This is “Keys to Economic Development”, section 19.3 from the book Macroeconomics Principles (v. 2.0).
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What are the keys to economic development? Clearly, each nation’s experience is unique; we cannot isolate the sources of development success in the laboratory. We can, however, identify some factors that appear to have played an important role in successful economic development. We will look separately at policies that relate to the domestic economy and at policies in international trade.
What domestic policies contribute to development? Looking at successful economies, those that have achieved high and sustained increases in per capita output, we can see some clear tendencies. They include a market economy, a high saving rate, and investment in infrastructure and in human capital.
There can be no clearer lesson than that a market-oriented economy is a necessary condition for economic development. We saw in the chapter that introduced the production possibilities model that economic systems can be categorized as market capitalist, command socialist, or as mixed economic systems. There are no examples of development success among command socialist systems, although some people still believe that the former Soviet Union experienced some development advances in its early years.
One of the most dramatic examples is provided by China. Its shift in the late 1970s to a more market-based economy has ushered in a period of phenomenal growth. China, which has shifted from a command socialist to what could most nearly be categorized as a mixed economy, has been among the fastest-growing economies in the world for the past 20 years. Its growth has catapulted China from being one of the world’s poorest countries a few decades ago to being a middle-income country today.
The experience of other economies reinforces the general observation that markets matter. South Korea, Hong Kong, Taiwan, Singapore, and Chile—all have achieved gigantic gains with a market-based approach to economic growth.
We should not conclude, however, that growth has been independent of any public sector activity. China, for example, remains a nominally socialist state; its government continues to play a major role. The governments of South Korea, Taiwan, and Singapore all targeted specific sectors for growth and provided government help to those sectors. Even Hong Kong, which became part of China in 1997, has a high degree of government involvement in the provision of housing, health care, and education. A market economy is not a nongovernment economy. But those countries that have left the task of resource allocation primarily to the market have achieved dramatic gains. Hong Kong and Singapore, in fact, are now included in the World Bank’s list of high-income economies.
If a market is to thrive, individuals must be secure in their property. If crime or government corruption makes it likely that individuals will regularly be subjected to a loss of property, then exchange will be difficult and little investment will occur. Also, the rule of law is necessary for contracts; that is, the rule of law is necessary to provide an institutional framework within which an economy can operate.
We will see in the chapter on socialist economies in transition, for example, that Russia’s effort to achieve economic development through the adoption of a market economy has been hampered by widespread lawlessness. An important difficulty of economies with extensive regulation is that the power they grant to government officials inevitably results in widespread corruption that saps entrepreneurial effort and economic growth.
Saving is a key to growth and the achievement of high incomes. All other things equal, higher saving allows more resources to be devoted to increases in physical and human capital and to technological improvement. In other words, saving, which is income not spent on consumption, promotes economic growth by making available resources that can be channeled into growth-enhancing uses.
High saving rates generally accompany high levels of investment. The productivity of this investment, however, can be quite variable. Government efforts to invest in human capital by promoting education, for example, may or may not be successful in actually achieving education. Development projects sponsored by international relief agencies may or may not foster development.
However, investment in infrastructure, such as transportation and communication, clearly plays an important role in economic development. Investment in improved infrastructure facilitates the exchange of goods and services and thus fosters development.
In 1974, the poorest nations among the developing nations introduced into the United Nations a Declaration on the Establishment of a New International Economic Order. The program called upon the rich nations to help them reduce the growing gap in real per capita income levels between the developed and developing nations. The declaration has come to be known as the New International Economic Order or NIEO for short.
NIEO called for different and special treatment of the developing nations in the international arena in areas such as trade policy and control over multinational corporations. NIEO reflected a widely held view of international relations known as dependency theory.
Conventional economic theory concerning international trade is based on the idea of comparative advantage. As we have seen in other chapters, the principle of comparative advantage suggests that free trade between two countries will benefit both and, in general, the freer the trade the better. But some economists have proposed a doctrine that challenges this idea. Dependency theoryThe idea that poverty in developing nations is the result of their dependence on high-income nations. concludes that poverty in developing nations is the result of their dependence on high-income nations.
Dependency theory holds that the industrialized nations control the destiny of the developing nations, particularly in terms of being the ultimate markets for their exports, serving as the source of capital required for development, and controlling the relative prices and exchange rates at which market transactions occur. In addition, export industries in a developing nation are assumed to have small multiplier effects throughout the rest of the economy, severely limiting any positive role than an expanded export sector might play. Specifically, limited transportation, a poorly developed financial sector, and an uneducated work force stand in the way of “multiplying” any positive effects of export expansion. A poor country thus may not experience the kind of development and growth enjoyed by the rich country pursuing free trade. Also, increased trade makes the poor country more dependent on the rich country and its export service firms. In short, the benefits of trade between a rich country and a poor country will go almost entirely to the rich country.
The development strategy that this line of argument suggests is that developing countries would need to become independent of the already developed nations in order to achieve economic development. In relative terms, free trade would leave the poor country poorer and the rich country richer. Some dependency theorists even argued that trade is likely to make poor countries poorer in absolute terms.
Tanzania’s president, Julius Nyerere, speaking before the United Nations in 1975, put it bluntly, “I am poor because you are rich.”
If free trade widens the gap between rich and poor nations and makes poor nations poorer, it follows that a poor country should avoid free trade. Many developing countries, particularly in Latin America, attempted to overcome the implications of dependency theory by adopting a strategy of import substitutionA strategy of blocking most imports and substituting domestic production of those goods., a strategy of blocking most imports and substituting domestic production of those goods.
The import substitution strategy calls for rapidly increasing industrialization by mimicking the already industrialized nations. The intent is to reduce the dependence of the developing country on imports of consumer and capital goods from the industrialized countries by manufacturing these goods at home. But in order to protect these relatively high-cost industries at home, the developing country must establish very high protective tariffs. Moreover, the types of industries that produce the previously imported consumer goods and capital goods are unlikely to increase the demand for unskilled labor. Yet unskilled labor is the most abundant resource in the poor countries. Adopting the import substitution strategy raises the demand for expensive capital, managerial talent, and skilled labor—resources in short supply.
High tariffs insulate domestic firms from competition, but that tends to increase their monopoly power. Recognizing that some imported goods, particularly spare parts for industrial equipment, will be needed, countries can establish complex permit systems through which firms can import vital parts and other equipment. But that leaves a company’s fortunes in the hands of the government bureaucrats issuing the permits. A highly corrupt system quickly evolves in which a few firms bribe their way to easy access to foreign markets, reducing competition still further. Instead of the jobs expected to result from import substitution, countries implementing the import substitution strategy get the high prices, reduced production, and poor quality that come from reduced competition.
No country that has relied on a general strategy of import substitution has been successful in its development efforts. It is an idea whose time has not come. In contrast, more successful economies in Asia and elsewhere have kept their economies fairly open to both imports and exports. They have shown the greatest ability to move the development process along.
Successful development in the developing nations requires more than just redirecting labor and capital resources into newly emerging sectors of the economy. That could be accomplished by both domestic firms and international firms located within the economy. But to complement the reorientation of traditional production processes, economic infrastructure such as roads, schools, communication facilities, ports, warehouses, and many other prerequisites to growth must be put into place. Paying for the projects requires a high level of saving.
The sources of saving are private saving, government saving, and foreign saving. Grants in the form of foreign aid from the developed nations supplement these sources, but they form a relatively small part of the total.
Private domestic saving is an important source of funds. But even high rates of private saving cannot guarantee sufficient funds in a poor economy, where the bulk of the population lives close to the subsistence level. Government saving in the form of tax revenues in excess of government expenditures is almost universally negative. If the required investments are to take place, the developing nations have to borrow the money from foreign savers.
The problem for developing nations borrowing funds from foreigners is the same potential difficulty any borrower faces: the debt can be difficult to repay. Unlike, say, the national debt of the United States government, whose obligations are in its own currency, developing nations typically commit to make loan payments in the currency of the lending institution. Money borrowed by Brazil from a U.S. bank, for example, must generally be paid back in U.S. dollars.
Many developing nations borrowed heavily during the 1970s, only to find themselves in trouble in the 1980s. Countries such as Brazil suspended payments on their debt when required payments exceeded net exports. Much foreign debt was simply written off as bad debt by lending institutions. While foreign debts created a major crisis in the 1980s, subsequent growth appeared to make these payments more manageable.
A somewhat different international financial crisis emerged in the late 1990s. It started in Thailand in the summer of 1997. Thailand had experienced 20 years of impressive economic growth and rising living standards. One element of its development strategy was to maintain a fixed exchange rate between its currency, the baht, and the dollar. The slowing of Japanese growth, which reduced demand for Thai exports, and weaknesses in the Thai banking sector were putting downward pressure on the baht, which Thailand’s central bank initially tried to counteract. As discussed there, this effort was abandoned, and the value of the currency declined.
The Thai government, in an effort to keep its exchange rate somewhat stable, appealed to the International Monetary Fund (IMF) for support. The IMF is an international agency that makes financial assistance available to member countries experiencing problems in their international balance of payments in order to support adjustment and reform in those countries. In an agreement between Thailand and the IMF, Thailand’s central bank tightened monetary policy, thereby raising interest rates there. The logic behind this move was that higher interest rates in Thailand would make the baht more attractive to both Thai and foreign financial investors, who could thus earn more on Thai bonds and on other Thai financial assets. This would increase the demand for baht and help to keep the currency from falling further. Thailand also agreed to tighten fiscal policy, the rationale for which was to prepare for the anticipated future costs of restructuring its banking system. As we have learned throughout macroeconomics, however, contractionary monetary and fiscal policies will reduce real GDP in the short run. The hope was that growth would resume once the immediate currency crisis was over and plans had been put into place for correcting other imbalances in the Thai economy.
Other countries, such as South Korea and Brazil, soon experienced similar currency disturbances and entered into similar IMF programs to put their domestic houses in order in exchange for financial assistance from the IMF. For some of the other countries that went through similar experiences, notably Indonesia and Malaysia, the situation in 1999 was very unstable. Malaysia decided to forgo IMF assistance and to impose massive currency controls. In Indonesia, the financial crisis and the ensuing economic crisis led to political unrest. It held its first free elections in June 1999, but violence erupted in late 1999, when the overwhelming majority of people in East Timor voted against an Indonesian proposal that the province have limited autonomy within Indonesia and voted for independence from Indonesia.
Remarkably, in the early 2000s, the economies of most of these countries rebounded, though they are now caught up in the global economic downturn.
As we have seen throughout this chapter, the greatest success stories are found among the newly industrializing economies (NIEs) in East Asia. These economies, including Hong Kong, South Korea, Singapore, and Taiwan, share two common traits. First, they have allowed their economies to develop through an emphasis on export-based, market capitalist strategies. The NIEs achieved higher per capita income and output by entering and competing in the global market for products such as computers, automobiles, plastics, chemicals, steel, shipbuilding, and sporting goods. These countries have succeeded largely by linking standardized production technologies with low-cost labor.
Second, the role of government was relatively limited in the NIEs, which made less use of regulation and bureaucratic controls. Governments were clearly involved in some strategic industries, and, in the wake of recent financial crises, in some cases it appears that this involvement led to some decisions in those industries being made on political rather than on economic grounds. But the principal contribution of governments in the Far Eastern NIEs has been to create a modern infrastructure (especially up-to-date communications facilities essential for the development of a strong financial sector), to provide a stable incentive system (including stable exchange rates), and to ensure that government bureaucracy will help rather than hinder exports (especially by not regulating export trade, labor markets, and capital markets).Bela Balassa, “The Lessons of East Asian Development,” Economic Development and Cultural Change 36, no. 3 (April 1988): S247–S290.
Chile adopted sweeping market reforms in the late 1970s, creating the freest economy in Latin America. Chile’s growth has accelerated sharply, and the country has moved to the upper-middle-income group of nations. Perhaps more dramatic, the dictator who instituted market reforms, General Augusto Pinochet, agreed to democratic elections that removed him from power in 1989. Chile now has a greatly increased degree of political as well as economic freedom—and has emerged as the most prosperous country in Latin America.
Over the last decade, Mexico also shifted from a strategy of import substitution and began to follow more free-trade-oriented policies. The North American Free Trade Agreement (NAFTA) turned all of North America into a free trade zone. This could not have occurred had Mexico not undergone such a dramatic shift in its development strategy. Mexico’s commitment to the new strategy was tested in 1994, when the country underwent a currency crisis, similar to that experienced in many Asian countries in 1997 and 1998. At that time, Mexico, too, entered into an agreement with the IMF to address economic imbalances in return for financial assistance. The U.S. government also provided support to help Mexico at that time. By 1996, the Mexican economy was growing again, and Mexican commitment to more open policies has endured. Only with the passage of time will we know for sure whether the changed strategy worked in Mexico as well, but the early signs are that it is working.
Although the trend in developing countries toward market reforms has been less heralded than the collapse of communism, it is surely significant. Will market reforms translate into development success? The jury is still out. Market reform requires that many wealthy—and powerful—interests be swept aside. Whether that can be achieved, and whether poor people who lack human capital can be included in the development effort, remain open questions. But some dramatic success stories have shown that economic development can be achieved. The fate of billions of desperately poor people rests in the ability of their countries to match that success.
Democracy as an economic institution has typically received mixed notices from economists. While virtually all the world’s rich nations have democratic systems of government, it isn’t clear that democracy is necessary for development.
India long provided the strongest counterexample to the idea that democracy promotes development. It has long been a democracy, yet its per capita income has kept it among the world’s poor countries. India’s government has traditionally opted for extensive regulation that has curtailed development. Countries such as China, with no democracy and a repressive government, have managed to generate very high rates of economic growth. China’s per capita income now exceeds that of India by about 50%. Lee Kuan Yew, Singapore’s former prime minister, put it this way: “I believe what a country needs to develop is discipline more than democracy. The exuberance of democracy leads to indiscipline and disorderly conduct which are inimical to development.”
Many economists have reached the conclusion that countries are likely to become democratic once they achieve a high degree of economic development. Political freedom, they argue, is a normal good. The demand for freedom thus increases as incomes rise, making the creation of democratic institutions a product of economic growth, not a cause of it.
Two recent studies—one by economists John Mukum Mbaku and Mwangi S. Kimenyi and the other by economists Michael A. Nelson and Ram D. Singh—challenge the conventional view, arguing instead that democracy and economic growth are compatible. Using statistical models that control for a variety of factors that affect economic growth, such as investment and population growth, both studies concluded that there is a positive relationship between political freedom and economic growth. In the latter study, the authors separately tested the direction of causality: does growth cause democracy or does democracy cause growth? They conclude that the direction of causality goes from democracy to economic growth. They also controlled for the level of economic freedom (an index of price stability, government size, discriminatory taxation, and trade restrictions), which many studies have concluded is critical for development. As argued in this chapter, more economic freedom does lead to higher economic growth, but so does more political freedom.
Just as pessimism that economic growth has a negative impact on the poor is dissipating, likewise the notion that developing countries must wait until they are developed in order for their citizens to experience political freedom is also falling by the wayside.
Sources: Jagdish Bhagwati, “Democracy and Development,” American Enterprise 6, no. 2 (March/April 1995): 69; John Mukum Mbaku and Mwangi S. Kimenyi, “Macroeconomic Determinants of Growth: Further Evidence on the Role of Political Freedom,” Journal of Economic Development 22, no. 2 (December 1997): 119–32; Michael A. Nelson and Ram D. Singh, “Democracy, Economic Freedom, Fiscal Policy, and Growth in LDC: A Fresh Look,” Economic Development and Cultural Change 64, no. 4 (July 1998): 677–96.