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Dani Rodrik: A de-globalised world?

Developing countries must resume push into tradable goods & services for high growth

Dani Rodrik 

It may take a few months or a couple of years, but one way or another the United States and other advanced economies will eventually recover from today’s crisis. The world economy, however, is unlikely to look the same.

Even with the worst of the crisis over, we are likely to find ourselves in a somewhat de-globalised world, one in which international trade grows at a slower pace, there is less external finance, and rich countries’ appetite for running large current-account deficits is significantly diminished. Will this spell doom for developing countries?

Not necessarily. Growth in the developing world tends to come in three distinct variants. First comes growth driven by foreign borrowing. Second is growth as a by-product of commodity booms. Third is growth led by economic restructuring and diversification into new products.

The first two models are at greater risk than the third. But we should not lose sleep over them, because they are flawed and ultimately unsustainable. What should be of greater concern is the potential plight of countries in the last group. These countries will need to undertake major changes in their policies to adjust to today’s new realities.

The first two growth models invariably come to a bad end. Foreign borrowing can enable consumers and governments to live beyond their means for a while, but reliance on foreign capital is an unwise strategy. The problem is not only that foreign capital flows can easily reverse direction, but also that they produce the wrong kind of growth, based on overvalued currencies and investments in non-traded goods and services, such as housing and construction.

Growth driven by high commodity prices is also susceptible to busts, for similar reasons. Commodity prices tend to move in cycles. When they are high, they are apt to crowd out investments in manufactures and other, non-traditional tradables. Moreover, commodity booms frequently produce ugly politics in countries with weak institutions, leading to costly struggles for resource rents, which are rarely invested wisely.

So it is no surprise that the countries that have produced steady, long-term growth during the last six decades are those that relied on a different strategy: promoting diversification into manufactured and other “modern” goods. By capturing a growing share of world markets for manufactures and other non-primary products, these countries increased their domestic employment opportunities in high-productivity activities. Their governments pursued not just good ‘fundamentals’ (e.g., macroeconomic stability and an outward orientation), but also what might be called ‘productivist’ policies: undervalued currencies, industrial policies, and financial controls.

China exemplified this approach. Its growth was fuelled by an extraordinarily rapid structural transformation towards an increasingly sophisticated set of industrial goods. In recent years, China also got hooked on a large trade surplus vis-à-vis the US— the counterpart of its undervalued currency.

But it wasn’t just China. Countries that had been growing rapidly in the run-up to the great crash of 2008 typically had trade surpluses (or very small deficits). These countries did not want to be recipients of capital inflows, because they realised that this would wreak havoc with their need to maintain competitive currencies.

It is now part of conventional wisdom that large external balances—typified by the bilateral US-China trade relationship—played a major contributing role in the great crash. Global macroeconomic stability requires that we avoid such large current-account imbalances in the future. But a return to in developing countries requires that they resume their push into tradable goods and services. In the past, this push was accommodated by the willingness of the US and a few other developed nations to run large trade deficits. This is no longer a feasible strategy for large or middle-income developing countries.

So, are the requirements of global macroeconomic stability and of growth for developing countries at odds with each other? Will developing countries’ need to generate large increases in the supply of industrial products inevitably clash with the world’s intolerance of trade imbalances?

There is in fact no inherent conflict, once we understand that what matters for growth in developing countries is not the size of their trade surpluses, nor even the volume of their exports. What matters is their output of modern industrial goods (and services), which can expand without limit as long as domestic demand expands simultaneously. Maintaining an undervalued currency has the upside that it subsidises the production of such goods; but it also has the downside that it taxes domestic consumption—which is why it generates a trade surplus. By encouraging industrial production directly, it is possible to have the upside without the downside.

There are many ways that this can be done, including reducing the cost of domestic inputs and services through targeted investments in infrastructure. Explicit industrial policies can be an even more potent instrument. The key point is that developing countries that are concerned about the competitiveness of their modern sectors can afford to allow their currencies to appreciate (in real terms) as long as they have access to alternative policies that promote industrial activities more directly.

So the good news is that developing countries can continue to grow rapidly even if world trade slows in and there is reduced appetite for capital flows and trade imbalances. Their growth potential need not be severely affected as long as the implications of this new world for domestic and international policies are understood.

One such implication is that developing countries will have to substitute real industrial policies for those that operate through the exchange rate. Another is that external policy actors (for example, the World Trade Organisation) will have to be more tolerant of these policies as long as the effects on trade balances are neutralised through appropriate adjustments in the real exchange rate. Greater use of industrial policies is the price to be paid for a reduction of macroeconomic imbalances.

Dani Rodrik, Professor of Political Economy at Harvard University's John F. Kennedy School of Government, is the first recipient of the Social Science Research Council's Albert O. Hirschman Prize. His latest book is ‘One Economics, Many Recipes: Globalization, Institutions, and Economic Growth’.

Copyright: Project Syndicate, 2009.