Unconditional Convergence: The Path to Economic Growth Is Industrialization, Not Exports August 16, 2019

Posted by OromianEconomist in Uncategorized.
Tags: Development, Economic growth, economics, exports, industrial policy, industrialization
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‘Since domestic instead of global trends now drive growth, developing countries are likely to show significant heterogeneity in long-term performance. Therefore, they have absolutely no option but to get their industrial policies right.’

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The Path to Growth Is Industrialization, Not Exports

Historically, industrialization has driven rapid growth in developing countries who will need unorthodox policies to attain or accelerate it.

Atul Singh, Fair Observer, 8 August 2019   

© Toukung design

On the seventh anniversary of the 9/11 attacks, Dani Rodrik posed a controversial question: “Is Export Led Growth Passé?” Writing on September 11, 2008, this famous Harvard professor argued that advanced economies were unlikely to run large current account deficits and import as they did in the past. Export markets would shrink and long-term success for developing countries would depend “on what happens at home rather than abroad.”

In 2016, Rodrik gave a key lecture at the University of Sussex in the UK developing this argument further. He argued that the “East Asia style growth miracles are less likely in the future.” Furthermore, if growth miracles happen, they would no longer be based on exports alone. Rodrik also made the case that growth in emerging markets has been unsustainably high in the last decade and will come down by a couple of percentage points.

In this day and age, it is common sense for most economists to hold a notion of convergence. As per this idea, Third World countries can grow fast and achieve standards of living similar to advanced economies in a matter of decades or less. As latecomers, these countries, also referred to as developing economies or emerging markets, have access to the latest thinking, new technologies, First World capital and global markets. This access should allow these poorer countries to converge with richer ones in a matter of decades or less.

Rodrik distinguishes between conditional and unconditional convergence. Most development economists hold the view that convergence is not inevitable but conditional. To achieve it, poorer countries must build up their economic and political institutions, develop human and physical capital, and employ sound economic stabilization policies that rein in fiscal deficits and curb inflation. These conditions are akin to the “Washington consensus” first coined by British economist John Williamson. Since 1989, the World Bank and the International Monetary Fund have faithfully preached this sermon to poorer countries ad infinitum.

Forget Institutions, Focus on Industrialization

As per the Washington consensus, convergence with richer economies is conditional on poorer ones instituting market-based critical reforms. The faster poorer economies bring in reform, the quicker they will catch up with richer ones. While the prescription for rapid growth and thus convergence to the First-World living standards is straightforward, the trouble with it is that there is no example of a single economy that has grown and converged following the dictums of free markets, improvement of institutions and all the other recommendations.Embed from Getty Images

Rodrik examines data from 1950 to 2012 to find just two examples of convergence. The first example is the solid three-decade-long growth of countries in the European periphery after World War II. The second is the spectacular growth of countries in East Asia. The so-called East Asian miracle allowed the East Asians to catch up dramatically with the West.

In the words of Lewis Preston, the president of the World Bank from 1991 to 1995, Asian economies achieved “rapid and equitable growth, often in the context of activist public policies,” raising “complex questions about the relationship between [the] government, the private sector, and the market.” The late Preston attributed this “extraordinary growth” to “the superior accumulation of physical and human capital.” He also argued that “these economies were also better able than most to allocate physical and human resources to highly productive investments and to acquire and master technology.”

Rodrik gives a simpler explanation than Preston for the East Asian miracle. He attributes it to rapid industrialization. After World War II, Japan was a one-party democracy, South Korea was a military dictatorship and Hong Kong was ruled by the British. None of them followed the Washington consensus. The common feature for all the economies that enjoyed spectacular growth over many decades is that they industrialized with a vengeance.

It turns out that industrialization, not institutional reforms, matter most in growing the economy at higher levels and allowing it to converge faster. Rodrik labels this as unconditional convergence. The agricultural sector does not allow for a dramatic increase in productivity. Services do not do so either. Rodrik points out that high-productivity services are skill-intensive and employ few people. Low-productivity services employ more people but do not drive growth. Industrialization seems to be the only way forward for increased productivity, high growth and economic transformation.

In the case of East Asia, both supply and demand side factors came together simultaneously to cause the miracle. Governments in places like South Korea, Taiwan and Japan bet big on domestic manufacturing. They protected infant industries, subsidized exports, kept their currencies low, developed special investment zones and put in massive resources to boost manufacturing. At the same time, the US developed a taste for cheap products and American demand fueled Asian exports. It is this demand that enabled the likes of Sony, Toyota, Samsung and LG to emerge on the global stage.

The success of East Asian economies has led many developing countries to assume that the export-led growth model is the only path to rapid economic development. This view misses the forest for the trees. The export-led growth model of East Asia is more an example of rapid industrialization than of exports per se. Exports just provided markets for its industries that were the primary driver of the economy.

Lessons From the 19th Century

To understand the impact of industrialization, it is instructive to study three countries: the UK, the US and Germany. The Industrial Revolution began in the United Kingdom. Innovations like the flying shuttle, the spinning jenny, the water frame and the power loom increased cloth production dramatically. Fewer people could produce much more in less time than individual spinners, weavers and dyers. This revolution was fueled by cheap energy from coal.

The revolution in iron and steel manufacturing soon led to the development of railroads and steamships. Better roads and a canal network developed speedily to distribute the products of British industries. The first commercial telegraphy system emerged as did stock exchanges, banks and industrial financiers. Even as industrialization gathered speed in the early 19th century, the UK proceeded to conquer an increasing share of the planet. By now, present-day Bangladesh and much of India was already a colony and a captive market. After 1757, in the words of Horace Walpole, the UK was also “a sink of Indian wealth.” It might be fair to say that the First Industrial Revolution did not occur because of adherence to the Washington consensus.

The Second Industrial Revolution is purported to have begun in 1793 when an English immigrant called Samuel Slater opened a textile mill in Pawtucket, Rhode Island. He immigrated to the US in defiance of British laws prohibiting the emigration of textile workers, earning the epithet of the “Father of the American Revolution” in the process. The US then proceeded to industrialize rapidly by liberally borrowing British innovations, which really meant intellectual piracy for which the US now damns China.Embed from Getty Images

Just as the British conquered much of the world, Anglo-Saxons in the US expanded from the original 13 colonies to gobble up more Native American land. They believed in “manifest destiny,” the inevitability of the continuous expansion of US territory to the Pacific and beyond. None other than Founding Father Alexander Hamilton took the view that political independence was meaningless without economic independence.

This legendary American whose statue still stands outside the Treasury building argued that the US would never be free from Britain or any other foreign oppressor as long as it depended on foreign manufacturers. The first major act passed by Congress was the Tariff Act of July 4, 1789, and laid the grounds for protecting the infant industries that would otherwise be ruined by British competition. Unknown to most, the US pioneered industrial policy that many other countries have emulated since.

In fact, protectionism played a key part in triggering the Civil War. Most Americans do not know this fact. They look back at the Civil War with rose-tinted eyes where a virtuous patriot from the North took on the sinful slave owners of the South, paying for the liberty of the enslaved with his life. It turns out that the 1846 abolition Corn Laws in the UK and the 1857 uprising in India might have played a key role in triggering the American Civil War.

After 1846, the UK embarked on a trajectory of free trade. Now, the UK imported food for its urban working classes from around the world. The US emulated the UK, but this led to economic discontent in the industrial North. As a result, the newly formed Republican Party emphasized protective tariffs in its 1860 platform. The agrarian South was not too pleased. Protectionism meant that it had to sell cotton to Yankee buyers instead of British ones and earn less.

Not only did the South miss out on the 1846 British bonanza, but also the windfall from the rise in the price of cotton thanks to the 1857 upheaval in India that disrupted global cotton supply. The North’s triumph in the Civil War ensured that protectionism remained standard American policy well into the 20th century. Even Woodrow Wilson’s call for a removal “of all economic barriers” fell on deaf ears as the Tariff Acts of 1922 and 1930 demonstrated. Only after World War II did the US emerge as a free-trade champion with its industries intact and growing while its competitors such as Germany, Japan and the UK had been conveniently bombed to smithereens.

If the British and the Americans pushed forth industrialization through a mix of private entrepreneurship and public policy, so did the Germans. Prince Otto von Bismarck consciously promoted trade and industry in unified Germany. A mercantilist policy of tariffs aimed to make the new German Empire “a self-sufficing economic community.” Lacking the resources of the US or the British Empire, Germany focused on developing its human capital. It established a superb education system, embedded engineering in its university education instead of leaving it to tinkerers as in Britain, and instituted a system of vocational training that remains the envy of the world.

The Mittelstand, the small and medium-sized industries that drive the German economy, emerged during this Bismarckian era. They benefited from favorable policies of the Iron Chancellor who funneled money not only into the Mittelstand, but also into heavy industry such as steel, railways and chemicals. Unlike his Anglo-Saxon counterparts, Bismarck instituted accident and old-age insurance and created the world’s first and most comprehensive welfare state. Historical evidence suggests that the German economic miracle was a result of intentional industrial policy, much like the East Asian one a few decades later.

Back to the Future Again

In 2016, this author observed that world trade was slowing down as anti-trade sentiments were rising in Europe and the US. For years, American business leaders and politicians argued that trade was a win-win. That was not entirely true. Trade resulted, results and will always result in winners and losers. CEOs and shareholders benefited from moving factories overseas, but workers in the US suffered. Many of these workers voted for Donald Trump.

Trump’s election as president marks the end of the postwar American consensus on trade. It certainly marks the end of the frenzied era of trade liberalization after the fall of the Berlin Wall in 1989. The US was protectionist for more than a century and a half since its independence. It only turned to free trade after World War II when it had an unprecedented edge over the rest of the globe. Now that Americans are suffering from the ravages of free trade, protectionism is back in fashion. There is no reason to assume that it will die after Trump.Embed from Getty Images

If protectionism is back in fashion, it follows that American demand for imports is not likely to increase as rapidly as it has in the past. So far, this demand has powered the industrialization of East Asia. In particular, it has enabled Chinese factories to become the workshop of the world. There is more than an element of truth in the claim that Walmart fueled the rise of Shenzhen. Under Trump, the US is no longer willing to fuel China’s rise, and even Thomas Friedman, a lifelong Democrat, is acting as a cheerleader. He has argued in the anti-Trump The New York Times that China deserves Trump.

Friedman has a problem with Chinese President Xi Jinping’s “Made in China 2025” modernization plan that aims to make companies in the Middle Kingdom “the world leaders in supercomputing, Artificial intelligence, new materials, 3-D printing, facial-recognition software, robotics, electric cars, autonomous vehicles, 5G wireless and advanced microchips.” Sadly for China, “all these new industries compete directly with America’s best companies.” Therefore, the US cannot allow the Middle Kingdom to “continue operating by the same formula” that propelled its rise.

As a patron saint of the American establishment, Friedman uses the “trade is a win-win” trope, but the condition for it is simple. China must let Google and Amazon compete freely and fairly with Alibaba and Tencent. However, Friedman laments that China cheats. Its diabolical military stole the plans for Lockheed Martin’s F-35 stealth fighter, avoiding all the R&D costs. Huawei’s 5G equipment can serve as an espionage platform. To top it all, China is militarizing islands in the South China Sea to push the US out. The great defender of democracy cannot countenance such impudence and ipso facto cannot continue to import wantonly from China.

In this brave new world, it is “America First” yet again. Trump has declared economic war not only on China, but also on neighbors like Mexico and Canada as well as allies like Japan and South Korea. On the demand-side, this new American protectionism marks the death knell of the export-oriented growth model that many trumpet.

As if changes on the demand-side were not enough, a quiet transformation is occurring on the supply-side. In a previous article, this author chronicled how smart manufacturing using new materials, additive manufacturing, a combination of hardware with software and the Internet of Things is leading to the Fourth Industrial Revolution. This is bringing back manufacturing to the US and even to Europe. No longer does Asia have the cost advantage. The labor arbitrage is ending and industrial production is returning to the West. It goes without saying the export-led model is now as dead as a dodo.

In the light of the new zeitgeist, what economic policy should developing countries follow? It seems industrialization with a focus on domestic markets is the only sensible option. Instead, many of them have gone into what Rodrik calls “premature de-industrialization.” In advanced economies such as the UK, Sweden and Japan, manufacturing reached a peak of about 30% of GDP in the 1960s and 1970s before giving way to services. In countries like Ghana, India and Brazil, manufacturing never reached the same level as in the advanced economies and services have taken over. This means they have de-industrialized prematurely and missed out on the productivity gains through manufacturing that richer countries achieved.

To bring prosperity to their people, developing countries need to industrialize and, at times, reindustrialize. To do so, they need to foster good macroeconomic fundamentals through reasonably stable fiscal and monetary policies as well as business-friendly policy regimes. More importantly, they must invest in human capital in the form of better schools, universities and, most crucially, vocational training. Good electricians, decent plumbers and competent mechanics enable a country to meet its tryst with prosperity.

Apart from getting macroeconomic fundamentals right, developing countries need sensible industrial policies that support manufacturing through both orthodox and unorthodox measures. Such measures require judgment, which in turn depends on the quality of a country’s politics, its governance standards and the visions of its leadership. Those countries that are dysfunctional, divided and dishonest are unlikely to do well. They might well become de facto colonies of old and new industrial powers.

Since domestic instead of global trends now drive growth, developing countries are likely to show significant heterogeneity in long-term performance. Therefore, they have absolutely no option but to get their industrial policies right.

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