Setting the Stage for Growth

by Mark Thoma on November 12, 2007

Dani Rodrik’s new book, One Economics, Many Recipes: Globalization, Institutions, and Economic Growth takes on a problem of fundamental importance, how to stimulate and sustain economic growth in underdeveloped countries and lift people out of poverty.

Past attempts to solve this problem can, for the most part, be identified with one of two polar extremes, solutions that involve pervasive and persistent government intervention, and solutions that rely upon extreme laissez faire market-oriented policies. Neither of these approaches has been very successful, and the book argues for a different approach that combines these extremes and allows market forces to operate in an environment shaped by government policy. Under this combination approach the government in partnership with the private sector uses industrial policy and institutional change to strategically kick-start, coordinate, and sustain economic activity.

If the barriers to development are difficult to identify, what should you do? One approach is follow a set formula such as the Washington Consensus. This provides a recipe to follow that is grounded in economic principles, relies upon markets to direct development activity, and is intended to be robust enough to work in a wide variety of circumstances. Unfortunately, there is little evidence that such a formulaic market-based approach works across the broad sets of conditions and institutions that exist in undeveloped countries. And the opposite approach, a heavy-handed, top down, highly interventionist, dictatorial approach does not seem to be able to find the keys to successful growth either.

The message is that too much reliance on either the government or the private sector has not, in general, produced the desired outcome of sustained long-run growth. To overcome this, the book recommends prescriptions that improve the information flow between the private and public sectors to reveal the important barriers to development. This calls for a collaborative effort between the government and the private sector devoted to identifying and removing the biggest impediments to entrepreneurial activity. A main point of the book is that although there are certain broad principles that guide the choice of industrial policies and institutional design, there is no one recipe that works for all countries. The endpoint is sustained economic growth, and the prescriptions are firmly grounded in traditional economic principles, but the exact path a country takes to reach its long-run objectives depends upon its unique circumstances and generally involves a combination of orthodox and unorthodox institutional practices.

While the first stage seems relatively easy to bring about, getting to the second stage, i.e. sustaining growth, is more difficult (the book lists over eighty instances of growth spurts, but only a few of those have been sustained over a long time period). As the book says, “Sustaining growth is more difficult than igniting it, and requires more extensive institutional reform,” and much of the discussion in the book is devoted to explaining a systematic approach to institutional design that promotes the necessary dynamism to sustain growth over the longer term.

Unfortunately, the general principles that explain the difference between the countries who make it to the second stage and those who do not are unclear. One of the book’s messages is that such systematic differences are difficult to identify due to unique conditions in each country, but since making it to the second stage is the goal of development policy, I still wish we had a better sense of the factors that explain why most countries are unable to make the transitions needed to sustain economic growth.

Perhaps the book’s discussion of a paper by Imbs and Wacziarg (2003) in the section on institutional design is related to this problem of determining which countries will survive the transition into the second stage. The paper estimates a typical development pattern and finds that development follows two distinct stages, an initial stage where sectoral employment and production become less concentrated and more diversified, followed by a second stage where this reverses and there is increasing sectoral concentration as the economy grows. In addition, the turning point is estimated to occur, on average, at relatively high levels of per capita GDP. Thus, graphing sectoral concentration against GDP per capita reveals a U-shaped pattern and, as Imbs and Wacziarg stress, the U-shaped pattern “is an extremely robust feature of the data.” Based upon this they conclude that “Countries diversify over most of their development path”.

This conclusion is based in part upon the result that the minimum of the U-shaped development path is at a relatively high level of income, but there is quite a bit of variation in the minimum across countries (partly explained by openness), and it is lower after 1980. In addition, the minimum is the point when the forces that are increasing concentration begin to dominate the forces that are decreasing it, but that is not necessarily the point where these forces begin to change.

What I am suggesting is that perhaps this process of clearing out unproductive, unprofitable firms is an essential part of getting to the second stage, and that this process must begin fairly early in the development process, earlier than the minimum point of the U-shaped curve. Initially, the clearing out doesn’t fully offset the growth spurt and there is increasing sectoral diversification overall, but eventually the forces of consolidation come to dominate the forces of diversification as successful firms gain strength and this causes sectoral diversification to end as the economy passes by the minimum point on the U-shaped development curve. Without this process in place to clear the path for stronger firms to emerge, and without it beginniing fairly early in the devekopment process, growth stagnates before the country ever reaches the minimum point on the U-shaped development curve.

Perhaps it is the failure of this cleaning out process to operate due to government ownership of some firms, government protection of certain favored sectors, regulation, labor restrictions, etc., that is a factor in preventing countries from getting to the second stage. The book recognizes barriers such as these can impede development and one of the key guiding principles the book gives for partnerships between the public and private sectors, and in building institutions to support growth is the creation and preservation of ‘dynamism.’ In this regard, among countries experiencing growth spurts, it might be interesting to find out what the sectoral concentration profiles look like for the countries that were able to make it to the second stage versus those that did not, particularly a comparison of measures such as exit rates. More broadly, however, the question is whether there are deeper connections between the U-shaped concentration curve that appears to provide a very robust characterization of the growth profile of developing countries, and the first and second stages of growth identified in the book.

And this brings me to my last point. Whether or not there’s anything to the conjecture above about stagnation due to the inability to clear out unproductive elements in the economy, a bigger message is that we need to learn more about the connections between the first and second stages of growth, i.e. about the transition itself. For example, what if removing the one or two most important impediments to jump-starting economic growth in the short-run is not the best means of getting to the second stage, or leads to a dead end where you cannot get to the second stage at all? Maybe some other development strategy involving the second and third most important barriers, say, won’t give quite as much boost initially, but gives the country a much better chance of surviving the transition and sustaining growth over the longer term. The example is simplistic, but the point is that this is a single, interconnected problem, not two separate problems, and the first stage must be devoted to bringing about a successful transition to the second stage. The book does a great job of listing the guiding principles for each stage, and of describing how to design institutions to sustain growth, but I would like to see the connections between the two stages, particularly how to set conditions in the first stage so as to make the second stage more likely, explored in more depth. As noted above, the kick-start phase seems relatively easy to bring about and there are scores of instances of this happening, but getting to the second stage is much more difficult and perhaps there is more that can be done to enable the transition to take place. In any case, since so many countries fail after growth is initiated, the transition is something we need to learn more about and this book provides a solid foundation from which to explore this issue further.