east asian miacle 1

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H.Goar Is the World Bank’s ‘market friendly’ approach a satisfactory explanation for the East Asian miracle? Stiglitz (1996) considers the miracle in terms of the Solow (1957) model and defines it as growth unexplainable in terms of inputs reflected in the Solow residual. The market friendly approach must therefore explain why growth in East Asian countries exhibited a positive Solow residual. The World Bank in their publication the East Asian Miracle attributes this growth to a “market friendly approach. The “market friendly” approach is defined as government industrial and competition policy to ensure “adequate investment in people, provision of a competitive climate for enterprise, openness to international trade and stable macroeconomic management.” (EAM 1993) Distinct from the pure free-market approach the market friendly approach is derived from recognition of imperfections in markets. Arrow and Debreau (1954) show that if perfect markets do not prevail intervention may be effective in reaching optimal outcomes. Stiglitz (1989) argues series of imperfections occur in the East Asia pre miracle. However, the differentiation between a market friendly approach envisioned by the World Bank and that of a government controlled system in response to a realization of the existence of imperfections in developing economies (Stiglitz (1989)) stems from the confinement and manner of the role of government (Yanagihara 1994). In short, the World Bank attributes East Asia’s growth to getting the ‘basics right’ and that intervention should only occur to allow these ‘fundamentals’ to be pursued as an acknowledgment of only few cases of market failure . According to the World Bank EAM report, private domestic investment and rapidly growing human capital were the principal engines of growth. HPAE’s developed an infrastructure that was complimentary to private investment. Tax incentives and policies that kept the relative prices of capital goods low also helped to create an investment friendly environment (EAM Report, 1993). Furthermore HPAE governments focused their education spending on universal primary education (EAM Report, 1993). Focusing on primary education as opposed to tertiary education not only prevented a ‘the brain drain’ and had higher returns to investment but also led to a more equitable income distribution. High levels of domestic financial savings

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Page 1: East Asian Miacle 1

H.Goar

Is the World Bank’s ‘market friendly’ approach a satisfactory explanation for the East Asian miracle?

Stiglitz (1996) considers the miracle in terms of the Solow (1957) model and defines it as growth unexplainable in terms of inputs reflected in the Solow residual. The market friendly approach must therefore explain why growth in East Asian countries exhibited a positive Solow residual. The World Bank in their publication the East Asian Miracle attributes this growth to a “market friendly approach. The “market friendly” approach is defined as government industrial and competition policy to ensure “adequate investment in people, provision of a competitive climate for enterprise, openness to international trade and stable macroeconomic management.” (EAM 1993) Distinct from the pure free-market approach the market friendly approach is derived from recognition of imperfections in markets. Arrow and Debreau (1954) show that if perfect markets do not prevail intervention may be effective in reaching optimal outcomes. Stiglitz (1989) argues series of imperfections occur in the East Asia pre miracle. However, the differentiation between a market friendly approach envisioned by the World Bank and that of a government controlled system in response to a realization of the existence of imperfections in developing economies (Stiglitz (1989)) stems from the confinement and manner of the role of government (Yanagihara 1994).

In short, the World Bank attributes East Asia’s growth to getting the ‘basics right’ and that intervention should only occur to allow these ‘fundamentals’ to be pursued as an acknowledgment of only few cases of market failure . According to the World Bank EAM report, private domestic investment and rapidly growing human capital were the principal engines of growth. HPAE’s developed an infrastructure that was complimentary to private investment. Tax incentives and policies that kept the relative prices of capital goods low also helped to create an investment friendly environment (EAM Report, 1993). Furthermore HPAE governments focused their education spending on universal primary education (EAM Report, 1993). Focusing on primary education as opposed to tertiary education not only prevented a ‘the brain drain’ and had higher returns to investment but also led to a more equitable income distribution. High levels of domestic financial savings sustained the HPAEs' high investment levels. East Asian countries had in common a high savings rate with an average savings rate of c. 37% of GDP in 1990 (World Bank Data) some 20 percentage points higher than the Latin American average. Some HPAE’s have also used more interventionist policies to increase the saving rate. For example China and Taiwan imposed high interest rates on loans for consumer items and imposed high taxes on luxury items (EAM Report, 1993). Furthermore the World bank cite agricultural and population trends; agriculture, while declining in relative importance, experienced rapid growth and productivity improvement and population growth rates declined more rapidly in the HPAEs than in other parts of the developing world.

In this sense then, according to the World Bank EAM report there is little that is nothing miraculous out the HPAEs' superior record of growth; it is largely due to superior accumulation of physical and human capital. However other than these policies to promote the basics, it argues that intervention is unnecessary. In reality, governments actually pursued a variety of Industrial policies to address market failures, which have surely had a profound effect on their economies as result of the scale and scope of the interventions.

In the case of East Asia, capital markets were particularly weak and institutions such as postal banks were created to encourage saving (Stiglitz, 1996). Such institutions also meant that capital allocation wasn’t left to the markets and was actually decided by the

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government. This ensured that firstly no capital left the country and those investments were based on long term social returns as opposed to short term profits (EAM Report, 1993). Strict performance criteria based on a range of factors ensured this and mitigated the opportunity for rent seeking. Yet, the extent of state control over capital allocation varied within East Asia however. For example, in Malaysia, Singapore, Thailand and Indonesia, banks are privately owned and exercise independent authority lending whereas China, Korea and Taiwan exercised tight control over capital allocation (EAM report, 1993). While the World bank acknowledged these policies they argued that the distortions were not as severe as those in other developing econimes, e.g. Brazilian directed funds attractive negative real interest rates of -23% v.s. S. Korean of -2.7 for industry. Development banks which monitored much of this capital have also been criticised as ineffective. Critics point to statistics that show the small percentage of overall loans made by such institutions. Stiglitz and Uy (1996) believe that such statistics are unconvincing as a loan by a development bank may be far more significant than the actual number of dollars lent due to its signalling or risk sharing effects.

Moreover, East Asian countries recognised that the inadequate incentive system in place for R&D and marketing activities meant that firms who invested in such activities were actually at a disadvantage (Stiglitz, 1996). HPAE governments have therefore implemented a number of programmes to address such issues and the region has since benefited from marketing and technological spillovers.

Capital market imperfections can also prevent a firm from increasing production and hence benefiting from increasing returns. Such a scenario calls for strategic trade intervention. This has also been implemented in East Asia and allowed infant industries to benefit from Arrow’s ‘learning by doing’ and production costs have lowered as a result (Stiglitz, 1996). Strategic trade intervention was heavily implemented in Japan during the 1960’s. The government helped targeted firms to grow so that they could benefit from increasing returns to scale. The argument behind this was no intervention would result in more firms and lower industry profits therefore (Stiglitz, 1996). The HPAE’s also supported specific, ‘key industries’ that had growth potential. For example, Japan and Korea used capital subsidization and import protection policies to promote heavy industry (Stiglitz, 1996). Whilst some argue that such policies can lead to rent seeking, in the case of Japan and Korea, in the case of Hyundai it has lead to formation of a world leading shipbuilder.

Critics cite industrial policy’s inability to pick winners. For example the EAM Report (1993) tells of how Japanese Government discouraged Honda from starting up in the automobile industry. However strict performance criteria ensured that errors like this were few and far between. This protection was based on conditioning that denied benefits to firms that failed to reach export targets (for example in South Korea) so that global competitiveness was incentivised and thus placing an emphasis on productivity. It must also be realised that industrial policy was not geared towards picking winners in the narrow sense of the term. Policies were instead focused on supporting winning industries and banks seemed to have discretion to select which firms within that industry to support (Stiglitz, 1996). Moreover such critics ignore the wider role government played in ‘spearheading the expansion of certain manufacturing sectors’ (Stiglitz, 1996). By increasing the technological and marketing knowledge, it has been able to create an entrepreneurial environment that has stimulated further economic growth. The World Bank also finds evidence that targeted industries have lower growth rates than other industries. Kwon (1994) however questions the economic data analysis used in coming to this controversial conclusion. Having re-estimated the model, Kwon (1994) shows that targeted industries in Korea performed well.

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As discussed, the World Bank dismisses industrial policies of the nature HPEAs enacted as ‘ineffective’ and finds little evidence that supports changing the structure of industry. It justifies this by concluding that industrial policy produced ‘market conforming’ results despite evidence in each case that the interventions as demonstrate had beneficial effects in many cases. Their conclusion flies in the face of much of the evidence; however likely a function of its inherently ideological foundations derived from the radical neoclassical Washington consensus (Amsden, 1994 & Harrison, 2001), the way the test has been formulated means that the results were probably a forgone conclusion.

Whilst ‘the fundamentals’ listed by the World Bank were obviously very influential in East Asia’s success story, Amsden (1994) argues that ‘the market friendly view’ fails to take into account the micro foundations embodied in the macro basics and hence its model for growth has been oversimplified. For example, the neo liberal approach by the World Bank assumes that export growth was simply a result of a pro export orientated policy. In reality, such export growth wouldn’t have been able to occur if it were not for firm’s international price competitiveness brought about by selective industry targeting policies.

Moreover, Perkins (1994) criticizes the World Bank (1993) for it wrongly suggesting that a one size fits all policy could have been used in the eight East Asian countries to the same effect therefore rejecting epistemological universalism of development a la Kenny and Williamson (2000). He asserts that in reality there were at least three models of East Asian development. Individual country’s policies were tailored to their natural resource endowments as well as their political and cultural values. For example, China’s approach to growth was far more interventionist than Hong Kong, reflecting its communist past.

In conclusion, the ‘market friendly’ approach is able to provide a good description of the main macro determinants of East Asia’s growth. However, its failure to recognise the important role that supporting institutions have played in this growth miracle, has resulted in an over simplified model that cannot be rolled out in other developing nations as the World Bank (1993) wrongly suggests. A more suitable explanation to East Asia’s growth is that HPAE’s implemented similar but country specific policies, in a way that best complemented their resource endowments, culture and political institutions in order to ‘get the basics right’. While at times these may have appeared minimal, they dramatically improved performance (like a catalyst in a chemical reaction, see (Stiglitz, 2001).