In Other Words

Developing an Identity

Journal of Development Economics, Vol. 72, No. 2, December 2003, Amsterdam During the 1990s, economic officials in Latin America seemed to do everything right. In several countries, they embraced radical, pro-market reforms in trade, banking, and other sectors at the urging of international financial institutions. Yet the region experienced abysmal economic growth between 1990 and ...

Journal of Development Economics, Vol. 72, No. 2, December 2003, Amsterdam

During the 1990s, economic officials in Latin America seemed to do everything right. In several countries, they embraced radical, pro-market reforms in trade, banking, and other sectors at the urging of international financial institutions. Yet the region experienced abysmal economic growth between 1990 and 1999. In contrast, Asian economies such as China, India, South Korea, and Taiwan grew significantly during the same period, despite their disregard for many of the prescribed remedies.

This divergence deserves closer scrutiny, argue Harvard University economists Ricardo Hausmann and Dani Rodrik. Hausmann and Rodrik are known for fearlessly questioning conventional wisdom within their profession — particularly that of the so-called Washington Consensus, which posits that poor countries will develop rapidly once they adopt policies that respect property rights and open their economies to foreign trade and investment. Clearly, such a simple recipe leaves out many important ingredients and frequently yields unsatisfying results. In their recent article "Economic Development as Self-Discovery" in the Journal of Development Economics, Hausmann and Rodrik describe "learning what one is good at producing" as one of those ingredients.

To obtain such knowledge, the authors assert, governments in developing countries must encourage private entrepreneurs to adapt foreign technologies and business plans to local conditions. Businesses that earn high profits invariably inspire imitators, further strengthening a nation’s economy. For example, Colombia became the largest supplier of cut flowers to the United States after several companies emulated the success of a pioneering flower venture established in 1969. Similarly, India’s information-technology industry has boomed in recent years because hundreds of local and foreign firms have followed the path of a few Bangalore-based companies that mined gold from a seemingly forbidding environment.

As such examples show, many developing nations could trigger economic growth if they only knew how best to employ their abundant resources. However, Hausmann and Rodrik highlight a key obstacle: Returns to private businesses that invest in innovation don’t necessarily offset the substantial costs of adapting their technologies and business plans. The flood of imitators that ensues if the business succeeds also washes away entrepreneurs’ profits. Therefore, a completely free-market, laissez-faire system won’t produce all the investment in innovation that a society ideally needs. As the authors observe, East Asian governments provided their firms "with both promotion (the carrot) and discipline (the stick)," whereas Latin America "had considerable discipline" in the form of trade openness but "too little promotion."

Hausmann and Rodrik submit that the larger social benefits of business and technological innovation in developing countries may justify government intervention to promote such activity. They are not the first to make that argument: Indeed, the understanding that society-wide returns exceed private returns is an important reason why early patent institutions in Europe typically granted property rights to whomever introduced a technology. Today, policymakers in low-income nations must design efficient programs that stimulate innovation but minimize the perverse side effects, such as hindering competition or slowing the diffusion of ideas that could boost the productivity and income of poor citizens.

Hausmann and Rodrik discuss several ways to help a country "discover" itself, even tentatively endorsing subsidies for entrepreneurs with good project proposals and performance. They further suggest that such policies may explain why East Asian economies such as Taiwan and South Korea outperformed developing countries in Latin America over the last few decades. The evidence for this latter claim is shaky, however. Supplied with plenty of labor and access to capital, innovators in developing countries who focus on industries with deep international markets have little to fear from local imitators. That truth likely explains why firms and sectors in less-developed countries that are geared toward foreign markets are invariably more productive than those with a domestic focus.

The lesson for protectionist-minded politicians in rich nations: Opening your markets to less fortunate neighbors is a powerful way to stimulate innovation. Such policies give foreign and domestic entrepreneurs greater incentives to establish new enterprises in — and transfer technologies to — developing societies.

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