced industries as the high-income countries. Whereas the reality was the developing countries only had backward industries, such as traditional agriculture and natural resources.

According to Structuralism, developing countries could not develop advanced industries because they were be set with structural rigidities, caused by their reliance on the market to develop advanced modern industries spontaneously. Structuralism advocates a “strong” developmental state, advising the governments of developing countries to adopt the import-substitution strategy with various price distortions and direct government allocation of resources to develop advanced modern industries. 

Under the influence of Structuralism, most developing countries enjoyed a period of investment-led growth. Those import-substitution projects became “white elephants.” Subsequently, the economies encountered stagnation and frequent crises. The income gap between developed and developing countries widened. 

Development Economics 2.0: Neoliberalism
Neoliberalism emerged in the 1980s, and it viewed government interventions as the main reason for the failure of developing countries to catch up with developed countries. Neoliberalism advocates a minimal state, advising developing countries to institute well-functioning market institutions similar to those in developed countries and believing that dynamic growth and structural transformation will happen spontaneously once there is a well-functioning market. 

Under the guidance of Neoliberalism, many developing countries adopted structural adjustment programs in the 1980s and 1990s to remove government interventions and distortions. International development institutions, like the World Bank and International Monetary Fund, also actively provided funds and policy advices to developing countries. The intention of structural adjustments was good, and the economic analysis of those programs appeared solid and convincing. However, the result was disappointing. The growth rate in the 1980s and 1990s was lower than that in the 1960s and 1970s, and the frequency of crises was even higher. The income gap between developed and developing countries widened further.

Stylized Facts of Successful Economies
There were some successful cases. Thirteen economies achieved 7% or more growth annually continuously for 25 or more years after WWII. These economies substantially narrowed their income gap with the advanced countries. According to the Growth Commission, these 13 economies have the following 5 stylized facts:
(1) Theyare all open economies. 
(2) They all achieved macro stability. 
(3) They all have high savings and high investments. 
(4) They all have a well-functioning market mechanism, or are moving toward a market economy. 
(5) They all have credible, committed, and pro-active governments.

The successful economies have well-functioning markets as advocated by Neoliberalism and proactive governments as advocated by Structuralism. They are neither in the regime of neoliberalism, nor structuralism. Michael Spence, the chairman of the Growth Commission, stresses that those five stylized facts are ingredients of success but not a recipe for success. 
 

However, without a recipe, how could the government in a developing country follow in these foot steps?

 

2. New Structural Economics- a new way to explore economic development

New structural economics is an application of the neoclassical approach to study the determinants and impacts of economic structure and its evolution in development, which is the nature of modern economic growth. According to the convention, I should call this approach structural economics. Why do I call this approach New Structural Economics? I add “new” to distinguish it from structuralism, just like the “new” in new institutional economics, which uses the neoclassical approach to study the determinants and impacts of institutions and institutional evolution, is used to distinguish it from “institutional school”, which prevailed in the United States at the turn of 20th century. 

The Main Arguments of New Structural Economics:
The main hypothesis is that economic structures, including the structure of technology and industry, which determines the labor productivity, and hard and soft infrastructure, which determines the transaction costs, is endogenous to the endowment structure, which is given at any specific time and changeable over time. Endowments and the endowment structure determine the economy’s total budgets and relative factor pricesat any specific time, which in turn determine that specific time’s:
1) comparative advantages, i.e., industries that have the lowest factor costs of production in the world;
2) the optimal industrial structure, i.e., when the industrial structure is consistent with comparative advantages determined by endowment structure. 

Then the income growth depends on upgrading the industrial structure to increase labor productivity, which in turn depends on the upgrading of the endowment structure, moving from labor intensive to capital intensive industries. That is the accumulation of capital. With the upgrading of industrial structure, improvements in “hard” and “soft” infrastructure are required to reduce transaction costs.

Then, how to change the endowment structure? 

Following comparative advantage (determined by the endowment structure) to develop industries is the best way to achieve dynamic growth and convergence.The economy with appropriate hard and soft infrastructure will be most competitive, produce the largest surplus, have the highest possible returns to capital and thus savings, ensure the fastest upgrading of the endowment structure, and achieve the most rapid industrial upgrading and income growth. 

In this process, a developing country can have the latecomer advantages and thus have a faster technological innovation and industrial upgrading than high-income countries, which lead to faster growth and convergence with high-income countries. So following comparative advantages determined by endowment structure is the recipe for development success. 

The Market and the State in New Structural Economics
To follow the comparative advantages is a concept understandable to economists. For the entrepreneurs, what they care about is profitability. How to translate the concept of following a country’s comparative advantages to influence the spontaneous choice of entrepreneurs? This requires a well-functioning market so that the relative factor prices reflect the relative supply of factors in the endowments. With such relative factor prices, entrepreneurs for their own profitability and competitiveness in the market will enter industries and adopt technologies which are consistent with the comparative advantages determined by factor endowments. 

But economic development is a dynamic process. It’s a process of continuous technological innovation and industrial upgrading. Two market failure issues arise during that process. One is the externality, i.e. the government needs to provide incentives for the first mover. And the second is coordination for improving institution and infrastructure. An enabling state is required to facilitate the structure changes. 
 

Those two conditions are precisely the stylized facts 4 and 5 of the Growth Commission Report. Also if a country follows its comparative advantages in their development, the country will be an open economy (fact 1) and achieve macro stability (fact 2). Following comparative advantages will generate the largest surplus and highest incentives for savings and investments (fact 3). So following comparative advantages is a prescription for development success.  

 

3. The Role of State in Structuralism, Neoliberalism and New Structural Economics

Structuralism and Development Failure
From the perspective of New Structural Economics, Structuralism failed because it ignored the endogeneity of structure and recommended developing certain industries that were too advanced compared to their countries’ level of development and defied their comparative advantages. The firms were non-viable in open competitive markets and required government subsidies and protection for their initial investment and continuous operations. This led to a misallocation of resources, rent-seeking, corruption, and political capture. 

Neoliberalism and Transition Failure
All transition economies started with many nonviable firms in their old priority sectors due to their comparative advantage-defying development strategy.

The Washington Consensus, based on Neoliberalism, failed to recognize that the distortions were endogenous to the need to protect nonviable firms in the priority sectors and advised the government to eliminate all distortions immediately, which caused the collapse of old priority sectors and deindustrialization. The Washington Consensus also opposed the government playing a proactive role by providing external compensation incentives and overcoming coordination failures by improving necessary hard and soft infrastructure to facilitate a firm’s entry into sectors consistent with the country’s comparative advantages. 

Pragmatic, Gradual Approach and Transition Success 
New Structural Economics provides an explanation for China’s success.
-The government continued to provide transitional support to nonviable firms in the old priority sectors and removed distortions only when firms in those sectors became viable or the sectors become very small.
-The government facilitated private firms’ entry into sectors that were consistent with the country’s comparative advantage, which was repressed before the transition, by setting up special economic zones/industrial parks to overcome infrastructure constraints; providing one-stop service to improve the business environment; and engaging in active investment promotion to attract foreign firms in the global value chain to invest in China, so as to bring access to the global market.

According to Neoliberalism, the dual track was P[B the worst transition approach, but it happened to be the best. 

Industrial Policy and Enabling State
From New Structural Economics’ point of view, some sort of industrial policy will be essential. The state’s facilitation is essential for rapid technological innovation and industrial upgrading, as well as diversification because of the need to address externalities and solve coordination problems. 
 

Industrial policy is a useful instrument for an enabling state to facilitate structural transformation.This is because the required coordination may differ among industries, and the government’s resources and capacity are limited so the government needs to use them strategically.

 

4. Industrial Policy

Why Industrial Policy Failed in Some Countries? - Comparative Advantage Defying and the Failure of Industrial Policy
 

The sad fact is that almost all governments in the world attempted to use industrial policies to play a facilitating role, but most failed. The reason is industrial policies in the past were influenced by Structuralism and went against the country’s comparative advantages. The firms in the industrial policy’s targeted sectors were non-viable in an open, competitive market. The factor costs of production were higher than those in countries with comparative advantages in those sectors. To support its investment and to ensure the firms’ continuous operation, governments supported the non-viable firms through all kinds of subsidies and protections. Those measures led to a misallocation of resources and rent-seeking. As a result, the attempts to pick winners ended up picking losers.

 

Latent Comparative Advantages and Picking Winners

For an industrial policy, including the smart specialization strategy, to be successful, it should target sectors that conform to the economy’s latent comparative advantage. The latent comparative advantage refers to an industry that has competitive, low factor costs of production internationally, i.e., consistent with the country’s comparative advantage determined by its factor endowments, but the transaction costs are too high, due to inadequate hard and soft infrastructure, to be competitive in domestic and international markets.

Firms will be viable and the sectors will be competitive once the government helps the firms overcome coordination and externality issues in the improvement of hard and soft infrastructure to reduce risks and transaction costs.

But how can the government pick the sectors that are in line with the economy’s latent comparative advantages? From the perspective of new structural economics, depending on a targeted industry’s distance to the global technology frontier, we can classify industries into five categories:
(1) Industries that a country still has a distance to the global technology frontier. The government should help to find out the binding constraint and help to remove that. 
(2) Industries that a country is already on the global frontier. The government should support firms to do R&D to maintain the leading- edge industry’s technological leadership globally.
(3) Industries that already lose comparative advantages, such as labor-intensive industries in China. The government should help firms either to the two ends of smiling curve, or relocate to low-income countries.
(4) Some short innovation-cycle, new industries. The government should encourage short innovation-cycle industries, which rely more on human capital than physical capital. Countries like China with abundant human capital can use its own large domestic market to leverage the human capital. The state also needs to create institutions to facilitate innovations. 

(5) Industries that are strategically important for national defense but the country does not have comparative advantage should be subsidized by the government. 

 

5. Conclusion:

Structuralism advocates a strong developmental state and is usually against comparative advantages. The goal was to build up advanced modern industries and use the government’s protection and subsidies as policy instruments.  

Neoliberalism advocates a minimal state and opposes the use of industrial policy. Its goal is to build up a well-functioning market institution, and it believes structure change will happen spontaneously in a well-functioning market. 
 

New Structural Economics advocatesan enabling state. Its role is to facilitate structural change by using industrial policy to overcome market failures in order to facilitate industries with latent comparative advantages to become competitive advantages in the market.