Economic Growth and Economic Policy

Mohsin Khan, Morris Goldstein, and Vittorio Corbo
Published Date:
September 1987
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Stanley Fischer

Economic growth has been high on the agenda of developing countries for at least four decades, and on the agenda of economics for centuries. The variety of theories of growth attests to the absence of a simple assured route to success. The variety of experiences of growth both offers a potentially fertile field for empirical generalizations and suggests the need for growth strategies that adjust to the structures of individual economies.

The growth performance of 68 developing economies in Africa, Asia, and Latin America in the last two decades is summarized in Table 1.1 The striking fact is the disparity of performance between Asia and the other two continents.2 Not only is the mean growth rate in Asia highest in each period; in addition there is only a small decline in the mean growth rate between decades, and in neither period is there a significant number of countries with negative per capita gross domestic product (GDP) growth in Asia. The difficulties of the period 1973-84 for Africa and Latin America are clearly visible in the fact that 40 percent of the countries in both groups had negative growth of per capita GDP from 1973 to 1984. Growth rates of per capita GDP in the two periods were positively correlated within each group, highest for Asia and lowest for Africa.3 The implication is that success was more permanent in Asia than in Africa.

Table 1.Growth of Per Capita GDP, 1965-841(In annual percent)
Africa2Asia3Latin America4
1965-731973-841965-73 1973-841965-73 1973-84
Percentage of countries with growth rates:
Below -2 percent62100025
-2 to 092177015
0 to 2422713134540
2 to 4241827272515
4 to 6992740255
Above 6 percent93271350
Source: World Bank, World Development Report 1986.

Table 1 demonstrates not only the differences among groups, but also a range of experiences within each group. Some of the differences are directly traceable to oil or to other special circumstances, but they reinforce the point that growth strategies and models of adjustment will have to be tailored to fit individual countries.

The purpose of this paper is to review facts and theories of long-run growth, development strategies, and the adjustment and growth problems facing many developing countries. I conclude with lessons of policy in developing countries.

Long-Run Growth

Growth rates in the industrial economies over long periods are modest by comparison with the recent Asian experience. Angus Maddison (1982) estimates growth rates of per capita GDP since 1700 of 1 percent a year or less for France, the Netherlands (the world leader in 1700), and the United Kingdom. Performance for ten industrial economies since 1870 is summarized in Table 2. Japan’s 2.7 percent is the most rapid rate of growth of per capita GDP in that period; no country shows aggregate growth in excess of 4 percent.

Kuznets (1959), summarizing his fundamental research by describing “modern economic growth as the adoption of the industrial system” (p. 110), develops the implications—that modern growth requires minimum levels of skill and literacy on the part of the population, a shift from personal or family organizations to larger scale units, the creation of transportation and communication infrastructure before the division of labor within the country can become a reality, and that growth is accompanied by urbanization as the labor force shifts away from agriculture, changes in demographics, and changes in social values. He emphasizes too the disparities among national growth processes: “the observable cases of modern economic growth are best viewed as combinations of the industrial system (including its minimum social concomitants) with the distinctive initial structure of each country” (p. 113). Theory has the task, though, of developing principles or classifications that make it possible to describe the growth process more generally than to treat each national experience as an historical accident.

Table 2.Growth of Per Capita GDP, 1870-1985(In annual percent)
CountryGDP Per CapitaAggregate GDP
Germany, Fed, Rep. of2.02.4
United Kingdom1.31.8
United States1.83.5
Source:Maddison (1982), updated from International Monetary Fund, International Financial Statistics, various issues.

Descriptions of the growth process in the industrial economies stress industrialization, or in Maddison’s (1982, p. 17) more encompassing term, the scientific-technical revolution. Growth proceeds as labor shifts from low-productivity agriculture to high-productivity manufacturing, and to services, but with productivity growth in agriculture often exceeding that in the rest of the economy. Chenery and Syrquin (1975) characterize the transition to development not only by a shift to manufacturing from primary production, but also at a later stage by an increase in the share of manufactured exports in GNP.

Modern analyses of growth are supply oriented, starting from the production function. In the neoclassical framework (Solow (1956, 1957), Denison (1974)) growth is accounted for by the accumulation of capital and labor, and by technical progress.4 Two important empirical results derived in this framework are the major role of technical progress in explaining the growth of per capita output, and the relatively small share of growth attributed to capital accumulation.

Denison’s calculations for the United States, presented in Table 3, show advances in knowledge accounting for more than half the growth of output per employee over the period 1929-82.5 Despite the importance of technical change, its sources and the role of policy in promoting technical progress are difficult to quantify. Maddison (1982, Chapter 3) cites the “institutionalization of innovation” as a cause of both a more even pace of technical progress in modern economies and more rapid technical advance. He notes encouragingly that a productivity slowdown of the type seen since 1973 has occurred before, and that it is not necessarily permanent.6

Table 3.Sources of Growth of U.S. National Income, 1929-82(In percent)
TotalPer Person Employed
Growth rate2.91.5
Percent of growth attributed to:
Labor input except education3212
Education per worker1427
Advances in knowledge2855
Improved resource allocation816
Economies of scale918
Source:Denison (1985), p.30.

In international comparisons, productivity growth (roughly corresponding to Denison’s advances in knowledge) accounts for more than half of Southeast Asian growth, and relatively little of Latin American growth, for periods from 1955 to 1973. De Melo (1985) reports the results of studies of productivity growth in five Southeast Asian countries, five industrial market economies, and five Latin American countries. Productivity growth accounts for 46-64 percent of total growth in Southeast Asia, for 30-55 percent in the industrial market economies, and for 12-34 percent in Latin America. The capital stock increased more rapidly in Southeast Asia than in Latin America.

Growth of capital accounts in Table 2 for 20 percent of the U.S. growth rate, or 0.3 percent a year of growth, over the 1929-82 period. The resolution of the puzzle of the relatively small contribution of capital starts from the relationship between the rate of growth of capital per worker and the rate of growth of output per worker, which depends on the share of capital in total output. The relationship is that a 1 percent annual rate of growth of capital per worker adds a fraction of 1 percent, equal to the share of capital in output, to the growth of output per worker. In the United States over the period 1929-82 capital per worker increased at an annual rate of about 1.2 percent. The share of capital in output is about a quarter. One quarter of 1.2 percent is the 0.3 percent a year contribution of capital accumulation per worker to the growth of output per worker in Table 2.7

A slightly different perspective comes from consideration of the rate of return to capital, usually estimated in the range of 10-15 percent a year. Using for convenience an estimate of 12.5 percent, an increase in the share of investment in GNP by 1 percent raises the level of GNP by 0.125 percent, temporarily adding 0.125 percent to the growth rate. It would thus take a massive increase in net investment of 8 percent of GNP to raise the growth rate of GNP from the supply side by 1 percent within a period of three to four years. If productive projects can be found, investment programs of the pre-World War II Soviet type can contribute significantly to increasing the growth rate of potential output. But, within the constant returns neoclassical framework, an increase in the share of investment in GNP raises the level of GNP permanently but the growth rate only temporarily.

Kendrick (1980), Maddison (1982), and others have argued that the growth accounting framework of Denison significantly underestimates the role of capital in growth. Kendrick develops a more inclusive concept of capital that includes government capital,8 and intangible capital, including research and development, education and training, and health and safety. About half of GNP is investment by this definition. By Kendrick’s calculations, capital accounts for 70 percent of U.S. growth over the 1929-69 period.

Returning to the narrower definition, the role of capital in growth would be understated by Denison if it is the vehicle for the embodiment of new technology in production. Further, to the extent that technical progress is embodied in capital, an increase in the investment rate raises the level of output more than indicated in the preceding discussion9. Despite the plausibility of the embodiment hypothesis, it has been difficult to find decisive measures of the extent to which increases in productivity have been the result of new technologies embodied in new investment goods.10.

Table 4.Investment Share and the Growth Rate of GDP, 1965-841
Industrial market
EconomicsAfricaAsiaLatin America
Source: International Monetary Fund, International Financial Statistics, various issues.

The embodiment hypothesis would explain the positive cross-sectional relationship between the growth rate of GNP and the share of investment in GNP that is shown in Table 4. The relationship is particularly strong for the developed economies. Probably coincidentally, the coefficient on the investment share in the regression for the industrial market economies is close to standard estimates of the return to capital.

Denison attributes a slightly larger share of the growth of U.S. output per worker to increased education than to capital accumulation. The Denison calculations start from a labor input series in which weights were assigned to workers with differing levels of education.11. The weights are based on earnings by educational level, adjusting as far as possible for differences in ability correlated with education.

Estimates of the returns to education in the United States are similar to those for physical capital, with the possibility that social returns may be higher.12

Despite a long tradition emphasizing increasing returns to scale in the growth process, their role has been difficult to pin down. Denison emphasizes the potential unreliability of his own calculations. Paul Romer (1986) argues that certain features of the growth process, such as apparently secularly increasing rates of growth, are more consistent with increasing than constant returns. Romer uses a one-sector production function.

Another approach focuses on what are sometimes called economies of agglomeration, or synergy. The notion is that coordinated expansion of many industries is more likely to be self-sustaining than more gradual processes. Suggestive descriptions of the early industrialization process point in the same direction:

. . .change begat change. . . A cheap supply of coal proved a godsend to the iron industry, which was stifling for lack of fuel. In the meantime, the invention and diffusion of machinery in the textile manufacture and other industries created a new demand for energy, hence for coal and steam engines; and these engines, and the machines themselves, had a voracious appetite for iron, which called for further coal and power . . . (Landes (1969, pp. 2-3)).

Rostow’s (1960) takeoff into economic growth has a similar emphasis. It is quite likely that economies of scale of this type are more important at early stages of development than in a large developed economy. Economies of scale may thus be more significant in the growth process in smaller less-developed economies than in the United States. It is in this context that access to export markets can become a significant source of increased growth.13 The expansion of international trade is given an important role in promoting growth in the periods 1820-1913 and 1950-73 by Maddison (1982, Chapter 3), though the contribution cannot be quantified.

The neoclassical analysis of growth places little emphasis on the role of government policy. Within that supply-side framework, investment incentives and educational spending could each contribute to raising the level of output; so too can government spending on infrastructure.

The political economy hypothesis that small governments are best for growth receives at best mixed support from the data. Dervis and Petri (1987) show that the share of government spending in GNP is smaller than average for the most rapidly growing middle income countries. Ram (1986) in a cross-section of 110 countries finds a positive partial correlation between the growth rate of GNP and the growth rate of government spending. Less formally, important counterexamples to the view that small governments are best for growth abound: although Japan has relatively low government spending, government plays an active role in coordinating economic strategies and in protecting domestic markets. Government spending in Germany is high. Government intervention in another of Europe’s growth successes, France, has been pervasive. The raw correlation between the share of government in GNP and the growth rate for the industrial market economies is in fact slightly negative; in the developing countries it is weakly negative in Asia and Latin America and positive in Africa.

The role of demand factors in growth has received less quantitative attention, though steady and rapid expansion of markets is often informally cited as an important stimulant to growth. The econometric evidence for the United States implies that expanding demand is a more important factor explaining investment than the cost of capital (Clark (1979)). Expanding international markets likewise serve as an investment-stimulating source of demand.14 The relation between macroeconomic policy and expanding markets is, however, complicated. In the short run, monetary and fiscal expansion serve to increase demand and stimulate demand-led growth, but once the economy nears full employment, the task of demand management becomes more difficult and supply factors become dominant. However difficult the task of demand management at full employment, there is no doubt that restrictive aggregate demand policies retard growth.

Convergence Hypothesis

The modest long-term rates of growth of the industrial economies and lessons learned from that growth are not necessarily relevant to the developing economies. The prime reason is that those countries are far from the technological frontiers; technical progress could play a significant role in their future growth without any major technological breakthroughs taking place.15

The convergence hypothesis asserts that countries that lag behind will catch up to the high income countries. The notion is consistent with the neoclassical approach with constant returns to scale and access (perhaps only gradually) to the same technologies around the world. A quick look at the evidence is not supportive of the hypothesis. Except for Japan, most of the countries currently in the ranks of the industrial market economies have been among the high income countries for at least a century. To be sure, some (including Argentina and Uruguay) have dropped out of the top ranks, relative positions shift, and some of the countries listed as upper middle income have per capita incomes above those of the lowest industrial market economies.16 But the overall picture is not one of rapid change.

Baumol (1986) finds convergence within Maddison’s group of sixteen industrial economies.17 When the sample is extended to 72 countries for which Summers and Heston have provided GNP data and 1950-80 growth rates, there is no convergence except among the highest income countries and within the centrally planned economy group. Nor is there convergence within the three groups, Africa, Asia, and Latin America, over the period 1965-84: in all three cases the correlation between the growth rate of GDP per capita and the initial level of income is positive, though it is almost zero for Latin America.18

Rostow (1979) offers another version of the convergence hypothesis in which growth rates are low in the lowest income groups, then accelerate as income rises, and eventually decelerate. The argument is based on his well-known Stages of Economic Growth, and on empirical results by Chenery and Syrquin (1975), and with shorter-run data by Kristensen (1974).

At most, the convergence hypothesis could demonstrate a tendency to eventual catch-up by the developing countries. Even so catching up would take a very long time. The low-income countries would have to grow 3.9 percent per capita a year faster than the industrial market economies to catch up within a century.19 Such growth is certainly not to be expected. However, the evidence for the convergence hypothesis is weak. And, as the Argentinian and Uruguayan, and in the longer run, Spanish and U.K. examples show, getting to the top is no guarantee of staying there.

The most important lesson of the historical record is the power of compound interest. The extraordinary progress of the developed economies over the last century was brought about with growth rates that look modest to those used to the 1950-70 data. The implication is that small differences in growth rates—for instance those brought about by changes in the share of investment in GNP of 2-3 percent—can have important long-run impacts on living standards.

Small changes in growth rates matter a great deal in the long run, and generally policy is likely at best to make small changes in growth rates. Work on the stages of economic growth nonetheless holds out hope for developing countries. Several economies have experienced a period of very rapid growth, associated with industrialization or raw material booms. Since 1950, output has grown at rates near 10 percent for a decade or more in some Latin American, Middle Eastern, and Southeast Asian countries. Such growth rates cannot be sustained for very long, for countries at the frontier are unlikely to grow much more rapidly than their historical average rates in Table 1 over prolonged periods. But there is precedent for developing countries to move, for a time, rapidly toward the frontier.

Strategies of Development

The neoclassical supply-side analysis of growth does not emphasize the role of economic policy. Nor does it provide signposts to rapid development, except perhaps in cases of Soviet-style industrialization through massive capital accumulation.

Two basic approaches to growth policy can be detected. One, coming down from Adam Smith, is laissez-faire, seeing growth policy as consisting mainly of reducing governmental impediments to growth. The other is more technocratic, looking to government policy to direct economic development in particular directions.

In the absence of guidance from theory, strategies for growth developed in the post-World War II period have seized on particular aspects of the structures of developing economies or of the growth process as the keys to rapid growth.20 Aside from the laissez-faire strategy of relying on the market, development strategies have focused on the most obvious characteristic of growth spurts, industrialization. They differ according to the methods used to encourage the development of industry.

Import substitution was the first such strategy. Developed in the late 1940s and early 1950s, the analysis of the problem of the developing economies started from their international role as suppliers of raw materials and agricultural products. The terms of trade had and would turn against these goods. Industrialization would not only bring rapid productivity growth but also reduce vulnerability to the swings and trends of primary product prices. The strategy was to develop industry to replace manufactured imports and to reduce reliance on primary exports. It emphasized the development of the internal market rather than exports as the source of demand for the products of the new industries. Domestic industry could be protected by high tariffs, and domestic agriculture, where supply was thought to be inelastic, could be taxed.

Despite rapid growth in the 1950s and 1960s, particularly of industrial output, several Latin American countries ran into difficulties—in the form of external and sectoral imbalances and on the fiscal front, leading to inflation.

Fishlow (1985), reviewing Latin American experience, argues that import substitution paradoxically increased foreign exchange vulnerability. The anti-export bias of the policy reduced the growth rate of exports. Reductions in marginal imports made the remaining imports even more crucial; further, the increasing sophistication of domestic manufactures increased the demand for imported inputs. Increasing current account deficits in the late fifties were solved in part by direct foreign investment, which meant increased rather than reduced dependence on the outside world.21

Although the import substitution strategy was developed in the Latin American context, the development strategies followed in much of Africa and Asia were similar.22 The difficulties that resulted on all three continents are not an inevitable consequence of an industrialization strategy. Rather they result from the emphasis on import substitution at the expense of the development of the primary sector and of exports.

Balance of payments difficulties and inflation in Latin America produced several reactions pointing in different directions: that the import substitution strategy should be pursued on a larger scale through a Latin American free trade area; that increased official capital inflows could solve both the government budget and foreign exchange problems; and that structural reform reducing foreign dependence and increasing the role of the state was needed. The free trade area solution brings the hard-to-quantify benefit of expanding markets that growth analysts have long emphasized. Nevertheless, the proposal has repeatedly failed to leave the ground, despite recent stirrings between Brazil and Argentina. Increased aid appeared for a while in the late fifties and early sixties, but was not a permanent solution. The third approach, closing the economy off further, was not attempted. In Africa, where the problems appeared later, aid inflows did increase, but fell far short of amounts required to maintain living standards.

The import substitution strategy is widely regarded as a failure, but manufacturing output in fact grew rapidly, on average 6 percent a year, in Latin America in the 1950s and 1960s.23 Development thinking and strategy in the 1960s continued to emphasize industrialization, but with greater attention to constraints.

From Repressed Economies to Liberalization

The standard World Bank two-gap model developed during this period24 focuses on the saving-investment balance and the foreign exchange constraints, both of which gaps can be closed through foreign capital inflows. Development strategies based on these models emphasized the flow of foreign resources to the developing countries, and capital inputs needed to generate planned outputs.

The models were generally criticized for assuming credit rationing in the international capital markets, and for ignoring substitution possibilities, and thus underestimating the equilibrating role of relative prices. Nonetheless, the two gaps plus the government budget constraint have to be at the center of any realistic economic model.

The 1970s saw the development of international monetarism as an explanation of both inflation and the balance of payments. The basic model had long been in use at the Fund for financial programing.25 Based on the simple accounting identity that the balance of payments deficit is equal to the change in international reserves, in turn equal to the growth of the money supply minus domestic credit creation, the analysis suggests that the rate of domestic credit creation is the key to controlling the balance of payments at a given exchange rate. As it is often put, the balance of payments is a monetary phenomenon. Since inflation is also a monetary phenomenon, the international monetarist approach appeared to offer a route both to stabilization of inflation and balance of payments equilibrium.

The identities from which Fund financial programing begin are correct, but it takes a subsidiary set of assumptions on the flexibility of prices and wages and the credibility of policy to reach international monetarist conclusions. As failed Southern Cone stabilization attempts based on preannounced paths for the exchange rate show, analysis of stabilization and exchange rate problems has to deal with the inflexibility of wages and expectations, and the effects of capital flows on exchange rates.

Consistent with domestic monetarism of the old Chicago school, international monetarism did not pay particular attention to growth policies. It relied on non-interventionist microeconomic policies combined with macroeconomic stability to allow markets to produce the right allocation of resources, both at a moment of time and intertemporally.

But markets in the developing countries are heavily distorted, with agricultural prices out of line with world prices, many financial markets thin or nonexistent, exchange rates overvalued, capital controls in place, tariffs high, and subsidies ubiquitous. The financial repression view of the development problem, associated with the work of Shaw and McKinnon26 in the Republic of Korea, argued that simple domestic capital market changes could unleash powerful forces for development. Deregulated interest rates would stimulate saving, helping reduce domestic absorption and strengthening the balance of payments, and make for more efficient investment decisions. The extraordinary growth of Korea, where real GDP doubled in the years 1967-73 and then grew another 70 percent in the next six years, lent support to the strategy, even though it has been difficult to find direct evidence of interest rate effects on saving.27

Liberalization and Export Promotion

The liberalization strategy developed in the mid-1970s, and still prominently associated with the World Bank, moves beyond financial repression to advocate the eventual removal of all the major economic distortions in developing countries. Liberalization, unlike industrialization, provides a clear policy agenda. Of course, the aim of the policies is largely to remove the consequences of past mistakes, and in that sense the long-run growth strategy is laissez-faire, not interventionist. But there are enough distortions to keep policymakers busy removing them for the foreseeable future.

Krueger, perhaps the leading exponent and analyst of the liberalization strategy, puts the case simply (1986, p. 15):

The highly successful developing countries have generally had liberalized trade and payments regimes, which in turn have been feasible only with relatively liberal domestic economic policies.

As she notes, it is important to concentrate on the major distortions, for every economy exhibits countless minor infractions, such as rent controls. Most developed economies are also guilty of significant distortions in agriculture, but the relative loss of efficiency from such distortions is smaller in the industrial economies where agriculture accounts for only a few percent of GNP.

Analysis of the liberalization strategy has concentrated on the foreign exchange markets, for both current account and capital transactions, the labor market, the market for agricultural commodities, the domestic financial markets, and the efficiency and possible privatization of government enterprises. Advocates of liberalization have been cautious about the order of liberalization and the coordination of liberalization with macroeconomic stabilization policies. A related issue is that of gradualism in the implementation of liberalization versus shock treatment.

The theoretical case for liberalization is that the removal of all distortions will improve the allocation of resources after the economy has fully adjusted,28 and provided the distribution of income has not worsened. The question of the right order in which to liberalize arises because the removal of a distortion in an economy in which there are many other distortions may worsen rather than improve the allocation of resources. For instance, if agriculture is taxed but imported agricultural inputs subsidized, removal of the subsidy alone may not be a good idea.

More concretely, consider the example of the order of liberalization of the balance of payments. There are issues of how to liberalize the current account, for instance, whether to start by replacing quantitative restrictions with an equivalent set of tariffs, which are then reduced, or whether gradually to reduce quantitative restrictions. But the most important issue is how rapidly to liberalize the capital account.

Liberalization of the capital account means that macroeconomic policy has to deal with the potentially powerful effects of capital flows on the exchange rate and domestic inflation in addition to the changes that need to be made as the current account is liberalized. It may also encourage capital flight, as domestic residents wait skeptically for the remainder of the liberalization policy to go into place. The experiences of Israel and the major Latin American countries in the late seventies attest to the power of international capital movements. An earlier example also illustrates the dangers of premature capital account liberalization. As a condition for a postwar loan, the United States in 1946 required Britain to make sterling convertible within a year. Convertibility, implemented in 1947, lasted only seven weeks as the proceeds of the loan (equal to more than 1 percent of U.S. GNP) were rapidly being exhausted.29

Capital flight aside, the effects of capital account liberalization are uncertain because the pace of international portfolio diversification is hard to predict. Optimal portfolios in small open economies should probably have a large share of foreign assets; correspondingly portfolios in large numbers should include some assets of small foreign economies. Eventually diversifications will be balanced, but flows during the adjustment period could be predominantly in one direction with major impacts on the exchange rate of the small economy. It is widely and appropriately agreed that capital account liberalization should be virtually the last step in a liberalization program—incidentally one that some successful European countries have not yet implemented.30

Many of the economies in which liberalization is needed suffer from high inflation and balance of payments problems. There is accordingly an issue of whether to try to straighten out the macroeconomic mess first and then attend to microeconomic problems, to attempt all the changes simultaneously, or to attempt a judicious blend by implementing some of the microeconomic reforms simultaneously with the macroeconomic. Because the private sector cannot respond well to price signals when there is macroeconomic disequilibrium, it is essential that macroeconomic stabilization be undertaken at the beginning of any program. Some microeconomic distortions, such as subsidies, may have major budgetary impacts, and it is therefore desirable that they be removed simultaneously with the macroeconomic stabilization. But no economic management team in any country has the capacity to attend to all serious structural distortions at the same time. Thus only selected microeconomic changes—preferably those with serious budgetary implication—should be attempted at the time of the macroeconomic stabilization.

The choice between gradualism and shock treatment turns on both economic and political economy considerations. A comprehensive immediate reform program has the advantage that, if successful, it takes the economy directly to a more efficient allocation of resources. Any staged program runs the risk of worsening the allocation of resources in the interim. However, when it is costly to reallocate resources, typically because unemployment rises in the transition, a policy that is announced beforehand and implemented gradually may be preferable. For instance, a gradual program of import liberalization gives existing producers time to plan the adjustments in their production plans.

The political economy argument revolves around the pressures that affected interests will bring on policymakers. Depending on the form of the government, those pressures may also be directed from individual ministries to the economic policymakers. Shock treatment puts the initiative in the hands of the policymakers whereas preannounced future policy changes give interest groups the time necessary to exert effective pressure.31 Although technocrats think of interest groups as an obstacle to desirable policy changes, they may also prevent foolish policy changes; shock attacks should only be implemented after the changes have been thought and calculated through with extreme care. Political economy considerations are also relevant to the choice between piecemeal and gradual reform: comprehensive programs have the advantage that interest group pressures will offset each other.32

How adequate is the liberalization agenda for growth? There is no question that it points to serious distortions that inhibit efficient production in most countries. There is no question that most of the distortions should be removed, many of them quickly. But there remains the question of whether the liberalization agenda is to be enhanced by a more positive vision of government policy.

One such vision, inherent in liberalization, is the outward-looking strategy, of which Balassa (1982) is a prominent exponent. The strategy is to align domestic with international prices and to encourage both exports and imports by setting a realistic exchange rate and removing import restrictions. The attraction of the strategy is the success of the East Asian countries, whose rapid growth has been accompanied by even more rapid growth of their international trade, and the success of Turkey since 1980.

Closely related is a strategy of export promotion, which relies on an alternative interpretation of the Southeast Asian experience. Japan, the Taiwan Province of China, and the Republic of Korea certainly do not have an anti-agriculture bias, and at some stage each liberalized by reducing protection of imported inputs. But they aggressively encouraged exports, both by setting undervalued exchange rates and by protecting domestic manufacturing industry from foreign competition. Their strategy has been much closer to a combination of import substitution and export promotion than pure liberalization: they rely on the international economy, they have relatively few distortions, but their governments are far from a laissez-faire philosophy and policies.

Of course, the success of outward-looking or export-promotion strategies depends heavily on the continued growth of the world economy and international trade. The strategy is thus vulnerable to the effects of policies in the industrial countries. That vulnerability has led to calls for international surveillance of the developed economies. Understandable as the impulse is, and although policies in developed countries could stand improvement, effective surveillance of this type is unlikely.

The broad strategic approaches reviewed in this section provide only background and general guidance to growth policy in developing countries. Liberalization, carefully carried out, will certainly have to be a major part of a growth strategy in most developing countries. It is also true that a major part of the government’s task is to avoid making big policy mistakes. But there is no pure laissez-faire policy. Government policy is bound to affect growth, at a minimum in the provision of physical and social infrastructure, more actively in encouraging investment at the least by avoiding excessive budget deficits that soak up saving, and beyond that, through exchange rate and export promotion policies.33

Economic Structures and Models

Broad guidelines are useful, but the effects of alternative adjustment and growth strategies have to be examined for each economy individually. In this section I first discuss common problems facing different groups of countries and then briefly advocate the use of economic models in economic policymaking, for both national governments and international institutions.

Both the heavily indebted and the primary producing countries face particular difficulties in the present world economy—and those which are both have an even harder task. Among the debtors it is convenient to separate countries into African and Latin American, equivalently those whose debts are primarily to official and private lenders, respectively, and to a significant extent, those which are low income and middle income, or less and more industrial.

The debt problem dogs economic policymaking in the debtor countries. The debtors face a choice among accepting and attempting to adjust to their current debt burdens and levels of net capital flows, treating the current difficulties as temporary and attempting, if necessary by arrears, to obtain more financing, and trying to reduce the debt burden through negotiation with creditors. Whether debtor governments have the internal political strength to enforce the radical reductions in living standards that the first strategy requires in several countries is not known. The miracle so far is that the debt crisis has seen a movement toward rather than away from democracy.

Unless the debtor countries themselves, the international institutions, and responsible governments bring pressure for a longer-term solution than the constant renegotiating that has been the pattern of the last five years, adjustment strategies will be difficult to map out. A similar strategic problem faces the creditor banks and the debtor countries: to the extent either makes a serious adjustment effort—in the banks’ case the creation of loss reserves, on the debtors’ side, macroeconomic adjustment—it weakens its case at the next bargaining session. One way or the other, it is important to resolve the uncertainties over the treatment of the existing international debts.

Whatever the treatment of the existing debts, one lesson of the current crisis will ease the task of policymaking. It is now clear that floating rate bank lending should be avoided for anything other than short-term balance of payments financing. Capital inflows can certainly contribute to development, but they should take the form of direct investment, or equity investment, or long-term official capital. Here the role of the international organizations comes to the fore: they will be more important sources of external development finance than they were in the 1970s.

The debtor countries cannot in the next few years look forward to any significant private inflows of funds and will have to plan their growth and adjustment strategies accordingly, with details of course differing from country to country. This is easily said, but the burden on low-income debtors, particularly in primary exporting sub-Saharan African countries with low-income levels, is severe. Their hope must be for a recovery of commodity prices; their strategies will have to be based on the assumption that those prices will rise little in the next few years. These are the countries where the removal of remaining domestic distortions, especially between agriculture and urban economies, may be extremely important, and where positive policies to increase agricultural output with the aim of attaining food security are possible.34 They are also the countries where official aid and the policies of the international organizations can have a large effect and where improved weather has already helped.

The problem for most countries is to make needed short-run macroeconomic adjustments while both macroeconomic policy and longer-run supply-side policies encourage growth.35 The short-run macro adjustments have to focus on the basics: the government budget, the balance of payments and the exchange rate, wages, and monetary policy. Both the balance of payments and the need for investment suggest tight budgets, with the exception that productive government investment spending should not usually be cut back. There is likely here to be a tradeoff between growth and the distribution of income, as governments may have to cut back on subsidies and transfer payments as a major part of a budget balancing strategy.

The wage problem, or more generally the problem of adapting the standard of living to reduced resource availability, is a key to both current account and inflation adjustment. Generally, the adjustments will imply an initial cut in real wages, followed by later increases as productivity rises. If there is indexing of wages, it will be necessary to adjust the base wage downwards. Incomes policy may take its place here as a means of reducing adjustment costs to the new structure of supply and demand.36

The problem of adjusting without causing a recession is difficult, but a successful devaluation that begins to shift resources into exports, the use of incomes policy, the avoidance of excessively high interest rates and continued government investment spending can help. Fund adjustment programs that recognize the effects of inflation on the government budget, and that recognize government investment37 as a source of growth will require less rigorous and more believable budget adjustments than was the norm in the past.38

To the extent that countries are also attempting to adjust from high inflation, they can look to the Argentinian, Israeli, and Brazilian stabilizations of 1985-86 for lessons. The primary lessons are that it is possible to disinflate without causing a recession—and, at least as important, that monetary and fiscal policy and wages have to be consistent with the new non-inflationary equilibrium.

At a general level, the long-run growth policies are to encourage investment in both physical and human capital, to remove distortions by liberalizing, to secure the economy’s agricultural base, and to encourage the development of industry in part through export promotion. Details, which are all that matter, have to be left to a careful analysis of the structure of each economy.

Such analyses draw on explicit or implicit economic models. Both the Fund and the World Bank in their consultative and lending roles have developed models for individual countries and groups of countries.39 The models need to be developed further for use in policy analysis, both by the international institutions and the countries themselves. The alternative to using models is to rely on general principles—for instance, that so long as policy is sound, market adjustment will produce satisfactory economic performance. The latter principle is right in the long run, but it is nonetheless advisable to use explicit models to try to anticipate difficulties that may arise in the adjustment process.40

The likelihood that the economy will achieve targets derived using models is of course slight. Policy mistakes or other shocks will produce deviations of outcomes from target levels. But the models enforce discipline on the analysis of adjustment, ensure the consistency of policy measures, and provide a framework in which the prospects of meeting balance of payments and growth targets can be coherently discussed. The target paths derived using models provide a baseline from which to judge events and to justify deviations that will inevitably be needed.

Lessons for Policymakers

The previous sections have summarized the conclusions of studies of long-run economic growth, discussed alternative growth strategies, and touched on the problems of adjustment and growth that now confront primarily African and Latin American countries. In adjusting and mapping out strategies, countries need to use models that connect their targets with their policies.

The approach suggested by this paper is eclectic—the fundamental reliance is on markets, but government policies make a difference for good or ill. But, as has been emphasized, success or failure depends on the details as they are developed for each country. There policy economists, both internal and external, can play an important role.

Keynes hoped economists would eventually attain the humble status of the dentist. The development economist active in policymaking is more like a doctor, called on to diagnose diseases and prescribe cures (always aware that the medicine may not be taken, and if taken may have unexpected side effects) for illness and sometimes to produce good health. Although the modern doctor is an impressive technician, many prefer the old-fashioned GP, whose experience and intuition more than compensate for the latest in technique.

Harberger (1984) has summarized the pragmatic lessons professionals have learned from studying and advising on economic policy in developing countries—and most apply also to developed countries. Here are the most important of his lessons:

1. Keep budgets under adequate control. Absolute balance may be impossible, but there is not much room for deficits.

2. Take advantage of international trade.

3. If tariffs are used, keep effective tariff rates reasonably uniform. If tariffs become excessive, use export incentives.

4. Use price and wage controls sparingly if at all.

5. It is rare that quotas, licenses, and quantitative restrictions are justified. They are inefficient and breed corruption.

6. Adopt a technical view of public enterprises. The right criterion is the efficient operation of the enterprise.

The missing, most important, commandment is:

7. Don’t let the exchange rate become overvalued.

This list is evidence not only of what should be done, but also of what often is done. The domestic distortions and problems that new policies have to cure were usually introduced within the same political system that now has to be reformed. This is not the place to expand on the political economy of reform,41 except to note that the outcome of policy packages depends not only on the economics but also on the political equilibrium.

There are two reasons for hope. One is that deep-rooted distortions are most likely to be eliminated at times of deep crisis. The other is that well-designed conditionality of outside lending can provide incentives for the adoption of better policies.


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Blades (1980), examining gross national product (GNP) data for sub-Saharan Africa, estimates that annual growth rates have a margin of error of +/- 3 percent. Whether these errors are significantly lower for decadal average growth rates depends on their serial correlation. Blade’s account suggests the errors would be positively correlated over time, but possible levels of correlation are difficult to infer.

Weighted average decadal growth rates of total rather than per capita GNP, taken from International Financial Statistics (International Monetary Fund) paint a different picture. Western Hemisphere growth of 5.7 percent and 5.9 percent in the sixties and seventies exceeds the corresponding 4.5 percent and 5.1 percent in Asia; African growth for those two periods was 4.8 percent and 3,8 percent, respectively. Asian performance is significantly superior for the few years for which there are data for the 1980s.

The correlations (R2) for Africa, Asia, and Latin America are 0.05, 0.41, and 0.16, respectively.

Inputs of raw materials are usually ignored in the basic framework, though they could easily be included. Of course discoveries of raw materials and changes in their prices have often had major effects on growth.

Denison warns that these results should not necessarily be regarded as typical, since patterns differ across countries. See, for instance, Denison (1967) for an analysis contrasting post-World War II European growth with that in the United States.

Romer (1987) shows that productivity growth in the United States since 1840 is negatively serially correlated over decades: a decade of lower than average productivity growth tends to be followed by a catch-up of higher than average growth.

Denoting output as Y, labor input as L, and capital as K, and with the constant returns to scale production function Y = F(K, L), per worker output is (Y/L) = f(K/L), with f’( ) equal to the marginal product of capital. Then denoting the growth rate of output per worker by gY/L, and that of capital per worker by gk/L:gY/L=(f()K/Y).gK/L

With capital receiving its marginal product, (f’() K/Y) is the share of capital in output.

Denison uses the national income accounts which attribute no rental return to government capital, thereby understating the share of capital in output.

In illustrative calculations, Solow (1960) assumes technical progress at the rate of 3 percent a year, and a share of capital equal to 0.3. A doubling of the rate of investment from 10 percent to 20 percent of GNP raises the level of GNP by 14 percent within a decade if technical progress is disembodied and by 26 percent if it is embodied.

Denison (1964) argues that the question of whether technical progress is embodied is of little practical significance in assessing the sources of growth in the United States. His argument is that within the range of historical experience of the U.S. changes in the age of capital goods—which is how embodiment affects the role of capital—have been relatively small.

Appendix I of Denison (1974) contains a full description.

Kendrick (1980, p. 98) estimates rates of return to human capital between 10.1 percent and 12.8 percent from 1929 to 1973.

Srinivasan (1986) finds little evidence that small economies perform systematically less well than larger units, attributing the result to international trade.

Before the 1950s the conventional wisdom for developing countries emphasized the development of primary exports as an engine of growth, encouraging the growth of complementary domestic industries.

Of course, modifications of technologies may be needed to adapt them to local conditions.

In World Development Report 1986 four small upper middle-income countries (Israel, Hong Kong, Trinidad and Tobago, and Singapore) could, by the income criterion, make it into the next rank.

Baumol, noting the criticism by Paul Romer (1986) that examination of the growth records of the successful countries biases the results by choosing countries that end up within a particular range of incomes, states that the tendency to convergence remains when the data for wealthy countries in 1950 are examined for convergence over the next three decades. The convergence hypothesis implies a negative correlation between the growth rate of income and the initial level of income.

The correlations (R) are for Africa 0.35; for Asia 0.62; and for Latin America 0.08.

The calculation is based on per capita GDP estimates for 1984 of $260 in the low-income economies and $11,430 in the industrial market economies from the World Development Report 1986. Of course the reported GDP data are not good measures of relative real incomes. The statement in the text is nonetheless accurate as a description of required rates of growth of measured GDP.

I draw here on interesting papers by Fishlow (1985) and Corbo (1986) describing in some depth Latin American development thinking and growth policies.

Corbo (1986) develops this argument in detail.

Of course, not all countries followed the same strategies. In Asia, India and China both pursued import substitution for long periods.

This compares with GDP growth averaging 4.8 percent a year. Data are from Corbo (1986).

Khan, Montiel, and Haque (1986) provide a simple exposition of this approach. Chenery and Strout (1966) is one of the classic references.

See Khan, Montiel, and Haque (1986) for an exposition, Polak (1957) for a highly influential paper, and Frenkel and Johnson (1976) for the Chicago contributions to the approach.

McKinnon (1973) is particularly influential.

See Giovannini (1985) for a careful study.

Mussa (1986) presents guidelines on trade liberalization.

Kindleberger (1984, pp. 430-32) discusses this episode. The loan was for $3.75 billion; U.S, GNP was $235 billion in 1947.

Edwards’ (1986) analysis suggests that starting with the current account is more prudent. McKinnon’s discussion of this paper contains an interesting review of developments in the Republic of Korea after the reforms of 1964-65, where a massive and unexpected capital inflow touched off an inflationary process. Lai’s discussion of the Edwards paper shows that agreement on the issue is not complete.

Mussa (1987) argues that too rapid an implementation of trade liberalization will increase the pressures brought by affected groups.

When accused of voting in his private interest in the House of Commons, David Ricardo is reputed to have replied that he had so many interests he did not know which way he came out on the issue.

The four-part growth strategy recently recommended by Balassa, Bueno, Kuczynski, and Simonsen (1986) for Latin America shares much of the emphasis of this section. It includes an outward orientation of economic policy, with emphasis on export promotion and efficient import substitution, attempts to improve saving and its allocation (meaning reductions in government deficits), a reduced role for government in direct production, and open markets by the developed countries.

Lele (1986) and Loxley (1986) discuss adjustment in Africa with special attention to agriculture.

Pfeffermann and Jaspersen (1986) provide a careful analysis of the problem of adjustment with growth in Latin America, emphasizing export growth.

Reductions in payroll taxes or temporary wage subsidies can ease the burden on the wage earner. But the budgetary implications of such policies have to be considered.

Of course, there are many examples of wasteful government investment projects. But there are also in all countries many positive return projects. The international organizations in discussing growth with adjustment strategies may have to examine the details of proposed government investment programs.

Aghevli and Marquez-Ruarte (1985) describe the successful Korean adjustment program in 1980-84, which followed reasonably orthodox procedures including a devaluation, and some, but relatively little, fiscal tightening.

See Khan, Montiel, and Haque (1986) for the structure of these models. Taylor (1986) provides a taxonomy of stabilization and growth models.

In Fischer (1986) I suggest that until a consistent model incorporating both real and financial sides of the economy is developed, two models can be used in economic policymaking. The first is a medium-term (four- or five-year) real model that produces paths of real activity consistent with the paths of the trade account and budget that are needed over the next four to five years. The second would be a shorter-term model incorporating the balance of payments-debt constraint, the government budget constraint, a description of the assets markets, wage and price formation, and monetary and fiscal variables linking government decisions to the required paths. Such models already exist and are widely used in the international institutions.

Krueger (1986) examines the political forces that create the need for liberalization.

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