Professor Robert Wade’s article, ‘After the Crisis: Industrial Policy and the Developmental State in Low-Income Countries’, is a bold and thought-provoking exposition of his long-held ideas on the political economy of development and the dynamics of structural change. I agree with much of what he suggests but would like to offer a couple of nuances on the relative roles of the market and the state in the process of economic development, and then suggest a framework for conceptualizing and operationalizing successful government intervention.
The need to differentiate between ‘good’ and ‘bad’ capital inflows is an important lesson from the recent global crisis. I have argued elsewhere that liberalizing inward direct investment should generally be an attractive major component of industrial policy (Lin, 2010). Foreign direct investment (FDI) usually flows to industries that are consistent with the recipient country’s comparative advantage. It is also less prone to sudden reversals in a panic situation than bank loans, debt financing or portfolio investment. In addition, FDI tends to bring technology, new managerial practices, access to markets, and social networking, which are often lacking in a developing country and yet crucial for the industrial upgrading process. By contrast, portfolio investment tends to target speculative activities (mostly in equity markets or the housing sector), which create bubbles and fluctuations. They are volatile by nature and often contribute to Dutch disease and currency crises. Wade takes the analysis further; he points out that FDI flows must be managed strategically for developing countries to avoid deficit-prone industrialization. He rightly suggests that priority be given to inflows that foster the growth of intermediate inputs and producer services within the national economy – this helps reduce the income elasticity of import demand.
I also agree with his reflections on the direction of the causality between growth and governance. Government failures have indeed been as pervasive and damaging in the developing world as market failures. But an exclusive focus on governance may be misguided. Governance is likely to be endogenous to the stage of economic development, and sustained economic growth in developing countries may be needed before their governance converges with that of high-income countries (Meisel and Aoudia, 2008).
I do not share Wade’s severe assessment of neoclassical economics on two points. First, despite the absence of convergence among world economies, the progress made by developing countries in recent decades cannot be underestimated. The fact that the majority of states have remained in the same income category over two decades may be the reflection of general progress (a tide-lifting-all-boats phenomenon) rather than a sign of general stagnation. Although relative incomes among various groups of countries may not have changed much, the absolute levels of incomes have increased steadily in recent decades. This has contributed substantially to the reduction of world poverty (Ravallion and Chen, 2008). Clearly, an open world economy has offered opportunities for many developing countries throughout the world to achieve sustained growth and improve their living standards (Growth Commission, 2008). This is true even in many countries that have not moved up the convergence ladder.
Second, the market is an important resource allocation mechanism at any given level of development. Economic growth occurs when firms are given the incentive system to take advantage of existing opportunities determined by the country’s endowment structure. They can also create potential new business niches by identifying and exploiting the economy’s latent comparative advantage. They spontaneously enter industries and choose technologies consistent with the economy’s comparative advantage only when the price system reflects the relative scarcity of factors in the country’s endowment. Therefore, a competitive market system should be the economy’s fundamental mechanism for resource allocation at each stage of its development. However, economic development is a dynamic process that requires industrial upgrading and corresponding improvements in ‘hard’ (tangible) and ‘soft’ (intangible) infrastructure at each stage. Such upgrading requires coordination and entails large externalities to firms’ transaction costs and returns to capital investment. Thus, in addition to an effective market mechanism, the government should play an active role in facilitating industrial upgrading and infrastructure improvements.
A framework for conceptualizing the facilitating role of the government in industrial upgrading and economic diversification could involve a six-step process as follows. (1) Developing country governments can identify the list of tradable goods and services that have been produced for about 20 years in dynamically growing countries with similar endowment structures and a per capita income that is about 100 per cent higher than their own. (2) Among the industries in that list, the government may give priority to those in which some domestic private firms have already entered spontaneously, and try to identify and help remove the obstacles to their development. (3) Some of those industries in the list may be completely new to domestic firms; in such cases, the government could adopt specific measures to attract firms in the higher-income countries identified in the first step to invest in these industries. (4) Developing country governments should pay close attention to private enterprises’ successful self-discoveries of industries that are not included in the list identified in step (1) and provide support to scale up those industries. (5) In developing countries with poor infrastructure and an unfriendly business environment, the government can invest in industrial parks or export processing zones and make the necessary improvements to attract domestic private firms and/or foreign firms that may be willing to invest in the targeted industries. Finally (6) limited incentives may also be provided to domestic pioneer firms or foreign investors that work within the list of industries identified in step (1) in order to compensate for the non-rival, public knowledge created by their investments (Lin and Monga, 2010).
Such a systematic approach may be useful for formulating and implementing rigorously the type of strategic government intervention that Wade advocates in his very timely article.