Foreign Policy: International Development: Is It Possible?

Foreign Policy
Spring 1998

International Development: Is It Possible?

By Joseph E. Stiglitz & Lyn Squire

Is development possible? Yes. Despite continuing concerns arising from the currency crisis in East Asia, the evidence of the last 25 years is unequivocal: the developing world has made dramatic advances on many fronts. Two examples illustrate this progress. One benefit of being born in the developing world in 1995 rather than 1970 is 10 years of extra life. Another is that per capita annual incomes are 50 percent higher. Thus, even with conservative assumptions about future growth, someone born in 1995 can expect to enjoy four times the lifetime income of someone born in 1970.

Almost everyone agrees that development cannot be equated solely with reductionist economic measures such as GDP. Nevertheless, higher output and hence higher incomes are important because they expand the choices available to individuals, families, and societies. The record of the last quarter century demonstrates two points: Aggregate economic growth benefits most of the people most of the time; and it is usually associated with progress in other, social dimensions of development. Indonesia is a classic case where GDP per capita increased by more than 170 percent in only 20 years (between 1975 and 1995), and the share of the population in poverty declined from 64 to 11 percent—a dramatic reduction in less than a generation. A recent compilation of cross-country evidence confirms the point. In 88 decade-long spells of growth drawn from across the world, the poorest fifth of the population benefited in 77 of the cases.

Contrary to the work of early development theorists such as Simon Kuznets, the evidence does not support the idea that increases in income are associated with increases in inequality. Thus, for the same 88 growth spells, inequality worsened in about half the cases and improved in the other half, but in most cases the changes were small. As a crude rule of thumb, per capita growth in excess of 2 percent almost invariably benefits the poor.

The evidence also shows that although there is no automatic link between income and other measures of development, there is a strong association. Using the World Bank classification of countries, low-income countries have a life expectancy of 63 years and an adult literacy rate of 66 percent. The corresponding figures for middle-income countries are 68 years and 82 percent, and for high-income countries 77 years and over 95 percent. Moreover, and more important, countries such as South Korea have made progress on both income and nonincome measures of development. Indeed, the two are complementary and mutually reinforcing.

If we accept that aggregate economic growth benefits most people most of the time and provides the means to achieve many of society's goals, then we should question how some countries have managed to grow much more quickly than others. An obvious answer is that countries that invest more will grow faster. This answer is only partially correct. Both East Asia and the former Soviet Union have achieved high rates of investment, but only East Asia has managed to translate this into increasing levels of income. Although investment may be necessary for growth, it is not sufficient.

Three conditions are critical: a stable and credible policy environment, an open and competitive economy, and a focused public sector.

Entrepreneurs will not invest in countries where the fiscal and monetary policy regime is unstable—investors require a degree of certainty. Worldwide, 80 percent of total foreign direct investment has gone to just 12 developing countries in the period 1990–95, countries that, at least until recently, have been well managed and highly stable.

Competition is a powerful force for ensuring that investment is well directed and yields the greatest possible benefits. On almost any measure of openness—share of trade in GDP or average levels of tariffs—the successful East Asian countries have been much more open than the slow-growing economies of Latin America, South Asia, and sub-Saharan Africa.

The failure of extensive state production of goods and services in the former Soviet Union and elsewhere, and the success of private investment in East Asia, provide a clear message for the public sector: It should focus its efforts on those areas where the private sector fails. Macroeconomic policy is one example where government involvement is pivotal. Defense, redistribution, the legal and judicial system, regulation of financial markets, and protection of the environment are all areas in which the public sector has to play the central role.

We have learned much in the last 25 years about the mechanics of development and about the broad strategies and policies that support rapid and equitable growth. But there is still more to learn about the particulars of development.

First, we need a much deeper understanding of how certain key markets function. The failure of state enterprises and the success of market economies have led to strong efforts to privatize and liberalize markets. But privatizing a natural monopoly before an effective regulatory framework is in place may lead to higher, not lower, prices and may establish a vested interest resistant to regulations that encourage competition. Striking the right balance between unfettered markets and state regulation is difficult and requires a thorough understanding of how markets work. Nowhere has this become more apparent than in the current crisis in East Asian financial markets.

Second, we need to recognize why some policies work in some situations and not in others.

Industrial policy—the provision of special incentives to particular industries or firms—has been an unquestionable failure in Latin America, South Asia, and sub-Saharan Africa. Not so in East Asia. There, industrial policies led to a rapidly growing and competitive industrial sector. Understanding the structure of incentives that govern the implementation of public policy, the delivery of public services, and public management in general will be key to future development.

Third, we need to learn how to deal with new issues generated by the process of development. Although the successes of East Asia over the past three decades are not a house of cards, the East Asian experience raises a host of fundamental questions: To what extent are East Asia’s lessons replicable? Do the problems these countries face today reflect a fundamental flaw in their strategy to deal with the demands of globalized capital markets, or do they arise from a too rapid departure from the principles of sound economic management that had long contributed to their success? What are the strategies that are most effective in achieving sustainable development—development that protects the environment as it raises living standards? And by the same token, can we combine rapid growth with a more rapid transition to democracy?

These questions highlight a larger truth that underlies the considerable progress in our knowledge and understanding of development: Simple ideologies will not suffice; indeed, they are likely to be dangerous. Neither of the extremes advocated—state-run development or unfettered markets—will likely lead to success. Moreover, the solutions to Latin America’s macroeconomic crises, characterized by high inflation, large public deficits, and high levels of public indebtedness, may not work in East Asia, with its low inflation, low public deficits (or actual surpluses) and, at least in some cases, low public indebtedness. The need to tailor our thinking about development strategies and our policy recommendations to the distinctive problems of each country, coupled with the continuing evolution of the global economy, requires that we keep learning and adapting our views. Otherwise, yesterday’s truths may well become tomorrow’s mistakes.