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Theories of economic development
Thursday, 21 April 2011 02:36

Theories of economic development are a dime a dozen.  Just last year at the Seoul G20 summit, a new one jumped onto the scene, in the form of the Seoul Development Consensus on Shared Growth.


Are any of these theories worth the paper they are printed on?  Do they help us understand economic development, and devise policies to make development happen?  Let’s have a quick look.


It was only after World War 2, and with the progressive decolonization of developing countries, that economists seriously turned their attention to the issue of economic development.  And their main sources of inspiration were the development experience of advanced countries with the Industrial Revolution, and the reconstruction of Europe and Japan after the War.


Walt Rostow’s Stages of Growth was one of the first major theories of economic development to see the light of day.  For Rostow, all societies are in one of five categories: the traditional society; the pre-conditions for take-off into self-sustaining growth; the take-off; the drive to maturity; and the age of mass consumption.  And the key to progressing through these stages is mobilizing domestic and foreign savings to generate sufficient investment. 


This thinking drove advanced countries to provide financial assistance to developing countries, and to push them to open up to foreign direct investment.  Did this work?  Often not, while investment is important, many other things are also necessary to complement investment, like a skilled work force, an efficient government, and financial markets.  Many investment projects turned out to be white elephants, like hospitals without doctors and nurses, schools without teaches, and bridges without cars.


That said, efficient and sound investment, especially in infrastructure, is important to development.  World Economic Forum indicators of the quality of infrastructure show a close relationship with economic development.  Hong Kong is ranked 1st in the world, Germany 2nd, France 4th, Singapore 5th, Japan 11th, United States 15th, Taiwan 16th, Korea 18th, Australia 22nd, Malaysia 30th, Thailand 35th, China 50th, Mexico 75th, Indonesia 82nd, Vietnam 83rd, India 86th, Philippines 104th, Cambodia 114th Bangladesh 133rd, and Nepal 139th.


Arthur Lewis’s theory of development was long believed to describe the structural transformations of development.  Lewis saw a world with two sectors: first, a traditional, overpopulated rural subsistence sector with surplus labor; and second, a high-productivity modern urban industrial sector into which labor is transferred.  The speed with which this transfer takes depends on the rate of investment in the latter sector, and this process of transfer of labor continues until the rural surplus labor is exhausted.


Lewis’s model also has shortcomings.  Many developing countries also have lots of poverty in their urban sectors, and investment is sometimes designed to save labor, rather than create jobs.  That said, his model does capture very well developments in countries like China where there has been and continues to be a massive internal migration from the country to the city.  The rural migrant worker population has grown from 30 million in 1989 to more than 200 million in 2009, and could even hit 350 million by 2050.    


Then there is the neocolonial dependence model is based on Marxist thinking.  According to this model, underdevelopment is due to the highly unequal international capitalist system of rich country-poor country relationship.  Poverty in developing countries is the result of rich country policies, and elites in developing countries.  Dominant countries are endowed with technological, commercial, capital and sociopolitical dominance over dependent countries. 


In defense of this thinking, we can say several things.  In Africa for example, the national boundaries were drawn up by colonial masters, and have little regard to pre-colonial tribal boundaries.  This makes national governance a challenge.  Further, in Africa and Latin America, countries have suffered by their dependence on natural resource exports.  The profits from these exports have often ended up in the pockets of corrupt leaders and elites, rather than the people.  And while many developing countries have a comparative advantage in agriculture, their access to world markets is blocked by protectionism in EU, US, Japan and Korea. 


In the 1980s, we saw the rise of “market fundamentalism”, with Ronnie Reagan in the US White House and Maggie Thatcher in London’s 10 Downing Street.  We had to wait almost another 20 years before we saw Japanese-style market fundamentalism in the form of Junichi Koizumi in Japan.  According to this approach, underdevelopment is the result of too much government intervention in developing countries.  Governments should free up markets by liberalization, deregulation, and privatization of state-owned enterprises.  An extension of this model is the theory that governments can do nothing right because politicians, bureaucrats, citizens and states use their power and authority of government for their own selfish ends.


Market fundamentalism was symbolized by the “Washington Consensus”, reflecting policies based on: fiscal discipline; reordering public expenditure priorities in a pro-poor way toward basic health and education; tax reform; liberalizing interest rates; a competitive exchange rate; trade liberalization; liberalization of inward foreign direct investment. but not comprehensive capital account liberalization; privatization; deregulation; and property rights.


Many people like to criticize market fundamentalism for its naivety and extremism.  Certainly, it underemphasized the important role that government can play in regulating markets.  But experience also shows that creating a free, business friendly environment can be very helpful for development.  According to World Bank indicators, Singapore and Hong Kong top the world in terms of the ease of doing business, while Korea, Japan and Thailand just make it into the world's top 20 countries.  Way down the list, Vietnam and China are ranked at 78th and 79th on the world list, whereas Indonesia is 121st, Cambodia is 147th and the Philippines 148th.


Another variant of market fundamentalism is the market-friendly approach which recognizes that there are indeed market imperfections and failures.  The states can thus play a role in providing infrastructure, and health and education services.  They can also play a role in protecting the environment and investment coordination. 


Investment coordination is a very important problem in developing countries.  For any one investment to succeed, several complementary investments may be necessary from other enterprises.  So, unless government attempts to coordinate joint investments, no investment may take place at all. 


A perfect example could be the Philippines which has a beautiful tropical environment, but much less tourists than say Thailand.  Government could play an important role by coordinating investments in airports, tourist resorts, training of tourism workers, etc.


One variant of the coordination failure theory is the proposal that we need a “big push” to move from an agricultural economy to industrialization.  Interest in this theory has been greatly inspired by the case of Korea, where the government played an important role in helping launch industrialization.  .


And last but not least, there is the Seoul Development Consensus for Shared Growth.  It is a set of principles and guidelines set up to assist the G20 nations and other global actors in working collaboratively with less developed countries.  It was agreed at the 2010 G-20 Seoul summit.


The six core principles of the Seoul consensus are: Focus on economic growth; Global development partnership; Global or regional systemic issues; Private sector participation; Complementarity; and Outcome orientation.  Then there are nine key pillars, the areas most in need of attention within developing countries: 1) infrastructure, 2) private investment and job creation, 3) human resource development, 4) trade, 5) financial inclusion, 6) resilient growth , 7) food security, 8) domestic resource mobilization 9) knowledge sharing.


The Seoul Consensus is a slap in the face to the older Washington Consensus, which was the expression of market fundamentalism.  The Seoul Consensus allows a larger role for state intervention, than the Washington Consensus. Rather than seeking to impose a uniform "top down" solution, it postulates that solutions should be tailored to the requirements of individual developing nations, with the developing countries themselves taking the lead in designing packages of reforms and policies best suited to their needs.


What to make of all these theories, and the many others that are in economists’ trash cans?


Perhaps the most sensible wisdom on this topic comes from the Hausmann-Rodrik-Velasco Growth Diagnostics Framework.  In short, no one size fits all.  Different countries face different problems, different biding constraints, like human capital shortages, lack of availability of finance, poor infrastructure.  Development specialists like us should analyze the nature of each country’s problems, based on our theories.  Development policies should target a few important problems, not try to do everything.


The experience of China is also instructive.  It has always taken a step-by-step, experimental approach, rather than a big bang or shock therapy.  It started by giving farmers greater freedom.  It then opened up gradually through special economic zones.  And even today, it is using Hong Kong very sensibly in its experiments to internationalize the RMB exchange rate, and open up its financial markets.      




Economic Development, Michael P. Todaro and Stephen C. Smith


Seoul Development Consensus for Shared Growth


The Global Competitiveness Report 2010-2011


Did the Washington Consensus Fail? by John Williamson, Peterson Institute for International Economics


Doing Business 2011, World Bank


Internal Migration in China and the Effects on Sending Regions


China’s Internal Migrants, by Andrew Scheineson


OECD, Agricultural Producer and Consumer Support Estimates database











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