I decided to see for myself what the fuss was about, and I must say I have rarely had my economic preconceptions so thoroughly tested. This book challenges a lot of free market notions I had taken for granted, and as this interview progresses, I will try to tease out some of those ideas with Studwell. For now, here’s my opening scene-setter question and Joe Studwell’s answer.
JS: The distinction I make is between the ‘economics of learning’ and ‘the economics of efficiency’. Poor countries lack technological capacity and have low quality human capital. This is why they need to target investible funds at a learning process and such a learning process requires nurturing and protection as well as competition.
It was ever thus. Anyone who disagrees is simply historically ignorant. The history of British, American, German, and indeed Australian development is the history of government policies that nurtured globally competitive firms, whether those policies were Britain’s Navigation Acts, the average 40% tariff applied in the US in the 19th century, German export subsidies of the late 19th and early 20th centuries, or Australia’s own long history of tariff protection and industry subsidy.
Those ‘infant industry’ policies allow learning to take place and produce more competitive firms, especially when subsidy is predicated on exports, or what I call ‘export discipline’, as has very much been the case in the fastest growth stories in Japan, ROK, Taiwan and now China. The capacity to export into the global market tells governments of development countries if they are getting an acceptable return on their subsidies to domestic firms.
However, the economics of learning only get you so far. There comes a point when an economy is close to the global technological frontier and it is much harder, if not impossible, to run cost-effective industrial policy. It is then necessary to enter the world of Adam Smith or (to put things in Australian terms) Colin Clark. It is no surprise that Smith produced his ideas in the late 18th century, when Britain was close to global technological dominance but the British consumer was getting screwed every day by oligopolies and monopolies set up in the infant industry era. Britain needed to be more efficient, more focused on short-run profit, more fair to the consumer. And that was what gradually happened in the 19th century.
Colin Clark made similar points in Australia in the early 1960s and was fortunate that Labor Party politicians were receptive to his arguments about the need for deregulation so that Australia could continue to progress on its development path (I was going to say to the promised land of Kath and Kim, but I’ll leave that out).
Anyhow, the basic point is that it is a stages game, and there are different solutions for different stages of development. This, of course, is horribly problematic for modern economics because everything is supposed to fit in the same spreadsheet — there are no stages. And behind this problem is the other one that so many contemporary economists are really just (drug-less) hippies, whose every statement begins with ‘Imagine!’: ‘Imagine that there are large numbers of participants in every transaction, imagine that information is perfectly dispersed…Dude, you’d get a perfect price function. Pass the dooby!’
So I have a number of issues with the economics profession as it is presently constructed. But economics offers us powerful analytical tools and there are also some very smart, historically literate economists. In the book I quote Charles Kindleberger’s question about whether there really can be only one kind of economics. My answer, as stated above, is that, at a minimum, there is an economics of development and an economics of efficiency and what we really need to understand is where and how they meet in the middle. (But please don’t ask for the answer to this question because I don’t know and it is the subject of my next book.)
Below is the second part of my exchange with Joe Studwell, whose book, as I said in the intro to part 1, has tested some assumptions about economic development I’ve been carrying around with me for a long time.
SR: Asia is home to some of the great cautionary tales of industry policy: Malaysia’s national car brand, Proton, and Indonesia’s aircraft manufacturer IPTN come to mind. So what is it that distinguishes those failed efforts from success stories such as Hyundai?
And how do you get around the argument that, even where state-backed companies succeed in the long term, they still represent a misallocation of resources and an attempt to pick winners? Why wouldn’t these governments have been better off creating favourable tax and regulatory conditions for industry to flourish, rather than backing specific industries themselves?
JS: This is a number of different questions.
First, what makes industrial policy cost-effective? The answer to this in east Asia has been what I term ‘export discipline’, or the conditioning of subsidy (in all its myriad forms) on a significant level of exports at the firm level. In essence, export discipline solves an information problem. If you give subsidy to entrepreneurs they are amazingly good at taking the money and pretending to do what you want in terms of developing globally competitive firms that carry an economy forward, but not actually doing so.
Most obviously they tend to concentrate on services, which employ and ‘upgrade’ relatively few people, avoid adding value through manufacturing by importing components of manufactured goods or even finished manufactured goods, and they tend to limit the competition they face by sticking to the domestic market. They then take the cash flows from subsidised domestic activity and invest it on a portfolio basis in more advanced and competitive economies.
This is the story of what my last book dubbed ‘godfathers’ — the oligarchs who dominate economies from south-east Asia, to Russia, to Latin America (KS Li, Ambramovich, Carlos Slim, if you want three examples). In essence these entrepreneurs outplay the state in its efforts to foster economic development based on technological learning and broad-based improvement of human capital.
When you have export discipline, the game changes. First, export discipline is almost inevitably bound up with a focus on manufacturing because manufactures are way more freely traded in the world than services (services are only 19% of world trade and have been stuck at that level for a quarter century). So entrepreneurs manufacture because manufactures are readily exportable.
Then comes the information bit. The capacity to export tells the state whether firms it subsidises and otherwise supports are globally competitive. Domestic financial institutions benefit from the same information feedback. Of course you can sell at a loss for a while, but not long if you have to export, say, 30% of your output, because it will bankrupt your firm. As a result, the capacity of the entrepreneur to deceive the state is undermined. He or she faces the horrible reality that in order to feed their insatiable desire for wealth and recognition (those ‘animal spirits’) they have to knuckle down, actually make stuff, and sell it in the viciously competitive world market.
Hyundai is a good example because founder Chung Ju Yung was himself a godfather, bribing his way to construction contracts under Syngman Rhee in the 1950s. Then came Park Chung Hee’s coup in May 1961. Park brought in so much export discipline that firms had to file their export returns to the government on a monthly basis. Suddenly Chung became a big fan of manufacturing for export and had to get rich that way.
In Southeast Asia, industrialisation programs like Proton and IPTN did not face export discipline. As a result the state’s return on industrial policy was very poor. Was it zero, however? I think not. There has been some industrial learning in Malaysia and, to a lesser extent, in Indonesia. So I doubt they would have been better off without Mahathir or Habibie, the main people who drove those programs. However, the performance was lousy by the standards of Japan, ROK, Taiwan and China and I talk in a lot more detail in the book about exactly why. After the Asian financial crisis, when the IMF went in to Indonesia and dismantled/emasculated its industrialisation strategy, it made things worse. If you look at IPTN, on which the Indonesians spent billions training engineers, designers and so on, many of the key people went off in the late 90s and 2000s to work in places like the US or Germany. Indonesia’s learning-oriented subsidy ended up going to the world’s richest nations (that’s why we have black humour).
On the inevitability of misallocation of resources in industrial policy, the answer is ‘yes’. There is a lot of waste in industrial policy. But the waste is at an acceptable level when you are far behind the technological frontier because you can see where you need to go. Steel, chemicals, plastics, construction materials, etc — you have to learn to make this stuff just like everybody before you. You have to fill your society with tacit, value-adding knowledge. Critically, manufacturing is the way to learn because people learn on the job, in factories, generating the capital to pay for their education. It is affordable in the way that more schooling for everybody would not be because school is just a sunk cost until you leave and get a job. (Indians — don’t get me started — only think about learning through investment in formal education and have no real manufacturing strategy, which is why they are relatively so much poorer than the Chinese.)
On ‘picking winners’, this is a term of abuse coined by neo-liberal economists in Europe in the 1970s (I have never managed to identify first use of the term) when they were beginning to criticise the industrial policies that made a country like Italy grow 5-6% for a quarter century after World War II. It is a term of abuse because, as far as I can see, successful industrial policy has never been about picking winners. It is about culling losers, which is very different. Culling losers means cutting off state support to subsidised firms that are failing to make the grade, judged by profit & loss and export performance. There is a period of culling losers going on in China right now, so you can watch live!
On ‘favourable tax and regulatory environments’, development requires these, but the objective remains that of learning, as I have said, not efficiency expressed in terms of short-run returns. That comes later. I think that perhaps the answer you want to this question is the following statement: if you can show me a country, other than anomalous offshore financial centres/trading entrepots, which has developed to the first rank through policies of free trade from the get-go, then tell me which country it is. (Certainly not yours or mine…)
Reading through the first part of this answer, I realise that I simplified and exaggerated considerably to make a point. Perhaps too much so. But people need to read the book!
Can we talk about the rugby now?
Below is the third part of my exchange with Joe Studwell, author of How Asia Works. Here’s part 1and part 2.
SR: In your previous answer you took a swipe at the IMF for its behaviour towards Indonesia during the currency crisis, so I wonder if you could say some more about the role of international institutions.
I notice that Michael Pettis, in his Amazon review of your book, says the merits of industry policy are so obvious as to be not worth debating. The fact it is debated ‘suggests to me how unreal academic economics has become and how divorced from historical understanding.’
But it’s not just academic economics, clearly. It’s also the policy advisers in the IMF and World Bank (and perhaps even the NGOs?) who push a pure free market line. How do you account for the fact that these institutions seemingly continue to ignore the evidence of successful industry policy? And how have Asian governments dealt with advice from the IMF, World Bank and others? Do they just ignore it?
JS: The story of the international institutions is a complex one, so I’d like to try to reflect that complexity. I would also like to say that I am not an expert in the history of these institutions and mostly know them from the work I have seen them doing in east Asia.
The first point is to consider the origins of the IMF, the institution that is best known for going in to countries after financial crises occur and agreeing (forcing?) and overseeing reform ‘programs’. The IMF was created at the end of the Second World War and gained its early crisis experience in the 1970s in already quite mature western European countries after the Bretton Woods fixed exchange rate regime broke down. The IMF played an important role cajoling countries that had employed what I earlier called the ‘economics of development’ or ‘economics of learning’ in order to get back on their feet after the Second World War towards what I called the ‘economics of efficiency’.
In other words, the institution moved countries along from one kind of economics to the next (at least in my conceptualisation). For the most part this involved deregulation, the imposition of freer markets and the gradual removal of currency controls (the latter not in the UK, for instance, until the advent of Margaret Thatcher as prime minister in 1979).
In the 1980s the IMF then took its medicine to Latin America with the onset of the Latin American debt crisis. As far as I can see (again, I am not an expert), Latin America had messed up its development policy in two main ways. First, land reforms were absent or ineffective (because of lousy execution). This left a very skewed income distribution in place, failed to give landless farmers any capital (in the form of land) with which to play the capitalist game, and did not maximise yields.
During the post-war industrialisation drives in countries like Brazil, agricultural exports either flatlined or fell, or imports increased, exacerbating the balance of payments stresses that occur in the early stages of industrialisation when countries always run trade deficits (because of the need to import producers’ goods — typically, machines to make stuff with). The second policy cock-up was the shortfall of ‘export discipline’ to ensure adequate returns on subsidy and protection to manufacturers.
The wrong agriculture policy and the failure to export enough manufactures created balance of payments pressures and a capital shortfall that were filled with foreign loans. When dollar interest rates rose under the Reagan Administration, the loans could not be serviced, and governments resorted to printing money (just like in the Philippines under Marcos, which was east Asia’s Latin American state).
In this respect, the deflationary macro policies the IMF brought in were necessary and stabilised the situation. However, the IMF also dismantled industrial policy and has never, as far as I can see, understood anything about agriculture. The upshot was that the IMF undermined Latin America’s ability to develop quickly and sustainably. But then one can say that the Latin Americans had already done that for themselves by borrowing lots of money and investing it unwisely.
I make the point in How Asia Works that, scaled for GDP, the Koreans borrowed more money overseas than any Latin American country, but it didn’t matter because they had export discipline which meant they were creating lots of globally competitive manufacturing firms. Latin America seems to have produced one: Embraer.
Anyhow, we can say the IMF did well in western Europe, and then did well-ish (at best) in Latin America. Next it came to east Asia after the Asian financial crisis. Here, for me, it really made a terrible mess of southeast Asia by imposing Anglo-Saxon financial systems in Thailand and Indonesia after the crisis, having already done the same thing in the Philippines following the fall of Marcos in 1986. Industrial policy has been almost completely undermined and the banking systems now focus loans on consumers (making very tidy profits, just like in post-crisis Latin America). But the banks do not support sensible developmental policies that make national economies more value-adding. It should be no surprise that southeast Asia has had east Asia’s best performing stock markets since the Asian crisis while, in terms of the real economy, a country like the Philippines is on the brink of a return to the Third World. The only positive thing the IMF has done in southeast Asia is to make the place work for hedge fund managers. In fact I often think the IMF should become a hedge fund.
In defence of the IMF, I would point out two things. In southeast Asia, Malaysia did much of what the other major economies did, but without an IMF intervention; it just copied them anyway. With that kind of lack of political leadership, a country is in a lot of trouble anyway. And second, the IMF intervention in South Korea, which got caught up in the crisis, was much better timed, at least in my view.
South Korea was already a US$10,000 GDP per capita country when the crisis hit and the IMF forced sales of equity in the financial system to foreigners, required major changes to company law, and oversaw other adjustments in favour of consumers and minority shareholders. Contrary to Ha Joon Chang (whom I admire enormously), I think these interventions were well-timed. Of course the good timing was totally by chance because the IMF does not believe in timing, if you get what I mean! South Korea, in short, was ready for the economics of efficiency.
So that’s the IMF. The World Bank, by contrast, was set up specifically to support economic development at the micro level, and should be judged on this basis. Its real name is the International Bank for Reconstruction and Development.
My own observation over the years has been that the World Bank has some fantastic people, but that the institution is only as good as the use governments make of it. This means knowing what you want and getting World Bank specialists to work within some kind of brief that is defined by the developing state. If you just ask the World Bank (or the IMF) what to do, the ideologues in these institutions will their list of currently fashionable options, almost all of which have been between useless and disastrous for the past 40 or more years.
Classic examples include ‘privatise your banks’, ‘develop your stock markets’, and ‘concentrate financial intervention on micro-finance’. Note that each one is a financial liberalisation policy, reflecting exactly what has been fashionable (often rightly so) in rich countries and is deemed to be good for poor ones too. We may be about to get a new fashion menu based more around ‘institutions’. Again my expectation is that in timing terms the advice will be out of kilter. The institutional stuff becomes critical after the basic structural stuff that I talk about in How Asia Works. However now we are getting on to the subject of my next book again…
Successful developing countries have ignored the fashion menu(s) and instead have asked the World Bank’s technical people to support a proper development strategy. This is what China did in the 1980s when it had the World Bank, for instance, bring over Korean government people to explain what they had done and produce a bunch of comparative historical development studies. The process is described from different perspectives in Ezra Vogel’s biography of Deng Xiaoping, and in Harold Jacobson and Michael Oksenberg’s China’s Participation in the IMF, the World Bank, and the GATT, and, in Chinese, in Wu Jinglian et al (eds), Chinese Economists 50 Forum Looking at Thirty Years: Retrospective and Analysis (中国经济50人看三十年：回顾与分析).
Other developing countries would do well to study the manner in which China, the ROK and Japan have handled the IMF and the World Bank and gotten value from them. It is basically about avoiding the ideologues and making use of the technical people. You don’t want people like the World Bank guy in Jakarta who, shortly before the fall of Suharto, held a press conference lauding a successful telecoms ‘privatisation’ that had actually just been handed to one of Suharto’s daughters. You do want the ones like Edwin Lim, the Filipino Chinese who led the early World Bank mission in China.
Your last question is the one about why the bad advice continues to flow. I think it mainly comes down to ignorance, although just the other day someone was saying that they once asked a USTR guy in a bar to name one instance in which policies of free trade from the get-go had led to a positive developmental outcome, and the person just got up and left.
So maybe there is some pre-meditated desire to screw poor countries. Friedrich List claimed that one British prime minister used to keep a copy of The Wealth of Nations in his pocket and quote it to French leaders at every meeting in a cynical attempt to have them accept their (then very backward) division of labour in grain and wine production and leave manufacturing and services up to Britain.