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[East Asia Forum] Growth engines and development traps

31 March 2016

Authors: James Riedel, Johns Hopkins University, and Pham Thi Thu Tra, MIT Vietnam

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There is nothing more compelling than a catchy metaphor to attract attention and garner support for policy prescriptions. ‘Engines’ and ‘traps’ are two of the most popular metaphors in the development literature. Both have been used repeatedly to advance various policy agendas in East Asia. But do these metaphors provide a reliable basis for growth policy?

The Honghe Hani Rice Terraces in Southern Yunnan, China. (Photo: AAP).

In 1948 Ragnar Nurkse used the metaphor of trade as the engine of growth in the 19th century as a rationale for an import-substitution industrialisation strategy. His argument was that, in the 20th century, trade could no longer be the engine of growth for developing countries that it had been during the preceding century, because of the declining demand for exports from low-income countries. In 1970 Irving Kravis demolished this argument, demonstrating empirically that trade had not been the engine of 19th-century growth — only the handmaiden — and that prospects for export growth after World War II were even greater than in the previous century. This indeed turned out to be the case.

Three decades after Nurkse, W. Arthur Lewis used the same rhetorical device in his Nobel lecture to make a similar argument — namely that while trade had been the engine of growth in developing countries in the first 25 years after World War II, it could not continue to play that role due to a decline in income growth and demand in developed countries. The year 1980 turned out to be inauspicious for Lewis’s thesis. It marked an economic watershed in China, after which the country went on to unprecedented double-digit growth following an export-oriented industrialisation strategy.

The metaphor of trade as an engine of growth lives on — China’s growth and prosperity are routinely attributed to exports, presumably because export-oriented manufacturing was the most dynamic sector of its economy. But this facile analysis begs the question of what was the driving force behind China’s export growth. Was it world demand or growth in China’s capacity to supply world markets?

It could hardly have been the former, since world demand (for which world income growth is a reasonable proxy) grew at a rate of less than one-fourth of that of China’s exports. Instead China’s export growth has been driven by growth in China’s capacity to supply exports. This capacity growth was driven by one thing: investment. Increased investment resulted not only in capital deepening, but also in technological change (via technology catch-up) and employment growth. No investment, no long-term growth.

The popular mantra in recent years is that China needs a ‘new growth model’. China, the argument goes, must transition from investment-led growth to consumption-led growth. But how does consumption — that is, demand — bring about increases in production capacity? At best it can only increase capacity utilisation and thereby increase growth in the short run. In the long run, production capacity can only be increased by capital accumulation and productivity-enhancing technological change — both of which are products of investment.

The impact of investment on growth does, of course, depend on how well product and factor markets function and how well the government fulfils its role as a provider of public goods. These in turn depend on policy choices and, more broadly, on political and economic institutions, the main concern of another popular metaphor, the ‘middle income trap’.

For past 10 years the idea of a middle income trap has come to dominate policy discussions, especially those about East Asia. The World Bank has pronounced that almost every middle-income country — and some countries that are barely in the middle-income range, including Vietnam and India — are all caught in a middle income trap.

The middle income trap and trade engine hypotheses basically amount to much the same thing. The trade engine hypothesis asserts that trade is the engine of growth, but the engine doesn’t work. The middle income trap hypothesis says that countries that follow comparative advantage by adopting the export-oriented industrialisation strategy are headed for a dead end, where the level of a country’s prosperity is limited to the productivity of unskilled workers in labour-intensive export-oriented manufacturing.

So how can countries escape the middle income trap? The solution universally prescribed is to change policy. What is needed, it is often argued, are policies that promote the production and export of ‘high-value products’, raise the ‘domestic value-added content of exports’ and transition to a ‘knowledge-based economy’.

This raises the question: what is a ‘high-value’ product? Are automobiles a higher-value product than fish? The obvious answer might seem to be yes, but if priced by weight both are valued at about US$5 per kilogram. The domestic value-added share of primary exports is also close to 100 per cent, while in manufacturing — thanks to global supply chains — it amounts to about 50 per cent in many countries, and in some cases is even lower. Does this mean countries should abandon industry in favour of agriculture?

Transitioning to a ‘knowledge-based economy’, which presumably means an economy in which the share of income earned from human capital is high and rising, is a worthy goal. Unfortunately, many of the countries that talk loudest about the need to transition to a knowledge-based economy, like Vietnam and Thailand, are the most politically resistant to educational reform, suggesting that much of the talk is simply hot air.

If we stipulate that policy changes are needed to allow middle-income countries to achieve their growth potential, it would hardly seem that middle-income countries are caught in a ‘trap’. If all that is needed to restore growth to its long-term potential is to abandon growth-inhibiting policies in favour of growth-promoting ones, then where is the trap? Just change policy!

But what if the policy changes that are needed to make a middle-income country more efficient and dynamic require policymakers (or politicians) to give up discretionary power to grant licenses, land-use rights, government procurement contracts and to direct credit to favoured enterprises and individuals? In other words, what if the policy changes needed to make the economy grow faster are not in the self-interest of rent-seeking authorities or politicians? Then a country is truly in a trap, but one that is political in nature, not economic.

How can countries escape from such a political trap? There is no easy answer. If there were, it would not be a trap.

James Riedel is William L. Clayton Professor of International Economics, Johns Hopkins University-SAIS.

Pham Thi Thu Tra is Lecturer, Royal Melbourne Institute of Technology-Vietnam.

This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘Stuck in the middle?’.

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