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Does Successful Development and Economic Transformation Require State Intervention in Industry and Technology?

Raj Nallari's picture

Proponents of state intervention argue that ‘market failures’ in information, coordination, credit and others necessitate ‘infant-industry protection’ and therefore an activist role for the government. For example, information about success or failure of new industries or technological adoption may be only available to investors and innovators and not shared with other entrepreneurs. Also, new industries and technologies require complementary human capital, and basic infrastructure among other things. In addition, credit market imperfections in developing countries and inequality in access to finance impedes the formation of high-skilled workers and large entrepreneurial class needed for industrialization.

So positive stimulus from intelligent governments would give an impetus to industry, including by favor labor-intensive and mineral-intensive industries with comparative advantage by subsidies and tax-cuts, directed credit, establishing public enterprises in such industries, directing foreign companies and investment in R&D related to the industry, keeping other FDI out unless needed for new technology. Akimata’s (1961) theory of “Flying Geese” originated specifically to explain the growth pattern of East Asia. There the firm (country) has a comparative advantage in labor-intensive traditional sector but the firm (country) with government support embarks on a somewhat ‘risky’ skill-intensive activity. In general, as skill level crosses a certain level, the marginal cost declines steeply but as skill grows further, the productivity ceases to grow at the same pace while the wage in the primary sector outpace them. This trend happens because skill does enhance the productivity but at different degrees in the product life. Thus, it takes the form of a U-shaped curve. In the beginning the wage rate as well as the skill level is low and the country is forced to import. Gradual familiarity leads to more productivity. Despite concomitant rise in wages, such productivity gains lead to exportables. Further increase in the wage depletes the comparative advantage in a particular product. Thus, the nation is forced to produce another good that uses labor less intensively and where high skills can be utilized more effectively. This is the story behind gradual upgrading of export from textile to chemicals to iron & steel to automobiles and finally to electronics. South Korea and Finland are two examples of this approach.

While a particular nation grows in skill and the products are upgraded from labor-intensive (L-intensive) to capital-intensive goods, another nation grows and takes over in L-intensive products. This happened in East Asia because they had a skill ladder where Japan began as the most skilled nation followed by other “Asian Tigers”. Kojima extended this model to incorporate transporting of one industry to another country where the wage is lower even though the productivity of the workers is not as high as the parent nation. This gradual shift of comparative advantage causes high growth of a particular nation at a particular time. For example, Taiwan supplanted Japan in the production of certain goods when Japan lost comparative advantage in it. Taiwan was followed by ASEAN and finally China took over.

Opponents, such as Larry Summers is believed to have said that industrial policy is like picking stocks and just because Warren Buffet is good at picking stocks does not mean that all of us should do the same. The majority of investors are better off holding a diversified portfolio. Similarly, just because Japan, South Korea, Taiwan, and a few other South East Asian countries have been successful with state intervention in promoting industrial and technological development, it doesn't mean other countries should emulate them. Most governments are better off by staying away from ‘picking winners and losers’ as development experience during past 60 years is replete with failure of ‘government failures’ not only in industry but in agriculture, tourism, financial services and other sectors. Even when there is shown to be ‘market failure’, opponents argue that industries never become adults from ‘infant-industry’ as they depend on government support for decades on end. They argue that comparative advantage defying state intervention takes the form of state favoring capital-intensive and skilled-labor intensive industries through subsidies and trade protection. The government aims to put the economy on a higher growth path by a strategy of ‘leap-frogging’ development. The further one moves away from comparative advantage, the more the costs of subsidization and support, and over time this becomes fiscally burdensome. Moreover, once the government support is withdrawn then the industry may become uncompetitive, generate less surpluses and resources to reinvest, and may have to close down, and when such support is stopped, the industry’s profits evaporate as private sector does not. Opponents still believe that East Asian countries would have grown even faster had they not employed industrial policies.

Some observers argue that diversified industries will not take hold in natural resource-endowed countries, such as in Africa and Middle East, because the ‘booming sectors of oil, minerals’ attract all the human and financial resources and government incentives, and therefore there is a ‘resource curse.’ The only reason rapid industrialization occurred is because of a lack of natural resources (except Malaysia and Indonesia, but even there industry is relatively weak and at the lower level of the ladder).

The ‘new industrial policy’ group argues that state intervention is needed in R&D and innovation policy to encourage low carbon, high growth. They argue that private sector does not internalize the carbon emissions, while state intervention will deal with this negative externality.

Debatable Questions:

  • Why did IT industries take-off in India and Ireland without state intervention?
  • Isn’t East Asian countries’ success more due to their ‘trade openness’ strategy rather than state-intervention – or is it that both state-intervention and openness that is a successful recipe for rapid development?
  • Is there an export diversified strategy for developing countries that works most of the time?
  • Is it true that the ‘natural resource curse’ works against economic diversification and development?
  • Is the new industrial policy more appropriate for the 21st century?

 

Comments

Submitted by James Leigland on
I'm a little surprised to see no mention here of the Bank's own massive (and ground-breaking) study of this issue, published in 1993, The East Asian Miracle: Economic Growth and Public Policy.

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