challenges of development in lagging regions

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challenges of development in lagging regions

    Development Strategy, Transition and Challenges of

    Development in Lagging Regions

    Justin Yifu Lin

    Peking University and Hong Kong University of Science and Technology

    Mingxing Liu

    China Center for Economic Research, Peking University

    First Draft: May 2003

    Revision: October 2003

     th Paper prepared for the 15 World Banks Annual Bank Conference on Development Economics

    to be held in Bangalore, India on May 21 and 22, 2003. Please send the correspondence of the paper to Justin Yifu Lin, China Center for Economic Research, Peking University, Beijing 100871, China; Email:


    Development Strategy, Transition and Challenges of Development

    in Lagging Regions

    Justin Yifu Lin and Mingxing Liu


    After the World War II, many LDCs adopted various measures to industrialize their economies, hoping to accelerate their processes of catching up with the DCs. However, except for a small number of economies in East Asia, the gaps between the LDCs and the DCs have enlarged. How to catch up with the DCs is still a daunting challenge for many LDCs. Recent studies find that the poor development performance in the LDCs is largely attributable to their problems in institutions, including all kinds of market distortions and government interventions. Following the policy advice, capsulated in the Washington Consensus, LDCs both in the socialist and non-socialist groups started to reform their institutions in the early 1980s. However, the growth performance of most LDCs has deteriorated further. The LDCs face another challenge of how to achieve dynamic development by successfully reforming their economies.

    In this paper, we argue that the poor growth performance of the LDCs after the World War II can be largely explained by their adoption of an inappropriate development strategy. Motivated by nation building, most LDCs, including the socialist countries, adopted a comparative advantage defying (CAD) strategy to accelerate the growth in capital-intensive, advanced sectors. Many firms in those prioritized sectors were nonviable in open, competitive markets because of the violation of their economies

    comparative advantages. For implementing the CAD strategy, the governments in the LDCs adopted a series of distortions in input and output markets to subsidize/protect the nonviable firms, resulting in rent seeking, soft-budget constraint, macroeconomic instability, and income disparities. Economic stagnation or even sudden collapse becomes unavoidable, prompting the LDCs, voluntarily or involuntarily, to start reforming their economies. The Washington consensus from the international development agencies advised the LDCs to carry out a package of reforms, including price liberalization, privatization, and elimination of other distortions. Without addressing the firms’ viability issue, the implementation of those policy

    recommendations would result in widespread bankruptcies, unemployment, and social/political instability. For fear of the above dreadful consequences, many governments found other disguised ways to protect/subsidize those nonviable firms after implementing the reform. In either case, not only the reforms toward a


    well-functioning market economy could not be completed but also the economic performance became poorer than that before the reform.

    In the paper, we argue that LDCs should follow a comparative advantage-following (CAF) strategy so that their firms would be viable, their economies competitive, and a sustained upgrading of their endowment structures as well as industrial structures possible. We also discuss the governments appropriate role in the CAF strategy and

    the way to complete the transition smoothly from an economy that adopted a CAD strategy to an economy that follows a CAF strategy.


I. Introduction

    After the World War II, many governments in the less developed countries (LDCs) adopted various policy measures to industrialize their economies. The per capita GDP, measured in comparable prices, has increased in almost all nations. However, as shown in figure 1, the gaps of per capita income between the developed regions and lagging behind regions widened substantially. Only a small number of economies in East Asia have actually narrowed the gap and converged to the level of per capita income in the developed countries (DCs). How to catch up with the DCs is still a daunting challenge for many LDCs after their development pursuit of several decades in

    ththe last half of 20 century.

    Figure 1: GDP per Capita, 1950-1992 (56 countries)

    (In 1900 Geary-Khamis Dollars)








    Western EuropeWestern OffshootsSouthern Europe

    Eastern EuropeLatin AmericaAsia


    Source: Angus Maddison, Monitoring the World Economy, 1820-1992, Development Center

    of OECD, pp212.

    The rapid increase in wealth and national power in the DCs after the industrial

    threvolution in the 18 century was rooted in their speedy upgrading of industries and technologies. Therefore, the early development attempt in the LDCs primarily focused on how to accelerate the development/adoption of the dominant

    industries/technologies of the DCs. Recent studies find that the poor development performance in the LDCs is largely attributable to their problems in institutions, including all kinds of market distortions, government interventions, macro instability, inequality in income distributions, colonial heritage, and so forth (Shleifer et al., 1998;


    Rodrick, 1998, 2003; Acemoglu et al., 2001a, 2001b, 2002a, 2002b; Djankov et al., 2003). To improve the economic performance, institutional reforms in fact have started in many LDCs, including the (former) socialist countries, since the late 1970s. Many of those reforms have followed a package of policy-advice based on neoclassical economics and are capsulated in the Washington Consensus (Williamson 1990). Nevertheless, with the various reform attempts and the improvements in many factors that are considered determinants of growth (Barro 1997), the growth performance of many LDCs has deteriorated further. Easterly (2001, p. 2) shows that in 1980-98, median per capita income growth in developing countries was 0.0 percent, as compared to 2.5 percent in 1960-79”. The contrast of growth performances

    in these two periods represents a disappointing outcome of the movement towards the “Washington Consensus” by developing countries (Krugman, 1995). The LDCs face

    another challenge of how to achieve dynamic development by successfully reforming their economies.

    In this paper, we attempt to answer the following questions: Why did most LDCs with their industrialization drives of several decades fail to narrow their income gaps to the DCs? Why did the institutional reforms based on the Washington Consensus fail to

    stimulate economic growth in most LDCs and sometime even cause serious crises? What are the lessons for LDCs from the few successful cases of convergence in the East Asian economies? How can the LDCs complete institutional reforms successfully and achieve simultaneously dynamic economic growth in their reform processes?

    The core of our arguments over the above questions is as follows: The optimal industrial/technological structure of an economy is endogenously determined by its endowment structure. Disregarding the nature of its own endowment structure and hoping to close the gap of its industrial/technological structure to that of the DCs as quickly as possible, the government in an LDC often pursued a capital-intensive heavy industries oriented development strategy once gaining political independence after the World War II. This development strategy caused many firms in the LDC governments priority sectors to be nonviable in open, competitive markets. Consequently, the LDC government introduced a series of distortions in its international trade, financial sector, labor market, and so on to support/protect the non-viable firms. Through those distortions it was possible to mobilize resources administratively to establish capital-intensive industries in the capital-scarce LDC and had an investment-led growth initially. However, the economy became very inefficient due to misallocation of resources, distortion of incentives, rampant rent seeking, suppression of private initiatives and so forth. When domestic resources


    depleted and a further resource mobilization from international sources to support the nonviable firms exhausted, the economy stagnated. Consequently, convergence failed to occur. Moreover, the various distortions and interventions enlarged income disparity domestically and debt burdens internationally, and often led to the eruptions of social conflict and financial crisis.

    Since the late 1970s, many poor-performing, crisis-hit LDCs, following the policy advice of Washington Consensus, have started their economic reforms. The Washington consensus, based on the neoclassical economics, which implicitly assumed that firms existing in the markets are viable, advised the LDCs to eliminate the existing distortions and interventions immediately so as to create well-functioning open, competitive markets. However, as the firms’ viability problem was not solved

    first, either the nonviable firms collapsed immediately, resulting in widespread unemployment and social/economic disruptions, or the government needed to protect/subsidize those nonviable firms through various disguised means of distortions and protections. Therefore, not only the reforms toward a full-fledged market economy could not be completed but also economic performance might become poorer than it was before the reform started. The paper suggests that the viability issue be addressed formerly in designing the LDCs economic reforms.

    The paper is organized as follows: Following the introduction, Section II discusses the impacts of an LDC governments development strategy on the viability of firms, the

    economic institutions, and the economic and social consequences. Section III explores the different experiences of economic reform and transition in LDCs and shows why policy advice capsulated in the Washington Consensus may not be appropriate. Section IV tests empirically some hypotheses derived from Sections II and III. Some concluding remarks are provided in Section V.

    1II. Development Strategy, Viability, and Institutions in LDCs

    Why the LDCs cannot catch up with the DCs has been a challenging question and puzzling phenomenon to economists. According to the neoclassical growth theory (Solow 1956), which assumes the same technologies are given to LDCs and DCs, the LDCs would grow faster than the DCs, the per capita income in LDCs would converge to the level of DCs, and the GDP growth rate in any country will eventually

     1 Discussions in this section draw heavily on Lin (2003).


    be the same as the population growth rate. However, empirical evidence shows that while the convergence occurred within the different states in the United States and among the DCs (Barro and Sala-I-Martin 1992; Baumol 1986), most LDCs failed to achieve the convergence (Pearson, et al. 1969; Romer 1994), and the economic growth rates in DCs continue to exceed their population growth rates.

    Unsatisfied with the inability of neoclassical growth theory to explain the continuous growth of per capita income in the DCs and the failure of most LDCs to converge with the DCs, Romer (1986) and Lucas (1988) pioneered a new growth theory. Their theory treats technological innovation as endogenously determined by the accumulation of human capital, research and development (R&D), learning by doing and so on. This new growth theory is insightful for explaining the sustained growth of per capita GDP in DCs, which use the most advanced technologies. However, the new growth theory cannot satisfactorily explain the extraordinary growth and convergence of the newly industrialized economies (NIEs) in Asia, including South Korea, Taiwan, Hong Kong, Singapore and recently China, during the last three decades of the twentieth century (Pack 1994; Grossman and Helpman 1994). During the catching up process, these NIEs investments in R&D, human capital, and learning

    by doing were much lower than those of the DCs.

    Prompted by the above failures of neoclassical and new growth theories, the economists redirect their attentions to the differences in institutions between DCs and LDCs. Many economists now believe that the LDCs failed to catch up with the DCs because of bad institutions due to the governments interventions and regulations,

    including widespread corruption, weak protection to the investors, and a high degree of social conflicts (Shleifer et al., 1998; Rodrick, 1998; Acemoglu et al., 2001a, 2001b, 2002a, 2002b; Djankov et al., 2003). As Rodrick (2003, p7) stated, institutions have

    received increasing attention in the growth literature as it has become clear that property rights, appropriate regulatory structure, quality and independence of the judiciary, and bureaucratic capacity could not be taken for granted in many settings and that they were of utmost important to initiating and sustaining economic growth.

    The legal origin (La Porta et al., 1998, 1999) and the institutional inheritance

    (Acemoglu et al., 2001a, b; Engerman and Sokoloff 1997 ) have been emphasized.

    Generally speaking, the government is the most important institution in an LDC. Its economic policies shape the macro incentive structure that firms in an LDC face. Both


policy reformers and researchers have tried to understand how government’s

    intervention and regulation occurs and how and whether it can be subsequently

    sustained (Rodrik 1996). The classical theory for the role of government (Pigou, 1938) has been called the helping hand view. An alternative strand of the grabbing-hand view (Shleifer and Vishny 1998) holds that the government interventions are pursued for the benefits of politicians and bureaucrats. Politicians use regulation to favor friendly firms and other political constituencies, and thereby obtain campaign contributions and votes. In addition, “an important reason why many of these permits and regulations exist is probably to give officials the power to deny them and to collect bribes in return for providing the permits” (Shleifer and Vishny 1993, p. 601).

    A recent paper presented by Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2002) provided an empirical test on the theories of grabbing hand, say, the barrier for business entry might arise from the corruption of bureaucrats.

Suppose that the government’s regulations in the LDCs could arise from the grabbing

    hand of government, or political elites, the unsolved question in the literature is how to understand the evolution of institutional structure under the governments

    interventions. In the LDCs, the institutional structure shaped by the government’s

    interventions is so complicated. We wonder what the incentives for political leaders to design such complicated systems are, because the increase of costs of expropriations and political control due to the complexity of institutions would diminish the gains of grabbing. Corruptions induced by the special interest groups might not be a good answer for this question either, because the benefited groups are often taxed or suppressed alongside with the protections/subsidies. Moreover, many interventions do not have obvious beneficiary groups.

In the paper we attempt to propose an alternative hypothesis for governments

    interventions and regulations in the LDCs. Many of the early generation of political leaders in socialist and non-socialist LDCs, such as Nehru in India, Nasser in Egypt, Sukarno in Indonesia, Mao Zedong in China, and Ho Chi Minh in Vietnam, were elites taking part in the independent movements or revolutions for the purpose of nation building. We argue that the institutions laid down by the early generation of political leaders were endogenously shaped by the conflicts between the elites

    ambitious drives of industrialization/modernization for nation building and their nations economic realities. The key to understand the cause of many

    interventions/regulations by the LDC governments is the viability issue of firms in the

    2governments industrialization drives.

     2 The bureaucrats in lower levels of government in LDC may use the interventions/regulations rooted in the


    For the purpose of explaining the root of administrative regulations and interventions in the LDCs, Lin (2003, p. 280) defines the term viability of a firm: “If, without any

    external subsidies or protections, a normally managed firm is expected to earn socially

    acceptable profits in a free, open, and competitive market, then the firm is viable. Otherwise the firm is nonviable. It is obvious that no one will invest in a firm if it is not expected to earn a socially acceptable normal profit. Such a firm will exist only if the government gives it support.

    The viability of a normally managed firm is related to whether the sector in which the firm operates, the products it produces, and the technology it uses in production are consistent with the nature of the economys factor endowment structure, namely the

    relative abundances of labor, capital, and natural resources in that particular economy. To illustrate how the viability problem may arise, assuming there is a simple economy that possesses two given factor endowments, capital and labor, and produces only one good. Each point on the isoquant shown in Figure 1 represents a technology of production or a combination of capital and labor required to produce a given amount of a certain product. The technology represented by A is more labor intensive than that of B, C, C, D, and D are the isocost lines. The slope of an isocost line represents the relative 11

    prices of capital and labor. In an economy where capital is relatively expensive and labor is relatively inexpensive, as represented by isocost lines C and C, the adoption of 1

    technology A to produce the given amount of output will cost the least. When the relative price of labor increases, as represented by the isocost lines by D and D, 1

    production will cost the least if technology B is adopted.

    In a free, open, and competitive market economy, a firm will be viable only if it adopts the least-cost technology in its production. In Figure 1, if the relative prices of capital and labor can be presented by C, the adoption of technology A costs the least. The adoption of any other technology, such as B, will cost more. Market competition will make firms that adopt technologies other than A nonviable. Therefore, in the above simple economy, the viability of a firm depends on its technology choice.

    In a free, open, competitive market, the relative prices of capital and labor are

    nation-building attempt for their personal grabbing-hand purpose. However, in our analysis the grabbing hand of bureaucrats should be viewed as a consequence instead of the cause of the distortions and regulations.


    determined by the relative abundance/scarcity of capital and labor in the economy’s factor endowments. Therefore, the viability of a firm depends on whether its choice of technology is on the least cost lines determined by the factor endowments of the economy.


     B ?

    A ?

    CDD C 1 1

    Labor Fig.1.Relative price of production factors and technique choice

    The above discussion can be extended to an economy with one industry that has many different products and an economy that has many different industries. A firm will be viable only if the sector in which the firm operates, the products it produces, and the technology it uses in production are consistent with the nature of the particular economys endowment structure (Lin 2003).

In a free, open, competitive market, without governments interventions, only viable

    firms will exist, therefore, the structure of industry and technology in the economy is

    3endogenously determined by the economy’s endowment structure. Most LDCs are

     3 To keep the technology structure fit for endowment structure can be summarized as the idea of appropriate technology that was first introduced in neoclassic trade theory by Atkinson and Stiglitz (1969), who formalized “localized learning by doing.” Schumacher (1973) made a similar argument in development economics. The study

    of appropriate technology has been recently revived by Diwan and Rodrick (1991), Basu and Weil (1998), and Acemoglu and Zilibotti (1999). But the appropriate technology argument does not answer the questions about what the relationship is between the choice of technology and the institutional structure, and what the appropriate role of LDC government should be in the process of economic growth. See Lin (2003) for further discussion.


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