Presentation Summary

Professor Justin Yifu Lin presented his ideas on approaches to development and transition at a distinguished speaker seminar on 5 December 2007. The seminar explored the reasons underlying both the dynamic economic growth of some countries—such as Japan, newly industrialized economies (NIEs) in East Asia, and recently the People's Republic of China (PRC) and Viet Nam—and the lack of such success in many other developing and transition countries. The seminar started with an overview of the industrial revolution and the subsequent division of the world into industrialized and non-industrialized countries and asked, "Why are some countries rich and others not?"

The proximate determinants of development generally consist of natural resources, physical capital, human capital, and technology. Some competing hypotheses (in short, luck, geography, institutions, culture, and openness) have also been proposed. Most economists now agree that institutions are a key factor in economic development. What really determines the shape of institutions and why some countries (like the PRC and Viet Nam in the 1980s) could take off without observable changes in the institutions—especially in the composition of vested interest groups—still remain puzzles. Following Keynes (1935) and Schultz (1977), Professor Lin argued that social thinking, instead of vested interests, is the key to shaping the institutionalized order of society. He further pointed out that the government is the most important institution, and that the quality of a country's government determines the success or failure of its development. The quality of the government is determined by the political leaders' behavior, which depends on their motivation to secure their tenure and historical status. In sum, Professor Lin stated, continuous technology innovation is the foundation for dynamic growth. If its institutions are right, a developing country can turn its late development into an advantage by adopting the technologies proven successful by the experiences of other countries.

Professor Lin next reviewed the prevailing social thinking and accompanying strategies at the early stages of development in developing countries, as well as transition strategies and their consequences in transition countries. Many developing countries pursued industrialization after achieving independence. The prevailing view on industrial structure at this stage was that developing countries with exports of primary goods and imports of machinery goods would be exploited by developed countries focusing on production and export of manufactured goods. The prevailing thought regarding government was that it should protect infant industries and correct market failures. As a result, political leaders in these developing countries attempted to develop advanced heavy industries. Professor Lin terms this type of strategy a comparative advantage defying (CAD) strategy. The prevailing thinking at this stage proved to be incorrect. Together with the CAD strategy, it ignored the non-viability problem of firms, huge policy burdens, and tremendous price distortion. Such a development strategy induced rent-seeking, unproductive profit seeking, and soft budget constraint problems, and caused great failures in developing countries.

Meanwhile, Japan, the Republic of Korea, the NIEs, and some other countries pursued a comparative advantage following (CAF) strategy and achieved sustained economic growth. In the CAF strategy, firms are encouraged to follow the economy's comparative advantage determined by the economy's endowments. This results in viable firms. Only if abundant resources in the country are priced appropriately—that is, in the absence of price distortion—will firms follow the economy's comparative advantage in choosing technology and industries.

The failure of the CAD strategy led to capitalist triumphalism and the new social thinking that countries should build up the necessary institutions for a well-functioning market economy. In many countries, shock therapy—massive privatization, comprehensive market liberalization, and strict fiscal discipline—was implemented. This therapy, however, treats the existing distortions in the socialist and developing countries as exogenous. In fact, they are probably second-best arrangements for protecting the numerous nonviable firms in those countries. Thus, despite the reforms, firms in the priority sectors still encountered policy burdens; governments were responsible for those burdens and were obliged to provide policy support. Because it is difficult to distinguish policy cost from regular management cost, privatized firms have higher incentives to seek protection and subsidies. Thus, privatization worsened soft budget constraints and the shock therapy led to rampant inflation in many former Soviet republics. A different transition approach—a dual-track approach—was pursued by the PRC, Viet Nam, and some other countries. They attempted to improve incentives by giving partial autonomy to farmers and state-owned enterprises (SOEs). A dual track in prices and resource allocation was introduced and private firms were allowed to enter the formerly non-priority sectors but SOEs and farmers were required to deliver the obliged quotas to the state as in the past. This approach resulted in simultaneous stability and dynamic growth.

The lecture also included some empirical exercises examining the CAD strategy. A proxy for development strategy (technology choice index, or TCI), defined as the ratio of added value per worker in manufacturing industries to GDP per worker, was used to conduct a series of tests for five hypotheses. To test the hypothesis that countries using the CAD strategy will have a higher incidence of government interventions and distortions, Professor Lin examined correlations between TCI and black-market premiums, an economic freedom index, expropriation risk, enterprise autonomy indicators, and openness. A regression of growth rate on TCI and other exogenous variables was used to examine the hypothesis that over an extended period of time, a country that adopts a CAD strategy will experience poorer growth performance. Regressions were also conducted to examine impacts of TCI on economic growth volatility and income distribution, respectively, controlling for other exogenous factors. The final hypothesis was about transition strategy and economic growth: if a country creates conditions to facilitate the development of formerly non-priority labor-intensive industries, it will achieve better overall economic growth. To test this hypothesis, regressions of average growth rate on the change in TCI, together with other explanatory variables, were conducted. The results of the above tests generally supported the hypotheses and suggest that the development strategy is the fundamental determinant of a county's institutions, economic performance, and income distribution.

Professor Lin turned his focus to East Asian economies at the end of his presentation. East Asian economies seem to be special in terms of development and transition performance since World War II. In contrast to the failed efforts of countries in Africa, why could development and transition "miracles" occur in East Asian economies that had similar ideas about development in the 1950s and 1960s and about transition in the 1980s and 1990s? In general, Professor Lin put forward, luck, geography, and culture are arguably factors in East Asia's success stories. The East Asian economies were constrained by the paucity of natural endowments in their choice of the CAD strategy. Thus, they were unable to fully pursue the CAD strategy. The characteristic of pragmatism in culture and in political thinking made it easier for East Asian economies to adjust their development strategies, Professor Lin contended.

In concluding his remarks, Professor Lin emphasized the importance of endowments as a binding constraint on a country's choice of technology and industry. Comparative advantage, he said, is the most important guiding principle not only for trade, but for economic development. Viability is the most important concept for understanding institutional distortions in developing countries: an enterprise will be viable in a competitive market only if the enterprise's technology and industrial choices are consistent with the country's comparative advantages, determined by the economy's endowments. As the best approach for policy in economic transition, Professor Lin recommended pragmatism: a gradual, piecemeal approach to reform and transition, he said, could enable the country to achieve stability and dynamic growth and allow the country to complete its transition to a market economy.

Q&A / Discussions
Discussions on automobile industry in the PRC

Q: In terms of CAD vs. CAF strategies, how do you evaluate the very rapid development of the PRC automobile industry in the last few years? Given that the PRC's GDP per capita is only around US$2000, do you think the development of the PRC's automobile industry is consistent with the country's current level of economic development and comparative advantage? If not, what is the implication for the PRC economy as a whole?

A: First, although nominal income per capita is still low in the PRC, its PPP level in the PRC is already about 15% of that in the US; second, most automobile firms are joint ventures, which basically use foreign capital to produce cars; finally, local automobile firms usually produce more economic compact cars instead of luxury cars. Thus, the current development situation is much better compared to that of the 1950s, and the development strategy nowadays is more realistic.

Q: Malaysian GDP per capita is much higher but they were not very successful in developing automobile industry.

A: The Malaysian market is smaller than the PRC's, so they were not very successful.

Q: The PRC still has the tariff of 25 percent for imported cars. Do you think the PRC's automobile industry will be still viable if the tariff is taken away?

A: Ten years ago, the tariff was 215 percent for imported cars but now it is only 25 percent. During the reduction of the tariff, the PRC's automobile industry in fact still developed quite quickly, suggesting that it is a viable industry now. The tariff of 25 percent is certainly some kind of protection, but the impact may not be very large.

Discussions on TCI

Q: TCI is doubtful to be able to represent CAD or CAF strategies. TCI is not a government-choice index or not an exogenous variable. Thus, it may be not a good proxy for government policy strategy.

A: We are trying to use other indicators but the data, especially sectoral data or micro-data, are not available. Thus, we just use this index for empirical tests, but we are still trying to search for a better index and a good dataset.

Discussions on CAD vs CAF strategies

Q How can policymakers identify ex ante whether a particular policy is a CAD or CAF policy?

A: This is a very hard question. It is very much dependent on local capacity to identify what are constraints and what are viable opportunities. This should be different from country to country. My approach for policy recommendation is just to provide some basic principles. To design policies, one may need to investigate at the firm level by asking firms whether they have incentives to go to a new field without government support, whether they are trying to approach a certain direction, among others. PRC and foreigners attribute PRC success to Deng Xiaoping, but in fact he did not really provide specific policies; instead, he allowed people to try different approaches and "cross the river by groping the stones." A typical example is PRC agricultural reform from collective farming to individual household farming, which was tried by some farmers first and then became a national policy. Thus, one should be humble in recommending policies, and it is more important help people to recognize their own approach to be successful.

Q: What do you think about Indian development strategies?

A: The Indian experience suggests that social thought is important and new ideas or knowledge should be introduced in a society to influence social thought. At the beginning, Indians did not believe that they could achieve change but as time went on, they observed what was happening in the PRC and started to think that India could also change if different policies were pursued. India then started to reform and has been achieving high growth.

Q: The pragmatic combination of CAD and CAF may be also useful but it is difficult to strike a balance between two strategies.

A: CAD policies are usually costly although technology in industries like space technology may have positive externalities in the economy.

Q: Compared to CAD strategy, CAF strategy can achieve more equal income distribution. If the PRC is adopting CAF, why is the income disparity in the PRC widening?

A: The PRC is in a transition from CAD to CAF strategy in a dual-track way. In the process, government intervention remains to support certain industries and non-viable firms. As a price of the dual-track approach, the income gap is widening. To solve this problem, we need to move to a complete market economy.

Discussions on other issues

Q: As you correctly stated, openness is endogenous. How can one country pursue the CAF strategy, controlling for openness?

A: One of the most important efforts is to create viable firms in the country. One should be clear about the target of reform, the areas that need to open and continuously need support, and the extent to which the country limits the support.

Q: When it comes to comparative advantage, do you include human capital, in addition to natural resources or technology?

A: Human capital is indeed important and should be considered as one of a country's endowments.

Q: How can a government make firms upgrade their technology? Is it the case that privatization can be done only when the country has got the right technology or has the market mechanism?

A: To upgrade firms' technology, market competition is very important. Government may provide some incentives for firms to adopt new technology. In terms of privatization, the PRC gradually privatizes SOEs when SOEs become viable.

Q: Taipei,China and Hong Kong, China contributed much to PRC economic growth. Without them, will the PRC economy still achieve dynamic growth like now?

A: Yes, Taipei,China and Hong Kong, China did provide much input to PRC economic growth at the beginning of the transition. But their roles are not dominant in economic growth.