Pragmatic Pluralism 4: Economic Development

This chapter provides a map through the complex jungle of economic theories. There are many different theoretical approaches, and each aspect of the economy has been analysed by a number of different ones. However, it is neither feasible nor productive for students to engage with every possible angle for every topic. Hence, the chapters on different topics, together with Building Block 8: Economic Theories, sets out an alternative approach: pragmatic pluralism. Rather than pursuing the extreme of either only focusing on one approach, or including every possible strand of thought for every topic, we propose a pragmatic middle ground: teaching a select number of approaches for each topic. In this way, it is possible to introduce students to the variety and diversity of economic thinking, whilst still having enough time and space to properly discuss each of the insights in detail with them.

Topics:

Main opposing perspectives

■ Classical political economy: Free trade and laissez-faire

■ Historical school: Infant industry protection

Main complementary perspective

□ Institutional economics: Laws and politics are crucial

Additional perspectives and insights

+ Ecological economics: Consumption growth shouldn’t be the goal

+ Evolutionary economics: Creative destruction

+ Marxian political economy: Technology and class conflict drive history

+ Structuralist economics: Development as international power struggle

+ Neoclassical economics: Modelling economic growth

+ Behavioural economics: Experimentally tested micro-interventions

To this day, there is a divide between those who think governments should use protection to develop their economy and those who argue in favour of free trade and laissez-faire policies. This debate has been playing out within academia and in the public debate for more than two centuries.

Before Adam Smith, mercantilist thinkers tried to understand how the small and previously insignificant country of the Netherlands with hardly any resources, could have become the wealthiest and most powerful country in the world in a short period. They observed that the Dutch consistently had a current account surplus as they imported low-value primary goods and exported high-value manufactured goods. Because of this, gold and silver flowed into the Netherlands and gave the Dutch government a seemingly endless amount of monetary reserves to use. Based upon this understanding, many different protectionist policies were conceived in order to enable other countries to achieve a positive balance of trade.

Adam Smith argued against these ideas and policies, claiming that free markets and free trade caused prosperity because it allowed the division of labor and productivity to expand. It is important to note here that Smith still saw an important role for the government, namely in providing good infrastructure, education and other public goods. He was, however, strongly against government policies, which focused on protecting industries because he argued this leads to rent extraction and unearned income. As such, his argument for the ‘free’ market was about making markets free from rent, rather than entirely free from government intervention.

The ideas of Smith and other classical political economists in turn triggered responses which attacked the idea that free trade was always beneficial for all countries involved. The German historical and American schools argued instead that national systems which invested in industry and infrastructure were needed to create prosperity. An important contribution was the infant industry argument, which contends that young industries should be protected with tariffs and subsidies in order to allow them to become competitive in international markets, before exposing them to it. Free trade in this sense favour the most competitive countries and not allowing developing countries to use activist industrial, trade and technology policies to catch up in terms of productivity, according to this view amounts to kicking away the ladder for developing countries to grow. Over the last decades, the free trade approach was often associated with the idea of the ‘Washington Consensus’ as many powerful institutions were based in this city and promoted such a ‘free-market’ approach to development. The more protectionist approach, on the other hand, is frequently linked to the concept of the ‘Beijing Consensus’ which is characterized by an active developmental as well as authoritarian state, incremental reform, experimentation, and export led growth. 

A nuanced version of the debate is how much developing countries should conform, or defy, their comparative advantages and the government should play a limited role facilitating the private sector aimed at making small steps in industrial and technological upgrading, or the government should pursue more activist infant industry protection to achieve bigger leaps of development (Chang & Lin, 2009). Both sides recognize the existence of market failures as well as government failures, thus recognizing the need for, but also difficulty of, effective government action to achieve industrial and technological upgrading. The debate is about where the right balance lies between deviating enough from comparative advantage so that learning and long-run growth take place, and not deviating too much from comparative advantage so that learning and short-run efficiency costs remain moderate. Relatedly, there is also a debate about whether balanced growth, inspired chiefly by Ragnar Nurkse which aims to develop all sectors simultaneously, or unbalanced growth, inspired by Albert Hirschman which advocates to concentrate investments in a few sectors, is more effective in developing an economy. 

Institutional economics provides key insights into how economies develop by looking at their political, economic and social institutions. An important contribution was made by Veblen, who distinguished between two main spheres: industrial and pecuniary activities. This became known as the Veblenian dichotomy. Within economies, Veblen argued that the former sphere has as goal to create output by combining inputs, while the latter is simply focused on enriching itself through predatory behavior. On a more abstract level, one can think of the former as being instrumental and about technology and workmanship, while the other is ceremonial and about social institutions and salesmanship. The interaction between these two spheres determine the level and form of economic development. A more recent contribution by Acemoglu and Robinson builds on the ideas of Veblen about predatory institutions, as they argue that economic development depends on the inclusiveness of political institutions. Non-elitist democratic structures are seen as fostering meritocracy and the rule of law, which create incentives for productive and innovative behavior. Relatedly, Douglass North focuses on how the historical development of property rights and enforcement of contracts reduced transaction costs, in other words the cost of carrying out an economic exchange. Other scholars focus on the legacy and lasting impact of colonialism and slavery, and how these were key in the development of rich capitalist centres.

Many institutional economists go beyond the idea that there is only one road to economic development. This has created a literature around the idea of varieties of capitalism which argues that there are multiple versions of capitalist economies that are successful, the most famous being the liberal and coordinated market economy. These varieties are assumed to come about because of national institutions, such as vocational training and education, corporate governance, and industrial and inter-firm relations. Hollingsworth & Boyer look at how different institutions create, often at a regional level, social systems of production, such as diversified quality mass production. Important among these institutions are trade unions, employers’ associations, national political structures, and multinational corporations. In doing so, they go beyond grand national typologies and analyse in detail how processes, such as globalization, change how economies look and operate.

Marxian political economy: The theories discussed so far assume that economic development is, or could be, a smooth peaceful process which creates prosperity. Marxian and evolutionary economists, however, argue that development is a very rough and turbulent process with many victims as well as victors. Marxian political economists argue that material conditions determine the historical development of societies, and thus place a lot of emphasis on technological developments and class conflict, respectively called the means and relations of production.

Evolutionary economists, such as Joseph Schumpeter, build on these ideas as they focus on how innovation comes about and what its consequences are. In particular, the idea of creative destruction, which describes how innovation causes some firms to grow while it destroys others, is important. Entrepreneurs can gain competitive advantage and extra profit by creating new production technologies, products and markets. An important insight here is that innovation is not only technological, but also social. A key point of debate is whether to view technological development as exogenous and something that is very difficult, if not impossible, to influence, or as endogenous and something that could and should be stimulated and shaped according to preferences of the population. 

Neoclassical economics: has focused on mathematically modelling long-run GDP growth. The most famous of such models is the Solow-Swan model, which itself builds on the earlier post-Keynesian Harrod-Domar model. Key factors explaining economic growth in the neoclassical growth model are the savings rate, and population and productivity growth. Later the Ramsey–Cass–Koopmans model was developed to provide neoclassical microeconomic foundations for the savings rate. More recently, Hausmann, Rodrik and Velasco developed the Growth Diagnostics approach which provides a framework for identifying the factors that are holding back economic growth. They assume that private investment and entrepreneurship lead to economic growth and developed the decision tree below showing possible causes.

Structuralist economics: While most theories of economic development, most notably modernization theory, look at processes on the national level, structuralist economics, also often called dependency theory, looks at the international level. Instead of assuming that countries isolated from each other develop through similar stages, the connections and power relations between countries are understood to be crucial for their development. The development of rich countries is thus fundamentally linked to the underdevelopment of poor countries, as the international power dynamics enriches the rich countries and impoverishes poor countries. The long histories of imperialism and colonialism play an important role in this, but many scholars argue that these global inequalities are relevant to this day. A less obvious reason for this, compared to the military and political dominance of rich countries, is that ‘terms of trade’ are structurally declining for developing countries. While rich countries produce high value industrial products, poor countries are specialised in low value raw materials and agriculture, and thus poor countries are continually disadvantaged. 

Many of the earlier structuralist economists, sometimes called classical developmentalists, argued that developing a country requires developing new economic sectors through import substitution industrialisation. More recent structuralist economists, also known as new developmentalists, have instead argued for export-led and profit-led growth strategies associated with the ‘Beijing Consensus’, rather than domestic-led and wage-led ones which are linked to the ‘Mumbai Consensus’. For this to succeed, they argue it is critical for a developing state to combine strategic industrial policy with ensuring the exchange rate is not overvalued for long periods of multiple years as this would cause demand to fall. Furthermore, they argue that state ownership and economic planning is desirable in non-competitive sectors, while market coordination should be pursued in competitive sectors, using China as an example of how this approach can look in practice.

Ecological economists push us to ask again what economic development is. Growth of material production and commodified consumption is rejected as the (ultimate) aim of economic development. Instead, they argue we should focus on improving our lives in a way that does not destroy nature. Therefore, the focus should not be on maximizing the value of market transactions (GDP), but on increasing human well-being in a sustainable manner. Some argue we need to embrace degrowth, advocating reductions in consumption and production, while others argue we need to be growth agnostic, not caring about the level of economic activity and solely focusing on enhancing human wellbeing ecologically sustainably. A related approach was developed amongst others by among others Amartya Sen and Martha Nussbaum, which focuses on enabling people to develop their capabilities. This capability approach inspired the Human Development Index which contains income, health and education measures. Finally, there are scholars who argue to abandon the concept of development, therefore often referred to as post-development theorists. They see development as an oppressive Eurocentric conception of modernization in which the global North is positively portrayed as the ideal and “advanced” and the global South as “backward” and “primitive”. Instead of believing in universalist policy advice by international agencies, they advocate for the promotion and defence of local grassroots movements with their unique cultural understandings of development. 

Behavioural economics: While most of development economics has a macrofocus, many recent studies in economic development by scholars, such as Abhijit Banerjee, Esther Duflo, and Michael Kremer, focus on the micro-level. With the help of field experiments, and in particular randomized control trials, they, for example, investigate which ‘micro-interventions’ are most effective in alleviating poverty. Particular emphasis is placed on understanding how the poor think and make decisions. With this knowledge, they hope to create better designed small interventions to marginally improve the welfare of the poor, as opposed to large-scale developmental plans and market-based solutions. 

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