This file is also available in Adobe Acrobat PDF format
ON A VISIT to a small Latin American country a few yearsback, my colleagues and I paid a courtesy visit to the minister of finance.The minister had prepared a detailed PowerPoint presentation on his economy’s recent progress, and as his aide projected one slide after another onthe screen, he listed all the reforms that they had undertaken. Trade barriers had been removed, price controls had been lifted, and all public enterprises had been privatized. Fiscal policy was tight, public debt levels low,and inflation nonexistent. Labor markets were as flexible as they come.There were no exchange or capital controls, and the economy was open toforeign investments of all kind. “We have done all the first-generation reforms, all the second-generation reforms, and are now embarking on third-generation reforms,” he said proudly.
Indeed the country and its finance minister had been excellent students of the teaching on development policy emanating from internationalfinancial institutions and North American academics. And if there were justice in the world in matters of this kind, the country in question wouldhave been handsomely rewarded with rapid growth and poverty reduction.Alas, not so. The economy was scarcely growing, private investment remained depressed, and largely as a consequence, poverty and inequalitywere on the rise. What had gone wrong?
Meanwhile, there were a number of other countries—mostly butnot exclusively in Asia—that were undergoing more rapid economicdevelopment than could have been predicted by even the most optimisticeconomists. China has grown at rates that strain credulity, and India’s performance, while not as stellar, has confounded those who thought that thiscountry could never progress beyond its “Hindu” rate of economic growthof 3 percent. Clearly, globalization held huge rewards for those who knewhow to reap them. What was it that these countries were doing RIGht?
THE PRIMACY OF ECONOMIC GROWTH
These are some of the greatest economic puzzles of our time, andthey are the questions around which the chapters in the book revolve. Fascinating and challenging as they are from a scholarly standpoint, theirsignificance runs much deeper. Our ability to answer these questions willhelp determine the extent to which the world’s poor lift themselves out ofdestitution, improve their standards of living, achieve better health andeducation, and attain greater control over their lives. Economic growth is the most powerful instrument for reducing poverty. If you look at a map ofthe world today and ask where there is the greatest incidence of poverty, thesimplest answer is: where there has been the least amount of growth sincethe onset of modern economic growth around the middle of the eighteenthcentury. Economic growth can be powerful over much shorter periods oftime as well. China’s rapid growth since 1980 has allowed more than 400million of its citizens to pull themselves above the poverty line.1 Of course, growth is not a panacea, and there are certainly cases where health andsocial indicators have not improved despite sustained growth over periodsof a decade or more. But historically nothing has worked better than economic growth in enabling societies to improve the life chances of theirmembers, including those at the very bottom.
As the vignettes with which I started indicate, these have beeninteresting times for students of economic growth. Some countries haveembarked on rapid growth after years of stagnation; others have collapsedfollowing a period of high growth; yet others have never experienced sustained growth. This book represents my attempt to understand the growthsuccesses and failures of the last few decades and to distill general lessonsfrom this experience. My objective is as much to shine a guiding light onfuture policies as it is to interpret the past. I aim in these essays to elucidatethe nature of the institutional arrangements—national and global—thatbest support economic development over the longer term.
All of this diverse experience with growth has happened in an eraof rapid globalization, during which countries have become increasinglyopen to forces emanating from outside their borders. The fact that theyhave responded so differently is evidence enough—if any is needed—thatnational policy choices are the ultimate determinant of economic growth.At the same time, successful countries are those that have leveraged theforces of globalization to their benefit. China and India would not havedone nearly as well without access to relatively open markets for goods andservices in the advanced countries. But their success was also due to their governments’ concerted efforts to restructure and diversify their economies.If China and India had nothing other than garments and agricultural products to export, the gains from foreign trade and investment would not havebeen nearly as large. Understanding how the forces of globalization interact with national economic policies is therefore indispensable as we interpretthe past and draw lessons for the future. This helps us rethink global economic governance from a slightly different perspective: instead of asking,“What do countries have to do to live with globalization?” we can ask,“How should the institutions of economic globalization be designed to provide maximal support for national developmental goals?” I devote a goodchunk of this book to the latter question.
The chapters that follow cover a wide range of topics—growth, institutions, globalization—but they advance, I think, a unified frameworkmotivated by a number of common predilections and preoccupations. Itmay be useful to lay out those predilections—some will call them biases—atthe outset.
A CREDO OF SORTS
First, this book is strictly grounded in neoclassical economicanalysis. At the core of neoclassical economics lies the following methodological predisposition: social phenomena can best be understood byconsidering them to be an aggregation of purposeful behavior by individuals—in their roles as consumer, producer, investor, politician, and so on—interacting with each other and acting under the constraints that their environment imposes. This I find to be not just a powerful discipline fororganizing our thoughts on economic affairs, but the only sensible way ofthinking about them. If I often depart from the consensus that “mainstream” economists have reached in matters of development policy, this hasless to do with different modes of analysis than with different readings ofthe evidence and with different evaluations of the “political economy” of developing nations. The economics that the graduate student picks up inthe seminar room—abstract as it is and riddled with a wide variety ofmarket failures—admits an almost unlimited range of policy recommendations, depending on the specific assumptions the analyst is prepared tomake. As I will argue in the chapters to come, the tendency of many economists to offer advice based on simple rules of thumb, regardless of context(privatize this, liberalize that), is a derogation rather than a proper application of neoclassical economic principles.
Second, I believe in the importance of a careful reading of the empirical evidence. In particular, our prescriptions need to be based on asolid understanding of recent experience. This may seem like a trivial pointto emphasize, but it is remarkable how frequently it is overlooked. It iscommon for policy advisors to recommend growth strategies to countrieswithout having a solid grasp of the ups and downs of their recent economicperformance—that is, without understanding the nature of the growth process in that economy. Econometricians are still hard at work looking forthe growth-promoting effects of policies that countries in Latin Americaand elsewhere embraced enthusiastically a quarter century ago. I am not apurist when it comes to the kind of evidence that matters. In particular, Ibelieve in the need for both cross-country regressions and detailed countrystudies. Any cross-country regression giving results are that not validatedby case studies needs to be regarded with suspicion. But any policy conclusion that derives from a case study and flies in the face of cross-national evidence needs to be similarly scrutinized. Ultimately, we need both kindsof evidence to guide our views of how the world works.
Third, I remain a believer in the ability of governments to do goodand change their societies for the better. Government has a positive role toplay in stimulating economic development beyond enabling markets tofunction well. This view is to be contrasted with two alternative perspectives. One of these, the public-choice or rent-seeking perspective, thinks ofthe government as the malign tool of private interests. When the government interferes, it does so only to enrich supporters, cronies, or the intervening bureaucrats themselves. From this perspective, the more we canrestrain government action, the better. The second perspective, that of thepolitical-economy school, does not take an ex ante position on whethergovernment is a positive or negative force, but fully endogenizes the behavior of government, and in doing so leaves it with no room to do anything(whether good or bad) that has not already been foreordained by long-standing structural determinants. To adherents of this perspective, thequestion “What should the government do?” is meaningless—or at leastone that they have difficulty dealing with. While both schools have contributed important insights, I believe they underestimate the roles that serendipity and imperfect knowledge play in policy formulation. In theworld of public policy, lots of $100 bills are left lying on the sidewalk. Therole of economists is to point those out, while that of political leaders is toengineer the bargains that will allow them to be picked up.
Fourth, I believe that appropriate growth policies are almostalways context specific. This is not because economics works differently indifferent settings, but because the environments in which households, firms, and investors operate differ in terms of the opportunities and constraints they present. “You don’t understand; this reform will not work herebecause our entrepreneurs do not respond to price incentives,” is not a validargument. “You don’t understand, this reform will not work here becausecredit constraints prevent our entrepreneurs from taking advantage ofprofit opportunities” or “because entrepreneurship is highly taxed at themargin” is a valid argument—assuming those borrowing constraints orhigh taxes can be documented. Learning from other countries is alwaysuseful—indeed, it is indispensable. But straightforward borrowing (or rejection) of policies without a full understanding of the context thatenabled them to be successful (or led them to be failures) is a recipe fordisaster. Once one understands that context, there will always be variationson the original policy (or different policies altogether) that will do a betterjob of producing the intended effects.
A fifth preoccupation is with prioritization, sequencing, selectivity, and targeting of reforms on the most binding constraints. One of theprofessional deformations of economists is to see an economy’s problemsalmost exclusively from the perspective of their own area of specialty. Atrade theorist will turn to developing economies and see lack of opennessto trade as the key obstacle to growth. A financial market economist willidentify imperfections in credit markets and lack of financial depth as themain culprit. A macroeconomist will worry about budget deficits, levels ofdebt, and inflation. A political-economy specialist will blame weakness inproperty rights and other institutions. A labor economist will point tolabor-market rigidities. Each of them will then advocate a demanding set ofinstitutional and governance reforms targeted at removing the presumeddefect. So trade openness will require not just removal of tariffs and quotason imports, but also improved governance, less corruption, better education, and smoothly functioning labor and credit markets. Financial depthrequires prudential supervision and regulation, an open capital account,appropriate macroeconomic management. Macroeconomic stability requires fiscal rules, central bank independence, adherence to international financial codes, and sundry “structural reforms.” Rarely will the advisor askwhether the problem at hand constitutes a truly binding constraint on economic growth, and whether the long list of institutional reforms on offerare well targeted at the economy’s present needs. But governments are constrained by limits on their resources—financial, administrative, human, andpolitical. They have to make choices on which constraints to attack firstand what kind of reforms to spend political capital on. What they need isnot a laundry list, but an explicitly diagnostic approach that identifies priorities based on local realities.
Finally, modesty. Economists have probably had more influence onpolicy in recent decades than at any other time in world history. But the sadreality is that their influence in the developing world has run considerablyahead of their actual achievements. Winston Churchill famously quippedthat Clement Attlee, his rival and successor as prime minister in 1945, was“a modest man, with much to be modest about.” To turn the quip on itshead, economists are an arrogant bunch, with very little to be arrogantabout. I hope the reader will agree that the essays in this book are different,for they were written in a spirit of humility. As social scientists, economistshave neither the ability of physicists to fully explain the phenomena aroundus, nor the expertise of physicians to prescribe effective cures when things go wrong. We can be far more useful when we display greater self-awarenessof our shortcomings. The emphasis on pragmatism, experimentation, andlocal knowledge that permeates the essays in the book is grounded in suchconsiderations.
A ROAD MAP OF THE BOOK
The chapters in the book are organized in three parts: growth, institutions, and globalization. Each part includes two substantive chaptersplus a shorter piece of synthesis. These essays were written at differenttimes over a period of around six years. All except one (chapter 4) has beenpublished previously. I selected them among my publications not becausethey are my favorites or are better known, but because they fit well togetherand are thematically well linked. In preparing them for inclusion in thisbook, I undertook only some minor updating and edits, mainly to providefor smoother transitions across the chapters and eliminate repetition.
Part A of the book focuses on economic growth: why have somecountries grown more rapidly than others, and what we can learn from thisexperience as we design growth strategies going forward? Chapter 1 offers abroad review of the evidence and presents two key arguments. One is thatneoclassical economic analysis is a lot more flexible than its practitioners inthe policy domain have generally given it credit for. In particular, first-ordereconomic principles—protection of property rights, market-based competition, appropriate incentives, sound money, and so on—do not map intounique policy packages. Reformers have substantial room for creativelypackaging these principles into institutional designs that are sensitive tolocal opportunities and constraints. Successful countries are those that haveused this room wisely. The second argument is that igniting economicgrowth and sustaining it are somewhat different enterprises. The formergenerally requires a limited range of (often unconventional) reforms thatneed not overly tax the institutional capacity of the economy (as discussedin chapter 2). The latter challenge is in many ways harder, as it requiresconstructing over the longer term a sound institutional underpinning toendow the economy with resilience to shocks and maintain productive dynamism (see chapters 4 and 5). Ignoring the distinction between these twotasks leaves reformers saddled with impossibly ambitious, undifferentiated,and impractical policy agendas.
Chapter 2 (coauthored with Ricardo Hausmann and Andres Velasco) focuses on igniting economic growth. It presents a framework foridentifying “binding constraints” on growth, so that reform strategies canfocus on areas with the biggest immediate impact. The diagnostics revolve around a decision tree. Starting from the very top, growth can be constrained by inadequate social returns, by a large wedge between social andprivate returns (lack of appropriability), or by poor access to finance. Economies suffering from each of these different constraints throw out different signals. For example, a finance-constrained economy is one wherereal interest rates are high, current account deficits are large, and investment is highly responsive to exogenous foreign inflows (e.g., remittances).The diagnostic analysis begins by trying to identify which of these areaspresents a more serious constraint, and then moves one level down. For instance, if low social returns are identified as the constraint, the next question turns on whether the reasons for that have to do with poor geography,low human capital, or inadequate infrastructure. The analysis continues infractal fashion at successively finer levels of resolution until the list of binding constraints is narrowed to a set small enough to be amenable to policy.The chapter discusses the application of this approach to three Latin American countries: El Salvador, Brazil, and Dominican Republic.
Chapter 3 is a shorter, synthetic essay that pulls the key themes inthe previous two chapters together and lays out a broad vision for formulating growth strategies. It emphasizes three steps in the process. The firststep consists of an analysis of growth diagnostics, along the lines discussedin the previous chapter. The second step involves policy design, where theobjective is to remove the identified constraint(s) with targeted, imaginative policies that are cognizant of the local realities. The third step is anongoing one, requiring the institutionalization of the diagnostic and policydesign activities, with the goals of strengthening the institutional infrastructure of the economy and maintaining productive vitality.
This provides a transition to part B of the book, which focuses oninstitutions specifically. The first chapter in this part (chapter 4) picks upthe theme of productive vitality and asks: what kind of institutions bestenable developing economies to diversify their productive structures sothat they can sustain economic growth in the longer run? The hallmark ofdevelopment is structural change—the process of pulling the economy’sresources from traditional low-productivity activities to modern high-productivity activities. This is far from an automatic process, and requiresmore than well-functioning markets. It is the responsibility of industrialpolicy to stimulate investments and entrepreneurship in new activities,especially those in which the economy may end up having comparativeadvantage. The usual argument against industrial policy is that governments can never pick winners. I show that this is the wrong way of thinkingwhat industrial policy does. Appropriately structured, industrial policy is a process of strategic collaboration between the private and public sectors, where the objectives are to identify blockages and obstacles to new investments and to design appropriate policies in response. The chapter describes the institutional features that such an industrial policy regimeneeds to have.
The focus of chapter 5 is the full gamut of market-supporting institutions that ensure economic prosperity in the long run. The chapter openswith a typology of institutions that allow markets to perform adequately.While we can identify in broad terms institutional prerequisites, I arguethat there is no unique mapping between markets and the nonmarket institutions that underpin them. The chapter emphasizes the importance of“local knowledge,” and advances the view that a strategy of institutionbuilding must not overemphasize best-practice “blueprints” at the expenseof experimentation. The question is, how do we design such institutionssensitive to local knowledge and needs? I argue that participatory politicalsystems are the most effective mechanism for processing and aggregatinglocal knowledge. In effect, democracy is a metainstitution for building goodinstitutions. I end the chapter with a range of evidence that shows thatparticipatory democracies enable higher-quality growth.
Chapter 6 concludes part B by providing a guided tour of some ofthe key issues and controversies spawned by the huge outpouring of literature on institutions in recent years. If we focus on institutions—the rules ofthe game in a society—as the fundamental determinant of long-run growth,does that mean that economic policies themselves have little role to play?If it is true that colonial history has had a big hand in shaping today’sinstitutional outcomes, does that mean that patterns of development arehistorically determined? If institutions “trump” geography as a deep determinant of incomes, does that mean that geography is of no consequence?If property rights are critical, does that imply that developing countries should adopt the property rights regimes that prevail in the UnitedStates or Europe? I argue in this chapter that the answers to each of thesequestions is no.
Part C of the book is devoted to globalization. In chapter 7, I identify the central dilemma of the world economy as the tension between theglobal nature of many of today’s markets in goods, capital, and services, and the national nature of almost all of the institutions that underpin and support them. The needs of efficiency, equity, and legitimacy cannot all bemet. If we want to advance economic globalization, we need to give upeither on the nation-state or on democracy. If we want to retain the nation-state, we need to give up on either deep economic integration or massdemocracy. And if we want to deepen democracy, we must sacrifice either the nation-state or deep integration. But the overall message of thechapter is not a pessimistic one. Our challenge is not markedly differentfrom that confronted by the designers of Bretton Woods system in theaftermath World War II. By designing appropriate institutions of globaleconomic governance—incorporating mechanisms of escape clauses and opt-outs—we can retain much of the benefit of economic globalizationwhile endowing national democracies with the space they need to addressdomestic objectives.
Chapter 8 works out the implications of this line of reasoning forthe international trade regime in particular. I argue that a World TradeOrganization whose primary goal was to enable countries to grow out ofpoverty, rather than maximize the volume of trade, would look differentfrom the WTO we have. In view of how open the global trade regime is currently, the big bucks in terms of growth are no longer in pushing for furtherincreases in market access for developing countries in rich-country markets. The real challenge going forward is to how to make the tightening webof global trade regulations compatible with developmental needs. Connecting with the arguments made earlier in the book, a desirable trade regimewould be one that provided much greater policy space to developing countries to pursue domestically crafted growth strategies, possibly including“unorthodox” policies such as export subsidies, trade protection, weakpatent rules, and investment performance requirements. It should be possible to design institutional safeguards to ensure that such policy space doesnot deteriorate into crass protectionism, and the chapter discusses whatsuch safeguards might look like. Under this new vision, the role of theWTO would be to regulate the interface between different national regulatory regimes rather than to narrow the differences among them. Developing countries would no longer short-change themselves by engaging in agame of reciprocal market access instead of ensuring that they have accessto the full range of policy tools they need.
Chapter 9 is a short final essay that brings together some of thebook’s main themes of the relationship between economic growth andglobalization. It ends with a proposal that was somewhat tongue-in-cheekwhen first formulated. If global trade negotiators are serious about makingglobalization work for developing countries, they should drop everythingelse on their agenda and focus on a temporary work permit program thatallows unskilled workers from poor nations to take up employment (forperiods of three to five years at a time) in rich countries. If globalization hasan unexplored frontier, it is that of labor mobility. Nothing else promises asbig a welfare bang for developing country workers as a relaxation of therestrictions on their international mobility. Remarkably, this pie-in-the-skyproposal has entered policy discussions. Ideas do matter.
A FINAL WORD
Making a book out of a collection of one’s previously publishedessays requires a certain hubris, which sits ill at ease with the spirit ofhumility that I claimed marks the essays themselves. I can say in my defense that this is not the first time I have attempted an effort of this kind. Butpreviously, each time I put a table of contents together, I found that thebook did not hang together. This time seemed different. Importantthemes—important in the sense that I still believe in them and feel the needto get them across—thread through the essays and connect different partsof the volume together. I will leave it to reviewers to judge whether theproverbial whole is greater than the sum of the parts. But I do hope thateven the reader who has encountered some of these essays before will findnew nuggets in rereading them in the context of the entire collection.
Return to Book Description
File created: 8/20/2007
Questions and comments to: firstname.lastname@example.org
Princeton University Press