Big Ideas in Economics, 1960s

• Government: Plays a central role; acts as the driving force behind development

• Accumulation: Is central to development process; coordination and scale problems require government involvement

• Trade and integration: Has no particular advantage beyond the import of capital goods and the purchase of necessary inputs

• Foreign capital: FDI is to be avoided, but government borrowing is acceptable, preferably from foreign sources

• Development assistance: Provide project-based lending of investable foreign exchange and resources to and the role of multilaterals governments

Big Ideas in Economics, 1980s

• Government: Plays a central role, but acts as the main obstacle to development

• Accumulation: Is central to development process; private sector investment is the key

• Trade and integration: Exports bring dynamic advantages; import competition is necessary for disciplining domestic producers

• Foreign capital: Government borrowing is to be avoided, but FDI is encouraged

• Development assistance and the role of multilaterals: Quick disbursing; policy-based lending to establish conditions for FDI and domestic investment

Comparison of the Two Ideas 1960s 1980sGovernment: central role• acts as the driving force

behind development• acts as the main obstacle

to development

Accumulation: central require government involvement

private sector investment is the key

Trade and integration:no particular advantage dynamic advantages

Foreign capital: FDI is to be avoided FDI is encouraged

Development assistance:project-based lending policy-based lending

GENERATIONS OF DEVELOPMENT ECONOMICS

• As an academic discipline, development economics had to be rediscovered or newly founded. Although classical economists were concerned with economic growth and the "progressive state," interest ended with the marginalist revolution of the 1870s. The last great book covering this wide range was John Stuart Mill's Principles of Political Economy published in 1848.

• A. Lewis began lecturing on development economics at the University of Manchester in 1950. The first seminar on development at the University of Oxford was offered by Hla Myint in 1950. The subject was introduced at Harvard and Yale in 1952-53.

• During the 1950s the number of journals devoted to economic development grew, the number of development articles tripled in the decade 1950-54 to 1960-64.

First generation (1950-75)

Newly independent governments in emerging countries and acceleration of their development at the outset in the 1950s

Grand models of development strategy that involved structural transformation

Extensive role of government in development programming or planning

The government was to • promote capital accumulation, • utilize reserves of surplus labor,• undertake policies of deliberate industrialization, • relax the foreign exchange constraint through import substitution,

and • coordinate the allocation of resources through programming and

planning

First generation (1950-75) contd.

Government would give reality to the slogans of the first generation by

• breaking Nurkse's "vicious circle of poverty”• via Rosenstein-Rodan's "big push" and • through "balanced growth" that would establish

complementarity in demand, • achieve Leibenstein's "critical minimum effort”, • break out of the "low-level equilibrium trap," • and fulfill the conditions of Rostow's "takeoff."

First generation (1950-75) contd.

By the late 1960s and early 1970s, • deficiencies in industrial programming and

comprehensive planning had become acute: "crisis in planning"

Causes of government failure: • deficiencies in the plans, • inadequate information and resources, • unanticipated dislocations of domestic economic activity,• institutional weaknesses, and• failings on the part of the administrative civil service

Second generation (1975- )

• Although the rationale for government interventions had been to remedy market failure,

• the The policy challenge now became to "get prices right."

• "getting prices right" does not guarantee economic development, but

• "getting prices wrong" frequently is the end of development.

Second generation (1975- ) contd.

Get policies right • neoclassical analysis as the basis for policymaking (Harberger

1993) • not only to remove price distortions but also to "get all policies right." • not differences in initial conditions but differences in policies • A country was not poor because of the vicious circle of poverty but

because of poor policies. • Markets, prices, and incentives should be of central concern in

policymaking.Correct policies were • to move from inward-looking strategies toward liberalization of the

foreign trade regime and export promotion; • to submit to stabilization programs;• to privatize state-owned enterprises; and • to follow the dictates of the market price system

Second generation (1975- ) contd

Disaggregated micro studies • "grand theories" came to be viewed as less useful than highly specific

applications• micro studies, could provide more direct policy implications for specific

policiesGrowth process in a more microeconomic fashion• The residual was recognized to be "a composite of the effects of many

different forces: 1. improvements in the quality of labor through education, experience and

training;2. reallocation of resources from low-productivity to higher-productivity uses;3. exploitation of economies of scale; 4. improved ways of combining resources to produce goods and servicesNumerous studies criticized • price distortions • high effective rates of protection• rent-seeking • Not adverse external conditions but inappropriate domestic policies

New Growth TheoryKnowledge as a source of increasing returns • the most powerful engine of production; enables us to subdue nature and

satisfy our wants • the only instrument of production that is not subject to diminishing returns • treated as a non-rival good and emphasizes aggregate non-convexities “New growth theory" is not literally new• "newness" in production functions that show increasing returns• technological progress and human capital formation are endogenized• greater emphasis on human capital (including learning), even more than on

physical capital• relevant for the question of convergence; convergence occurs as the

"technology gap“ between countries is overcome and poor countries catch up with rich ones by growing faster. Free mobility of capital among countries will speed this convergence as the rate of diffusion of knowledge increases.

• "Learning by doing" (Arrow 1962) and "learning by watching" (King and Robson 1989) are also knowledge-producing activities and sources of scale economies

• "learning by doing" model emphasizes the increase in productivity from the important process of "continuous improvement“ (Solow 1997)

New Political Economy• The inquiry into the causes of differential development performance

led to more attention to the politics of policymaking• A positive theory of politics - the analytical concepts and

principles for interpreting why governments do what they do are analogous to those of neoclassical economic analysis

• Postulates of rationality, the concept of self-interest or self-goal choice, and the techniques of marginal analysis and equilibrium outcomes have been applied to political markets and political objective functions.

• attempts to endogenize the decisions of politicians, bureaucrats, and administrators. It seeks to open windows in the black box of the "state" by using various strands of thought:

• public choice, collective choice, transaction costs, property rights, rent-seeking, and directly unproductive profit-seeking activities

• an underdeveloped economy has commonly given rise to an overextended state and to a negative or exploitative state

New Market Failures

• Existence of imperfect and costly information, incomplete markets, and transaction costs and of the absence of futures markets

• Correction of the new market failures provided a basis for a potential role for more pervasive government intervention

• More emphasis was actually given to government failures than to market failures

• The recognition of risk and information imperfections did improve analysis of two sectors that had been relatively neglected by the first generation: agriculture and finance

• first generation's emphasis on industrialization, second generation on rural development

Big Facts by 2000sLost decade in Latin America• enormous slowdown in growth that has occurred throughout the

developing world Downfall of socialism• long-awaited transition from stagnating Marxist central planning

to a capitalist economy has gone horrifically worse than anyone would have dared predict.

Financial crises of the 1990s• Mexico in 1994; Thailand, Korea, and Indonesia in 1997;

Russia and Brazil in 1998; Ecuador in 1999; Turkey in 2000; and Argentina today

Collapse of sub-Saharan Africa • Many nation-states have descended at least once into chaos:

Angola, Burundi, Ethiopia, Liberia, Mozambique, Rwanda, Sierra Leone, Somalia, Sudan, Uganda, and Zaire (now Congo)

Rise of India and China• From 1982 to 1999, per capita income in China grew at 5.8

percent (up from 3.2 percent in 1960–81) and in India at 3.6 percent (up from just 0.08 percent in 1960–81).

Washington Consensus• Rules of good behavior for promoting economic growth • Perceived to be the key elements of what Krugman (1995)

has called the “Victorian virtue in economic policy,” namely “free markets and sound money”

1. Fiscal discipline 2. Reorientation of public expenditures 3. Tax reform 4. Interest rate liberalization 5. Unified and competitive exchange rates 6. Trade liberalization 7. Openness to DFI 8. Privatization 9. Deregulation10.Secure Property Rights

second-generation reforms

1. growing recognition that market-oriented policies may be inadequate without more serious institutional transformation, in areas ranging from the bureaucracy to labor markets

• example, trade liberalization may not reallocate an economy’s resources appropriately if the labor markets are “rigid” or insufficiently “flexible.”

2. concern that financial liberalization may lead to crises and excessive volatility in the absence of a more carefully delineated macroeconomic framework and improved prudential regulation

• Hence the focus on non-intermediate exchange-rate regimes, central bank independence, and adherence to international financial codes and standards

3. in response to the complaint that the Washington Consensus represented a trickle-down approach to poverty, the policy framework was augmented with social policies and anti-poverty programs

“Augmented” Washington Consensus • augmented in the thinking of multilateral agencies and policy

economists with a series of so-called second-generation reforms that were more institutional in nature and targeted at problems of “good governance.”

Previous 10 items, plus: 11. Corporate governance12. Anti-corruption13. Flexible labor markets14. Adherence to WTO disciplines15. Adherence to international financial codes and standards16. “Prudent” capital-account opening17. Non-intermediate exchange rate regimes18. Independent central banks/inflation targeting19. Social safety nets20. Targeted poverty reduction

East Asian anomaliesInstitutional domain: Standard ideal “East Asian” patternProperty rights: Private, enforced by the rule of law Private, but

government authority occasionally overrides the law (esp. in Korea).Corporate governance: Shareholder (“outsider”) control, protection of

shareholder rights Insider controlBusiness-government relations: Arms’ length, rule based Close

interactionsIndustrial organization: Decentralized, competitive markets, with tough

anti-trust enforcement Horizontal and vertical integration in production (chaebol); government mandated “cartels”

Financial system: Deregulated, securities based, with free entry. Prudential supervision through regulatory oversight Bank based, restricted entry, heavily controlled by government, directed lending, weak formal regulation.

Labor markets: Decentralized, de-institutionalized, “flexible” labor markets Lifetime employment in core enterprises (Japan)

International capital flows: “Prudently” free Restricted (until the 1990s)

Public ownership: None in productive sectors Plenty in upstream industries.

Washington Consensus and a Chinese counterfactual

Problem Solution• Low agricultural productivity Price

liberalization• Production incentives Land privatization• Loss of fiscal revenues Tax reform• Urban wages Corporatization• Monopoly Trade liberalization• Enterprise restructuring Financial sector reform• Unemployment Social safety nets• … and so on

A taxonomy of “natural” barriers to industrialization

• A. Learning externalities• 1. Learning-by-doing (e.g., Matsuyama, 1992)• 2. Human capital externalities (e.g., Azariadis and Drazen,

1990)• 3. Learning about costs (e.g., Hausmann and Rodrik, 2002)B. Coordination failures (market-size externalities induced by

IRS)• 1. Wage premium in manufacturing (e.g., Murphy, Shleifer,

and Vishny, 1989)• 2. Infrastructure (e.g., Murphy, Shleifer, and Vishny, 1989)• 3. Specialized intermediate inputs (e.g., Rodrik 1994, 1995)• 4. Spillovers associated with wealth distribution (e.g., Hoff and

Stiglitz 2001)

A taxonomy of “natural” barriers to industrialization

• Market-creating institutions• Property rights• Contract enforcementMarket-regulating institutions• Regulatory bodies• Other mechanisms for correcting market failuresMarket-stabilizing institutions• Monetary and fiscal institutions• Institutions of prudential regulation and supervisionMarket-legitimizing institutions• Democracy• Social protection and social insurance