Article

Lessons from Economic Development

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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What have we learned about the path to successful development?

During the past 30 years, developing countries have roughly doubled their average incomes and achieved striking gains in health and education. A few have seen their living standards rise fivefold, a rate of progress that is extraordinary by historical standards. Several developing countries have managed to double average incomes in a much shorter time period than did the industrial countries in earlier periods of their development (see Chart 1).

Chart 1.Periods during which output per person doubled in selected countries

Source World Bank. World Development Report 1991.

At the same time, the picture in many parts of the developing world has been dismal. Despite the vast technological advances of the 20th century, about one quarter of all developing countries have witnessed an actual fall in living standards in the past 30 years. As a result, more than one billion people, one fifth of the world’s population, live on less than one dollar a day—a standard of living that Western Europe and the United States attained 200 years ago.

The sharp contrast between success and failure is the starting point of the World Development Report 1991. Why have country experiences been so different? The processes driving economic development are by no means fully understood. But, much can be

learned from the tremendously diverse record. Rapid industrialization, pushed by the heavy hand of government through discrimination against agriculture and infant-industry protection, was a favored strategy for many years. Today, there is clear evidence that such distortions impede development.

Instead, the most crucial determinants appear to be investments in human and physical capital, along with the strengthening of market competition. The Report concludes that countries must strive to create a market-friendly environment, in which governments allow markets to function well, while intervening efficiently when markets prove inadequate.

Paths to development

Throughout history, the pace of development has been influenced by factors beyond the control of individual countries. Over the past 30 years, the average growth of developing countries has tracked the average growth of industrial countries remarkably (see Chart 2). Yet, faced with similar external factors, individual countries have performed quite differently—in the past, some countries, for example, Nigeria and Mexico, even regressed after favorable price shocks. A study of 33 countries did not find a statistical association between differences in growth rates and the magnitude of external shocks, and an analysis of 40 countries suggested that improvements in domestic policies and institutions could be a more powerful source of better performance than improvements in external conditions.

Chart 2.The annual change In per capita GDP In OECD and developing countries, 1965-90

(In percent)

Source: World Bank data

What actions, then, will promote rapid economic development in the 1990s? On the external side, lower trade barriers, lower real interest rates, and larger capital flows will improve development prospects for all. But, how well individual countries do under better global conditions—or even despite poor ones—will depend crucially on domestic factors as elaborated below.

The World Development Report 1991 has been prepared by a team led by Vinod Thomas that included Surjit S. Bhalla, Rui Coutinho, Shahrokh Fardoust, Ann E. Harrison, Daniel Kaufmann, Elizabeth M. King, Kenneth K. Meyers, Peter A. Petri, T.N. Srinivasan, and N. Roberto Zagha. The International Economics Department prepared the data and projections. Clive Crook was the principal editor. Stanley Fischer played a principal role in the initial stages of the Report’s preparation. The work was carried out under the general direction of Lawrence H. Summers.

Copies are available from World Bank Publications, P.O. Box 7247-8619, Philadelphia, PA 19170-8619 USA, $16.95, in English, French, and Spanish.

Domestic sources of growth

In more than 60 developing countries examined, changes in the use of capital and labor made a large contribution to changes in output. But, more significantly, differences in growth performance arose less from differences in the growth of capital than from growth in total factor productivity. Countries that have registered the highest growth rates—namely, the economies of East Asia— were the ones with the highest productivity growth. In countries where growth has stagnated, there has been little improvement in productivity.

But, what drives productivity? The answer is technological progress, which in turn is affected by history, culture, education, institutions, and policies. Technology is diffused and assimilated through investments in physical and human capital and through trade. Preliminary analysis links the growth in productivity and output to education and economic policy. The levels of schooling of the labor force significantly contribute to increases in productivity and output. A better policy environment also triggers higher productivity and output.

The evidence goes further. In addition to the individual effects of education and policy on productivity and growth, there seems to be an interactive effect when they are combined (see Chart 2). Such an interaction appears even stronger when considering productivity, rather than output. These results do not show causation, but they suggest the benefits of investing in education and improving the policy climate simultaneously.

A detailed study of the World Bank’s investment projects confirms the importance of policies in raising the efficiency of investments. The rate of return to public and private sector projects implemented under policies that do little to distort prices is consistently higher than under policies that result in more distortions. A substantial improvement in policy is associated with a 5-10 percentage-point increase in the rate of return for projects, or a 50-100 percent increase in the average return.

Market-friendly approach

In creating the best environment for changes in productivity to take place, governments must look carefully at how the state and markets interact. The four critical areas—human resources, the domestic economy, the international economy, and macroeconomic policy—are interrelated, and because of such links, if handled properly, promise to render disproportionate benefits. For example, a relatively undistorted domestic economy rewards those who build up their human capital more generously than does a distorted one, and microeconomic efficiency makes it easier to keep inflation low.

Chart 3.Policy distortion, education, and growth for 60 developing economies, 1965-87

Sources: International Currency Analysis, Inc., various years, World Bank data.

Note. High distortion reflects a foreign exchange premium of more than 30 percent; low distortion, a premium of 30 percent or less. Education is measured by the average years all schooling, excluding postsecondary schooling of the population age fifteen to sixty-four. High education is defined here as more than 3,5 years; low education. 3.5 years or less

Investment in people. Improving people’s education and health is key to economic performance, and therefore, to development. Increasing the quantity and quality of investments in people thus rightly forms a central part of the development agenda. But markets in developing countries cannot be relied upon to provide people—especially the poor—with adequate education, health care, nutrition, and family planning.

Many governments are investing far too little in human development with predictable results; in Brazil and Pakistan rapid growth alone was insufficient to improve the social indicators, such as life expectancy, literacy, and infant mortality. In Chile and Jamaica, however, investments in people improved these indicators, even in periods of slow growth. These varying country experiences show that different levels of investments in human resource development and their quality have strongly contributed to these differences (see accompanying article by Elizabeth King).

Competitive microeconomy. Domestic and external competition has very often spurred innovation, the diffusion of technology, and an efficient use of resources. Japan, the Republic of Korea, Singapore, the United States, and Europe’s most successful economies have all established global competitive advantage through the rigors of competition. Conversely, in much of the developing world, systems of industrial licensing, restrictions on entry and exit, inappropriate legal codes concerning bankruptcy and employment, inadequate property rights, and price controls have all weakened the forces of competition and held back technological change and the growth of productivity.

An efficient domestic economy also requires public goods of correspondingly high quality. These include, most fundamentally, a regulatory framework to ensure competition, and legal and property rights that are both clearly defined and conscientiously protected. In addition, investment in infrastructure, such as irrigation and roads, which provide high returns, is essential.

Global links. When international flows of goods, services, capital, labor, and technology have expanded quickly, the pace of economic advance has been rapid. Openness to trade, investment, and ideas has been critical in encouraging domestic producers to cut costs by introducing new technologies and to develop new and better products. The positive effect of import competition on firms in, for instance, Chile, Mexico, and Turkey, and greater competition in export markets on firms in Brazil, Japan, and the Republic of Korea confirm the decisive contribution to efficiency that the external economy can make. Removing barriers to international trade means that a country’s own population is not a constraint to achieving economies of scale. Singapore, with a population of about 2.7 million, exports about $35 billion worth of manufactured goods annually—nearly twice as much as does Brazil with a population of about 147 million, or three times as much as Mexico with a population of about 85 million.

The international flow of technology has taken many forms: foreign investment; foreign education; technical assistance; the licensing of patented processes; the transmission of knowledge through labor flows and exposure to foreign goods markets; and technology embodied in imports of capital, equipment, and intermediate inputs. Policies to promote these flows include greater openness to investment and to trade in goods and services, as well as appropriate education and on-the-job training. Nontariff barriers, which are especially distorting, need to be phased out, and tariffs reduced, often substantially.

For policymakers everywhere: seven lessons in reform Successes provide the “dos,” failures, the “don’ts.”

Lack of ownership undercuts the programs. For success, a program needs to be viewed as a country’s own, and nationals need to participate in its design and development.

Flip-flops in reform hurt credibility. Flexibility is important, yet bold, seemingly irreversible steps by the government build confidence, especially in countries with a record of policy reversals.

Institutional demands must not be glossed over. Policymakers should emphasize the need for developing institutional capacity from the outset, as institution building takes time.

Attention to macroeconomic instability is fundamental. In very unstable and inflationary settings, up front and substantial reduction of the fiscal deficit is paramount.

Vulnerable people must not be forgotten. Special programs of assistance to the poor must be put in place, and programs to compensate and retrain discharged civil servants are often needed when the public sector retrenches.

Partial attempts often fail. There is a premium on simultaneously taking complementary actions, such as external liberalization and domestic deregulation.

It pays to be realistic. Policymakers and external agencies need to be realistic in preparing the financing plan to support the reforms. It also pays not to promise too much too soon, yet to be loud and clear about the importance of reforming.

Stable macroeconomy. A stable macro-economic foundation is one of the most important public goods that governments can provide. When government spending has expanded too far, the result has often been large deficits, excessive borrowing, or monetary expansion, and problems in the financial sector. These have been quickly followed by inflation, chronic overvaluation of the currency, and losses of export competitiveness. Excessive borrowing can also lead to domestic and external debt problems and the crowding out of private investment. Strengthening the confidence of the private sector is now a basic component of efforts to spur renewed growth and generate employment in several countries with previous experience of macroeconomic instability, including Argentina, Bolivia, Ghana, the Philippines, and Turkey.

A government can maintain a prudent fiscal policy by looking carefully at the division of economic tasks between the government and the private sector. That is desirable in any case. In reappraising their spending priorities, implementing tax reform, reforming the financial sector, privatizing state-owned enterprises, and using charges to recover the cost of some state-provided services, governments can meet the goals of microeconomic efficiency and macroeconomic stability at the same time.

Rethinking the state

The experience in fostering investments and better policies suggests how governments and markets can interact most productively as well as avoid costly conflicts. Put simply, governments need to do less in those areas where markets work, or can be made to work, reasonably well. Governments need to let domestic and international competition flourish. At the same time, governments need to do more in areas where markets cannot be relied upon. Above all, this means investing in people, building social and physical infrastructure, and protecting the environment. It also requires a strengthening of political and economic institutions and more efficient policies for income redistribution and growth.

It has often been argued that a democratic polity makes economic development more difficult to achieve. Reform almost always comes at the expense of certain vested interests, and macroeconomic stabilization usually means at least a temporary rise in unemployment: the claim has been that only authoritarian governments can make such hard choices. This is patently false. Evidence from large samples of countries offers no support at all for the view that individual freedoms hold growth back. Neither does it endorse the notion that authoritarian governments, on average, show greater promise for achieving rapid growth. Looking beyond growth to the other elements of economic development, the lesson of experience is clear: political freedoms, and civil liberties—such as a free press and the free flow of information—seem to be associated with progress in health and education in large groups of countries.

Clearly, economic policies are not chosen in a vacuum. All but the most repressive governments need to retain a measure of popular support for their actions. Often this support has been bought with an assortment of damaging policy interventions (such as high tariffs, currency overvaluation, and industrial licensing), as well as corruption and wasteful public spending. One of the most questionable categories of public spending is that on the military. In many countries it is well in excess of the combined public expenditures on education and health.

Governments sometimes intervene in the market to address political instability and other political constraints. But the result is that all too often, the combination of pervasive distortions and predatory states leads to development disasters. A vicious circle of harmful interventions entrenches special interests. Reversing this process requires political will and a political commitment to development.

Institutional development also assists in political and economic progress. The establishment of a well-functioning legal system and judiciary, and of secure property rights, is essential. Reform of the public sector is a priority in many countries. That includes civil service reform, rationalizing public expenditures, reforming state-owned enterprises, and privatization. Related economic reforms include better delivery of public goods, supervision of banks, and legislation for financial development. Strengthening these institutions will increase the quality of governance and the capacity of the state to implement development policy and enable society to establish checks and balances.

Experience also suggests that a relatively equitable distribution of income and assets broadens the base of political support for difficult changes. But caution is needed. Redistribution through distorting prices (such as subsidized credit) can be damaging, and the benefits often go to the less needy. Many of the policies recommended in the Report are expected to tilt the distribution of income in favor of the poor.

Finally, economic reform itself is an essential means for strengthening market and state institutions and achieving development. What are the lessons on the nature of economic reform (see box)? Swift reforms help to neutralize the resistance of interest groups opposed to change; at the same time, more gradual reforms may allow time to address their concerns. Countries such as Chile, Ghana, Indonesia, the Republic of Korea, and Mexico show that packages of comprehensive reform, with at least some bold changes made at the start of the program, are more likely to succeed, whereas the social cost of not reforming rapidly can be very great, as Argentina, Cote d’lvoire, Peru, countries in Eastern Europe, and others discovered in the 1980s. There is no single formula for success, but swift and comprehensive reforms—with strong, accompanying measures to reduce poverty and protect the environment directly—will usually be the right way forward.

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