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Long live comparative advantage
Saturday, 21 February 2009 07:57

Chief economist of the World Bank is perhaps one of the most prestigious positions in economics.  The position has been occupied by the likes of Jo Stiglitz, Larry Summers, Nicholas Stern and Stanley Fischer, to name just a few.  But when Justin Yifu Lin was appointed to the position, everyone focussed on the fact that he was the first Chinese to hold this position -- indeed, the first Chinese to hold such a distinguished position as an economist.

But Justin Lin, like his predecessors, has very much earned this position as evidenced by his 2007 Marshall Lectures, "Development and Transition: Idea, Strategy, and Viability".


Lin attacks one of economics' perennial questions -- why do some countries grow and develop, and why others do not.  He is particularly interested in why a group of small East Asian economies and China achieved such amazing economic development these past few decades, whereas the developing countries in Africa and Latin America did not manage such success.

Lin starts at the beginning.  He notes that until the industrial revolution of the 18th century, there had been no major economic development in the world.  That development which did occur was mainly extensive, meaning that it permitted a higher population rather than a higher standard of living.  The income gap between the richer and poorer parts of the world was about 50% compared with the 20 times of today.  And apart from the ruling classes, craftsmen and merchants, everyone was in the agricultural sector.

The industrial revolution started in England and then spread to Europe and the Western offshoots in the New World.  But that was as far as it got.

The 20th century, particularly after World War 2, saw decolonisation and independence in the "developing world".  There were high hopes for the resource-rich countries of Africa and Latin America.  But, it was only a handful of resource-poor East Asian economies that were able to develop rapidly.  Why?

Following political independence, many developing countries wanted to become economically independent.  They wanted to match the economic strength of their colonial masters and avoid exploitation.  The political and social elites of the developing world adaopted an ideology of economic nationalism.  So they sought to develop capital-intensive heavy manufacturing through an import substitution strategy.  Governments regarded economic growth as their responsibility and established many public enterprises.

This approach was supported by many economists in academic circles who believed that government should play a leading role in an industrialisation push for development.  These were the days of the infant industry argument. 

But it did not work.  Fundamentally, and this is Lin's key point, this strategy did not work because it was based on the dominant social thinking of the day which was quite simply wrong.  It was a comparative advantage-defying (CAD) strategy.  For Lin, social thinking is the deepest fundamental determinant of government policy and social and economic institutions in a country, which in turn determines a country's economic performance. 

Developing countries have a relative abundance of natural resources or unskilled labour, and a scarcity of human and physical capital.  So, in these countries only labour- and resource-intensive industries will have a comparative advantage in open, competitive markets.  It is not surprising therefore that this CAD strategy failed to deliver, and even caused crises and disastrous consequences.  A CAD strategy can establish some advanced industries in developing countries.  But it inevitably leads to inefficient resource allocation, suppressed work incentives, rampant rent-seeking behaviour, deteriorating income distribution and poor economic performance.

The CAD Strategy was initiated by idealistic nationalistic leaders behaving as benevolent guardians with bounded rationality.  They were deeply influenced by their own aspiration for nation building, radical view of economic development and the successful experience of the USSR's industrialisation under Stalin's leadership before World War 2. 

Why did Japan and the New Industrial Economies of Asia develop so well?  Lin dismisses factors like geography, culture, institutions, trade etc.  None of these can explain why a region suddenly embarks on dynamic growth.  The answer is simple.  While some of these countries did go through early phases of import substitution, they quickly switched to export-oriented strategies based on labour-intensive manufactured products, which could be described as comparative advantage following (CAF) strategies.  Japan and the NIEs followed their comparative advantages in each stage of their economic development.   

This was partly good fortune, as they were also influenced by the dominant social thinking of the 1950s and 1960s.  And some countries like Korea and Taiwan did launch heavy manufacturing initiatives.  But being resource poor, they could not afford the costs of these CAD policies.  And Asian pragamatism made it easier for them to adjust their policies. 

Lin also looks at the experience of Eastern Europe, and China and Vietnam in their transition from central planning to a market economy.  Lin notes the huge costs of Eastern Europe's shock therapy.  When the number of non-viable firms is very large, and their output value make up a very large share of the economy, shock therapy is too disruptive.  The dual-track approach of giving partial autonomy to state-owned enterprises and farmers, and allowing a market economy to grow in parallel to the planned economy, and ultimately overtake it, is better, as evidenced by the examples of China and Vietnam.  Deep and extensive reforms are not required for dynamic growth at the outset of the transition.  A small change that provides the right incentives can unleash dynamic growth on a weak institutional base, leading to a transition to a market economy. 

Lin concludes that:

-- "Continuous technological upgrading is the most important driving force for a country's long-term dynamic growth in modern times. ...

-- Ideas are the most vital determinants of whether a developing country will be able to achieve long-term dynamic growth.  With the guidance of the right ideas, a developing country will be able to exploit the advantage of backwardness, achieve dynamic growth and converge with developed countries. ...

-- The government is the most important institution in a developing country.  The policies pursued by the government will shape the quality of other institutions and the incentive structure in the economy. ... A political leader's behaviour and policy choices are, however, shaped by current social thinking as well as domestic and economic constraints.  With good intentions therefore political leaders can adopt incorrect policies and cause government failure in the country's development.

--  The endowments are the most important binding constraint on a country's choice of technology and industry.  A country's endowments can be accumulated and altered through time.  At any given time, they determine the total budget of the country ...

-- Comparative advantage is the most important guiding principle not only for trade, but for economic development in a developing country.  A developing country that relies on its comparative advantages to guide its choice of industry and technology will be most competitive in domestic and international markets, producing the largest possible economic surplus, accumulating the largest possible capital and upgrading its endowment structure as well as its technology and industry in the fastest possible way.  ...

--  Viability is the most important concept for understanding the cause of various institutional distortions ind eveloping countries.  An enterprise will be viable in a competitive market only if its technology and industrial choices are consistent with its comparative advantages, determined by the economy's endowment structure.

--  Pragmatism is the most imost important policy guidance for economic transition.  ...  A gradual, piecemeal approach to reform and transition ... could enable the country to achive stability and dynamic growth simultaneously and allow the country to complete its transition to a market economy...."

Lin also reminds us of the importance of China's Confucian culture in East Asia, the core of which is 'zhongyong', the golden mean, which advises people to maintain balance, avoid extremes and achieve harmony with the outside, changing world.  He reminds us of the political philosophy and policy principles of zhongyong which have been promoted by Chinese leaders these past years -- 'shishiqiushi' (finding truth from facts), 'jiefangsixiang' (freeing one's mind from dogmatism), 'yushijujin' (adapting to the changing environment) and 'hexie' (harmony).

Lin's analysis is most certainly incisive and welcome in terms of highlighting the wrong-headed policies in much of the developing world in the Post World War 2 period.  But while comparative advantage is the dominant social thinking of all economists, experience shows that convincing the layman politician of its logic is more challenging.  And even when convinced, in democratic societies, many politicians do not have the luxury of waiting for the long run benefits of comparative advantage or suffering some of its distributional consequences.  So, they cannot resist the temptation of providing assistance to interest groups which might defy comparative advantage.  China's present government may have greater policy freedom in respect of comparative advantage.

One can only hope that in the wake of today's financial and economic crisis, our steroid-charged American friends might look to Chinese philosophy and take on some 'zhongyong'.  Hope springs eternal.  


"Development and Transition: Idea, Strategy, and Viability" by Justin Yifu Lin, Marshall Lectures, Cambridge University, 31 October-1 November, 2007

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