In a nutshell
The secret of China’s success lies its use of both the ‘invisible hand’ and the ‘visible hand’.
It is important to learn from the mistakes of both excessive intervention and neoliberal laisser-faire: both the market and the state must play their essential roles in economic development and transition.
New structural economics can provide useful insights for developing countries in the Middle East and North Africa.
It is a dream for every developing country to become a modern industrialised high-income country. Yet among nearly 200 developing economies after the Second World War, so far only two – South Korea and Taiwan – have grown from low to high income. China may become the third by 2025.
Among the 101 middle-income economies in 1960, only 13 became high income by 2008. Of the 13, eight were European countries, which had a small income gap at the beginning, or oil-producing countries. The other five were Japan and four small East Asian economies: Hong Kong, Singapore, South Korea and Taiwan.
Why has the majority of developing economies been trapped in middle- or low-income status?
The primary reason is because most of them followed Western mainstream economic theories to form their development and transition strategies and failed to maintain a balance between the market and the state.
Emerging after the Second World War, the first edition of development economics – structuralism – emphasised market failures and advised the government to mobilise and allocate resources directly to develop large-scale, capital-intensive industries similar to those in high-income countries.
The intention was respectable. The strategy relied on various market interventions and distortions to develop the advanced industries, resulting in misallocation of resources, rent-seeking and corruption, and causing economic stagnation, frequent crises and widening the gap with high-income countries.
After the 1970s, ‘neoliberalism’ became the new mainstream set of ideas in development economics, emphasising government failures. This view advocated the use of ‘shock therapy’ to implement the ‘Washington consensus’ reform of privatisation, ‘marketisation’, stabilisation and liberalisation so as to eliminate government interventions and distortions and to establish a well-functioning market system similar to that in developed countries.
For those socialist and other developing countries that adopted this transition strategy, the results were economic collapse, stagnation and frequent crises. Economic performance was worse than before the transition.
For those few successful economies after the Second World War, their common feature was to have not only an ‘efficient market’ but also an ‘effective state’ in their economic development and transition.
Why is it important to have an efficient market?
This is because the development of industries and adoption of technology according to a country’s comparative advantage determined by its factor endowments is a precondition for industry to develop competitive advantages in domestic and international markets.
Enterprises pursue profits. Only if relative factor prices reflect relative factor scarcities in endowments will enterprises choose their technologies and industries according to the comparative advantages determined by factor endowments. Such relative prices will exist only if the market is competitive.
Why is it also important to have an effective state?
This is because economic development is a process of continuous structural transformation in technological innovation, industrial upgrading and improvement in hard infrastructure and soft institutions. It is essential to have first movers in technological innovation and industrial upgrading. The government needs to compensate for the first movers’ externality and uncertainty.
The success of first movers also depends on improvements in related infrastructure and institutions, which is beyond individual entrepreneurs’ capacity and needs the government to coordinate various enterprises to make the improvements or to provide them itself.
Only with the market and the state playing their respective roles will technological innovation and industrial upgrading proceed smoothly according to changes in comparative advantage during economic development. Therefore, an economically successful country must have the market as its foundation and on top of that the state playing an active, facilitating role.
China was a poor country with a per capita GDP less than one third of sub-Saharan African countries’ average before economic reform and opening up in 1979. Since then, China has achieved an average annual growth rate of 9.6% in the past 38 years. Moreover, the country is the only emerging market economy not to have suffered a systemic financial and economic crisis.
An important reason for China’s success is that it did not follow the Washington consensus. Instead of shock therapy, China adopted a pragmatic, dual track approach.
On the one hand, it provided continuously transitory protection and subsidy to large-scale, capital-intensive state-owned enterprises, which violated China’s comparative advantages but were essential for national defence and people’s basic needs.
On the other hand, it liberalised private and foreign firms’ entry to China’s comparative advantage industries with the state actively facilitating the industries to become the nation’s competitive advantages in domestic and international markets by overcoming bottlenecks in hard and soft infrastructure.
The rapid development, fast accumulation of capital and quick change of comparative advantages enabled those industries, which went against China’s comparative advantages originally, to become the country’s comparative advantages. They also provided the conditions for the government to deepen reforms, remove protections and subsidies and allow the market to play a decisive role in resource allocation.
Three lessons for other developing countries
China’s economic development and transition provide three lessons for other developing countries.
First, it is important to be pragmatic and realistic. It is essential to have a good understanding of oneself and correct understanding of others – that is, to have an objective and comprehensive assessment of the country’s basic realities and conditions, including its development stage as well as its natural resources, labour and capital endowments, and key problems and their origins.
What it means to understand others correctly is to have a systematic analysis of countries at different development stages and types, and to have an objective assessment of the relations, differences and complementarities between oneself and other countries.
It is especially important to have a careful study of the comparative advantages and features of the development stage of one’s own country and other countries and not to copy simplistically other countries, especially the theories, policies and experiences from developed countries with conditions different from one’s own.
Second, it is important to have economic development and transition strategies suitable for one’s own country. There are many dimensions of such strategies, including the use of industrial policy.
Technological innovation and industrial upgrading are necessary for a developing country’s development. The upgraded industry needs to be consistent with the comparative advantage determined by a country’s factor endowments so as to make the firms in the industry have the lowest factor costs of production in the country and elsewhere in the world.
But transaction costs for firms in a developing country are generally high due to imperfections in infrastructure, the business environment and legal institutions. It is necessary to reduce firms’ transaction costs to increase their market competitiveness.
It is the government’s responsibility to improve infrastructure, the business environment and legal institutions. But its resources are limited and, therefore, they should be used strategically to improve infrastructure and other binding constraints in suitable locations so as to reduce transaction costs for the targeted industries to turn from comparative advantage to competitive advantages quickly.
In this way, small wins can be accumulated to become large wins. With vibrant economic development, the improvement of infrastructure, the business environment and legal institutions can be extended step-by-step nationwide.
Third, it is important to learn lessons from the mistakes of both the excessive intervention advocated by structuralism and the laisser-faire advocated by neoliberalism and to have the market and state play respectively their essential roles in the economic development and transition.
New structural economics
In recent years, reflecting on the weaknesses of structuralism and neoliberalism, I have advocated ‘the new structural economics’ (Lin, 2012a, 2012b; and Lin and Monga, 2017), which is generalised from the success and failure of China and other developing countries’ development and transition.
From the perspective of new structural economics, the secret of China’s success is its use of both the ‘invisible hand’ and the ‘visible hand’, forming an organic integration, complementarity and mutual improvement of the functions of the market and the state. The applicability of a theory generalised from a country to other countries depends on the similarity of pre-conditions in the country and other countries.
I hope, due to the similarity of pre-conditions in developing countries, that the new structural economics will provide useful insights for developing countries in the Middle East and North Africa for overcoming development challenges in their roads ahead.
Lin, Justin Yifu (2012a) New Structural Economics: A Framework for Rethinking Development and Policy, World Bank.
Lin, Justin Yifu (2012b) The Quest for Prosperity: How Developing Economies Can Take Off, Princeton University Press.
Lin, Justin Yifu and Celestin Monga (2017) Beating the Odds: Jump-starting Developing Countries, Princeton University Press.