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Multilateral institutions

Lessons from the past

by Ronny Bechmann, Gerhard Ressel, Oliver Lerbs
The ideas of Justin Yifu Lin, a Chinese academic, will shape World Bank policy. He was appointed as the Bank’s chief economist in June, making him the first person from a developing country to hold the position. Lin’s writing focuses on comparative cost advantages in international competition. He thus adheres to the tradition of the free-trade school, which was established by the classic theorist David Ricardo in the 19th century. [ By Ronny Bechmann, Gerhard Ressel and Oliver Lerbs ]

Lin’s work explores the issue of why some developing countries are achieving great success in economic growth and poverty reduction, while others are falling behind even further. Conventional theories do not convince him. In his opinion, factors such as geography, culture and institutional features do not suffice to explain the divide.

In view of the economic performance of Australia, an arid country, Lin disputes the theory that favourable geographical factors are essential for a prosperous economy. Nor are cultural characteristics enough to explain the difference, in his view, as demonstrated by the gulf between North and South Korea. In 1950, when the country was divided, the same cultural values prevailed in both North and South, but the subsequent economic development of the two was completely different.

The third factor often brought into the equation is the issue of institutions (and their rules and regulations). If designed sensibly, they provide incentives to work, learn or invest. But even this does not give a full explanation. Otherwise, those countries that adhere strictly to the good-governance principles of the World Bank would be the successful ones. However, many emerging-market countries in Asia do not even allow for democratic participation.

In light of this, Lin argues that the key factor is government, and the quality of government. The Chinese economist advocates that governments make use of the comparative cost advantages of their particular country (see box on p. 384). If they make clever strategic decisions, they can help their countries to achieve greater prosperity in a gradual manner. If they adopt misguided policies, how­ever, they can ruin entire economies.


Misguided policy

Lin believes that “false ideas” have left their mark on many development strategies, with disastrous consequences. For example, in the drive to modernise, leaders of developing countries soon after indepen­dence tended to apply inappropriate methods when trying to industrialise their countries. Lin does not blame post-independence leaders of self-serving beha­viour. He argues that they were striving for economic and military autonomy, which they equated with independence from imports.

The policy of autarchy resulted in decades of stagnation. Many countries tried to develop a heavy industry of their own, even though doing so was at odds with their comparative cost advantages. Though their competitive strength was actually cheap labour, they invested instead in expensive plant and equipment.

Lin refers in this connection to India’s Prime Minister Jawaharlal Nehru. Mao Tse Tung provided another extreme example. In the late 1950s, he ordered that cooking pots and even harvesters be melted, in order to increase steel production. The “Great Leap Forward” failed, and some 20 to 30 million people died of starvation. In his writings, however, Lin does not delve into details of this particular catastrophe, nor does he express any moral judgment on it. One should bear in mind, of course, that his homeland is not a democracy.

According to Lin, the second major distorted idea was based on the first: governments used subsidies to keep businesses alive artificially. They typically funded businesses which would have collapsed otherwise. Governments that did not command the tax revenue needed for doing so, created market monopolies, overvalued their own currency or controlled commodity prices.

This type of economic policy has several drawbacks.
– The risk of corruption is huge, as government agencies decide directly how funds are allocated.
– Few new jobs are created, with the result that income gaps widen.
– The technology in use becomes obsolete, because the capital-intensive sector of the national economy is cut off from international competition and thus technical progress.
– The national budget does not have funds for promising, labour-intensive industries, which could be made competitive on the global market.

The strategy of pressing ahead with industrialisation and thus curbing one’s comparative advantages soon led to stagnation – not only in countries that belonged to the Soviet sphere of influence.

The third false idea, however, was based on criticism of autarchy policies. While it would have been appropriate, according to Lin, to give state support to industries according to their comparative advantages, it was attempted to reduce the role of governments. Privatisation, price liberalisation and fiscal discipline became the mantras of reform programmes, as was reflected in particular in structural adjustment policies which the World Bank and the International Monetary Fund imposed on many developing countries. Moreover, this approach also marked transition strategies in the former Soviet bloc in the 1990s.

Lin is in favour of liberalisation. However, he argues that it was overlooked at the time that many companies in the countries affected were not viable. A gradual, double-track strategy would have served to avoid high unemployment. That is what China has been doing since Deng Xiaoping. This approach favours private initiative in agriculture and other labour-intensive sectors, but, at the same time, guarantees the state certain quotas of production at fixed prices. The government is thus able to protect weak companies from free-market competition for a while, thereby preventing the economy from collapsing.

Current trends

Lin’s views do not indicate any conceptual revolution at the World Bank. His beliefs are in line with the course taken in past years, but are probably more pragmatic than the good-governance emphasis of recent years. The Bank had re-assessed the role of the state in the era of James Wolfensohn, when Joseph Stieglitz was the chief economist.

The rapid development in countries with development strategies similar to China’s suggests that Lin is correct. Nevertheless, it seems questionable that it still makes sense to emphasise solely comparative advantages. Many influential economists hold the view that, in today’s global economy, such advantages no longer play the role they once did. Instead, attention is focussing on the fact that economic growth goes along with spreading technologies, and that the key is to learn by imitation. Harvard Professor Robert J. Barro is an economist who argues like this. If countries concentrate too much on undifferentiated products, they may miss opportunities of becoming better and cheaper in the area of higher-grade products through learning, forgoing market shares in the world economy.

Furthermore, it has become more difficult to specialise according to one’s own comparative advantages. A few decades ago, it was obvious what exactly these advantages were. Today, that is no longer that clear. Historically, the comparative advantage of poor countries lay in the mass production of simple goods. After all, they typi­cally lack capital and know-how for premium products. In the model Lin uses, capital and labour are combined for production at the domestic level, but he does not con­sider international value-chains. However economic reality, which is driven by globali­sation, is increasingly about international networking. Access to capital and technology is no longer as exclusive as it was a few years ago.

Moreover, the quality of labour makes a difference, and quality varies between “old” and “new” industrialised countries. For example, education levels vary. In this regard, it is important that governments become active to modify and improve their nations’ comparative advantages. In trade between long-established industrial countries, comparative advantages hardly matter anymore. The dominant intra-industrial trade among such countries is mainly based on the “love of diversity”: some French people like German cars, while some Germans like French cars.

Lin belongs to the economics mainstream. He too is of the belief that technological progress is the strongest force driving long-term development of an economy. Nevertheless, Lin emphasises that there are various strategies for innovation. He even states that coming late may be used as an advantage. Poor nations, after all, do not have to carry out expensive research, but can instead adopt whatever technology is appropriate, modifying it slightly if necessary – for example, so it can be used by a larger workforce.

However, Lin points out that greater research-and-development efforts become necessary at the national level once rich-world examples are of no further help. Motor scooters are an example. Today, they are essential means of transport in many Asian cities, but industrialised nations still only produce them in small quantities. New research must therefore be carried out in Asia. That is even more so in the case of defence technology and other products relevant to national security. Lin’s thinking clearly marks him out as a pragmatist. In times when prices are high for primary products and food, this will perhaps help the World Bank to find solutions in a systematic manner, rather than taking action in haste.