Insufficient Economic Convergence in the World Economy: How Do Economists Explain Why Too Many Countries Do Not Catch-up?

Abstract

This essay reviews different economic perspectives on the development of productivity and living standards in developing countries. It shows that neoclassical approaches to the problem of economic convergence fail to provide a satisfactory explanation of why economic convergence does not take place. In doing so, it reviews seven heterodox arguments on why developing countries do not converge. The article argues that the lack of economic convergence is a result of market forces which lead to the reproduction of underdevelopment. Therefore, comprehensive state interventions are needed to overcome underdevelopment. The article discusses different alternative policies which are needed to trigger development, thus countering the perspectives of neoliberal economists and the Washington Consensus.

Keywords

Macroeconomics underdevelopment economic convergence Keynesian paradigm Washington Consensus

Introduction

Development is disappointing in most developing countries, at least when it is measured in terms of converging productivity and living standards with those common in developed countries. This is in sharp contrast to the optimistic prediction of mainstream economic thinking. As Solow (1956) shows, in neoclassical growth models real gross domestic product (GDP) per capita in countries with similar preferences and technologies will converge. This convergence effect is substantially strengthened by international capital flows to developing countries which have higher rates of return than developed countries. Mobility of capital increases the stock of capital in developing countries and stimulates technological transfer. The same happens when labour is allowed to be internationally mobile (Barro & Sala-i-Martin, 1990). As per these arguments, if such expected effects do not occur, the explanation for this must be found in insufficiently liberalized market mechanisms, distorted incentive structures or bad institutions in developing countries. Policies in the tradition of the Washington Consensus (Williamson, 1990, for a summary) are recommended to lead markets to break this impasse and non-convergence trend.

The analysis in this article shows that even perfect market conditions do not lead to convergence, since there are market forces at work which reproduce underdevelopment. When we speak about convergence, we do not mean that developing countries should copy the living style, type of production and consumption, and the technologies dominant in highly industrialized countries. The argument is that even a ‘conventional’ catch-up is difficult to achieve and implies the overcoming of certain market forces. A more radical ‘alternative’ development process is even more demanding and implies as a precondition the overcoming of market forces which reproduce underdevelopment. In any case, developing countries need a radical increase in productivity without which no conventional or alternative development is possible.

This article is divided into four sections. The second section shows that most countries in the world were not able to achieve productivity levels and living standards comparable with developed countries. Economic thinking has produced a whole set of approaches which are able to explain this lack of convergence. In the third section, seven of these approaches are reviewed. In the final section, some conclusions are drawn.

Empirical Development

Convergence is defined as real GDP per capita of a country as a per cent of real US GDP per capita. The values indicate productivity levels as well as levels of average consumption standards. Ninety per cent of developing countries show no, or very low, convergence. However, there have been successes in combating absolute poverty. But as developed countries also increased their per capita GDP, convergence was limited to a relatively small number of countries. Figures 1 to 3 show that there was not much movement towards convergence in Africa, South Asia and Latin America. On the other hand, South-East Asian, or so-called tiger, countries were successful in convergence, which later slowed down (Figure 4). The most successful countries in terms of convergence (as shown in Figure 5) are Japan, as an early mover (since the early 1990s in a crisis), China as a latecomer, and Taiwan, Singapore, Hong Kong and South Korea. The successfully converging countries, including the South-East Asian tigers, did not follow market policies in the spirit of the Washington Consensus. They all developed under active and intense government interventions (Stiglitz, 1996).

Figure 1.

Source: Penn World Table version 9.0 (2017), calculating per capita real GDP (output-side real GDP at chained purchasing power parities (in mil. 2011US$) divided by population (in millions). For an explanation of variables, see Feenstra, Inklaar and Timmer (2015).

Figure 2.

Figure 3.

Figure 4.

Figure 5.

Theoretical Explanation for Insufficient Convergence

Free Trade and Underdevelopment

List (1841), influenced by Alexander Hamilton during his exile in the USA, argued that free trade would ‘kick away’ the ladder of development in Germany, which, at that time, was less developed than England. List recommended a package of three policies to avoid this: first, tariffs or other instruments to protect infant industries; second, state-owned or state-supported companies serving as role models; and third, attracting qualified foreign migrants.

Free trade models are based on the approaches of David Ricardo and Heckscher–Ohlin. Both models have a static and narrow view of the optical allocation of given factors of production. David Ricardo’s model of comparative advantages is based on different technologies among countries, whereas the Heckscher–Ohlin model is based on different factor endowments but with the same technology in all countries. In both models, free trade increases the allocative efficiency of the world. The Heckscher–Ohlin model cannot be usefully applied to explain trade between developed and developing countries, as it misses the key difference between these countries, namely the different levels of technology and innovative power. The Ricardo model of comparative advantages cannot explain all types of international trade, but it delivers a powerful analysis of how the market mechanism works in the field of international trade. Two conclusions of the Ricardo model are important. First, the market mechanism leads to a concentration of low-tech production in countries with a low level of technological knowledge. Second, the exchange rate protects countries with a low level of technological knowledge in a way that they can take part in international trade. But the welfare implications of the model are a different story altogether, since they neglect the consequences of free trade for the productive power of nations (in line with the analysis of List).

To take an example: developing country ‘D’ and the industrial country ‘I’ both produce computers and garments, and there is no international trade. Country I is better in the high-tech production of computers and in the low-tech production of garment. For country D, the computer industry is the industry with the highest development and productivity. However, country I still has a bigger advantage in the computer industry than in the garment industry. Now, when the countries enter into free trade, the allocation in the world improves: on a world level, the same quantity of goods can be produced with lower inputs. But the computer industry in country D collapses. The productivity level in the developing country drops, while rising in the industrial country.

As this example shows, the problem of the market mechanism under free trade is not only that it can reduce the productivity level in the developing country. Even more important is that the concentration on low-tech and unskilled labour-intensive production in developing countries takes away the chance for dynamic productivity development. All the positive learning effects, including research and development, are concentrated in developed countries, which increase their innovative power and leave the developing countries lagging behind. Thus, developing countries are bonded in their low productivity specialization.

It is very unlikely that the market mechanism will lead to new industries in developing countries to allow catching up (Rodrik, 2004). This is largely because of the following reasons. First, there are information externalities. New products and new technologies or innovations, in general, involve a process of discovery. From its very character, new productions are risky, can fail and make it difficult for private investors to invest. To make matters worse, if a firm is successful, follower firms can, in many cases, easily imitate the successful firm. Second, there are coordination externalities. Most innovations need a high level of investment. Economies of scale and scope prevent innovative firms starting from a small scale. In many cases, a whole bundle of investment is needed, which goes far beyond a single firm. A new product or new technology may need new infrastructure (from transportation to new communication technologies), which cannot be handled by a single firm. Specific skills of employees and firms producing complementary goods or inputs may be needed to achieve this task.

Mainstream conviction in free trade recommends a specialized division of labour among countries on the basis of their comparative advantages. However, this recommendation does not match the lessons and conclusions from empirical data. For example, Imbs and Wacziarg (2003, p. 64) found that successful countries ‘diversify most of their development path’. Only the existence of different industries is able to create synergies and increase the likelihood of successful entrepreneurship and innovations in new areas. Development has a lot to do with random self-discovery, which cannot be explained by comparative advantage (Rodrik, 2004). In a similar direction, Cimoli, Dosi and Stiglitz argue that ‘[e]mulation…is the purposeful effort of imitation of “frontier” technologies and production activities irrespectively of the incumbent profile of “comparative advantages”. It often involves explicit public policies aimed at “doing what rich countries are doing” in terms of production profile or the economy’ (Cimoli et al., 2009, p. 544). Furthermore, it is important to note that, historically, the rise of the now developed countries was not a result of free trade (Chang, 2002).

Low-tech Tasks in Global Value Chains (GVCs)

Since the 1990s, the characteristics of globalization changed with the revolution in information and communication technology, reduction in transportation costs and deregulation of international trade and capital flows. These developments allowed multinational companies to break down their production processes into different ‘tasks’ and allocate these tasks all over the world, in line with their profit motives. Developing countries with relatively low-wage costs and other cost-saving factors, such as weak environmental or working standards, became attractive to take over specific tasks. Offshoring in the form of subsidiaries or subcontracting is not a new phenomenon, but never before in history did it happen to such an extent. Some even speak of a new industrial revolution (Blinder, 2005).

Pure domestic value-adding production activities—for example, a haircut—dropped from 85 to 80 per cent of world GDP between 1995 and 2014. Value adding in traditional trade—for a good such as oil or a machine which is completely produced in one country and sold to another one—increased from 6 to 7 per cent of world GDP in 1995–2014. Simple global value chains (GVCs), where national borders are crossed only once during the production process, showed an increase from around 5 to 8 per cent of world GDP. Complex GVCs, with more than one border crossing during the production process, increased from around 3–5 per cent of world GDP (Dollar, 2017, p. 2f).

In GVCs, lead firms (or intermediate firms acting for lead firms) offshore tasks with low value addition. The model of comparative advantages can again be applied to analyse the allocation of tasks. As in traditional trade, developing countries have a comparative advantage in low-tech and low-skilled tasks, and developed countries in high-tech and high-skilled tasks (Feenstra, 2010). Several consequences follow. First, developing countries do not only produce low-tech goods as in traditional trade—like garments in the above example—they produce the low-tech tasks in the production of low-tech goods. For example, in garment production, countries like Bangladesh or Vietnam take over low value-adding activities, such as trimming and cutting, whereas high-value activities such as design, research for new material, branding or logistics are taken over by foreign lead firms or foreign intermediate traders. This mechanism can lead to a further reduction in the productivity level and can intensify the above-discussed lack of dynamic industrial development.

Second, there is the hope that the lead firm will transfer skills and technology to developing countries. However, even if the lead firm transfers technology to developing countries, this will have limited impact, as only low-tech task will be transferred. If the producer in the developing country produces the task in a satisfactory way, there is no incentive for the lead firm to improve further the technology or skill level in developing countries. In traditional manufacturing sectors (e.g., textiles, footwear) and natural resource-based sectors (e.g., copper, fruits), local firms benefit from GVCs usually in terms of product upgrading (better or new products in the area of the task) and process upgrading (new technologies or organizations to produce the task), as these firms are often forced to comply with overseas quality and social standards. Such an effort is in the interest of lead firms, which in many cases support the upgrading. Functional upgrading (shifting or extending the position in GVCs to more skilled activities) is rare, because lead firms tend to secure the know-how of their skill-intensive operations to themselves. Global buyers in GVCs tend to divide their innovation activities between strategic ones (with highest value-added) performed in home locations and non-strategic ones outsourced to various locations in developing countries. Global upgrading in complex product sectors (e.g., automobiles, computers, aircrafts) is usually small, and functional upgrading very unlikely (Giuliani, Pietrobelli & Rabellotti, 2005; Humphrey & Schmitz, 2002; Pietrobelli & Rabellotti, 2004; Schmitz, 2007).

Third, power asymmetries are vital in GVCs. Monopsonistic structures dominate. A monopsonist has a demand monopoly and the market power to reduce prices of sharply competing suppliers to a minimum. Suppliers are pushed to almost profitless production, whereas the lion’s share of profits along the value chain is pocket by the lead firm. ‘Value crabbing’ in GVC—this means the concentration of profits in lead firms—must be seen as an important factor to increase profits of multinationals and increase the profit share of, and in, developed countries. At the same time, profits in developing countries are downgraded and the pressure on wages and working conditions increased (Milberg & Winkler, 2013). One can speak about a new global exploitation model which was established together with GVCs (Azarhoushang, Bramucci, Herr & Ruoff, 2015).

Negative Terms of Trade Effects

Exploitative structures between developed and developing countries can also be observed when developing countries have absolute advantages. The latter especially exist in developing countries in the area of primary commodities, such as extraction of relatively abundant resources (coal, iron ore and so on) and agricultural products (coffee, rice, sugar cane and so on). Singer (1949) and Prebisch (1950) have already made the argument that the production of primary commodities leads in the long run to negative terms of trade effects for developing countries. Deteriorating terms of trade imply that a country must quantitatively export more products to receive the same amount of imports. In the case of developing countries, this implies that they must export quantitatively more primary commodities to get the same quantity of high-tech products produced in developed countries.

Following Singer and Prebisch, there are four reasons why terms of trade tend to deteriorate in developing countries. First, primary commodities have lower price elasticities than manufactured goods. If prices of primary commodities decrease, demand do not necessarily increase, which contrasts with manufactured goods. Price fluctuations thus put more pressure on producers who sell their products on global markets. Second, income elasticity for primary products is also relatively low. For example, it is not necessary to buy more of a simple food if income increases. Third, technological developments in the field of synthetic substitutes and efficiency gains in reducing inputs of primary commodities tend to reduce the demand for primary commodities. Fourth, primary commodities usually are produced and sold in highly competitive markets, while manufacturing products are produced by multinational corporations which in many cases have monopsonistic and/or oligopolistic positions. Singer (2003), looking at long-term trends, supports these assumptions, finding that prices for primary commodities which were produced in developing countries dropped in relation to manufactured goods produced in developed countries. As in the case of low-tech production of goods or tasks in GVCs, specialization according to market forces on primary commodities does not seem to be a sufficient strategy for developing countries in catching up (Ruoff, 2016).

Natural Resources, Dutch Disease and Rent-seeking

The expression ‘Dutch disease’ was coined in the 1970s, when increasing off-shore production and export of oil in the Netherlands let to poor development of the manufacturing sector which had earlier been internationally competitive. Corden and Neary (1982) analysed the Dutch disease phenomenon. Their main argument was that the extraction and export of scarce and highly priced natural resources (oil, gas and so on) leads to substantial real appreciation and a loss of competitiveness for the manufacturing sector. This cannot be a surprise, as countries exporting a lot of scarce natural resources cannot at the same time export a lot of manufactured goods. For the manufacturing sector, the exchange rate is then overvalued to such an extent that manufacturing has no chance to develop. As employment and technological spillovers of oil or gas extraction are rather low and natural resource-rich countries suffer from a loss of competitiveness in the dynamic manufacturing sector, the country loses its productive power. Growth may be high as long as natural resource prices are high, as the domestic non-tradable sector is stimulated by high revenues from natural resources. But the country is in danger of suffering in the long term from low productivity growth and crisis. Lastly, when the natural resources are used up, the resource-based development model collapses.

There are more problems for countries with scarce natural resources (Herr, 2016; Humphreys, Sachs & Stiglitz, 2007). Natural resource prices are traditionally volatile and especially since the financialization tendencies of the last decades, driven by speculative exaggerations (Evans & Herr, 2016). This exposes natural resource-rich countries to frequent shocks. Even when natural resource revenues are usefully spent, there is the danger that projects with respect to industrial or social welfare purposes cannot be finished if revenues suddenly run dry. Usually natural resource-rich countries have poor tax systems. This implies that losses incurred from declining oil revenues cannot be quickly compensated. Last but not least, natural resource-rich countries suffer from rent-seeking and high levels of corruption in many cases. It is easier and more rewarding to try to participate in natural resource rents than to become an entrepreneur.

In the light of these problems, it becomes understandable why so many resource-rich countries suffer from Dutch disease and a resource curse—from Nigeria, Angola, Venezuela to Iran or Russia, only to mention a few. Norway is the big exception because of its good institutional framework. Extensive development aid in the form of money inflows can lead to similar effects as Dutch disease, that is, an overvalued exchange rate and rent-seeking behaviour (Rajan & Subramanian, 2005). For this reason, development aid should primarily be given as costless knowledge and technology transfer or training. High remittances can also lead to Dutch disease effects.

Premature Deindustrialization

Deindustrialization can be defined as the fall in the share of manufacturing employment, or an absolute fall in such employment (Dasgupta & Singh, 2006, p. 1). Deindustrialization, in this sense, is historically a normal phenomenon and reflects the fast increase of productivity in manufacturing and consumer preferences which switch with higher income to non-manufactured products (Lawrence & Edwards, 2013). However, this process of deindustrialization happens in a number of developing countries at very low GDP per capita levels.

In the 1960s and 1970s, manufacturing employment in the USA, Japan, Germany, Britain, Italy, France and other Western European countries peaked at income levels of around USD 14,000 (in 1990 USD) and employment shares of around 25 per cent or more of total employment, such as in Germany and Sweden which reached around 30 per cent. Very high peak values also include countries such as South Korea (in 1989), Malaysia (in 1997) or Argentina (already in 1958). In contrast, in many developing countries, manufacturing peaks at income levels of USD 700 (in 1990 USD) and at maximum employment levels of only around 15 per cent. For example, industrial employment in India peaked at around 12 per cent of total employment in 2002, in Indonesia at around 13 per cent in 2001, in Ghana at around 15 per cent in 1978 or in Zimbabwe at five per cent in 1985 (Rodrik, 2015). In many developing countries, the market mechanism leads to a specialization away from manufacturing. Developed countries and a number of developing countries such as the Asian tigers or China obviously have comparative advantages and the capacity to produce manufactured goods for the whole world.

Rodrik (2015) calls this phenomenon premature deindustrialization. Following Kaldor (1966, 1967), industrialization is at the core of economic development. The industrial sector, as mentioned, is usually the most dynamic sector and of key importance for dynamic development. It is questionable whether other sectors in developing countries can take over the lead in a development process. Theoretically, high-quality services could take over this function. But service-led growth in this field is highly skill-intensive and does not engage a substantial amount of low-skilled labour. In developing countries, the level of skills is usually low. In addition, it is questionable whether the employment dynamic of high-skilled services is sufficient to create the needed employment (Rodrik, 2015). In this context, we are sceptical that convergence can be triggered with very low level of manufacturing and industrialization.

There are other negative effects of premature deindustrialization (Rodrik, 2015). Industrialization is crucial to democratic processes; it causes urbanization which subsequently leads to the development of a big working class fighting for social and political reforms. Class struggle in the end builds and strengthens institutions, which is vital for social and economic development. To sum up, if countries are not able to industrialize, there is the danger that no sufficiently big economic sector is created which increases productivity and innovation. There are not enough big companies which have to operate in the formal sector, which are unionized, and which must follow certain general rules. And there is no social basis in form of a working class for creating acceptable equal living conditions.

Low Quality of Domestic Currencies

Approximately 180 currencies in the world have different qualities and take over different functions. The quality of a currency depends on the trust that wealth owners (rich and poor households, firms, financial institutions) show vis-à-vis currencies. Trust depends on past and more so, expected stability of the currency, which is expressed in a low inflation rate and stable exchange rate, its fungibility, the size of the currency area, the political and social stability of the country, and many other factors, up to the military power of the money-issuing country. A currency hierarchy exists with only a handful of currencies, such as the US Dollar and the Euro, taking over all national money functions and international money functions. There are approximately 20 currencies in the world, such as the Australian Dollar or the Swedish Krona, that take over all domestic money functions but no international ones. Thus, the majority of currencies are low-quality currencies which do not only not take over international functions but only partly take over national functions. Monetary wealth denominated in these currencies in a very limited extent serves the needs of wealth owners.

The limited role of currencies even for domestic money functions is shown by the extent of dollarization (including euroization). A common indictor for dollarization is the share of domestic foreign currency deposits on total domestic deposits in a country. Median deposit dollarization of all emerging market economies was somewhat over 17 per cent. This does not sound very high, but there are big differences (Catão & Terrones, 2016).¹ It must be added that in many countries, dollarization is legally prohibited or restricted, as in Brazil or Chile. And there are many countries with very high deposit dollarization, with shares of 50 per cent or higher.

Dollarization is the capital flight of the small and not internationally acting wealth owner. Big wealth owners in developing countries keep their monetary wealth outside their country. The amount of monetary wealth of wealth owners kept outside their countries is statistically not known. But one can imagine that, in most of developing countries, especially the ones following market radical policies, much more than 50 per cent of monetary wealth is kept in foreign currency.

There are many severe disadvantages when a country is not able to produce a currency which is sufficiently accepted by domestic and, consequently, foreign wealth owners. First, the low quality of a currency leads to currency mismatch. Currency mismatch is caused by dollarization, because there is a high correlation between deposit dollarization and domestic credits given in foreign currency (credit dollarization) (Chiţu, 2012). Domestic financial institutions use domestic foreign currency deposits obviously to give domestic foreign currency loans. Currency mismatch is also caused by foreign credit. The latter is almost exclusively dominated by foreign currencies in developing countries (Eichengreen, Hausmann & Panizza, 2007). Currency mismatch implies that a real depreciation of the domestic currency increases the real debt burden of debtors in foreign currency. A sharp depreciation then leads to financial crises, which have become so frequent in developing countries after the liberalization of finance in the 1970s. It is also no surprise that Chiţu (2012) found that dollarization was an important contributor to the severity of the crisis that hit many developing countries after the outbreak of the US subprime crisis in 2007.

Second, international capital flows are unstable. Developing countries were regularly afflicted by boom–bust cycles, that is, periodic high capital inflows creating high currency mismatch, followed by sudden capital outflows and financial crisis (Williamson, 2005). Third, monetary policy is severely restricted in countries with low-quality currencies. In these countries, interest rates must be pushed up by Central Banks to compensate for the low quality of their currencies. High interest rates reduce domestic investment and increase income inequality. High currency mismatch also restricts the use of the exchange rate to regain competitiveness via real depreciation. Countries can be caught in a constellation of high current account deficits, overvaluation of their currencies and a policy of very high interest rates by their Central Banks fearing a situation of high currency mismatch depreciation. In addition, in countries with high currency mismatch, there is a very restricted lender of last resort for the domestic banking system. The importance of this function of Central Banks could be excessively observed in developed countries hit by the subprime crisis (Herr, 2014).

Fourth, and probably most important, is the breakdown of a sustainable Keynesian–Schumpeterian credit-investment-income-creation-saving mechanism which is at the centre of economic development. When a Central Bank refinances a stable domestically financed healthy expansion process, then monetary wealth in domestic currency is endogenously created. But the problem is that in a typical developing country, 50 per cent or more of monetary wealth creation is exchanged in foreign currency by wealth owners. This leads to an unacceptable depreciation of the domestic currency and, finally, a monetary policy which stops the economic expansion very early. By this process, high GDP growth rates in developing countries and convergence are suppressed. An expansion can develop for some time, as long as the country can attract sufficient capital inflows (gross, not necessarily net), or domestic investment is directly financed by credit dominated in foreign currency. However, a credit and investment expansion based on increasing currency mismatch is not sustainable. It becomes understandable that the countries which managed to achieve a certain convergence, like China and other Asian countries earlier, developed under a regime of strict capital controls, including highly regulated domestic financial markets (Herr, 2010; Stiglitz & Uy, 1996).

Inequality

Inequality in a typical developing country is substantially higher than in developed countries.² Global inequality, which compares all humans in the world irrespective of their nationality, increased from 50 to 69.7 from 1820 to 1988. Then, it dropped to 66.8 in 2008 and 62.5 in 2013 (Milanovic, 2014; The World Bank, 2016, p. 80f). The global Gini coefficient depends on income differences between countries and inequalities within countries. Data show that the reduction of the global Gini coefficient in recent years is based on the positive average income development of populous countries like China and, to a lesser extent, India. However, within-country inequality substantially increased. The World Bank calculated the population-weighted average national Gini coefficient to show this effect. This Gini rose sharply between 1988 and 1998 from 34 to 40 and then declined to 39 until 2013 (The World Bank, 2016, p. 82). High inequality is an obstacle for economic development. Berg and Ostry (2017), in their econometric work, found that longer periods of high growth become unlikely if inequality becomes too high. In a comprehensive meta-analysis, Neves, Afonso and Silva (2016) concluded that there is a negative relationship between higher inequality and lower growth, especially in developing countries.

Classical and neoclassical economists tend to argue that higher inequality can stimulate growth. They base their belief on the arguments that higher inequality leads to higher savings and, following Say’s Law, higher investment. Also positive incentives are created by higher inequality. Neither argument is convincing. First, savings are the result of income creation; ex ante saving is not needed and logically cannot provide the funds for investment—actually ex ante savings reduce aggregate demand and can suppress investment (Keynes, 1937). Second, high profits are not needed for high investment. Profit for good entrepreneurship should be possible. But the lion’s share of non-work income is not based on entrepreneurship, and it is based on existing wealth, most of it inherited. Third, certain wage dispersion might be needed, but not at a level found in the typical developing countries in which wage dispersion is the main factor for income inequality (Herr & Ruoff, 2016).

There are convincing theoretical arguments about lower inequality leading to higher growth. Myrdal (1972, p. 102f) stressed the positive effects of a more equal income distribution for development in five points. First, if the reproduction of the power of labour for the poorer is improved (better health care, better housing and sanitation, better education), productivity will increase. Second, mobility in society will increase with positive economic and social effects. Third, the rich are not always the best entrepreneurs and tend to be a parasite class. Fourth, higher equality adds to social coherence and national consolidation. Fifth, the build-up of welfare states in Western countries after World War II must be considered as one of the most profitable investments of societies, even though the gestation period of this kind of investment is long term (refer also Ostry, Berg, & Tsangarides, 2014).

From the demand side, high inequality and high insecurity reduce consumption demand. The main argument is that high-income groups have a lower propensity to consume in comparison with low-income groups. Without sufficient consumption demand, which is by far the biggest demand element in almost all countries, overall demand will suffer and also compress investment demand. A relatively equal income distribution and the inclusion of all societal groups in economic progress become a precondition for sustainable growth also from the demand side. For some countries, it might be possible to overcome the negative demand effects of inequality by high current account surpluses, high indebtedness of private households or high fiscal deficits. But all these strategies are problematic for the world economy or the sustainability of the growth model (Hein, Detzer & Dodig, 2015). It is worthwhile mentioning that inequality within countries is of crucial importance for the demand argument. The increase of inequality within countries during the last decades leads to expectations of lower GDP growth.

Economic thinking has produced a whole set of theoretical approaches to explain why unregulated markets do not lead to convergence between developed and developing countries. Countries can suffer from several of these drawbacks, showing how difficult a task it is for a country to develop. And there are two more obstacles for development which have not been mentioned yet. First, developing countries are, on average, more severely affected by the impact of global warming and other ecological problems than developed countries. They also have less means to protect themselves against these developments. Second, it is obvious that only comprehensive government interventions, partly against market mechanisms, can trigger development. However, the political constellation in many developing countries does not allow such policies. Elites in the countries may not be interested or capable of implementing policies which lead to convergence. They may be part of a ‘global middle class’ with similar living styles, fashions and values. For them, a needed national project of development (including inclusive growth) may sound as an alien adventure, neither realistic nor preferable. However, there have been historical crossroads which allow policies in favour of development.

Conclusions and Alternatives

As a conclusion, 10 recommendations for good development policy are offered as an alternative to the Washington Consensus. They are based on a development-oriented highly regulated type of capitalism (Dullien, Herr & Kellermann, 2011) in the tradition of John Maynard Keynes and Karl Polanyi. In such an approach, markets can play an important role, but they have to be embedded in comprehensive government regulations and institutions. The recommendations concentrate on economic and social dimensions. Additional policies are needed, such as increasing democracy and participation, undertaking land reforms in some countries and so on, which cannot be discussed here.

Fighting Inequality

High-income inequality leads to a lack of aggregate demand and many negative supply side and social problems. Policies for a more equal income distribution substantially increase productivity and stimulate consumption demand. Developing countries should strive for a kind of ‘Fordist’ model based on mass consumption, relatively equal income distribution and high productivity development. Inequality is a multifaceted phenomenon and a whole package of policies is needed to fight against it (Gallas, Herr, Hoffer & Scherrer, 2016). Among them are policies for minimum wages, reduced wage dispersion, a regulated financial system with low real interest rates, fight against rent-seeking in all versions, build-up of a basic welfare state and redistribution via the tax system. All the big East Asian miracle countries which managed to catch-up did this under a regime of comparatively very equal income distribution (Stiglitz, 1996).

Public Goods and Public Utilities

Public goods serve different positive purposes. In the field of education or health care, they add to a more equal income distribution and increase the productivity. In the field of, for example, communication, information and transportation infrastructure, including public transport, they add also to more homogenous living conditions and, of course, to the productivity level of an economy. To support women and ensure gender equality should become an explicit policy in these fields.

Natural monopolies in the field of public utilities, for example, electricity supply, water supply, waste management or hospitals, should belong to the government. This also has the advantage that the investment dynamic and ecological reorientation of a country can directly be at least partly managed by state-owned companies. Of course, these companies should be managed in an efficient way and should, as a rule, be cost-covering. Public–private partnerships are not a preferable model, as in many cases the private partner pockets the profits and the state bears the risk. Of course, the government should buy the expertise to guarantee the highest quality of its projects.

Comprehensive Industrial Policy for Industrialization

As the market pushes developing countries to low-tech production, or even prevents a substantial industrialization, government interventions are needed to push for an upgrading of existing industries and also to search for new industries. New industries have to be protected and/or supported to withstand foreign competition. Selected foreign direct investment (FDI) can support such a development, for example, when a high local content for such investment is negotiated, including substantial transfer of technology and skill. For successful industrial policy, an intensive information flow among government, employers’ associations, trade unions and social society groups is needed. Government interventions in these fields are even possible today. They can be disguised as regional policy, technology policy or policies against unfair competition (Cimoli et al., 2009; Ohno, 2013; Rodrik, 2004). In this context, exchange rate policy should be used as a general protection of the domestic economy. Industrial policy is the instrument for selective protection and support.

Prevent Dutch Disease

Natural resource-rich countries should extract and export natural resources only to a limited extent. At least populous natural resource-rich countries should prevent the natural resource sector becoming the dominant sector in the economy. To prevent overvaluation, export revenues from natural resources should be invested abroad to a large extent. Norway, for example, invests most of its natural resource revenues in sovereign wealth funds abroad. In the ideal case, an exchange rate policy should be followed to prevent a deficit of the industrial sector (Herr, 2016). However, a better option may be not to invest so much in a potentially unstable financial system and keep natural resources underground.

Companies extracting and exporting natural resources should be government-owned to prevent domestic and foreign rent-seeking behaviour. Countries should follow policies to process natural resources and keep more value added within the country. The usage of natural resource revenues should be transparent and socially controlled. Obviously, revenues from natural resources spent domestically should be used by governments to improve public goods and public utilities and carry out comprehensive industrial policy. Countries should avoid all kinds of Dutch disease, including excessively high development aid, remittances and capital inflows.

Strictly Regulated Financial System including Capital Controls

In developing countries, capital controls are an important element of financial market supervision and a stable development (Stiglitz, 2004; Williamson, 2005). First, capital controls are needed to prevent currency mismatch. For this purpose, portfolio investment in form of debt securities should be forbidden and short- and long-term credit highly regulated. Also, governments should not become indebted in foreign currency. Portfolio investment in form of equity and FDI does not create currency mismatch, but portfolio equity is not of much use for a country. FDI should be invited but should be integrated in a national industrial policy strategy. Second, capital import controls prevent high capital imports and an overvaluation of the exchange rate. As a complementary instrument, the Central Bank should intervene in foreign exchange markets. Third, capital import controls can prevent dangerous international boom–bust cycles and can help to stabilize international capital flows. Finally, especially capital export controls increase the room of domestic monetary policy and allow a lower level of real interest rates.

It was shown above that dollarization creates several negative effects; for example, it leads to currency mismatch, reduces the role of the Central Bank as lender of last resort and restricts credit expansion in domestic currency. Policies should be followed to reduce dollarization. The financial system should be strictly supervised to prevent non-performing loans. Credits for real estate investments and consumption credits should be restricted. In developing countries, a bank-based financial system is preferable, and share markets and debt securities should have a subordinated role. State-owned and collectively owned banks, as well as development banks, can play an important role to deliver long-term credits for investment for low interest rates.

Never Accept Current Account Deficits— Push for Exports

A high level of international trade is not in contradiction with regulated trade and a comprehensive industrial policy. Developing countries should be export-oriented in order to search for new international markets with higher domestic value added. Current account deficits are dangerous because they are usually closely connected with foreign indebtedness. Foreign debt will increase when the deficit is not completely financed by FDI and portfolio equity. Current account deficits can be prevented by controlling capital imports, Central Bank interventions in the foreign exchange market and an exchange rate policy which keeps the current account balanced.

Current account surpluses can lead to export-led growth. Current account deficits can reduce domestic demand and output. For a single country, high current account surpluses may be a good engine for growth. However, a current account surplus of a country leads to corresponding deficits in other countries. Also developing countries should not push for high surpluses and should prevent themselves from causing disturbances in the world economy. But they should definitely not be forced into current account deficits which can have enormous negative effects.

Wage Discipline and Managed Exchange Rate as Nominal Anchors

To increase the quality of a currency in a developing country, and in this way, improve the chances for development, current account deficits and high foreign debt have to be avoided. A second key factor for building up the quality of a currency is a low and relatively stable inflation rate. The main anchor for this is a stable development of nominal unit labour costs. The latter depend on nominal wages and labour productivity. In a closed economy, the inflation rate in the medium term depends on changes of nominal wages minus the trend productivity changes. Of course, price-level shocks can be caused by changes in the prices of natural resources or food. From this, relationship follows the desideratum that the nominal wage level should increase according to trend productivity, plus a low (target) inflation rate. In this case, the medium-term inflation rate remains at a low level (Herr, 2009; Keynes, 1930). Wage increases in all sectors should take the medium-term national productivity development as a guideline to limit wage dispersion between sectors.

Macroeconomic wage coordination is desirable. Strong trade unions and strong employers’ associations are preferable for such coordination. Scandinavian countries can serve as a role model. In many developing countries, minimum wages take over the function of wage coordination. Minimum wages are then determined in a tripartite body and serve as a guideline for all wage increases, although such an institutional arrangement is not ideal, and wage bargaining in developing countries (including wage coordination leading to less wage dispersion) is desirable. In a situation of very weak unions, it is a working model for stable wage development.

In developing countries, the nominal exchange rate becomes the second nominal anchor for the price level. This is one of the reasons why developing countries cannot afford flexible exchange rates. They should follow a managed exchange rate regime with adjustments when the current account gets in disequilibrium. A managed exchange rate uses, besides the interest rates, first of all capital controls and Central Bank interventions to realize the exchange rate target. When the domestic inflation rate becomes high, the Central Bank has to fight against inflation even if it increases unemployment. The build-up of a domestic currency which takes over all domestic monetary functions is a long-term priority for development. Capitalist economies are monetary production economies and need functional money. Of course, everything should be done to avoid such a policy. But it has to be accepted that high inflation rates trigger cumulative inflationary processes which destabilize economic and social development. Too low nominal wage increases, or even wage cuts, lead to deflation, and this is even worse than high inflation. To fight against deflation, a Central Bank needs the help of trade unions, including in minimum wage policy, in order to enforce the nominal wage anchor.

Comprehensive Tax System and Fiscal Discipline

Developing countries need public goods in an extensive way for a social policy and the development of the enterprise sector. For this purpose, sufficient public revenues have to be created by a comprehensive tax system and other means which are based on a broad tax base. Included in the tax system should be a redistribution component with a progressive income tax and high consumption taxes for luxurious goods. For developing countries, room for budget deficits is smaller than for developed countries. Fiscal discipline is one of the instruments to increase the reputation of a currency. Of course, this does not exclude anti-cyclical fiscal policy and indebtedness for public investment. But it excludes excessive fiscal deficits in the logic of so-called functional finance to create full employment, in the tradition of Lerner (1943).

Ecological Restructuring

Ecological restructuring should not be left to developed countries in spite of the fact that they have been causing most of the damage and promoted the technologies and living styles which led to the present critical situation. The ecological problem can be tackled by restructuring, for example, the energy and transportation sector. A Green New Deal with high investment in ecologically critical sectors could be combined with employment policies (Dullien et al., 2011).

Demand Management

The volume of aggregate demand, as well as the structure of aggregate demand, can lead to crises, lack of development and unemployment in capitalist societies. Two demand elements are at the centre of these developments. The first one is investment, which should be guided by three elements: a government-owned sector concentrated in the area of public utilities, a non-profit sector in form, for example, of building societies and collectively owned companies, and private investment. The investment dynamic should be subordinated to comprehensive industrial policy and have a vision of how the country should develop. Additional instruments to stimulate investment are development banks and, of course, monetary policy and government subsidies and procurement. The second one is consumption demand, which has to be stimulated by fair income distribution and social policy. In this direction, Keynes (1936, p. 325) argued as follows:

Moreover, I should readily concede that the wisest course is to advance on both fronts at once. Whilst aiming at a socially controlled rate of investment…. I should support at the same time all sorts of policies for increasing the propensity to consume…. There is room, therefore, for both policies to operate together; to promote investment and, at the same time, to promote consumption.

Looking at demand management, a policy of a balanced current account and anti-cyclical fiscal policy has to be added. Such a policy approach allows the combination of economic and social upgrading which presuppose each other.

Footnotes

Notes

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