Dismantling the Washington Consensus

Indeed, the report has picked up on a lot of the ideas put forward by Dani Rodrik in his book One Economics, Many Recipes. Like Rodrik, the Commission stresses that there is no ‘one size fits all’ set of development policies that can be applied indiscriminately across countries. While the report does emphasize some basic principles for sound economic management, it also stresses experimentation and adaptation to local conditions, and explicitly focuses on removing the constraints on growth, an approach pioneered by Rodrik, Ricardo Hausmann and Andres Velasco in their  2005 paper Growth Diagnostics.

More significantly (and controversially) the Commission’s report accepts that industrial policies can play an important role in economic development by transforming the capabilities of domestic economies, boosting exports, and diversifying the economic base.

Perhaps Larry Summers was the canary in the coal mine after all. It is high time that policy makers and economists moved on from the debates of the 1980’s, when the Washington Consensus was (at least in part) a response to the failed import substitution policies that failed to generate growth and development and stifled market incentives and the diffusion of knowledge. Stabilizing, privatizing and liberalizing made some sense in the context of rebuilding planned Communist economies and reigniting growth after the stagflation of the 1970’s, but the pendulum swung too far in the direction of free markets and small governments. Too little attention was paid to the development of institutions upon which all markets depend, and the role of good, competent governments.

Now, at last, the tide seems to be turning. There is simply too much accumulated evidence, as the Commission’s report shows, that the successful high-growth economies of recent decades combined market incentives with strategic government intervention to spur high savings and investment rates, export promotion and the acquisition of modern skills and technologies.

The money quote from the report’s take on industrial policy follows, but you can download the report from the Commission’s website and read the whole thing:

All of the sustained, high-growth cases prospered by serving global markets. The crucial role of exports in their success is not much disputed. But the role of export promotion is. Many of them tried a variety of policies to encourage investment in the export sectors in the early stages of their development, and several of these measures would qualify as industrial policies. They tried to promote specific industries or sectors through tax breaks, direct subsidies, import tariff exemptions, cheap credit, dedicated infrastructure, or the bundling of all of these in export zones.

Nonetheless, the significance of these policies is hard to prove. Even though most of the high-growth successful economies tried industrial policies, so did a lot of failures. Nor do we know the counterfactual: whether the high-growth cases would have succeeded even without targeted incentives. All sides of this debate were reflected in the Commission’s workshop on industrial policies, and in its own deliberations. The cut-and-thrust of the argument usefully clarified some of the virtues and risks of export promotion.

Some in the broader debate argue that industrial policies are not necessary. The private sector, in pursuit of profit, will discover where a country’s comparative advantage lies and invest accordingly. Others argue that markets fall short in certain respects. Outside industrial investors (entering via FDI) may not know how to do business in a new location, for example. Those that enter first, regardless of whether they are successful, provide a benefit to other potential entrants. Their rivals and successors will learn from their experiment, without having borne the costs or risks. This can lead to a suboptimal level of experimentation, unless the government steps in to encourage it.

To take another example, in countries where large numbers of workers are underemployed in agriculture, the social return to factory employment may exceed the private return. It may be necessary to subsidize employment or investment outside agriculture to compensate for this gap. (This point is explained in greater detail in the section on labor markets.)

Some skeptics might concede that markets do not always work, but they argue that industrial policies don’t either. This is either because governments do not know what they are doing—they lack the expertise to identify successful targets for investment, and will waste resources on plausible failures—or because they knowingly subvert the process to their own ends, dispensing favors to their industrial allies. There is, of course, considerable variation across countries in the competence of government and in the undue influence of special interests. But those who worry about government competence or capture would prefer to rule out promotional activities altogether. The risk of failure or subversion is too great, they say; better not to try.

But there are also risks to doing nothing. A flourishing export sector is a critical ingredient of high growth, especially in the early stages. If an economy is failing to diversify its exports and failing to generate productive jobs in new industries,  governments do look for ways to try to jump-start the process, and they should.