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Lin Yifu:Reflection and Reconstruction of Development Economics

Lin Yifu is a renowned economist who is a graduate of National Chengchi University, Peking University, the University of Chicago and Yale University. He was the senior vice president and chief economist of the World Bank, specialized in development economics, agricultural economics, and institutional economics. Lin Yifu was nominated as 2014 Chinese Business Leaders Awards in 2014. The following is the transcript of Professor Lin Yifu’s speech.)

After World War II, a number of colonies or semi-colonies gained their political independence and started to pursue modernization. Intellectuals in both developed and developing countries at that time all observed the gap between developed countries and emerging politically-independent developing countries that are in the process of modernization. They were aware that there must be a reason why developed countries were advanced and developed, and there must be theories serving as the development guidance. Developing countries should learn from theories of developed countries and put them into practice to realize modernization, which could be considered as “getting scriptures from the West”.

What is the current economic development performance of developing countries over 70 years after World War II? According to the World Bank’s research, from 1950 to 2008, only two in two hundred developing economies entered the middle-income stage from the low-income stage, and then made it to the high-income stage. They are South Korea and Taiwan, China.

From 1950 to 2008, only 13 middle-income economies went to the high-income stage, 8 of which are western European countries with smaller gaps or oil-producing countries. Apart from these countries, another 5 economies were Japan and the “Four Asian Tigers”. Hence, after World War II, at least 180 in over 200 economies fell into the middle-income trap or low-income trap after 70 years of efforts. This result is far from ideal. After years of research in development economics, I draw a conclusion that until now, no country has reached the goal of catching up with developed countries by making policy based on mainstream development theories of western countries. From mainstream theories, policy adopted by a few economies with better development performance or transformation performance are misguided.

It is known that development economics is a new subdiscipline separated from modern economics in the context that politically-independent countries and countries free from semi-colony status started to pursue modernization after World War II. After World War II to 1970s, the mainstream theory was structuralism.

Why it is called structuralism? Development economists at that time aimed at helping developing countries become developed countries. In their opinion, higher income level of developed countries was due to their higher labor productivity level, and lower labor productivity level of developing countries resulted in their lower income level. Developed countries had higher labor productivity level because they had advanced capital-intensive large industries. On the contrary, agricultural industry was dominant in developing countries, which was an inevitable cause to the low productivity level. It was believed that the income level gap was the result of different industrial structures, which seemed to be reasonable. Why developing countries did not the same develop advanced industries as developed countries? It was considered that developing countries had various structural constraints. Due to cultural and historical differences, people were unwilling to save and less sensitive to price signals, leading to market failure and failure in mobilizing and distributing resources to advanced industries. Thus, it was believed that in order to catch up with developed countries, developing countries must depend on governments to directly mobilize and distribute resources to develop modern large industries. It is a feature of the Stalinist model. In fact, after World War II, countries in Latin America, Africa and South Asia countries all adopted the same policy framework, which was direct government intervention in mobilizing resources to develop modernized advanced industries. Originally, developing countries mainly imported advanced industrial products instead of producing them. According to policy framework at that time, a country did not have to import these products as long as it developed this kind of industries domestically. This policy framework was called “heavy industry first” or “import substitution strategy”. Under this framework, government’s intervention in mobilizing resources to establish modernized large industries usually could generate 5 to 10 years of rapid investment-driven economic growth. However, after this period, the economy stalled with frequent crisis. As a result, the gap between developing countries and developed countries would be widened rather than narrowed. In other words, the policy framework based on “structuralism”, the development economics version one, was a failure. Hence, people began to reflect on development economics from 1970s.

In 1980s, so-called “neoliberalism”, the second version of development economics, came into being. It was considered that the cause of widening gap between developing countries and developed countries was too much government intervention in developing countries, which resulted in government failure and the market forces had not been fully explored. It made sense theoretically, because developed countries depended less on government intervention and gave full play to market forces. On the contrary, most developing countries employed structuralism after World War II, which means more government intervention. Their economic growth rates were less than 3% and usually 2% or 1%, even registered zero growth, resulting in a widening gap between them and developed countries. In terms of government intervention, a theoretical model could be established easily to prove that government intervention would give rise to misallocation of resources. Government intervention would create rentals and generate rent seeking, which brought about corruption and further widened the income gap. Misallocation of resources and rent seeking led to low efficiency and failure in increasing national wealth effectively. Therefore, neoliberals believed that poor development of developing countries resulted from too many government failures. Thus they suggested terminating all improper government interventions. Taking neoliberalism as theoretical basis, “Washington Consensus” was formed and widely spread in 1990s. It was believed that liberalization and privatization were the most significant in marketization; the faster and the more the liberalization and privatization, the better; meanwhile, tightening monetary policy should be implemented to balance fiscal revenues and expenditures to achieve successful market economy.

Metrical research has shown that the average economic growth rates of developing countries in 1980s and 1990s were lower those in 1960s and 1970s when structuralism was dominant, but the risk frequency was higher. Thus some scholars call that period when “Washington Consensus” based on neoliberalism was dominant “two lost decades”.

The “Four Asian Tigers” and Japan were a few successful economies. In 1960s, Hongkong, Singapore, South Korea and Taiwan in Asian area started to implement export-oriented strategies with focus on labor-intensive processing industries. Taking the opportunity of developed western countries’ labor-intensive industry transfer to developing countries, they attracted a large amount of foreign capital and technologies and achieve economic take-off in a short period. The prevailing theories at that time could not explain the economic development performance of the “Four Asian Tigers”. According to the mainstream theory in 1950s and 1960s, the main approach to catch up with developed countries was to implement import substitution strategy to develop the same industries as developed countries. Nevertheless, in that period, a few successful developing economies such as the “Four Asian Tigers” and Japan took the opposite approach. Instead of developing advanced industries directly, they developed traditional labor-intensive processing industries such as clothing industry and shoemaking industry as well as simple electronic processing industry by adopting export-oriented strategy, which means developing small-scale, traditional and low-tech industries for export. According to mainstream theories at that time, developing countries could not surpass developed countries by developing backward industries, and the export-oriented strategy was wrong. In fact the opposite was true. In 1980s, socialist countries such as China and Vietnam started reforms and realized stable economy and rapid development. But China did not cancel all protective subsidies as neoliberalism and “Washington Consensus” promoted. Instead, China implemented a dual-track system with the principle of “gradual policy application for different age groups”. Protective subsidies were provided to large state owned enterprises that in need of subsidies; meanwhile, restrictions on traditional labor-intensive light industries were lifted to attract investments, and the government provided guidance based on the situation. In 1980s and 1990s, some theorists held the opinion that the planned economy was inferior to the market economy, so economic transformation was a must. Nonetheless, they regarded China’s dual-track economic system was the worst, because distortion in the system would easily generate rent seeking, which would breed corruption, widen income gap and reduce resource distribution efficiency. Looking back at past three decades, a few economies who realized stable and rapid economic development in the transformation period employed a reform that was considered as the worst approach by mainstream theories at that time. China, Vietnam and Cambodia are typical examples. Mauritius, a small African country, was the earliest to adopt gradual double-track system. In 1960s, the same as other developing countries, Mauritius applied the import substitution strategy which took heavy industries as the priority. It generated many distortions. Mauritius began its transformation in 1970s with the approach of “gradual policy application for different age groups”. It established an Export Processing Zone to focus on ready-to-wear clothing industry and textile industry. Mauritius introduced these industries from Taiwan and Hongkong, China by attracting investments to realize rapid and stable development while keeping the original distortion. Now, Mauritius can be regarded as the most successful country in Africa with an income per capita of over 10,000 U.S. dollars.

Hence, a theoretically correct approach often fails in practice. I study development economics. So far, I haven’t seen any developing country making policy based on mainstream theories achieve successful development. I want to put an emphasis on it. No country. I witness the success of a few economies realizing rapid and stable development, but their policies were against mainstream theories and mainstream theories failed to explain their success. For instance, during the development and transformation process, the “Four Asian Tigers”, China and other successful economies adopted the market economy or shifted to the market economy, which seemed to agree with the market forces stressed in neoliberalism, but these economies also had very active governments. The development and transformation approach of the “Four Asian Tigers”, Japan and China neither solely relied on government but ignore the market as proposed by structuralism nor only relied on the market without government intervention as suggested by neoliberalism. Their policies dynamically integrated an effective market and an active government.

Theories should be used for assisting people in understanding the world and changing the world. According to structuralism and neoliberalism, the above-mentioned economies should not succeed. Thus, neither structuralism nor neoliberalism can help people understand the success of these economies. In terms of changing the world, policy based on mainstream theories also failed. I don’t mean policy against mainstream theories will be successful, but I haven’t seen any policy following mainstream theories succeed. In other words, mainstream theories cannot help people change the world. Accordingly, we must reflect on existing theories and make conclusions.

I went back China to work in 1987. The first inflation appeared in 1988 which reached 18%. In that context, a returnee learning western theories would hold an opinion of lifting interest rate to decrease investment demand, increase saving and reduce consumption demand so as to lower inflation. But at that time, instead of increasing the nominal interest rate, China applied an approach of improvement and rectification by cutting investments and projects to lower the total demand. According to mainstream theories, this approach was definitely incorrect because it indicated an irrational government. Then how did China register an annual growth of 10% from 1979 to 1988? There must be explanations. I thought it over carefully. It was because China had a great number of capital-intensive state owned enterprises. If these SOEs collapsed or went bankrupt, it would lead to large-scale unemployment and social instability; furthermore, many SOEs were related to national defense security. Because the main cost of these capital-intensive SOEs was cost of funds, if interest rate increased in this context, their cost would go up and generated losses. If government did not provide subsidies, these SOEs suffering from losses would collapse, leading to massive unemployment or defense security risk. Thus the government had to give fiscal subsidies, which means to increase money supply. It would result in inflation again. Therefore, a more effective approach was to cut investments and cancel projects irrelevant to national security. According to mainstream theories at that time, this policy intervention was wrong, but practices had proven its effectiveness.

Similarly, Olivier Blanchard, the chief economist of the World Bank, has retired recently. He had a reflection before his retirement. He said new Keynesianism and new classical macroeconomics could do nothing for addressing current crisis. For example, in 2010, there were so-called “green shoots” of recovery in developed countries. The International Monetary Fund proposed a policy suggestion of quitting proactive fiscal policy and maintaining relaxed monetary policy. However, Olivier Blanchard found although this policy seemed to be very clear theoretically, the result was not as good as expected. Now he considers that when the interest rate is close to zero, quitting proactive fiscal policy will reduce demand, and the investment demand will not increase, leading to a double-dip recession. He points out that many people opposed the idea of financing government deficit by issuing currency, but now a number of economists begin to support the idea. It means theories of developed countries are changing constantly; hence, developing countries must take specific conditions and applicability of these theories into consideration when put them into use.

When New Structural Economics was proposed, I repeatedly stressed that we needed to go back to Adam Smith. I didn’t mean going back to The Wealth of Nations, or to Adam Smith’s proposal of making the “invisible hand”, market, play its role, or emphasizing the importance of trading and labor division. What I mean was to refer to Adam Smith’s research approach which could be observed from the full title of The Wealth of Nations, An Inquiry into the Nature and Causes of the Wealth of Nations. It is a scientific method to study the nature and the determinant of a problem. Different eras have different features, so it is wrong to mechanically apply conclusions of The Wealth of Nations or research conclusions of any scholar, because research conclusions are on specific situations in the past. The world is changing constantly and we must keep pace with the times. Therefore, we should adopt Adam Smith’s research method to study and address problems rather than solve current problems based on conclusions of The Wealth of Nations.

Therefore, if we intellectuals want to contribute to the modernization of China, we must focus on the localization of socialist science in China. When a problem occurs, if we adhere to the research attitude, conduct in-depth analysis to explore the nature and the determinant of the problem, a solution will be found. The applicability of a theory is determined by the similarity of conditions. China is a developing country whose conditions are similar to other developing countries. Theories proposed based on China’s situations will be more significant in solving China’s problems compared with theories from developed countries. If so, we will be able to fulfill Chinese intellectuals’ ambition of “cultivating personalities, regulating the family, governing the country and bringing peace to the world”.

◆please indicate the source if authorized: National Economics Foundation

◆photo:National Economics Foundation