Book Summary: “One Economics, Many Recipes” by Dani Rodrick

Title: One Economics, Many Recipes: Globalization, Institutions and Economic Growth
Author: Dani Rodrick
Scope: 3 stars
Readability: 3 stars
My personal rating: 4 stars
See more on my book rating system.

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Topic of Book

Rodrick argues that the advise economists have given to developing nations is flawed and must be more tailored to their particular needs.

Key Take-aways

  • The central economic paradox of our time is that “development” is working while “development policy” is not.
  • No nation has succeeded in industrializing exclusively through free trade. All have included a substantial amount of government intervention in the economy. These interventions often varied greatly from nation to nation.
  • Asian nations who have industrialized in the last two generations have departed from free trade principles.
  • Multilateral institutions too often give developing nations a laundry list of institutional reforms that they need to accomplish in order to promote economic growth. This is often called the “Washington Consensus.”
  • Too often the results are poor. These reforms lead to stability, but they do not necessarily lead to growth.
  • Even in wealthy, industrialized nations, institutional reform largely came after industrialization, not before it.
  • Because developing countries have many problems and limited resources, they must focus their efforts on a small number of limiting factors that are unique to their economy.
  • Rather than establishing institutions that are copies of Western institutions, they must reform existing institutions to make them better.
  • Both of the above mean that what works in one developing nations will be very different from what works in other developing nations.
  • Igniting economic growth is common. What is difficult it sustaining that economic growth over time.
  • Rodrick introduces the concept of “Growth Diagnostics” to enable developing nations to identify the binding constraints in their economy that can be targeted with reform of existing institutions.

Important Quotes from Book

On a visit  to a small Latin American country a few years back, my colleagues and I paid a courtesy visit to the minister of finance. The minister had prepared a detailed PowerPoint presentation on his economy’s recent progress, and as his aide projected one slide after another on the screen, he listed all the reforms that they had undertaken. Trade barriers had been removed, price controls had been lifted, and all public enterprises had been privatized. Fiscal policy was tight, public debt levels low, and inflation nonexistent. Labor markets were as flexible as they come. There were no exchange or capital controls, and the economy was open to foreign investments of all kind.

The economy was scarcely growing, private investment remained depressed, and largely as a consequence, poverty and inequality were on the rise. What had gone wrong?

Meanwhile, there were a number of other countries—mostly but not exclusively in Asia—that were undergoing more rapid economic development than could have been predicted by even the most optimistic economists… Clearly, globalization held huge rewards for those who knew how to reap them. What was it that these countries were doing right?

Our ability to answer these questions will help determine the extent to which the world’s poor lift themselves out of destitution, improve their standards of living, achieve better health and education, and attain greater control over their lives. Economic growth is the most powerful instrument for reducing poverty… historically nothing has worked better than economic growth in enabling societies to improve the life chances of their members, including those at the very bottom.

This book represents my attempt to understand the growth successes and failures of the last few decades and to distill general lessons from this experience. My objective is as much to shine a guiding light on future policies as it is to interpret the past. I aim in these essays to elucidate the nature of the institutional arrangements—national and global—that best support economic development over the longer term.

All of this diverse experience with growth has happened in an era of rapid globalization, during which countries have become increasingly open to forces emanating from outside their borders. The fact that they have responded so differently is evidence enough—if any is needed—that national policy choices are the ultimate determinant of economic growth.

I believe that appropriate growth policies are almost always context specific. This is not because economics works differently in different settings, but because the environments in which households, firms, and investors operate differ in terms of the opportunities and constraints they present.

But governments are constrained by limits on their resources—financial, administrative, human, and political. They have to make choices on which constraints to attack first and what kind of reforms to spend political capital on. What they need is not a laundry list, but an explicitly diagnostic approach that identifies priorities based on local realities.

A key theme in these works, as well as in the present analysis, is that growth-promoting policies tend to be context specific. We are able to make only a limited number of generalizations on the effects on growth, say, of liberalizing the trade regime, opening up the financial system, or building more schools.

Neoclassical economic analysis is a lot more flexible than its practitioners in the policy domain have generally given it credit for. In particular, first-order economic principles—protection of property rights, contract enforcement, market-based competition, appropriate incentives, sound money, debt sustainability— do not map into unique policy packages. Good institutions are those that deliver these first-order principles effectively. There is no unique correspondence between the functions that good institutions perform and the form that such institutions take.

Development policy has always been subject to fads and fashions. During the 1950s and 1960s, “big push,” planning, and import-substitution were the rallying cries of economic reformers in poor nations. These ideas lost ground during the 1970s to more market-oriented views that emphasized the role of the price system and an outward orientation.4 By the late 1980s a remarkable convergence of views had developed around a set of policy principles that John Williamson (1990) infelicitously termed the “Washington Consensus.” These principles remain at the heart of conventional understanding of a desirable policy framework for economic growth, even though they have been greatly embellished and expanded in the years since.

Toward the end of the 1990s, this list was augmented in the thinking of multilateral agencies and policy economists with a series of so-called second-generation reforms that were more institutional in nature and targeted at problems of “good governance.”

How does such a list fare when held against the light of contemporary growth experience?

South Korea’s and Taiwan’s growth policies, to take two important illustrations, exhibit significant departures from the mainstream consensus. Neither country undertook significant deregulation or liberalization of its trade and financial systems well into the 1980s. Far from privatizing, they both relied heavily on public enterprises. South Korea did not even welcome direct foreign investment. And both countries deployed an extensive set of industrial policies that took the form of directed credit, trade protection, export subsidization, tax incentives, and other nonuniform interventions.

One would also be led astray by China’s boom since the late 1970s and by India’s less phenomenal, but still significant growth pickup since the early 1980s. While both of these countries have transformed their attitudes toward markets and private enterprise during this period, their policy frameworks bear very little resemblance to what is described in table 1.1. India deregulated its policy regime slowly and undertook very little privatization. Its trade regime remained heavily restricted late into the 1990s. China did not even adopt a private property rights regime, and it merely appended a market system to the scaffolding of a planned economy.

China took a very different approach to reform—one that was experimental in nature and relied on a series of policy innovations that departed significantly from Western norms. What is important to realize about these innovations is that in the end they delivered—for a period of a couple of decades at least— the very same goals that the Western economist would have been hoping for: market-oriented incentives, property rights, macroeconomic stability. But they did so in a peculiar fashion that, given the Chinese historical and political context, had numerous advantages.

For example, the Chinese authorities liberalized agriculture only at the margin while keeping the plan system intact. Farmers were allowed to sell surplus crops freely at a market-determined price only after they had fulfilled their obligations to the state under the state order system.

First, China relied on highly unusual, nonstandard institutions. Second, these unorthodox institutions worked precisely because they produced orthodox results, namely market-oriented incentives, property rights, macroeconomic stability, and so on. Third, it is hard to argue, in view of China’s stupendous growth, that a more standard, “best-practice” set of institutional arrangements would have necessarily done better. Of course, it is entirely possible that these Chinese-style institutions will turn out to be dysfunctional in the longer run and therefore in need of reform themselves. My point is simply that they sparked an unprecedented rate of economic growth in a manner that is hard to envisage the mainstream alternatives accomplishing.

The Chinese experience with nonstandard growth policies is hardly unusual; in fact, it is more the rule than the exception. The (other) East Asian anomalies can be viewed as part of the same pattern: nonstandard practices in the service of sound economic principles.

In fact, principles such as appropriate incentives, property rights, sound money, and fiscal solvency all come institution-free. We need to operationalize them through a set of policy actions. The experiences above show us that there may be multiple ways of packing these principles into institutional arrangements… From this perspective, the “art” of reform consists of selecting appropriately from a potentially infinite menu of institutional designs.

A direct corollary of this line of argument is that there is only a weak correspondence between the higher-order principles of neoclassical economics and the specific policy recommendations in the standard list.

Suppose we now remove the constraint and ask him to summarize the stylized acts as he sees them. Here is a list of four stylized facts that he would come up with.

1. In practice, growth spurts are associated with a narrow range of policy reforms.

One of the most encouraging aspects of the comparative evidence on economic growth is that it often takes very little to get growth started.

This is good news because it suggests countries do not need an extensive set of institutional reforms in order to start growing. Instigating growth is a lot easier in practice than the standard recipe, with its long list of action items, would lead us to believe.

2. The policy reforms that are associated with these growth transitions typically combine elements of orthodoxy with unorthodox institutional practices.

No country has experienced rapid growth without minimal adherence to what I have termed higher-order principles of sound economic governance—property rights, market-oriented incentives, sound money, fiscal solvency. But as I have already argued, these principles have often been implemented via policy arrangements that are quite unconventional.

3. Institutional innovations do not travel well.

The more discouraging aspect of the stylized facts is that the policy packages associated with growth accelerations—and particularly the nonstandard elements therein—tend to vary considerably from country to country.

4. Sustaining growth is more difficult than igniting it, and requires more extensive institutional reform.

These considerations suggest that successful growth strategies are based on a two-pronged effort: a short-run strategy aimed at stimulating growth, and a medium- to long-run strategy aimed at sustaining growth.

The last two centuries of economic history in today’s rich countries can be interpreted as an ongoing process of learning how to render capitalism more productive by supplying the institutional ingredients of a self-sustaining market economy: meritocratic public bureaucracies, independent judiciaries, central banking, stabilizing fiscal policy, antitrust and regulation, financial supervision, social insurance, political democracy. Just as it is silly to think of these as the prerequisites of economic growth in poor countries, it is equally silly not to recognize that such institutions eventually become necessary to achieve full economic convergence.

The key step is to develop a better understanding of how the binding constraints on economic activity differ from setting to setting. This understanding can then be used to derive policy priorities accordingly, in a way that uses efficiently the scarce political capital of reformers.

The proposed methodology can be conceptualized as a decision tree (see figure 2.1, discussed below). We start by asking what keeps growth low. Is it inadequate returns to investment, inadequate private appropriability of the returns, or inadequate access to finance? If it is a case of low returns, is that due to insufficient investment in complementary factors of production (such as human capital or infrastructure)? Or is it due to poor access to imported technologies? If it is a case of poor appropriability, is it due to high taxation, poor property rights and contract enforcement, laborcapital conflicts, or learning and coordination externalities? If it is a case of poor finance, are the problems with domestic financial markets or with external ones? And so on.

The principle to follow is simple: go for the reforms that alleviate the most binding constraints, and hence produce the biggest bang for the reform buck. Rather than utilize a spray-gun approach, in the hope that we will somehow hit the target, focus on the bottlenecks directly.

The central economic paradox of our time is that “development” is working while “development policy” is not. On the one hand, the last quarter century has witnessed a tremendous and historically unprecedented improvement in the material conditions of hundreds of millions of people living in some of the poorest parts of the world. On the other hand, development policy as it is commonly understood and advocated by influential multilateral organizations, aid agencies, Northern academics, and Northern-trained technocrats has largely failed to live up to its promise.

I will outline here a way of thinking about growth strategies that avoids these two extremes. The approach consists of three elements. (a) diagnostic analysis, (b) policy design, and (c) institutionalization. First, we need to undertake a diagnostic analysis to figure out where the most significant constraints on economic growth are. Second, we need creative and imaginative policy design to target the identified constraints appropriately. Third, we need to institutionalize the process of diagnosis and policy response to ensure that the economy remains dynamic and growth does not peter out.

An important reason why the Washington Consensus, and its subsequent variant, second-generation reforms, have failed to produce the desired outcome is that they were never targeted on what may have been the most important constraints blocking economic growth.

The trick is to find those areas where reform will yield the greatest return, or where we can get the biggest bang for the reform buck. What we need to know, in other words, is where the most binding constraint on growth lies. Otherwise, we are condemned to a spray-gun approach: we shoot our reform at as many targets as possible, hoping that some will turn out to be the real live ones. That is in effect what the augmented Washington Consensus does.

Correspondingly, the analysis of industrial policy needs to focus not on the policy outcomes—which are inherently unknowable ex ante—but on getting the policy process right.

Innovation in the developing world is constrained not on the supply side but on the demand side. That is, it is not the lack of trained scientists and engineers, absence of R&D labs, or inadequate protection of intellectual property that restricts the innovations that are needed to restructure low-income economies. Innovation is undercut instead by lack of demand from its potential users in the real economy—the entrepreneurs. And the demand for innovation is low in turn because entrepreneurs perceive new activities to be of low profitability.

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