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«Policy Research Working Paper 5313 Public Disclosure Authorized Growth Identification and Facilitation The Role of the State in the Dynamics of ...»

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Public Disclosure Authorized

Policy Research Working Paper 5313

Public Disclosure Authorized

Growth Identification and Facilitation

The Role of the State in the Dynamics

of Structural Change

Justin Yifu Lin

Public Disclosure Authorized

Célestin Monga

Public Disclosure Authorized

The World Bank

Development Economics

Office of the Vice President

May 2010

Policy Research Working Paper 5313


Active economic policies by developing countries’ of government interventions. First are policies that governments to promote growth and industrialization facilitate structural change by overcoming information have generally been viewed with suspicion by economists, and coordination and externality issues, which are and for good reasons: past experiences show that such intrinsic to industrial upgrading and diversification. Such policies have too often failed to achieve their stated interventions aim to provide information, compensate objectives. But the historical record also indicates that for externalities, and coordinate improvements in the in all successful economies, the state has always played “hard” and “soft” infrastructure that are needed for the an important role in facilitating structural change and private sector to grow in sync with the dynamic change helping the private sector sustain it across time. This in the economy’s comparative advantage. Second are paper proposes a new approach to help policymakers in those policies aimed at protecting some selected firms developing countries identify those industries that may and industries that defy the comparative advantage hold latent comparative advantage. It also recommends determined by the existing endowment structure—either ways of removing binding constraints to facilitate in new sectors that are too advanced or in old sectors that private firms’ entry into those industries. The paper have lost comparative advantage.

introduces an important distinction between two types This paper—a product of the Office of the Vice President, Development Economics—is part of a larger effort in the department to revisit strategies for achieving sustainable growth in developing countries. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at research@worldbank.org.

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.

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1. Introduction The current global crisis, the most serious downturn since the Great Depression, has forced economists and policymakers to rethink their approaches to macroeconomic management.1 For developing countries, in the midst of a financial and economic turmoil that was not of their own making, the road ahead is likely to be rocky. Because of the sluggish recovery in high-income countries and the heavy cost of the crisis there (lower growth, high unemployment, and rising public debt) and the increasing cost of capital, they will have to confront a more difficult global environment for their exports and financing conditions. Yet, in order to continue tackling the enormous challenge of poverty and achieve convergence, they must return to the pre-crisis path of dynamic growth.

How to promote economic growth has been a main topic for economic discourse and research since the publication of Adam Smith’s The Wealth of Nations in 1776. Theories and empirical evidence show that market mechanisms are essential for valuing the basic ingredients for production (factor endowments) and providing the right price signals and the appropriate incentive system for efficient allocation of resources. However, modern economic growth—a fairly recent phenomenon in human history, as Maddison (2001) pointed out—is a process of continuous technological innovation, industrial upgrading and diversification, and improvements in the various types of infrastructure and institutional arrangements that constitute the context for business development and wealth creation (Kuznets 1966). Market mechanism may not be sufficient and the government has a potential role to play in helping firms overcome the various problems of information, coordination, and externality, which arise inevitably in the process of modern economic growth.

Historical evidence shows that all countries that have successfully transformed from agrarian economies to modern advanced economies—including those old industrial powers in Western Europe and North America, as well as the newly industrialized economies in East Asia—had governments that played a pro-active role in assisting individual firms in overcoming the coordination and externality problems in the process of their structural transformation. In fact, the governments in high-income countries today continue to play that role. However, the sad fact is that almost every government in the developing world has attempted, at some point in its development process, to play that facilitating role, but most have failed. In this paper, we will argue that these pervasive failures in developing countries are mostly due to the inability of governments to come up with good criteria for identifying industries that are appropriate for a given country’s endowment structure and level of development. In fact, governments’ propensity to target industries that are too ambitious and not aligned with a country’s comparative advantage largely explains why their attempts to “pick winners” resulted in “picking losers.”2 We will argue that, by contrast, spontaneously or intentionally, the governments in successful developing countries have typically targeted mature industries in countries with an endowment structure similar to theirs and with a level of development not much more advanced than theirs.

The main lesson from development history and economic theory is straightforward: the government’s policy to facilitate industrial upgrading and diversification must be anchored in


See for instance Blanchard et al. (2010), Krugman (2009) or Monga (2009).

For protecting jobs, the governments in both developed and developing countries may also support old, declining industries, of which their countries have already lost comparative advantages. Such policies will fail as well.

3    industries with latent comparative advantage so that, once the new industries are established, they can quickly become competitive domestically and internationally.

This paper proposes a new approach to help policymakers in developing countries identify the industries where their economies may have a latent comparative advantage and remove binding constraints to facilitate private firms’ entry into those industries. The paper broadens the scope of analysis of industrial policy by introducing an important distinction between two types of government interventions. First are policies that facilitate structural change by overcoming information and coordination and externality issues, which are intrinsic to industrial upgrading and diversification. Such interventions aim to provide information, compensate for externalities, and coordinate improvements in the “hard” and “soft” infrastructure that are needed for the private sector to grow in sync with the dynamic change in the economy’s comparative advantage. Second are those policies aimed at protecting some selected firms and industries that defy the comparative advantage determined by the existing endowment structure—either in new sectors that are too advanced or in old sectors that have lost comparative advantage.

The remainder of the paper is organized as follows: Section 2 explains the importance of wellfunctioning markets and the rationale for a facilitating state in the process of dynamic economic growth. Section 3 briefly reviews some important lessons from early industrial development strategies around the world and analyzes the role of the state in the process of structural change in today’s advanced economies. It also examines similar attempts by developing countries’ governments to adopt policy interventions to facilitate industrial upgrading and economic diversification, and analyzes the reasons for the success or failure of those attempts. Building on the foundations of new structural economics (Lin 2010), Section 4 provides a framework for formulating industrial policy based a new approach entitled “growth identification and facilitation.” Section 5 offers some concluding thoughts.

2. Structural Change, Efficient Markets, and a Facilitating State

Economists have long been intrigued by the mystery of modern economic growth, typically observed through the seemingly divergent evolution of the change in per capita gross domestic product (GDP) among countries. Since taking off sometime around 1820 (Maddison 2001), the world growth rate has risen almost steadily, peaking during a “golden age” (1950-1973) when it averaged almost 3 percent per year. But such progress has been uneven across regions of the world, countries, and time. Sustained growth has led to improved livings standards, first in Western Europe, North America, and Japan, and more recently in newly industrialized economies (NIEs) and other emerging market economies. Cross-country income distribution that initially widened (with the proportional gap between the richest and poorest countries growing more than fivefold from 1870 to 1990)3 has slowed in recent decades among groups of countries.

With the narrowing of the top end of the distribution, there seem to be some “convergence clubs” among nations (Evans 1996). Still, many of the poorest countries—especially in Africa—are excluded from the convergence process.

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the variation of living standards across countries and time mostly reflects differences in the rate of capital accumulation and the rate of productivity growth. Empirical studies carried out from the perspective of development accounting show that among these two broad factors, “productivity differences among countries are the dominant explanation for income differences.

Similarly, differences in productivity growth are the most important explanation for differences in income growth rates among countries” (Howitt and Weill 2010: 43-44). Over the long term, productivity growth is associated with technological change4 and structural change, that is, to reduce the costs of producing the same outputs with better knowledge and to relocate resources from lower value-added industries to higher value-added industries.5 It can therefore be said that continuous technological innovation, industrial upgrading, economic diversification, and an acceleration of income growth are the main features of modern economic growth (Kuznets 1966; Maddison 2006).6 Each country at any specific time possesses given factor endowments consisting of land (natural resources), labor, and capital (both physical and human), which are the total budgets that the country can allocate to primary, secondary, and tertiary industries to produce goods and services. The endowments in a country are given at any specific time but changeable over time. Conceptually, it is useful to add infrastructure to that mix as an important additional component in an economy’s endowments, as they are also given at any specific time and changeable over time (Lin 2010).7 Infrastructure includes hard (or tangible) infrastructure and soft (or intangible) infrastructure.

Both these types of infrastructure are essential to the competitiveness of domestic firms because they affect transaction costs and the marginal rate of return on investment.

At any given point in time, ceteris paribus, the structure of a country’s endowment, that is the relative abundances of factors that the country possesses, determines the relative factor prices and thus the optimal industrial structure (Ju, Lin, and Wang). A low-income country with abundant labor or natural resources and scarce capital will have comparative advantage and be competitive in labor-intensive or resource-intensive industries. Similarly, a high-income country with abundant capital and scarce in labor will have comparative advantage and be competitive in capital intensive industries. Therefore, the optimal industrial structure in a country, which will make the country most competitive, is endogenously determined by its endowment structure. For a developing country to reach the advanced countries’ income level, it needs to upgrade its industrial structure to the same relative capital-intensity of the advanced countries. However, to


Technology is defined here as knowledge (intangible intellectual capital) of how to transform basic inputs into final utility. It differs from human or physical capital by its non-rival nature. Efficiency is the way technology is used—with the goal of optimality, especially in the allocation of resources.

In the growth literature, structural change has not received as much attention as technological change because of the use of a one-sector model, which is incapable of handling issues related to structural change, in the standard growth accounting and regression research.

Maddison (2006) estimated that in Western Europe, the annual per capita income growth rate before the 18th century was about 0.05 percent, accelerated to about 1 percent in 18th and 19th centuries, and reached 2 percent in the 20th century. The required time for doubling per capita income thus reduced from 1400 years before the 18th century to 70 years in the 18th and 19th century and further to 35 years in the 20th century.

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