Rethinking Economic Development Policy: The Emergence of Challenges in the Modern Era

This blog is based on a working paper published by the International Monetary Fund.

Economic development policy prescriptions have been premised in large measure on the history of economic growth patterns experienced worldwide. These growth patterns are characterized by sustained increases in productivity and standards of living, and are accompanied by structural transformation of their economy with attendant reallocation of resources across agricultural, industrial, and services sectors. Low income countries tend to possess largely agrarian economies, which harbor low productivity processes that inhibit growth of income per capita. As these economies begin the process of industrialization, productivity growth is enhanced as resources are drawn out of agriculture and into more productive activities, thus enhancing economic growth and allowing these countries to eventually attain middle income status, with the attendant higher standards of living. At some point along the path of economic development, middle income countries begin to shift resources increasingly toward the production of services, and enter into the club of high income, post-industrial services-based economies, which today characterizes all modern developed economies around the world.

However, share of manufacturing in world output has remained stable at about 16-17 percent for the past half century. Thus, countries wishing to industrialize are in competition for this limited world demand for manufactures. Moreover, the pace of globalization in recent years, accompanied by improved technologies, faster communications, and sophisticated supply chains have disrupted the traditional patterns of structural transformation driven by industrialization, and given rise to a need to rethink policies designed to enhance economic development in many parts of the world.

Traditional patterns of economic development were evident in postWorld War II Japan, the Asian Tigers of South Korea, Taiwan, Singapore, and Hong Kong in the latter part of the 20th century, and more recently in China, and to a lesser extent, India. These economies pursued policies of openness to international markets. As they entered into the process of industrialization, they were encouraged to promote industries with significant export potential. Export promotion required them to upgrade labor skills and make important investments in capital that would keep them competitive in world markets.

In contrast, some countries had begun to industrialize and successfully moved into the middle income status, only to see the process stall. Brazil, Malaysia, Mexico, and Peru all achieved this status in the 1960s, but failed to adopt policies that encouraged the development of human capital and investment in physical capital that would enhance productivity and propel them into the ranks of high income economies. Instead, with large and increasing domestic demands for manufactured goods, their policies of supporting industries for home consumption versus encouraging production of goods for competitive international export markets, stymied much needed productivity enhancing investments that such competition would require. Once the burgeoning domestic demand for manufactures was largely saturated with the depletion of cheap labor moving from agriculture into urban manufacturing, industrialization stagnated. This premature deindustrialization prevented these countries from realizing the full benefits of the industrialization phase of economic development, as they became trapped in the middle income status of economic development. This problem was compounded by the behemoth of China’s rapid industrialization (and to a lesser extent, India) absorbing an ever-increasing share of the limited world production of manufactured goods. Against this competition, re-industrialization for these economies that would be focused on export markets, without the advantage of cheap labor, is seemingly problematic.

Low income countries, particularly in Southeast Asia and SubSaharan Africa, were slow to industrialize. As late-comers to the process, they face the same dilemma as those nations caught in the middle income trap and seeking to re-industrialize while in competition with China and India to secure a share of the limited world market for manufactured goods. However, with China moving up the value chain of manufactures and beginning to vacate the market in supplying lower quality manufactured goods, an opening was created for low income countries to accelerate their economy’s industrialization. Several Southeast Asia economies pursued this opportunity and experienced an unprecedented surge in growth. Vietnam is a particularly poignant success story. The country pursued export promotion policies that were crucially supplemented with investment in public capital, i.e. modernizing their infrastructure and promoting institutional reforms that in turn attracted foreign investment in private capital goods. Their progress in filling the void left behind by China has propelled their economy rapidly toward middle income status, as their largely agrarian society has embraced light manufacturing with an eye to world markets.

Low income countries in Sub-Saharan Africa (SSA) have not been able to participate in filling the supply void of lower quality manufactures that are gradually being shed by China. They have failed to provide the investments in public capital and the institutional reforms demanded by foreign investors in order to jump-start the process of industrialization. Several SSA countries have focused government support on resource-extraction industries as central to their economies’ produce, such as Ghana, following the rejuvenation of gold mining in the 1980s, Botswana’s growing dependence on its diamond industry, and Nigeria’s continued reliance on oil. While the export of precious metals and oil have brought wealth into their economies, that wealth masks the underlying conditions of their labor markets that bode ill for the prospect of long-run economic growth through industrialization. The number of workers in the extractive industries is a very small part of the population, and much of the wealth that those industries have created was used to purchase manufactures from abroad. This trade did create jobs and draw agricultural manufacturing employment into the services sector. However, those newly created jobs tend to be in the low-end services, such as retail and wholesale trade, with productivities even lower than that of agriculture. All the while, technology is demanding ever increasing skills to compete on the international stage. In this sense, the gold, diamond, and oil industries of these countries have led to a deindustrialization that has served to retard prospects for future, sustained economic growth.

One success story in recent years is India’s transformation that involved a shift of employment from low-productivity agricultural jobs and into selective high-productivity service jobs for which there is a growing world demand. India was able to accomplish this form of structural transformation that effectively by-passed much of the industrialization that would have traditionally been expected for the economy to experience the high rates of economic growth that it has been able to sustain for the past 40 years. However, it is unlikely that other nations will be able to emulate India’s success. It was the beneficiary of a confluence of favorable factors that enabled the country to pursue tradable high-productivity services. These included the historic emphasis (since 1947) on developing scientific and technical manpower, the historic accident of a British rule that left a large educated segment of the population fluent in English – the lingua franca of the information and communications industry, and the Indian diaspora that resulted in advanced training abroad in technical fields of study. The net effect was to infuse the Indian workforce with talented up-to-date skills needed for the growing demand for employment in the rapidly expanding IT and telecommunications fields. More importantly, while the high-productivity services have been a significant source of economic growth in the post-reform period beginning in 1991, from the perspective of structural transformation, i.e., the pattern of sectoral reallocation of labor, the growth experience has been lackluster at best. The employment in high productivity services has risen a measly 1.28 percentage points.

What lies ahead for the design of policies intended to promote economic development, particularly among low-income countries? The traditional goal of encouraging the development of appropriate public fundamentals, to include modern infrastructure, enlightened institutions, and human capital formation are as essential as ever. However, they cannot, of themselves, be counted on to gain the needed foreign direct investment in physical capital that is critical for industrialization to take place. Emphasis will have to be given to export promotion of goods, be they manufactures or services, that require high-productivity jobs. Businesses will have to respond to incentives to continually upgrade the skills of their employees, with a focus on so-called escalator industries that feed the process of quality enhancement in the goods and services produced in order to remain competitive on the world markets. Attempting to replicate the Indian experience also seems unlikely for most SSA countries, and certainly not in the short-run. Vietnam is a more hopeful scenario, but late-comers to industrialization are facing an uphill battle to secure a significant share of the world’s limited supply of manufactures. Hopes for solid economic development in low-income countries will therefore require a sustained commitment to a longer-run view taken by policy-makers, as the gains are not likely to be realized quickly.

Dr. Manoj Atolia is the Bernard F. Slinger Professor and Chair of the Economics Department.

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