1. The Washington Consensus Revisited A New Structural Economics Perspective Justin Yifu Lin National School of Development Peking University

2. Overview of Presentation Introduction: the Failure of Washington Consensus The New Structural Economics Viability, Development strategy and the Endogenous Nature of Distortions in A Transition Economy Viability and the Failure of Washington Consensus Concluding remarks 2

3. INTRODUCTION: THE FAILURE OF WASHINGTON CONSENSUS 3

4. The Surprising Contrast of Transition Performance in China/Vietnam and Eastern Europe/Former Soviet Union After the transition started in the earlier 1980s, China and Vietnam continued to grow dynamically, whereas the transition in Eastern Europe and Former Soviet caused the collapse and stagnation of their economies. The contrasting transition performance was unexpected by economists: – China and Vietnam followed a dual-track gradual transition approach, which was considered doomed to fail – Eastern Europe and Formal Soviet Union economies followed the Shock Therapy based on the Washington Consensus, which was considered to lead the economy to a “J-curve” transition path The above failure of economists’ prediction suggests the needs for rethinking the existing economic theory of transition 4

5. THE NEW STRUCTURAL ECONOMICS 5

6. Let’s go back to Adam Smith But not to The Wealth of Nations, which reflects findings of Adam Smith’s research Let’s go back to Adam Smith’s methodology, that is, An Inquiry into the Nature and Causes of the Wealth of Nations 6

7. The Nature of Modern Economics The rapid, sustained income growth is a modern phenomenon 7 The nature of modern income growth is a process of continuous changes in the structure of technologies, industries, and soft and hard infrastructure of the economy

8. New Structural Economics An application of neoclassical economic approach to study the determinates of economic structure and its evolution in development, which is the nature of modern economic growth Why do I call this approach New Structural Economics? – By convention, it should be called structural economics – Add “new” to distinguish it from structuralism 8

9. What Determines Structure and its Change? The main hypothesis. Industrial structure is endogenous to endowment structure, which is given at any specific time and changeable over time – This is a new angle – Most development policies failed because they neglect the endowments and its structure Initial endowments. Determine the economy’s total budgets and relative factor prices at any specific time, which in turn determine: – Comparative advantage – Optimal industrial structure (endogenous) Dynamics. Income growth depends on: – Upgrading industrial structure – Upgrading of endowments – Improvements in “hard” and “soft” infrastructure Following comparative advantage (determined by the endowment structure) to develop industries is the best way to upgrade the endowment structure and to sustain industrial upgrading, income growth, and poverty reduction. 9

10. The Market and the State Firms maximize profits…choice of technology and industries based on relative factor prices… Need for a competitive market system Industrial upgrading and diversification needs to: – Address externalities – Solve coordination problems Need for a facilitating state 10

11. Stylized Facts of Successful Economies !3 economies achieved average annual growth rate of 7% or more for 25 years or more in post WWII According to the Growth Report, these economies had the following stylized facts – Open and advantage of backwardness – Macro stability – High savings and high investment rates – Market economy – Proactive govenrment 11

12. NSE and The Growth Commission’s Stylized Facts of Successful Economies Policy Recommendation from NSE – Following comparative advantage Preconditions Market economy Facilitating State The results: – Openness and advantage of backwardness – Competitiveness and strong external as well as fiscal accounts: fewer home-grown crises and larger scope for countercyclical fiscal policies. – Large economic surplus and high returns to investment: high rate of savings and investment. Growth Report Stylized Facts: #4 #5 12 #1 #2 #3

13. VIABILITY, DEVELOPMENT STRATEGY AND THE ENDOGENOUS NATURE OF DISTORTIONS IN TRANSITION ECONOMY 13

14. Viability and the Endogenous Nature of Distortions Failed to understand the endogeneity of industrial structure to the endowment structure, socialist economies as well developing countries attempted to build up large-scale, modern industries which were too far advanced compared to their countries’ level of development. The firms were non-viable in competitive markets and required government’s subsidies and protections for their initial investment and continuous operation through various distortions in factor/product prices and government’s direct interventions in resource allocations. The distortions and direction interventions led to misallocation of resources, rent-seeking, corruption, and political capture. After the initial investment-led growth, the socialist economies and other developing countries were trapped in stagnation and frequent crises. 14

15. VIABILITY AND THE FAILURE OF WASHINGTON CONSENSUS 15

16. Why the Washington Consensus Failed All transitional economies started with many nonviable firms in their old priority sectors due to their comparative advantage-defying development strategy. The Washington Consensus failed to recognize that the distortions were endogenous for the protection of nonviable firms in the priority sectors and advised the government to eliminate all distortions immediately – caused the collapse of old priority sectors and the subsequent social/ political instability – Or for fear of the above consequence, the government reintroduced other disguised protections and subsidies which were even less efficient The Washington Consensus also neglected the needs for the government to play a proactive role in facilitating the entry into new sectors consistent with the country’s comparative advantages. 16

17. Why Did the Dual-track Approach Succeed? The government continued to provide transitional support to nonviable firms in the old priority sectors and removed distortions only when firms in those sectors became viable or the sectors become very small. The government facilitated private firms’ entry to sectors that were consistent with the country’s comparative advantage, which were repressed before the transition. The dynamic growth in the new sectors created conditions for reforming the old sectors. Firms in old sectors may become viable due to the rapid accumulation of capital The dual-track approach also resulted in the income disparity, rent-seeking, and wide spread corruption, the remedy to those problems requires the completion of transition from the dual-track economy to a well-functioning market economy 17

18. Concluding Remarks The Washington Consensus failed because it did not recognize the endogeneity of distortions in the transition economies It is imperative to incorporate the concept of viability in neoclassical analysis – To avoid over ambition in development policies – To be pragmatic in policy reforms